    [Senate Hearing 111-673, Volume 3]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 111-673

                     WALL STREET AND THE FINANCIAL CRISIS:
                       THE ROLE OF CREDIT RATING AGENCIES

    =======================================================================

                                    HEARING

                                   before the

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                     of the

                                  COMMITTEE ON
                             HOMELAND SECURITY AND
                              GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                         ONE HUNDRED ELEVENTH CONGRESS

                                 SECOND SESSION

                                   ----------

                                 VOLUME 3 OF 5

                                   ----------

                                 APRIL 23, 2010

                                   ----------

           Available via http://www.gpoaccess.gov/congress/index.html

           Printed for the use of the Committee on Homeland Security
                            and Governmental Affairs

        WALL STREET AND THE FINANCIAL CRISIS: THE ROLE OF CREDIT RATING
                                    AGENCIES

                                 VOLUME 3 OF 5

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                                                            S. Hrg. 111-673

                     WALL STREET AND THE FINANCIAL CRISIS:
                       THE ROLE OF CREDIT RATING AGENCIES

    =======================================================================

                                    HEARING

                                   before the

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                     of the

                                  COMMITTEE ON
                             HOMELAND SECURITY AND
                              GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                         ONE HUNDRED ELEVENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                 VOLUME 3 OF 5

                                   __________

                                 APRIL 23, 2010

                                   __________

           Available via http://www.gpoaccess.gov/congress/index.html

           Printed for the use of the Committee on Homeland Security
                            and Governmental Affairs

            COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                   JOSEPH I. LIEBERMAN, Connecticut, Chairman
    CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
    DANIEL K. AKAKA, Hawaii              TOM COBURN, Oklahoma
    THOMAS R. CARPER, Delaware           JOHN McCAIN, Arizona
    MARK L. PRYOR, Arkansas              GEORGE V. VOINOVICH, Ohio
    MARY L. LANDRIEU, Louisiana          JOHN ENSIGN, Nevada
    CLAIRE McCASKILL, Missouri           LINDSEY GRAHAM, South Carolina
    JON TESTER, Montana                  ROBERT F. BENNETT, Utah
    ROLAND W. BURRIS, Illinois
    PAUL G. KIRK, JR., Massachusetts

                      Michael L. Alexander, Staff Director
         Brandon L. Milhorn, Minority Staff Director and Chief Counsel
                      Trina Driessnack Tyrer, Chief Clerk
             Patricia R. Hogan, Publications Clerk and GPO Detailee

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                         CARL LEVIN, Michigan, Chairman
    THOMAS R. CARPER, Delaware           TOM COBURN, Oklahoma
    MARK L. PRYOR, Arkansas              SUSAN M. COLLINS, Maine
    CLAIRE McCASKILL, Missouri           JOHN McCAIN, Arizona
    JON TESTER, Montana                  JOHN ENSIGN, Nevada
    PAUL G. KIRK, JR., Massachusetts
                Elise J. Bean, Staff Director and Chief Counsel
                             David H. Katz, Counsel
                            Laura E. Stuber, Counsel
                Christopher J. Barkley, Minority Staff Director
                   Anthony G. Cotto, Counsel to the Minority
                         Mary D. Robertson, Chief Clerk

                                C O N T E N T S

                                     ------
    Opening statements:
                                                                       Page
        Senator Levin................................................     1
        Senator Kaufman..............................................     8
    Prepared statements:
        Senator Levin................................................   105
        Senator Coburn...............................................   112

                                   WITNESSES
                             Friday, April 23, 2010

    Frank L. Raiter, Former Managing Director, Residential Mortgage
      Rating Group, Standard & Poor's................................    10
    Richard Michalek, Former Vice President and Senior Credit
      Officer, Structured Derivative Products Group, Moody's
      Investors Services.............................................    12
    Eric Kolchinsky, Former Team Managing Director, Structured
      Derivative Products Group, Moody's Investors Service...........    14
    Arturo Cifuentes, Ph.D., Former Moody's Senior Vice President,
      Current Director, Finance Center, University of Chile,
      Santiago, Chile................................................    16
    Susan Barnes, Current Managing Director, Mortgage-Backed
      Securities, Former North American Practice Leader, Residential
      Mortgage-Backed Securities, Standard & Poor's..................    45
    Yuri Yoshizawa, Group Managing Director, Structured Finance,
      Moody's Investors Service......................................    47
    Peter D'Erchia, Current Managing Director, U.S. Public Finance,
      Former Global Practice Leader, Surveillance, Standard & Poor's.    48
    Raymond W. McDaniel, Jr., Chairman and Chief Executive Officer,
      Moody's Corporation............................................    76
    Kathleen A. Corbet, Former President (2004-2007), Standard &
      Poor's.........................................................    78

                         Alphabetical List of Witnesses

    Barnes, Susan:
        Testimony....................................................    45
        Prepared statement...........................................   155
    Cifuentes, Arturo, Ph.D.:
        Testimony....................................................    16
        Prepared statement with attachments..........................   144
    Corbet, Kathleen A.:
        Testimony....................................................    78
        Prepared statement...........................................   210
    D'Erchia, Peter:
        Testimony....................................................    48
        Prepared statement...........................................   173
    Kolchinsky, Eric:
        Testimony....................................................    14
        Prepared statement...........................................   140
    McDaniel, Raymond W., Jr.:
        Testimony....................................................    76
        Joint prepared statement with Yuri Yoshizawa.................   186
    Michalek, Richard:
        Testimony....................................................    12
        Prepared statement...........................................   119
    Raiter, Frank L.:
        Testimony....................................................    10
        Prepared statement...........................................   114
    Yoshizawa, Yuri:
        Testimony....................................................    47
        Joint prepared statement with Raymond McDaniel...............   186

                                  EXHIBIT LIST

     1.a. Memorandum from Permanent Subcommittee on Investigations
      Chairman Carl Levin and Ranking Minority Member Tom Coburn to
      the Members of the Subcommittee................................   220

       b. Excerpts from Documents Related to Credit Rating Agencies:
      Competitive Pressures Affecting Ratings, chart prepared by the
      Permanent Subcommittee on Investigations.......................   231

       c. Excerpts from Documents Related to Credit Rating Agencies:
      Ratings Methodology, chart prepared by the Permanent
      Subcommittee on Investigations.................................   234

       d. Excerpts from Documents Related to Credit Rating Agencies:
      Deteriorating Subprime Mortgages, chart prepared by the
      Permanent Subcommittee on Investigations.......................   236

       e. Excerpts from Documents Related to Credit Rating Agencies:
      Grandfathering, chart prepared by the Permanent Subcommittee on
      Investigations.................................................   238

       f. Excerpts from Documents Related to Credit Rating Agencies:
      Chronic Resource Shortages, chart prepared by the Permanent
      Subcommittee on Investigations.................................   240

       g. Revenue of the Three Credit Rating Agencies: 2002-2007.
      Source: this matter.com/money..................................   242

       h. 2006 Originations and RMBS Issuance. Source: Standard &
      Poor's Rating Services, U.S. Residential Mortgage Subprime
      Market, March 29, 2007.........................................   243

       i. Percent of the Original AAA Universe Currently Rated Below
      Investment Grade. Source: Blackrock Solutions as of February 8,
      2010. Prepared by the Permanent Subcommittee on Investigations.   244

       j. Estimation of Housing Bubble: Comparison of Recent
      Appreciation vs. Historical Trends, chart prepared by Paulson &
      Co, Inc........................................................   245

       k. Biggest Clients of the Credit Rating Agencies. Source:
      Anna Katherine Barnett-Hart, ``The Story of the CDO Market
      Meltdown,'' March 2009.........................................   246

       l. Cash Flow & Hybrid Mezzanine SF CDOs of ABS: Exposure to
      Subprime RMBS Collateral by Cohort. Source: Standard & Poor's,
      ``Overview and Impact of the Residential Subprime Market,''
      March 2007.....................................................   247

      m. Typical Structure of a Residential Mortgage Backed
      Security. Source: Standard & Poor's data. Prepared by the
      Permanent Subcommittee on Investigations.......................   248

          Documents Related to Competitive Pressures Affecting Ratings

    Standard & Poor's Documents:

     2. Standard & Poor's internal email, dated May 2004, re:
      Competition with Moody's (We just lost a huge Mizuho RMBS deal
      to Moody's. . . . *** Losing one or even several deals due to
      criteria issues, but this is so significant that it could have
      an impact in the future deals.)................................   249

     3. Standard & Poor's internal email, dated August 2004, re: SF
      CIA: CDO methodology invokes reactions (We are meeting with
      your group this week to discuss adjusting criteria for rating
      CDOs of real estate assets this week because of the ongoing
      threat of losing deals. *** Lose the CDO and lose the base
      business - a self reinforcing loop.)...........................   250

     4. Standard & Poor's internal email, dated November 2004, re:
      APB Meeting - Nov 4 (I think the criteria process must include
      appropriate testing and feedback from the marketplace.)........   254

     5. Standard & Poor's internal email, dated March 2005, re:
      LEVELS 5.6(c) (Version 6.0 could've been released months ago
      and resources assigned elsewhere if we didn't have to massage
      the sub-prime and Alt-A numbers to preserve market share. ***
      We have known for some time (based upon pool level data and
      LEVELS 6.0 testing) that--Subprime: B and BB levels need to be
      raised--ALT A: B, BB and BBB levels need to be raised (we have
      had a disproportionate number of downgrades)...................   258

     6. Standard & Poor's internal email, dated June 2005, re:
      Privileged Criteria Deliberations: CWHEQ 2005-C (Why these
      questions come up every month is obvious--issuers don't like
      the outcome. However, the right thing to do is to educate all
      the issuers and bankers and make it clear that these are the
      criteria and that they are not-negotiable. If this is clearly
      communicated to all then there should be no monthly questions.
      . . . *** Screwing with criteria to ``get the deal'' is putting
      the entire S&P franchise at risk--it's a bad idea.)............   261

     7. Standard & Poor's internal email, dated February 2006, re:
      EMC Compares (I don't think this is enough to satisfy them.
      What's the next step?).........................................   263

     8. Standard & Poor's internal email, dated February 2006, re:
      comstock (If our current structure, which we have been
      marketing to investors and the mgr, (and which we have been
      doing prior to the release of the beta cash flow assumptions)
      doesn't work under the new assumptions, this will not be good.
      Happy to comply, if we pass, but will ask for an exception if
      we fail . . .).................................................   267

     9. Standard & Poor's internal email, dated May 2006, re:
      Privileged & Confidential Committee Deliberations - Madaket
      Funding (I submit for your consideration the banker's argument
      to waive the one failing run.).................................   269

    10.a. Standard & Poor's internal email, dated May 2006, re:
      Broadwick Funding (It was a known flaw not only in that
      particular ABACUS trade, but in pretty much all ABACUS trades .
      . .)...........................................................   271

       b. Standard & Poor's internal email, dated April 2006, re:
      ABACUS 2006-12 - Writedowns immediately prior to Stated
      Maturity (Don't even get me started on the language he cites .
      . . which is one of the reasons I said the counterparty
      criteria is totally messed up.)................................   275

       c. Standard & Poor's internal email, dated May 2005, re:
      Adirondack CDO (. . . this is exactly the kind of backroom
      decision-making that leads to inconsistent criteria, confused
      analysts, and pissed-off clients.).............................   279

    11. Standard & Poor's internal email, dated May 2006, re:
      Confidential - Criteria Changes in LEVELS 5.7 (We certainly did
      intend to do anything to bump us off a significant amount of
      deals. *** [H]eard your ratings could be 5 notches back of
      moddys [sic] equivalent. [G]onna kill your resi biz.)..........   287

    12. Standard & Poor's internal email, dated June 2006, re:
      question on impact to CDOs (We assume this scenario to be
      negative for the corporate business because Moody's will be
      giving out higher ratings on secured loans so issuers will be
      less likely to ask for an S&P rating on the issue.)............   288

    13. Standard & Poor's internal email, dated August 2006, re: Can
      you call me? Have left you numerous messages (How many millions
      does Morgan Stanley pay us in the greater scheme of things? How
      many times have I accommodated you on tight deals?)............   290

    14. Standard & Poor's internal email, dated August 2006, re:
      Loss severity vs gross/net proceeds (They've become so beholden
      to their top issuers for revenue they have all developed a kind
      of Stockholm syndrome which they mistakenly tag as Customer
      Value creation . . .)..........................................   293

    Moody's Documents:

    15. Moody's internal email, dated December 2003, re: Noel Kirnon
      (The Derivatives team has achieved a year to date 96% market
      share compared to a target share of 95%.)......................   295

    16. Moody's internal email, dated January 2006, re: BES and PEs
      (Top Achievements in ``05: 1. Protected our market share in the
      CDO corporate cash-flow sector . . .)..........................   296

    17. Moody's internal email, dated April 2006, re: Jay Siegel
      Exit Interview (He described RMBS as the worst team to work on
      at Moody's. It is difficult to maintain market share in a
      market that has become commoditized and where Moody's expected
      loss analysis means higher cost for issuers.)..................   297

    18. Moody's internal email, dated April 2006, re: MGIC Home Re
      2006-1 Committee#3 (At this point, I would feel comfortable
      keeping the previously committeed levels since such a large
      adjustment would be hard to explain to Bear, . . .)............   299

    19. Moody's internal email, dated May 2006, re: Magnolia 2006-5
      Class Ds (I am worried that we are not able to given these
      complicated deals the attention they really deserve, and that
      they (CS) are taking advantage of the ``light'' review and the
      growing sense of ``precedent''.)...............................   302

    20. Moody's internal email, dated October 2006, re: managing
      expectations: 2 different stories (I mention this to reinforce
      the expectation that concessions we make in the interest of
      getting the deal(s) rated will be used against us.)............   307

    21. Moody's internal email, dated December 2006, re: legal
      points outstanding (Have been speaking to Plamen and my feeling
      is that the only way we'll maybe get Taberna to agree to the
      covenants is if you rate down to Aa2 on the B Notes at the same
      levels as the other agencies.).................................   308

    22. Moody's internal email, dated March 2007, re: DQ Hit for
      Jake's ACE Deal (I just spoke with Sue Valenti at Deutsche
      regarding this deal and she is resisting the changes to the LC
      levels. She is pushing back dearly saying that the deal has
      been marketed already and that we came back ``too late'' . . .)   312

    23. Moody's internal email, dated June 2007, re: Rating
      application for Belden Point CDO (We are okay with the revised
      fee schedule for this transaction. We are agreeing to this
      under the assumption that this will not be a precedent for any
      future deals and that you will work with us further on this
      transaction to try to get to some middle ground with respect to
      the ratings.)..................................................   315

    24.a. Moody's internal email, dated October 2007, re: 3Q Market
      Coverage-CDO (Market share by deal count dropped to 94%, though
      by volume it's 97%. It's lower than the 98+% in prior quarters.
      Any reason for concern, are issuers being more selective to
      control costs (is Fitch cheaper?) or is it an aberration.).....   318

       b. Moody's internal email, dated October 2007, attached copy
      of Moody's internal memorandum, Credit Policy issues at Moody's
      suggested by the subprime/liquidity crisis, prepared by the
      Moody's Chief Risk Officer.....................................   319

                    Documents Related to Ratings Methodology

    Standard & Poor's Documents:

    25. Standard & Poor's internal email, dated March 2005, re:
      Wachovia Report Cites Questions Of S&P's Integrity (I would
      like to discuss how we plan on ultimately ``spinning'' our
      revised correlation assumptions . . .).........................   324

    26. Standard & Poor's internal email, dated May 2006, re: an
      error in the new correlation assumptions? (I have already
      brought this issue up and it was decided that it would be
      changed in the future, . . .)..................................   326

    27. Standard & Poor's internal email, dated December 2006, re:
      Synthetic CDO-2 of ABS (both Cash and Synthetic) (Rating
      agencies continue to create and [sic] even bigger monster - the
      CDO market. Let's hope we are all wealthy and retired by the
      time this house of cards falters.).............................   328

    28. Standard & Poor's internal email, dated January 2007, re:
      Summary of Conference Call (Can anyone give me a crash course
      on the ``hidden risks in CDO's of RMBS''?).....................   330

    29. Standard & Poor's internal email, dated March 2007, re:
      Proposed plan for review of criteria (This is because our
      published criteria as it currently stands is a bit too unwieldy
      and all over the map in terms of being current or
      comprehensive. . . . our SF rating approach is inherently
      flexible and subjective, while much of our written criteria is
      detailed and prescriptive.)....................................   332

    30.a. Standard & Poor's instant message, dated April 2007, (we
      rate every deal . . . it could be structured by cows and we
      would rate it).................................................   337

       b. Standard & Poor's instant message, dated May 2007, (no
      body gives a straight answer about anything around here anyway
      *** how about we come out with new criteria or a new stress and
      actually have clear cut parameters on what the hell we are
      supposed to do)................................................   338

    31. Standard & Poor's internal email, dated May 2007, re:
      Modelling of some spread compression on Static CDOs (. . . the
      cash-flow criteria from 2004 . . . actually states that . . .
      in the usual vague S&P's way . . . Still, consistency is key
      for me and if we decide we do not need that, fine but I would
      recommend we do something. Unless we have too many deals in US
      where this could hurt.)........................................   340

    32. Standard & Poor's internal email, dated July 2007, re:
      Weekly RMBS/CDO Surveillance performance update (It remains to
      been [sic] seen if S&P is really prepared to witness drastic
      rating actions, just to avoid the slower ``notching'' process
      and public criticism.).........................................   344

    33. Standard & Poor's internal email, dated September 2007, re:
      SIFMA Rating Agency Panel October 4 (I have tried to stay away
      from underlying rating performance and place the issue more on
      the newness of the underwriting standards that defied all
      common sense.).................................................   351

    34. Standard & Poor's internal email, dated November 2007, re:
      Resi Mortgage Operations - Conduit & Originator Reviews (We
      believe our analytical process and rating opinions will be
      enhanced by an increased focus on the role third parties can
      play in influencing loan default and loss performance. . . .
      Should have been doing this all along.)........................   357

    Moody's Documents:

    35. Moody's internal email, dated January 2006, re: 2006
      Priorities for M3 team (Not recalibrating the Prime model and
      not fixing the simulation will create a growing number of
      inconsistencies (problems) in the existing models as was the
      case through most of 2004.)....................................   359

    36. Moody's internal email, dated April 2006, re: Goldman CES
      Deal: Building OC with Cap (I am getting serious pushback from
      Goldman on a deal that they want to go to market with today. .
      . . oldman needs more of an explanation (I do not know how to
      get around this without telling them we were wrong in the
      past).)........................................................   361

    37. Moody's internal email, dated October 2006, re: Pro-rata
      modeling criteria (Our problem here is that nobody has told us
      about the changes that we are later expected to adhere to.
      Since there is no published criteria outlining the change in
      methodology how are we supposed to find out about it?).........   362

    38. Moody's internal email, dated April 2007, (If in our opinion
      15% of the ratings are inflated, the impact to the cdo note
      ratings would be significant.).................................   366

    39. Moody's internal email, dated June 2007, re: Please READ M-1
      sign off (Over time, different chairs have been giving
      different guidelines at different point of time on how much
      over-enhancement we need for a bond to be notched up to Aaa, .
      . .)...........................................................   367

    40. Moody's internal email, dated August 2007, re: Seasoning
      benefit in Alt-A model is fully functional now (. . . maybe
      this is more like rearranging the deck chairs on the Titanic .
      . .)...........................................................   368

    41. Moody's internal email, dated August 2007, re: UBS CDO
      Research (This is depressing: ``In our skewed sample of 111
      mezzanine ABS CDOs, collateral losses extend into senior AAA
      tranches. We predict that 10% of senior AAA tranches we
      examined will default. Overall, the expected loss of senior AAA
      tranches is 1%. For BBB tranches, 55% will default and expected
      losses are 65%. This is horrible from a ratings and risk
      management point of view; perhaps the biggest credit risk
      management failure ever.'')....................................   370

    42. Moody's internal email, dated August 2007, re: Deal
      Management (. . . each of our current deals is in crisis mode.
      This is compounded by the fact that we have introduced new
      criteria for ABS CDOs. Our changes are a response to the fact
      that we are already putting deals closed in the spring on watch
      for downgrade. This is unacceptable and we cannot rate the new
      deals in the same away [sic] we have done before. . . . bankers
      are under enormous pressure to turn their warehouses into CDO
      notes.)........................................................   372

    43. Moody's internal email, dated November 2007, re: Fitting a
      default model on 2006 Alt-A data (My staff is sensitive to both
      priorities and the risks associates with demands to do
      something ``quick and dirty'' that then becomes part of a
      rating process. The reason Ahish pushed back was that the
      proposed use of the data would quite likely lead to false
      conclusions that might be used for rating decisions.)..........   373

    44. Moody's internal email, dated November 2007, re: Moody's
      Follow Up (It seems, though, that the more of the ad hoc rules
      we add, the further away from the data and models we move and
      the closer we move to building models that ape analysts
      expectations, no?).............................................   381

             Documents Related to Deteriorating Subprime Mortgages

    Standard & Poor's Documents:

    45. Standard & Poor's internal email, dated July 2005, re:
      Washington Mutual (I have been a mortgage broker for the past
      13 years and I have never seen such a lack of attention to loan
      risk.).........................................................   383

    46.a. Standard & Poor's internal email, dated September 2006,
      re: Nightmare Mortgages (This is frightening. It wreaks of
      greed, unregulated brokers, and ``not so prudent'' lenders.)...   384

      b. Standard & Poor's internal email, dated September 2006, re:
      Nightmare Mortgages (. . . this is like another banking crisis
      potentially looming!!).........................................   392

    47. Standard & Poor's internal email, dated October 2006,
      forwarding a October 19, 2006, The Wall Street Journal article,
      More Home Loans Go Sour, and remarking about article, Pretty
      grim news as we suspected - note also the ``mailing in the keys
      and walking away'' epidemic has begun - I think things are
      going to get mighty ugly next year!............................   393

    48. Standard & Poor's internal email, dated October 2006,
      forwarding a October 26, 2006, The Wall Street Journal article,
      Home Prices Keep Sliding; Buyers Sit Tight, and remarking about
      article, . . . just curious . . . are there ever any positive
      repots on the housing market?..................................   396

    49. Standard & Poor's internal email, dated February 2007, re:
      Data sharing between surveillance and servicer evaluations
      (Also remember, our data is the aggregrate [sic] and most of
      the deals alledgely [sic] have better (cough, cough) subprime
      loans.)........................................................   400

    50. Standard & Poor's internal email, dated March 2007, re:
      Subprime Vintage Comparison (After 12 months of seasoning, the
      2006 vintage had approximately 13% in total delinquencies, . .
      .).............................................................   404

    51. Standard & Poor's internal email, dated March 2007,
      forwarding a March 8, 2007 BusinessWeek Online article, The
      Mortgage Mess Spreads; and remarking about article, This is
      like watching a hurricane from FL moving up the coast slowly
      towards us.....................................................   407

    52.a. Standard & Poor/American Legal & Financial Network email,
      dated March 2007, re: member firms reaction to troubled
      servicers (To give you a confidential tidbit among friends the
      subprime brou haha is reaching serious levels . . .)...........   410

       b. Standard & Poor's, Structured Finance Ratings - Overview
      and Impact of the Residential Subprime Market, Monthly Review
      Meeting, March 19, 2007........................................   412

       c. Standard & Poor's internal email, dated March 2007, re:
      Pre-empting bad press on the subprime situation (In a meeting
      with Kathleen Corbet today, she requested that we put together
      a marketing campaign around the events in the subprime market,
      the sooner the better.)........................................   439

    53. Standard & Poor's internal email, dated April 2007, re: PWR
      16 (. . . unbelievable . . . the bankers make shi**y loans with
      such skinny margins tha [sic] they can't make any money and
      expect us to eat it. . . . the opportunity cost of doing the
      deal at that ridiculously low fee and risking eroding our
      pricing structure going forward was deemed too high . . .).....   441

    54.a. Standard & Poor's internal email, dated July 2007, re:
      Tomorrow's FT Column - Saskia Sholtes (We did sound like the
      Nixon White House. Instead of dismissing people like him or
      assuming some dark motive on their part, we should ask
      ourselves how we could have so mishandled the answer to such an
      obvious question. I have thought for awhile now that if this
      company suffers from an Arthur Andersen event, we will not be
      brought down by a lack of ethics as I have never seen an
      organisation [sic] more ethical, nor will it be by greed as
      this plays so little role in our motivations; it will be
      arrogance.)....................................................   442

       b. Standard & Poor's internal email, re: November 21, 2006
      Q&A after Conference Call - How Bad is 2006 Subprime
      Collateral? (Although the Rating Agencies have ``increased''
      their Loss Coverage %, David Liu thinks it will not compensate
      ``enough'' for the poor performance of year 2006 Subprime
      collateral. According to David, ``the Rating Agencies were
      caught off guard, too!'')......................................   446

    55. Standard & Poor's internal email, dated November 2007, re:
      November presentation (Macroeconomic factors as well as the
      combination of these higher risk characteristics coupled with
      fraud seem to be the most likely reasons for the anomalous
      behavior.).....................................................   449

    56. Excerpt from The McGraw-Hill Companies, Inc. Minutes,
      Regular Meeting of Board of Directors, December 5, 2007, (Mr.
      Terry McGraw noted the 2005-06 vintage loans appear to be the
      key problem areas in the recent subprime situation.)...........   453

    Moody's Documents:

    57. Moody's internal email, dated April 2007, re: near future
      downgrades (Here is what I suggest. I will create a folder on
      the p-drive: . . . which stores info on subprime RMBS which
      were identified as potential ``near future downgrades''.)......   457

    58. Moody's internal email, dated November 2007, re: Overnightor
      NY - November 26th (You're right about CDOs as WMD--but it's
      only CDOs backed by subprime that are WMD.)....................   460

                      Documents Related to Grandfathering

    Standard & Poor's Documents:

    59. Standard & Poor's internal email, dated June 2004, re:
      LEVELS (What happens when we migrate to 6.0? Will they want
      three versions in play, to facilitate pools structured across
      different time frames?)........................................   463

    60. Standard & Poor's internal email, dated June 2005, re: new
      CDO criteria (The overarching issue at this point is what to do
      with currently rated transactions if we do release a new
      version of Evaluator.).........................................   466

    61. Standard & Poor's internal email, dated July 2005, re:
      Evaluator 3 (This has become such an intractable mess!!).......   468

    62. Standard & Poor's internal email, dated October 2005, re:
      Tomorrow's AM Agenda (How do we handle existing deals
      especially if there are material changes that can cause
      existing ratings to change?)...................................   471

    63. Standard & Poor's internal email, dated October 2005, re:
      CDO model (It raises several franchise level issues which could
      be viewed as precedent setting from a policy perspective.).....   474

    64. Standard & Poor's internal email, dated November 2005, re:
      Disclaimer - Help (Lord help our f**king scam . . .)...........   476

    65. Standard & Poor's internal email, dated November 2005, re:
      E3 FAQ (We will also run all deals through both E3/Low and E3/
      High to determine if the result on E2.4.3 is within the
      tolerance levels.).............................................   478

    66. Standard & Poor's internal email, dated December 2005, re:
      Transition and ongoing surveillance process for E2.4.2 versus
      E3 (My view is that arrangers will be quite happy to hear that
      their deal falls within our acceptable tolerance levels and
      just get on with their trade.).................................   479

    67. Standard & Poor's internal email, dated December 2005, re:
      Call from Abby Moses, Derivatives Week re: status of CDO
      Evaluator 3 (. . . it would be helpful to have a policy
      framework communicated to the market on when S&P will apply new
      criteria in model derived ratings to outstanding transactions
      and when it won't. . . . we are not being as transparent as we
      need to be.)...................................................   483

    68. Standard & Poor's internal email, dated December 2005, re:
      E3 docs (The important thing is to begin to ``craft'' the
      ``politically correct'' external tolerance band message.)......   486

    69. Standard & Poor's internal email, dated January 2006, re:
      LNR ``Rabo Tango are withdrawing any interest from LNR because
      they had a call with S&P who confirmed that this was being
      rated off the old methodology.'')..............................   490

    70. Standard & Poor's internal email, dated February 2006, re:
      Fixed Income Activity Report (Though the tolerance bands have
      provided some ``cushion'' as it pertains to mitigating a rating
      action based solely on a model based change . . . they have
      also created confusion given their lack of transparency.)......   492

    71. Standard & Poor's internal email, dated March 2006, re:
      Moody's (The official Moody's line is that there is no
      ``grandfathering'' and that old transactions are reviewed using
      the new criteria. However ``the truth is that we do not have
      the resources to review thousands of transactions, so we focus
      on those that we feel are more at risk.'').....................   493

    72. Standard & Poor's internal email, dated June 2006, re: RMBS
      LEVELS 5.7 and its Impact on Outstanding Deals (different from
      cdo *** . . . although the RMBS Group does not ``grandfather''
      existing deals, there is not an absolute and direct link
      between changes to our new ratings models and subsequent rating
      actions taken by the RMBS Surveillance Group.).................   494

    73. Standard & Poor's internal email, dated November 2006, re:
      Hot Topics Polling Questions (Should S&P consider
      ``grandfathering'' existing ratings when implementing criteria
      changes?)......................................................   497

    74. Standard & Poor's internal email, dated July 2007, re:
      Special APB meeting (How do we handle the grandfathering issue
      in the context of consistent application of criteria.).........   500

    75. Standard & Poor's internal email, dated October 2007, re:
      Here are thoughts around RMBS (Ratings no longer grandfather -
      need batch processing for all deals rated within 12 months of
      criteria or model changes)  ...................................   502

    Moody's Documents:

    76. Moody's internal email, dated May 2007, re: Upcoming CLOs/
      grandfathering list (We appreciate your willingness to
      grandfather these transactions w/r/t Moody's old methodology.).   504

    77. Moody's internal email, dated May 2007, re: Stratford CLO (.
      . . they thought it would make sense to use the old
      methodology, . . .)............................................   506
    78. Moody's internal email, dated June 2007, re: PDR/LGD
      methodology (It might be useful to know what our official
      position is on this issue in case it arises again.)............   508

    79. Moody's internal email, dated July 2007, re: Notching Status
      (Shall we still provide rating for those bond we did not rate
      then using the old methodology and the old loss coverage
      number?).......................................................   510

    80. Moody's Structured Finance Credit Committee, March 31, 2008,
      Meeting Notes (Rating changes when methodologies change . . .
      This decision to selectively review certain ratings is made due
      to resource constraints.)......................................   512

                Documents Related to Chronic Resource Shortages

    Standard & Poor's Documents:

    81. Standard & Poor's, Framework For Analytics Policy Board
      Review of Rating Surveillance Standards, January 27, 2006, (A
      few areas (Asian Corporates, U.S. public power, student loans
      and less active RMBS issuers in the U.S.) are substantially
      below par.). (excerpt).........................................   514
    82. Standard & Poor's internal email, dated April 2006, re:
      Discussion with Lal (Each time I consider what my group is
      faced with, I become more and more anxious.)...................   522

    83. Standard & Poor's internal email, dated June 2006, re: Temp
      (In addition to the project above that involved some 863 deals,
      I have a back log of deals that are out of date with regard to
      ratings.)......................................................   524

    84. Standard & Poor's internal email, dated December 2006, re:
      Please continue temps (Currently, there are nearly 1,000 deals
      with data loads aged beyond one month.)........................   526

    85. Standard & Poor's internal email, dated January 2007, re:
      Data COE Resources Available for US ABS (. . . I want to take a
      moment to reiterate my concerns regarding the significant
      deficit in terms of the # of analysts currently assigned to
      work on US ABS and RMBS data needs.)...........................   529

    86. Standard & Poor's internal email, dated February 2007, re:
      Headcount for RMBS Surveillance? (I talked to Tommy yesterday
      and he thinks that the ratings are not going to hold through
      2007. . . . We do not have the resources to support what we are
      doing now.)....................................................   531

    87. Standard & Poor's internal email, dated February 2007, re:
      What's the problem now??? (We really need help. Sub prime is
      going down hill. The 20% not covered in our system is also of
      great concern.)................................................   535

    88. Standard & Poor's internal email, dated April 2007, re:
      Staffing for RMBS Surveillance (This model shows that the R-
      Surv staff is short by 7 FTE - about 3 Directors, 2 AD's, and 2
      Associates.)...................................................   536

    89. Standard & Poor's internal email, dated October 2007, re:
      Alt. A Aged List (. . . we will take the appropriate rating
      action on any of the deals that we reviewed that are on the
      aged list.)....................................................   538

    Moody's Documents:

    90. Moody's internal email, dated January 2006, re: 2006
      Priorities for M3 team (As a new product, good idea--but I
      think we need full functionality w/M3 first, esp. if we're to
      remain short-staffed for yet another year.)....................   539

    91. Moody's internal email, dated May 2007, re: Paper on inter-
      CDO correlations - update from ABS Steering Committee
      (Unfortunately, our analysts are owerwhelmed [sic] . . .)......   541

    92.a. Moody's SFG 2002 Associate Survey, Highlights of Focus
      Groups and Interviews, May 2, 2002.............................   543

       b. Moody's Investor Service, BES-2005, Presentation to
      Derivatives Team, April 7, 2006................................   559

                       Documents Related to Failed Deals

    93.a. Moody's internal email, dated December 2006, re: Subprime
      performance (Holy cow - is this data correct? I just graphed it
      and Freemont is such an outlier!!).............................   587

       b. Standard & Poor's internal email, dated January 2007, re:
      Quick question: Fremont (No, we don't treat their collateral
      any differently . . .).........................................   589

       c. Standard & Poor's internal email, dated January 2007, re:
      Quick question: Fremont (Since Fremont collateral has been
      performing not so good, is there anything special I should be
      aware of?).....................................................   590

       d. Standard & Poor's internal email, dated February 2007,
      forwarding a January 29, 2007 Reuters article, Defaults cause
      Fremont to end ties to 8,000 brokers...........................   592

       e. Moody's downgrade of GSAMP Trust 2007 - FM2 containing
      Fremont mortgages..............................................   594

       f. Standard & Poor's downgrade of GSAMP Trust 2007 - FM2
      containing Fremont mortgages...................................   595

    94.a. Standard & Poor's instant message, dated April 2007, (i
      heard some fury . . . james yao at ubs)........................   598

       b. Standard & Poor's internal email, dated April 2007, re:
      Vertical 2007-1/UBS/James Yao (Don't see why we have to
      tolerate lack of cooperation. Deals likely not to perform.)....   599

       c. Standard & Poor's internal email, dated April 2007, re:
      VERTICAL ABS CDO 2007-1, LTD.UBS (Sarah and I have been working
      with James Yao from UBS but we have not been getting
      cooperation from him.).........................................   600

       d. Moody's Pre-Closing Committee Memorandum, Closing: April
      10, 2007, Deal: Vertical ABS CDO 2007-1, Ltd. (Vertical ABS CDO
      2007-1, Ltd. is a mezzanine Hybrid ABS transaction that is
      expected to be 95% synthetic (CDS assets) at closing.).........   601

       e. List of assets included in Vertical ABS CDO 2007-1,
      prepared by Moody's............................................   614

       f. Moody's internal email, dated October 2007, re: Updated:
      Rating Review Committee - Vertical ABS CDO 2007-1 EOD (Eric and
      I spoke to UBS. They said that they still have not decided
      whether to liquidate or keep the deal as is . . .).............   617

       g. Fitch internal email, dated October 2007, re: Vertical
      Capital (. . . Vertical has over a dozen CDOs outstanding. Most
      of the 2007 deals we are reviewing are rapidly encountering
      serious difficulties . . .)....................................   618

       h. Standard & Poor's internal email, dated October 2007, re:
      (BMP) Moody's Downgrades Vertical ABS CDO 2007-1 Notes; Further
      (Oh, well. The cat is out of the bag.).........................   620

       i. Moody's internal email, dated October 2007, re: Debtwire:
      (DW) ABS CDOs begin to liqudate; rating agency downgrades
      ``detonating'' market, source says (. . . the picture is not
      pretty.).......................................................   624

       j. Standard & Poor's internal email, dated October 2007, re:
      Vertical CDO 2007-1 (. . . this is fairly urgent . . . We want
      to review this transaction and see the results under the worst
      possible outcome.).............................................   626

       k. Moody's downgrade of Vertical ABS CDO 2007-1, Ltd.........   629

       l. Excerpts from Connecticut Superior Court Memorandum Of
      Decision on Plantiffs'' Application For A Prejudgment Remedy
      (#124), Pursuit Partners, LLC et al v. UBS AG et al, September
      8, 2009. (excerpts)............................................   630

      m. UBS internal email, dated August 2007, re: Mezz CDO
      Offerings (Here is some new stuff we would offer the vertical .
      . .)...........................................................   642

       n. UBS internal email, dated August 2007, (sold some more
      crap to pursuit.)..............................................   644

       o. UBS internal email, dated July 2007, re: ABS Subprime &
      Moody's downgrades (It sounds like Moodys is trying to figure
      out when to start downgrading, and how much damage they're
      going to cause--they're meeting with various investment banks.)   645

    95.a. Moody's internal email, dated July 2007, re: Analyst for
      Brighton (The reason is that Delphinus was a mezz deal with a
      lot of cushion, so we did not really care that much.)..........   646

       b. Standard & Poor's internal email, dated August 2007, re:
      Delphinus closing date vs effective date (Yes, the concern is
      that the deal would've never passed (and actually would've been
      worse) if they included the assets that they claimed they are
      dummies.)......................................................   647

       c. Excerpt from Moody's Main Rating Change Report for
      Delphinus CDO 2007-1, Ltd......................................   651

       d. Moody's downgrade of Delphinus CDO 2007-1, Ltd............   652

       e. Standard & Poor's downgrade of Delphinus CDO 2007-1 Ltd...   654

    96.a. Standard & Poor's internal email, dated August 2007, re:
      S&P CDO Monitor Kodiak CDO I: Urgent (Next thing I know, I'm
      told that because it had gone effective already, it was
      surveillance's responsibility, and I never heard about it
      again.)........................................................   657

       b. Moody's downgrade of Kodiak CDO I, Ltd....................   662

       c. Standard & Poor's downgrade of Kodiak CDO I, Ltd..........   663

    97.a. Moody's letters assigning rating to Long Beach RMBS,
      January - December, 2006.......................................   665

       b. Washington Mutual, 2006 Transaction Statistics, re: Long
      Beach RMBS transactions........................................   677

       c. Status of selected Long Beach RMBS transactions, as of
      April 19, 2010.................................................   678

                                Other Documents

    98. Moody's Investors Service: Managing Director's Town Hall
      Meeting, September 10, 2007, (What happened in ``04 and ``05
      with respect to subordinated traunches is that our competition,
      Fitch and S&P, went nuts. Everything was investment grade. It
      really didn't matter.).........................................   684

    99. Excerpts from Standard & Poor's and Moody's Downgrades, July
      10-12, 2007 and January 30, 2008...............................   765

    100. Fitch Ratings, Structured Finance, The Impact of Poor
      Underwriting Practices and Fraud in Subprime RMBS Performance,
      November 28, 2007..............................................   776

    101. Goldman Sachs internal email, dated November 2007, re: NYT
      (Of course we didn't dodge the mortgage mess. We lost money,
      then made more than we lost because of shorts.)................   787

    102. Goldman Sachs internal email, dated October 2007, re: Early
      post on P and L (Sounds like we will make some serious money
      *** Yes we are well positioned)................................   788

    103. Goldman Sachs internal email, dated May 2007, re: LBML 06A
      (bad news . . . wipes out the m6s and makes a wipeout on the m5
      imminent . . . costs us about 2.5mm . . . ood news . . . we
      own 10mm protection on the m6 marked at $50 . . . we make $5mm)   790

    104. Goldman Sachs internal email, dated July 2007, re: Private
      & Confidential: FICC Financial Package 07/25/07 (Tells you what
      might be happening to people who don't have the big short.)....   792

    105. White Paper on Rating Agency Reform prepared by Arturo
      Cifuentes and Jose Miguel Cruz, Department of Industrial
      Engineering, University of Chile, Santiago, Chile, May 2010....   794

    106. Responses to supplemental questions for the record
      submitted to Raymond W. McDaniel, Jr., Chairman and Chief
      Executive Officer, Moody's Corporation.........................   803

    107. Responses to supplemental questions for the record
      submitted to Yuri Yoshizawa, Group Managing Director,
      Structured Finance, Moody's Investors Service..................   927

    108. Responses to supplemental questions for the record
      submitted to Peter D'Erchia, Current Managing Director, U.S.
      Public Finance (Former Global Practice Leader, Surveillance),
      Standard & Poor's..............................................   931

    109. Richard Blumenthal, Attorney General, State of Connecticut,
      prepared statement.............................................  1201

        WALL STREET AND THE FINANCIAL CRISIS: THE ROLE OF CREDIT RATING
                                    AGENCIES

                                  ----------

                             FRIDAY, APRIL 23, 2010

                                         U.S. Senate,
                  Permanent Subcommittee on Investigations,
                        of the Committee on Homeland Security
                                      and Governmental Affairs,
                                                        Washington, DC.
        The Subcommittee met, pursuant to notice, at 9:36 a.m., in
    room SD-G50, Dirksen Senate Office Building, Hon. Carl Levin,
    Chairman of the Subcommittee, presiding.
        Present: Senators Levin and Kaufman.
        Staff Present: Elise J. Bean, Staff Director and Chief
    Counsel; Mary D. Robertson, Chief Clerk; David H. Katz,
    Counsel; Laura E. Stuber, Counsel; Adam Henderson, Professional
    Staff Member; Christopher Barkley, Staff Director to the
    Minority; and Anthony G. Cotto, Counsel to the Minority; Kevin
    Rosenbaum, Research Clerk; Robert Kaplan, Intern; Ryan McCord,
    Law Clerk; Ted Schroeder and Nhan Nguyen (Senator Kaufman).

                   OPENING STATEMENT OF SENATOR LEVIN

        Senator Levin. Good morning, everybody. Today's hearing is
    the third in a series of Subcommittee hearings focusing on some
    of the causes and consequences of the 2008 financial crisis, a
    man-made economic assault on our country that is still
    foreclosing on homes, shuttering businesses, and driving
    unemployment. We saw the beginning of the assault in our first
    two hearings, which examined how U.S. financial institutions
    turned to high-risk lending strategies to earn quick profits,
    dumping hundreds of billions of dollars in toxic mortgages into
    the financial system, like polluters dumping poison upstream in
    a river. At the second hearing, we showed how regulators saw
    what was going on, understood the risk, but sat on their hands
    or fought each other rather than stand up to the banks which
    were profiting from the pollution.
        Those toxic mortgages were scooped up by Wall Street firms
    that bottled them in complex financial instruments and turned
    to the credit rating agencies to get a label declaring them to
    be safe, low-risk, investment-grade securities. Today, we are
    focusing on the role played by the credit rating agencies. Next
    week, we will look at the last stage of the economic assault,
    when Wall Street investment bankers magnified and spread the
    risk posed by toxic mortgages through the use of complex
    structured finance transactions.
        For a hundred years, Main Street investors trusted U.S.
    credit rating agencies to guide them toward safe investments.
    Even sophisticated investors, like pension funds,
    municipalities, insurance companies, and university endowments,
    have relied on credit ratings to protect them from Wall Street
    excesses and distinguish between safe and risky investments.
        But now that trust has been broken. We have used as case
    histories the two biggest credit rating agencies in the United
    States, Moody's and Standard & Poor's, and the ratings they
    gave to the key financial instruments that fueled the financial
    crisis--residential mortgage backed securities (RMBSs), and
    collateralized debt obligations (CDOs). The Subcommittee
    investigation found that those credit rating agencies allowed
    Wall Street to impact their analysis, their independence, and
    their reputation for reliability. And they did it for the
    money.
        This chart, Exhibit 1g,\1\ shows that from 2002 to 2007,
    the three top credit rating agencies doubled their revenues,
    from less than $3 billion to over $6 billion per year. Most of
    this increase came from rating complex financial instruments.
    According to Standard & Poor's, between 2000 and 2006,
    investment banks underwrote nearly $2 trillion in mortgage-
    backed securities, $435 billion or 36 percent of which were
    backed by subprime mortgages. All of those securities needed
    ratings. Moody's and S&P each rated about 10,000 RMBS
    securities over the course of 2006 and 2007. Credit rating
    executives got paid Wall Street-sized salaries.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1g, which appears in the Appendix on page 242.
    ---------------------------------------------------------------------------
        At the same time, the credit rating agencies were operating
    with an inherent conflict of interest, because the revenues
    they pocketed came from the companies whose securities they
    rated. It is like one of the parties in court paying the
    judge's salary or one of the teams in a competition paying the
    salary of the referee. The credit rating agencies assured
    Congress and the investing public that they could ``manage''
    that conflict and that their ratings were independent and
    rigorous. But the documents tell a different story.
        First, some background. Credit ratings assess the
    creditworthiness of a particular financial instrument like a
    corporate bond, mortgage-backed security, or CDO. Essentially,
    they predict the likelihood that the debt will be repaid. We
    have all heard of AAA ratings, which are at the top of the
    credit rating scale and are supposed to designate the safest
    investments. The ratings below that, which range from AA down
    to C, designate investments at greater risk of default.
    Investments with AAA ratings have historically had an expected
    loss rate of less than 0.05 percent, while the expected loss
    rate for BBB investments is under 1 percent. That is why
    financial instruments with AAA through BBB ratings are
    generally called ``investment grade,'' while those with ratings
    of BBB or Baa3 or below are referred to as ``below investment
    grade'' or sometimes ``junk'' investments.
        A variety of U.S. laws and regulations rely on credit
    ratings to gauge risk. For example, the amount of risk-based
    capital that a bank must hold is determined in part by the
    credit ratings of its investments. Some investors, like pension
    funds, are barred from holding below-investment-grade assets.
    Because so many statutes and regulations reference ratings,
    issuers of securities and other financial instruments work hard
    to obtain favorable credit ratings to ensure more investors can
    buy their products.
        Over the last 10 years, Wall Street has engineered ever
    more complex financial instruments for sale to investors.
    Because these so-called structured finance products are so hard
    to understand, investors often place heavy reliance on credit
    ratings to determine whether they can or should buy them.
        Residential mortgage-backed securities (RMBSs), are one of
    the oldest types of structured finance. To create these
    securities, issuers bundle up large numbers of home mortgages
    into a pool, figure out the total revenue coming into the pool
    from all the mortgages, and then design a ``waterfall'' that
    assigns portions of the total incoming revenue to what are
    called ``tranches.'' Tranches are not collections of mortgages;
    they are simply recipients of income from the waterfall of
    mortgage payments coming into the pool.
        Each tranche is used to issue a mortgaged-backed security
    that receives a credit rating and is then sold to investors.
    The tranches that are first in line to receive revenues
    represent the safest investments in the pool and are designed
    to get AAA ratings. Tranches lower down the line get their
    revenues only after the more senior tranches are paid, and
    their securities get lower credit ratings.
        Wall Street did not stop there. They collected securities
    from RMBS transactions, put those into a pool, and
    resecuritized them into what are called collateralized debt
    obligations (CDOs). A CDO might contain, for example, BBB-rated
    securities from 100 different residential mortgage pools. CDOs
    often also contain other types of assets, such as corporate
    bonds or credit default swaps. Wall Street firms also created
    so-called synthetic CDOs which did not contain actual assets
    but simply referenced them. Like RMBS mortgage pools, CDOs were
    sliced and diced into tranches and the resulting tranches used
    to create securities. The securities were rated--some AAA--and
    then sold to investors.
        In exchange for large fees, Wall Street firms helped design
    the RMBS and CDO securities, worked with the credit rating
    agencies to obtain favorable ratings, and then sold the
    securities. Without credit ratings, Wall Street would have had
    a much harder time selling those products because each investor
    would have had to rely on themselves to figure them out. Credit
    ratings helped make the sales possible by labeling certain
    investments as safe, using their trademark AAA ratings.
        Wall Street firms also used financial engineering to
    combine AAA ratings--normally reserved for ultra-safe
    investments--with riskier securities, such as RMBS securities
    backed by high-risk mortgages. Because the underlying mortgages
    were high risk, those RMBS securities paid out a higher rate of
    return than safer loans. When those higher-paying securities
    also got AAA ratings, investors snapped them up.
        For a while, everyone made money: banks and mortgage
    brokers got rich selling high risk loans, Wall Street
    investment banks earned big fees creating and selling mortgage-
    based securities, and investors profited from the higher
    returns.
        But those AAA ratings created a false sense of security.
    High-risk RMBS and CDOs turned out not to be safe investments.
    We heard in our first hearing how many of the high-risk
    mortgages backing those securities were riddled with poor-
    quality loans, contained fraudulent borrower information, or
    depended upon borrowers being able to refinance their loans
    before higher loan payments kicked in. When housing prices
    stopped climbing and many borrowers could no longer refinance
    their loans, delinquency rates skyrocketed. RMBS and CDO
    securities rated as investment grade began incurring losses and
    were sharply downgraded.
        For example, take a CDO known as Vertical ABS CDO 2007-1.
    In early 2007, UBS, which is a major bank, asked Standard &
    Poor's and Moody's to rate this CDO. The UBS banker, however,
    failed to cooperate with the analysts. One S&P analyst wrote in
    an email to colleagues: ``Don't see why we have to tolerate
    lack of cooperation. Deals likely not to perform.'' That is
    Exhibit 94b.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 94b, which appears in the Appendix on page 599.
    ---------------------------------------------------------------------------
        Despite the analyst's judgment that the CDO was unlikely to
    perform, Standard & Poor's rated it anyway. So did Moody's. In
    April 2007, both agencies gave AAA ratings to the CDO's top
    four tranches. But just 6 months later, both agencies
    downgraded the CDO, which later collapsed. One of the
    purchasers, a hedge fund called Pursuit Partners, sued over the
    CDO's quick demise. Standard & Poor's and Moody's were dropped
    from the lawsuit since current law does not authorize private
    lawsuits against them even for reckless or unreasonable
    ratings, but the court ordered UBS to set aside $35 million for
    a possible award to the investor. The legal pleadings included
    internal emails at UBS referring to the supposedly investment-
    grade Vertical securities as ``crap'' at the same time the bank
    was selling them.
        Take another example. In January 2007, S&P was asked to
    rate an RMBS being assembled by Goldman Sachs using subprime
    loans from Fremont Investment and Loan, a subprime lender known
    for loans with high rates of delinquency. On January 24, 2007,
    an analyst wrote seeking advice from two senior analysts: ``I
    have a Goldman deal with subprime Fremont collateral. Since
    Fremont collateral has been performing not so good, is there
    anything special I should be aware of?'' One of the analysts
    responded: ``No, we don't treat their collateral any
    differently.'' And the other analyst asked a question: ``Are
    the FICO scores current?'' Answer: ``Yup,'' came the reply.
    Then, ``You are good to go.''
        In other words, the analyst did not have to factor in any
    greater credit risk for an issuer known for poor-quality loans,
    even though 3 weeks earlier S&P analysts had circulated an
    article about how Fremont had severed ties with 8,000 brokers
    due to loans with some of the highest delinquency rates in the
    industry coming from those brokers. In the spring of 2007,
    Moody's and Standard & Poor's provided AAA ratings for five
    tranches of RMBS securities backed by Fremont mortgages. By
    October, both companies began downgrading the CDO. Today all
    five AAA tranches have been downgraded to junk status.
        Now, those are just two examples of securities given AAA
    ratings that turned out not to be worth the paper that they
    were written on. And there are many more.
        In fact, throughout 2006 and 2007, the toxic mortgages
    flooding the financial markets began going bad in record
    numbers. Delinquency rates skyrocketed. It became more and more
    apparent that the investment grade ratings given to subprime
    RMBS securities could not hold.
        Finally, in July 2007, within days of each other, Moody's
    and Standard & Poor's announced mass downgrades of hundreds of
    subprime mortgage-backed securities. The mass downgrades
    shocked financial markets, and the subprime secondary market
    dried up overnight. Banks, securities firms, pension funds, and
    others were left holding billions of dollars of suddenly
    unmarketable securities. The value of those securities began
    dropping like a stone, and the financial crisis was on.
        Two months later, in October, Moody's began downgrading
    over $10 billion of CDOs. On January 30, 2008, Standard &
    Poor's downgraded over 8,000 securities, including 6,300 RMBS
    and 1,900 CDO securities, an unprecedented onslaught of
    downgrades. The CDO market, like the RMBS market, evaporated.
    Financial firms around the world were suddenly stuck with even
    more unmarketable securities, and by September 2008, major
    global financial institutions like Lehman Brothers, AIG,
    Citibank, Goldman Sachs, and Morgan Stanley were either bailed
    out, bankrupt, or struggling.
        Looking back, if any single event can be identified as the
    immediate trigger of the 2008 financial crisis, my vote would
    be for the mass downgrades starting in July 2007, when the
    credit rating agencies realized that their AAA ratings would
    not hold, and finally stopped labeling toxic mortgages as safe
    investments. Those mass downgrades hit the markets like a
    hammer, making it clear the investment grade ratings had been a
    colossal mistake.
        This chart, Exhibit 1i,\1\ shows just how big a mistake it
    was. It shows that 91 percent of the AAA subprime RMBS
    securities issued in 2007 and 93 percent of those issued in
    2006 have since been downgraded to junk status. The numbers for
    Option ARM mortgages are even worse. Option ARMs, which we
    examined at our first hearing on Washington Mutual Bank, allow
    borrowers to pick from several types of payments each month,
    including a ``minimum payment'' that results in a growing,
    rather than declining, loan balance. The chart shows that 97
    percent of the Option ARM securities issued in 2006 and 2007
    are now in junk status.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1i, which appears in the Appendix on page 244.
    ---------------------------------------------------------------------------
        Had the credit rating agencies taken more care in handing
    out their initial ratings or had they issued downgrades in a
    more responsible manner, they could have reduced the impact of
    the toxic mortgages. But they did not, and there are a whole
    host of reasons why.
        First, let us talk about the credit rating models. Credit
    rating agencies use complex mathematical models to predict
    foreclosure rates for mortgages which, in turn, are critical to
    determine the ratings for mortgage-backed securities. The key
    problem was that the mortgage industry had changed drastically
    in the last 10 years. High-risk mortgages like subprime,
    interest-only, Option ARMs, and hybrids became widespread,
    displacing traditional, low-risk, 30-year fixed-rate mortgages.
    The credit rating agencies simply did not have data on how
    these higher-risk mortgages would perform over time.
    Traditional 30-year fixed-rate mortgages had default rates of 1
    to 2 percent; the higher-risk mortgages were expected to have
    higher default rates, but no one knew how high. With very
    little data, the credit rating agencies made assumptions in
    their models that turned out to be way wrong.
        Moody's and S&P knew their modeling assumptions were wrong
    and began revising their models. In the summer of 2005, S&P had
    revamped its CDO model, but put the model on hold for more than
    a year, as it struggled to rationalize why it would not use the
    new model to retest existing CDO securities. It is clear from
    over a year of internal emails that S&P delayed and delayed the
    decision, anticipating that the revised model would require
    existing CDO securities to be downgraded, disrupt the CDO
    market, and reduce public confidence in its CDO ratings. It
    would also have disrupted S&P profits from CDO ratings.
        In July 2006, S&P made a major change to its RMBS rating
    model, but decided not to retest existing RMBS securities. The
    revised RMBS model projected much higher default rates for
    high-risk mortgages and required greater protections against
    loss, including 40 percent more credit protection for BBB-
    graded subprime securities. That meant a 40-percent larger
    cushion to protect against losses. Re-evaluating existing RMBS
    securities with the revised model would likely have led to
    downgrades, angry issuers, and even angrier investors, so S&P
    did not do it. Moody's did not either; after strengthening its
    RMBS model to issue new ratings, it chose not to apply it to
    existing securities. Recently, S&P has adopted a policy
    requiring retesting of rated securities within 1 year of a
    model change.
        A second reason the credit rating agencies did not blow the
    whistle sooner on poorly performing RMBS and CDO securities was
    competition. The drive for market share and the revenues from
    increased volumes of ratings created pressure on both agencies
    to provide favorable credit ratings to the investment bankers
    bringing in business.
        A 1995 article captures how the credit agencies used to
    operate. A journalist wrote: ``Ask a treasurer for his opinion
    of rating agencies, and he will probably rank them somewhere
    between a trip to the dentist and an IRS audit. You cannot
    control them, and you cannot escape them.'' Well, all that
    changed as the revenues from structured finance ratings came
    pouring in.
        Ratings and fees began to be played off against each other.
    For example, after a Moody's analyst emailed that he could not
    finalize a rating until the issue of fees was resolved, an
    investment banker from Merrill Lynch responded: ``We are okay
    with the revised fee schedule for this transaction. We are
    agreeing to this under the assumption that this will not be a
    precedent for any future deals and that you will work with us
    further on this transaction to try and get to some middle
    ground with respect to the ratings.''\1\ Now, Moody's assured
    the Merrill analyst that its deal analysis was independent from
    its fees. Nonetheless, that is what Merrill was asking for.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 23, which appears in the Appendix on page 315.
    ---------------------------------------------------------------------------
        In another email, an S&P analyst commented: ``Version 6.0
    [of the ratings model] could've been released months ago and
    resources assigned elsewhere if we didn't have to massage the
    sub-prime and Alt-A numbers to preserve market share.''\1\ Some
    witnesses here today will describe how the environment changed
    from an academic culture focused on accurate ratings to one of
    intense pressure to get the deals done and preserve market
    share.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        The documents also show how the crushing volume of ratings
    undermined the ratings process. Despite record profits, both
    credit rating agencies were understaffed and overwhelmed with
    complex deals that investment bankers wanted to close within
    days. The documents show how investment bankers argued with the
    credit rating analysts, substituted worse assets at the last
    minute, and pressured analysts to waive their procedures and
    standards. We even saw instances of bankers pushing to remove
    analysts who were not playing ball. And at times, analysts who
    resisted banker demands or challenged ratings were restricted
    from rating deals.
        A focus on short-term profits also permeated the industry.
    One of the witnesses here today will describe how when he once
    questioned a banker about the terms of a deal, the banker
    replied, ``IBG-YBG.'' When asked what that meant, the banker
    explained, ``I'll be gone, you'll be gone.'' In other words,
    why give me a hard time when we are both making a lot of money
    and will be long gone before the house of cards comes crashing
    down?
        In addition to inaccurate models and competitive pressures,
    the credit rating agencies failed to adjust their ratings to
    take into account credit risks from the fraud and lax
    underwriting standards that increasingly characterized the
    mortgages securitized and sold on Wall Street.
        In August 2006, an S&P employee wrote: ``[T]here has been
    rampant appraisal and underwriting fraud in the industry for
    quite some time as pressure has mounted to feed the origination
    machine.''\2\ In September 2006, another S&P employee wrote:
    ``I think it is telling us that underwriting fraud, appraisal
    fraud, and the general appetite for new product among
    originators is resulting in loans being made that should not be
    made.''\3\ A colleague responded that the head of the S&P
    Surveillance Group ``told me that broken down to loan level
    what she is seeing in losses is as bad as high 40's--low 50
    percent. I would love to be able to publish a commentary with
    this data but maybe too much of a powder keg.'' Well, not
    taking into account mortgage fraud and lax underwriting
    standards did, indeed, turn into a powder keg, one that helped
    blow up the RMBS and CDO markets and triggered the 2008
    financial crisis.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 14, which appears in the Appendix on page 293.
        \3\ See Exhibit No. 1d, which appears in the Appendix on page 236.
    ---------------------------------------------------------------------------
        In the fall of 2007, Moody's CEO Ray McDaniel called a town
    hall meeting to talk to his employees after the mass downgrades
    that shut down the subprime market. ``What happened in 2004 and
    2005,'' he said, ``is that our competition, Fitch & S&P, went
    nuts. Everything was investment grade. It really didn't
    matter[.] . . . No one cared because the machine just kept
    going.''\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 98, which appears in the Appendix on page 684.
    ---------------------------------------------------------------------------
        A Moody's managing director later responded our ``errors
    make us look either incompetent at credit analysis, or like we
    sold our soul to the devil for revenue, or a little bit of
    both.'' He said, ``I would like more candor from senior
    management about our errors and how we will address them in the
    future.''
        That is what we are calling for today as well: candor not
    only about what went wrong, but what can be done to prevent
    still another credit rating disaster in the future. The House
    and the Senate financial reform bills before Congress offer a
    number of measures to increase credit rating oversight. Both
    bills would, for example, eliminate the statutory prohibition
    on the SEC's evaluating rating models, though clearer language
    authorizing the SEC to set standards for credit rating models,
    methodologies, and criteria is, in my judgment, still needed.
    The bills would also beef up the SEC's enforcement authority
    toward credit rating agencies and subject the agencies to
    lawsuits by investors for reckless or unreasonable ratings. The
    bills should be further strengthened, in my judgment, by
    directing regulators to tackle the inherent conflicts of
    interest that arise when rating agencies are paid by the people
    that they rate. Our investigation provides strong support for
    better controls on credit rating agencies whose failures
    contributed to the economic damage still plaguing our country.
        One more matter. Yesterday, the Subcommittee was made aware
    of a longer version of an email that was included in the
    Exhibit Book as Exhibit 23. We were not aware of the longer
    version earlier when that book was put together, so we have
    added it to the book as Exhibit 23 Addendum. The emails show
    Merrill Lynch trying to make a direct link between the fees it
    paid and the ratings it would receive on a deal, but the longer
    email shows that Moody's told Merrill Lynch that its deal
    analysis was independent of any fee discussion. And that was
    surely a welcome response, but a very inappropriate request on
    the part of Merrill Lynch.
        My Ranking Member, Senator Coburn, had planned on being
    here today and had looked forward to it, but he was called away
    to matters in Oklahoma, so we will have to proceed without him.
    I do want to thank him and his staff again for their tremendous
    ongoing support of this investigation.
        I want to call on Senator Kaufman, who has also been a
    major supporter of what we are trying to do on this
    Subcommittee, and we are very grateful for his being on this
    Subcommittee and for that great participation. Senator Kaufman.
        Senator Kaufman. Thank you, Mr. Chairman, and thank you for
    holding this hearing, and I thank the witnesses.
        Since this meltdown occurred, as I travel around, after
    concern about jobs, the single most concern is about what
    happened on Wall Street and what are we going to do about it.
    And I got to tell you that the most scorn is on the rating
    agencies. That may not be deserved, but that is where it is,
    the idea that, as the Chairman said, you had this incredible
    growth in revenues at the same time they were rating thousands
    of residential mortgage-backed securities AAA that now turn out
    to be junk. AAA to junk is just a hard thing for people to deal
    with. How can you miss so badly?
        The problem we are dealing with today is what happened, but
    really more important is what are we going to do about it? I
    think both are important. AAA will never mean again what it
    used to mean. I do not care what we do here. I do not care what
    happens. AAA will not mean what it used to mean because people
    are just beginning to determine the incredible conflict of
    interest the Chairman pointed out, and also the way that rating
    agencies have protected and the way they view their job, when
    you hear them talk about the fact that they really have no
    responsibility to the average investor out there. That is not
    their customer. The customers are the people that just does not
    go with people. People do not understand that.
        The problem is, outside of the great people that inhabit
    the United States, that the two greatest things that make this
    country great are democracy and our capital markets. That is
    what makes us great. And the credibility of our capital markets
    is in tatters.
        Now, fortunately, in the rest of the world, they have
    capital markets where you even take a greater chance in many
    cases to get involved. But I do not think that is beginning to
    be the perception. And the idea that the average person cannot
    use rating agencies to determine the quality of the product
    means very simply people will stop using the product. Our
    markets will no longer be credible. They have lost a lot of
    credibility already.
        If we do not deal with this, this is not something we are
    just going on as business as usual. I spend a lot of time in
    New York. I spent a lot of time with people in New York. They
    think, oh, well, over that, now we are on to the next thing. It
    is not going to be that way. This is not going to go on
    forever. Our markets, if we lose our credibility, not only have
    the folks on Wall Street lost an incredible business, not only
    the rating agencies an incredible business, but the United
    States of America has lost one of the keys to its success. So
    what the Chairman is doing here with these hearings is
    incredibly important if we are going to maintain the
    credibility of our U.S. markets.
        Thank you, Mr. Chairman.
        Senator Levin. Thank you very much, Senator Kaufman.
        Now let me welcome our first panel of witnesses for this
    morning's hearing: Frank Raiter, Former Managing Director for
    Mortgage-Backed Securities at Standard & Poor's; Richard
    Michalek, Former Vice President and Senior Credit Officer for
    the Structured Derivative Products Group at Moody's; Eric
    Kolchinsky, a Former Team Managing Director of the Structured
    Derivative Products Group at Moody's Investors Service; and,
    finally, Dr. Arturo Cifuentes, a Former Moody's Senior Vice
    President and current Director of the Finance Center at the
    University of Chile in Santiago, Chile. We thank you for coming
    a great distance.
        Mr. Raiter, I understand that you are here under a
    subpoena, but I appreciate all of you being here, whether a
    subpoena was issued or not. We appreciate your being with us
    this morning. We look forward to your testimony.
        We have a rule on this Subcommittee that all witnesses who
    testify before the Subcommittee are required to be sworn, so at
    this time I would ask all of you to please stand and raise your
    right hand. Do you swear that the testimony you are about to
    give will be the truth, the whole truth, and nothing but the
    truth, so help you, God?
        Mr. Raiter. I do.
        Mr. Michalek. I do.
        Mr. Kolchinsky. I do.
        Mr. Cifuentes. I do.
        Senator Levin. We have a timing system here that does the
    following: About a minute before the red light comes on, you
    will see the light change from green to yellow, which will give
    you an opportunity to conclude your remarks. Your written
    testimony will be printed in the record in its entirety. We
    would ask that you attempt to limit your oral testimony to no
    more than 5 minutes.
        Mr. Raiter, I think we will have you go first.

      TESTIMONY OF FRANK L. RAITER,\1\ FORMER MANAGING DIRECTOR,
          RESIDENTIAL MORTGAGE RATING GROUP, STANDARD & POOR'S

        Mr. Raiter. Good morning, Senator Levin and Senator
    Kaufman. From 1995 until my retirement in 2005, I was the
    Managing Director and head of Residential Mortgage Ratings at
    Standard & Poor's. As such, I think I had an inside view of the
    role of rating agencies in the recent economic crisis.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Raiter appears in the Appendix on
    page 114.
    ---------------------------------------------------------------------------
        The failure of the major rating agencies--Fitch, Moody's
    and Standard & Poor's--to adequately assess the risks
    associated with new mortgage products introduced in the past
    decade is the result of several factors. The first was the lack
    of oversight of the rating agencies by the SEC and the various
    financial regulatory bodies that wrote regulations requiring
    ratings. The second was the impact these decisions had on
    management of the rating agencies. And the third factor was the
    disconnect between senior managers and the analytical managers
    responsible for assigning ratings. The final factor was the
    separation of the initial ratings process from the subsequent
    surveillance of performance of the rated bonds.
        The first factor, a lack of regulatory oversight, resulted
    from the failure of regulators to appreciate the unique
    position the rating agencies assumed in the financial markets.
    The rating agencies were granted their preferred status by the
    SEC. Other regulators followed suit and incorporated ratings
    into their investment and capital rules. There was no
    regulatory oversight nor were standards established to measure
    the performance or quality of ratings.
        The preferred position of the rating agencies led directly
    to the second factor. Management of the rating agencies came to
    believe that the increasing revenues and profits they were
    enjoying were the results of superior management skill and
    insight rather than the oligopoly granted them by the various
    regulators and the accommodative Federal Reserve interest
    rates. This success bred complacency and an aversion to change.
        This resistance to change was a primary cause of the
    failure of the ratings and the ultimate financial crisis.
    Analytical managers were driven by the desire to create and
    implement the best risk analytics and methodologies possible.
    Senior management, on the other hand, was focused on revenue,
    profit, and ultimately share price. Management wanted increased
    revenues and profit while analysts wanted more staff, data, and
    IT support which increased expenses and obviously reduced
    profit.
        In the Residential Mortgage Ratings Group, as in all the
    rating groups in structured finance, the analysts were
    responsible for both producing ratings and developing and
    maintaining ratings criteria. Balancing these two missions was
    a significant issue in the residential ratings group where
    revenues grew tenfold between 1995 and 2005, and rating volumes
    grew five- or six-fold without similar increases in staff.
    Rating production was achieved at the expense of maintaining
    criteria quality.
        Adequate staffing was not the only challenge faced in
    trying to maintain the quality of the rating process. The
    accuracy of the predictive models used to evaluate risk was
    also critical to the quality of the ratings. The version of
    LEVELS model developed in 1996 was based on a data set of
    approximately 250,000 loans. It was, I believe, the best model
    then used by a rating agency. As new models were programmed and
    tested, analysts continued to collect larger data sets for the
    next versions of the model. In late 2002 or early 2003, another
    version of the model was introduced based on approximately
    650,000 loans. At the same time, a data set of approximately
    2.8 million loans was collected for use in developing the next
    version of the model. By early 2004, preliminary analysis of
    this more inclusive data set and the resulting econometric
    equation was completed. That analysis suggested that the model
    in use was underestimating the risk of some Alt-A and subprime
    products. In spite of this research, the development of this
    model was postponed due to a lack of staff and IT resources.
    Adjustments to the model used in 2004, with the identified
    problems, were not made until March 2005. To my knowledge, this
    version of the model based on the 2.8 million loan data set was
    never implemented.
        The final condition contributing to the failure of the
    rating agencies was the separation of the initial ratings
    process from the subsequent surveillance of ratings
    performance. While the rating process utilized ever improving
    models, surveillance operated under their own criteria. At S&P,
    the manager of surveillance refused to use the ratings model in
    reviewing the performance of outstanding bonds. In fact, the
    resistance to ``re-rate'' bonds with each new model came from
    upper management. The concern was that ``re-rating''
    outstanding deals with new information would significantly
    increase rating volatility and possibly result in lost revenue.
    By 2005, when adjustments were made to the model, it should
    have been intuitively obvious that some bonds rated in 2004 did
    not provide the necessary protection to support the assigned
    ratings.
        In conclusion, it is my opinion that if S&P had vigorously
    pushed to implement the version of the model based on the 2.8
    million loan data set in late 2004 or early 2005, the economics
    of deals incorporating the lowest quality subprime and Alt-A
    loans would have disappeared. In addition, the riskiest
    transactions submitted for ratings in 2005, 2006, and 2007
    would likewise have been assigned much higher enhancement
    requirements which might have made it unprofitable for lenders
    to make additional loans. If the surveillance department had
    ``re-rated'' existing deals each time ratings criteria were
    adjusted, transactions would have been put on Credit Watch or
    been downgraded in 2005 which would certainly have sent an
    early warning to investors and tempered their demand for
    similar bonds.
        This concludes my opening comments.
        Senator Levin. Thank you very much. Mr. Michalek.

      TESTIMONY OF RICHARD MICHALEK,\1\ FORMER VICE PRESIDENT AND
     SENIOR CREDIT OFFICER, STRUCTURED DERIVATIVE PRODUCTS GROUP,
                       MOODY'S INVESTORS SERVICES

        Mr. Michalek. Mr. Chairman and Senator Kaufman, my name is
    Richard Michalek. I am a former employee of Moody's Investors
    Service, a subsidiary of Moody's Corporation. I joined the
    Structured Derivative Products Group at Moody's in June 1999,
    and my position was eliminated in December 2007. At the end of
    my tenure at Moody's, I held the title of Vice President and
    Senior Credit Officer.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Michalek appears in the Appendix
    on page 119.
    ---------------------------------------------------------------------------
        My general responsibilities included performing legal
    analysis on the structure and documentation of complex
    structured finance transactions in order to assign a rating to
    that transaction and to assist in the development of, and
    refinement to, rating practices, policies, and methodologies
    used by the group. My regular responsibilities included
    participating in rating committees within the group, and on
    request for other groups at Moody's; consulting on legal
    matters for other groups in the New York, London, and Asian
    offices of Moody's when requested; and speaking at industry
    conferences on a wide variety of legal and structural issues. I
    prepared and published the group's quarterly and annual review
    and survey of activity. I assisted with the legal portion of
    semi-annual training sessions for new hires in the Structured
    Finance Department.
        During my last year at Moody's, my primary responsibilities
    were split between serving as the senior legal analyst on the
    team responsible for developing, refining, and implementing the
    methodology for assigning ratings to highly complex credit
    derivative product companies and being the project leader
    responsible for developing a methodology for rating collateral
    managers.
        Immediately prior to joining Moody's, I was a
    securitization consultant advising the New Zealand law firm of
    Chapman Tripp, and prior to that I was an associate lawyer in
    the New York office of the law firm Skadden Arps. I am admitted
    to practice law in New York State and was admitted to the bar
    as a solicitor in Wellington, New Zealand. I have a JD/MBA from
    Columbia University Law School and Columbia University Graduate
    School of Business.
        My testimony today is based on and primarily limited to my
    experience working in the Structured Derivative Products Group
    within Moody's Investors Service, and while I had the
    opportunity to interact with several other groups within
    Moody's, I do not profess any particular expertise or advanced
    knowledge of the methodologies or practices employed in those
    groups. My testimony today is also not being delivered with the
    intention to bring harm to any individual or to stand in
    judgment of individual behavior. On the contrary, as I hope my
    oral remarks and written statement will illustrate, I believe
    that any imperfections, flaws, and failures observed or
    identified in the credit rating process of structured
    derivative products are neither surprising nor unexpected in
    light of the framework of incentives presented to the competent
    and otherwise rational people comprising the credit rating
    agencies.
        Credit rating agencies serve the important function of
    providing buyers and sellers of credit--that is, investors in
    and issuers of a promise to pay--an independent measure of the
    risk presented. In theory, these agents are independent, and
    because of repeat experience and a rationalization of costs,
    they should be able to provide this measure of risk at a lower
    cost than would otherwise be faced if the buyers or sellers
    produced the analysis themselves.
        My experience as an analyst, however, in the Derivatives
    Group and as a resource in the Derivatives Group for other
    groups in Moody's for legal issues provides what I hope would
    be a useful perspective with respect to a couple of questions
    the members might like to ask.
        I know one question that is being asked: Just how
    independent are these agencies, particularly within an ``issuer
    pays'' framework?
        Another question that is and should be asked is: What
    consequences do rating agencies suffer under the current or any
    proposed framework when these measures of risk either fail to
    perform as reasonably expected or which can be shown to have
    lacked a level of care commensurate with the risk of harm that
    may foreseeably befall the user who relies on such measures?
        As for that first question, in my view, the independence of
    the Derivatives Group changed dramatically during my tenure.
    The willingness to decline to rate or to just say no to
    proposed transactions steadily diminished over time. That
    unwillingness to say no grew in parallel with the company's
    share price and the proportion of total firm revenues
    represented by structured finance transactions. The apparent
    loss of bargaining power by the rating agencies in general and
    of the group in particular was coincident with the steady drive
    towards commoditization of the instruments we were rating.
        As our customers, principally the investment banks,
    produced more and more product for yield-hungry investors and
    as the quality distinction as between the different rating
    agencies lost some of its importance, the threat of losing
    business to a competitor rating agency, even if not realized,
    absolutely tilted the balance away from the independent arbiter
    of risk towards a captive facilitator of risk transfer.
        The second question--in essence, what price is paid or
    should be paid if a rating agency gets it wrong?--is in my view
    asking a handful of more fundamental questions. Who should bear
    the risk of getting it wrong, particularly when it is within
    reach to either not get it wrong or to choose not to rate? If
    we accept that the ratings are the rating agency products,
    should all the ratings issued by a rating agency be entitled
    equally to the same defenses for product liability? I am of the
    opinion that much more could have and should have been done to
    improve processes and procedures, but I am not so naive as to
    fail to appreciate that in the extremely competitive
    environment of hyper growth where the message from management
    was not, ``Just say no'' but, instead, ``Must say yes,'' any
    available resource had to be spent on remedial corrections.
    Installing improvements were left for the someday pile.
        I am in the camp that believes that, to some degree,
    ratings provide an important public good. I also believe that
    some ratings, in light of the public good they provide, deserve
    some measure of protection from liability and opportunistic
    claims of negligence. However, to the extent that agencies are
    to remain wholly private entities understandably concerned with
    market share and net profits, a distinction based on the extent
    of the public good provided might be made with respect to the
    products being rated. Where some question can reasonably be
    raised as to the extent of the public benefit from rating one
    or more of the highly complex or novel instruments, the
    liability for getting it wrong might be more fairly assigned to
    the private parties involved.
        I am confident that if questions of negligence were not
    easily dismissed by protestations of free speech opinion, at
    least for that subset of ratings on products where the benefit
    of the rating falls primarily to the private parties involved,
    the agencies would redirect some of their extraordinary profit
    margins into resources and research and would once again have
    an incentive to just say no.
        That concludes my oral remarks. Thank you, Mr. Chairman.
        Senator Levin. Thank you very much, Mr. Michalek. Mr.
    Kolchinsky.

    TESTIMONY OF ERIC KOLCHINSKY,\1\ FORMER TEAM MANAGING DIRECTOR,
    STRUCTURED DERIVATIVE PRODUCTS GROUP, MOODY'S INVESTORS SERVICE

        Mr. Kolchinsky. Thank you very much. Good morning. I would
    like to thank Chairman Levin and the Subcommittee for holding
    this hearing on the role of the rating agencies in the
    financial crisis.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Kolchinsky appears in the
    Appendix on page 140.
    ---------------------------------------------------------------------------
        My name is Eric Kolchinsky, and during the majority of
    2007, I was the Managing Director in charge of the business
    line which rated subprime-backed CDOs at Moody's Investors
    Service. More recently, I was suspended by Moody's after
    warning the compliance group regarding what I believed to be a
    violation of securities laws within the rating agency.
        In my opinion, the cause of the financial crisis lies
    primarily with the misaligned incentives in the financial
    system. Individuals across the financial food chain, from the
    mortgage broker to the CDO banker, were compensated based on
    quantity rather than quality. The situation was no different at
    the rating agencies.
        It is my firm belief that the vast majority of the analysts
    at Moody's are honest individuals who try hard to do their
    jobs. However, the incentives in the market for rating agency
    services favored, and still favor, short-term profit over
    credit quality and quantity over quality.
        At Moody's, the source of this conflict was the quest for
    market share. Managers of rating groups were expected by their
    supervisors to build, or at least maintain, market share. It
    was an unspoken understanding that loss of market share would
    cause a manager to lose his or her job.
        Senior management would periodically distribute emails
    detailing their departments' market share. These emails were
    limited to managing directors only. Even if the market share
    dropped by a few percentage points, managers would be expected
    to justify ``missing'' the deals which were not rated.
    Colleagues have described enormous pressure when their market
    shares dipped.
        While, to my knowledge, senior management never explicitly
    forced the lowering of credit standards, it was one easy way
    for a managing director to regain market share. I do not
    believe that this was done in a deliberate manner. Instead,
    during the bubble years, it was quite easy to rationalize
    changes in methodology since the nominal performance of the
    collateral was often quite exceptional. Easier still was
    avoiding asking whether the collateral standards had declined
    or whether some of the parties had ulterior motives in closing
    the transaction.
        I began to receive these emails when I was promoted to
    managing director. They would list all the deals in the market
    for the relevant period and the amounts rated by Moody's, S&P,
    and Fitch.
        I believe that my 2007 dismissal from the rating agency was
    a consequence of placing credit quality above market share. I
    was a managing director in the derivatives group, which was
    responsible for rating CDOs. CDOs were an extremely lucrative
    area for Moody's: In the first two quarters of 2007, the group
    generated over $200 million of revenue. This amount accounted
    for approximately one-fifth of the total revenue of the entire
    rating agency.
        However, trouble for the securitization was already
    brewing. In early 2007, New Century, a major subprime lender,
    imploded. During the course of the year, the prices of
    synthetic subprime bonds precipitously declined. The end of
    this initial phase of the crisis was heralded by the fall of
    two Bear Stearns hedge funds which heavily invested in CDOs.
    The resulting price dislocation sent bankers hurrying to finish
    CDOs already in progress and to clean up their balance sheets.
        In September 2007, I was told that the ratings of the 2006
    vintage of subprime bonds were about to be downgraded severely.
    While the understaffed RMBS group needed time to determine the
    new ratings, I left the meeting with the knowledge that the
    then current ratings were wrong and no longer reflected the
    best opinion of the rating agency.
        This information was crucial for the few CDOs in my
    pipeline, which were being aggressively pushed by bankers. If
    the underlying ratings were wrong, the ratings on these CDOs
    would be wrong, also. I believed that to assign new ratings
    based on assumptions which I knew to be wrong would constitute
    securities fraud. I immediately notified my manager and
    proposed a solution to the problem.
        My manager declined to do anything about the potential
    fraud, so I raised the issue to a more senior manager. As a
    result of my intervention, a procedure for lowering subprime
    bond ratings going into CDOs was announced on September 21,
    2007. I believe this action saved Moody's from committing
    securities fraud.
        Just about a month later, in mid-October, another periodic
    market share email was sent to the managing directors in my
    group. Along with the email, our business manager noted that
    our market share dropped from 98 percent plus to 94 percent in
    the third quarter. My manager immediately replied to the email
    and demanded an accounting of the missing deals.
        This was the most disturbing email I had ever received in
    my professional career. A few days before, Moody's had
    downgraded over $33 billion in subprime bonds. At the time,
    this was the largest ever single downgrade at Moody's. As a
    direct result of the October 2007 additional downgrades, over
    $570 billion of ABS CDOs would be downgraded through the end of
    2008.
        Despite the massive manifest errors in the ratings assigned
    to structured finance securities and the market implosion we
    were witnessing, it appeared to me that my manager was more
    concerned about losing a few points of market share than about
    violating the law.
        In late October, less than a month after that email and
    less than 2 months after I intervened, my manager asked me to
    leave the group. I was given a smaller position with less
    responsibility and less pay in a different group.
        While Moody's has acknowledged that the rating situation in
    September 2007 constituted a ``problem,'' they failed to act to
    prevent a nearly identical situation in 2009 in connection with
    a transaction called Nine Grade Funding. Instead of following
    some common-sense steps to prevent a violation of the law,
    Moody's management chose to suspend me after I pointed out the
    breach.
        Recent rating activity indicates that market participants
    still prefer the most aggressive ratings. Rating firms which
    have taken conservative positions have seen their market shares
    tumble. We will no doubt see the results of this lesson when
    the regulatory spotlight is turned off. Credit standards will
    once again plunge as rating agencies race to build their market
    share.
        The only way to prevent this from occurring is to recognize
    that the function which the rating agencies perform is a quasi-
    regulatory one, much like accountants. A single set of public
    standards needs to be implemented, to be used for regulatory
    purposes only. This will allow rating agencies to compete for
    clients without being forced to lower credit standards.
        Thank you very much.
        Senator Levin. Thank you very much, Mr. Kolchinsky, for
    that testimony. Dr. Cifuentes.

    TESTIMONY OF ARTURO CIFUENTES, PH.D.,\1\ FORMER MOODY'S SENIOR
    VICE PRESIDENT, CURRENT DIRECTOR, FINANCE CENTER, UNIVERSITY OF
                         CHILE, SANTIAGO, CHILE

        Mr. Cifuentes. Thank you, Mr. Chairman, thank you, Senator
    Kaufman, for the invitation to be here in this hearing.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Cifuentes with attachments
    appears in the Appendix on page 144.
    ---------------------------------------------------------------------------
        My name is Arturo Cifuentes, and I am a professor at the
    University of Chile. I recently moved back to Chile after
    living in the United States for 30 years. I spent probably the
    last 15 years working in finance.
        I worked at Moody's--I have to say that--from 1996 until
    the end of 1999 when ratings really mattered and AAA meant
    something.
        This is the second time I am testifying before the Senate.
    I testified 2 years ago, and I made some observations regarding
    the problem at hand and some suggestions that I thought could
    be implemented, and I have articulated, I believe, in my
    testimony today all the relevant points that I wanted to make.
    So I am not going to read anything. I am just going to make
    three points which I believe are relevant in the context of
    what we are talking about here.
        The first observation that I would like to make is the
    following: Moody's and S&P are two different companies. They
    give ratings. A rating is basically nothing but an opinion
    about the credit risk of a security. Moody's gives ratings
    based on expected loss. S&P gives ratings based on probability
    of default. I do not want to go into the technical matters of
    what that means, but believe me, they are two different things.
    And they both profess to give ratings based on different
    benchmarks, different standards, different models, different
    approaches. They are two different companies in different
    buildings, different people.
        If you take a look, even a casual look, at the ratings
    given by Moody's and S&P, there is a high degree of agreement
    between the ratings given by these two companies, which makes
    you wonder whether the ratings are really independent. That is
    something probably I think that raises some issues and should
    be investigated in more detail. There are certain mathematical
    methods actually to do that in a careful fashion, but you
    become very suspicious if you see such a degree of agreement
    between AAAs given by the two rating agencies. Considering the
    approaches, they should be a little bit different, so you
    wonder are these two companies dancing independently or is this
    carefully calibrated footwork to make sure credit ratings are
    aligning with market share. That is something that I think is a
    little bit concerning.
        The other issue that I would like to address here today is
    something that is more just applicable to the subprime market.
    The rating agencies have said on many occasions that the
    ratings they gave to transactions involving subprime loans
    performed so badly because they rely on data provided by the
    bankers and the data was not good. So allegedly they were not
    at fault because they used information that they did not have
    the opportunity to verify and it turns out to be wrong.
        I do not believe that is a reasonable explanation. For one
    thing, that was not the case when I worked at Moody's. We
    always checked everything that the bankers told us. Whenever we
    are looking at the securitization for the first time, we look
    in a certain amount of detail to make sure the data presented
    to us actually was meaningful and accurate.
        If that were the case, it seems to me as a market
    participant that if the ratings were given on information that
    you did not verify, it seems to me that they should come up
    with a warning, something along the lines that, ``We are giving
    a rating based on information that we believe is true but we
    have not checked,'' or something like that. I think that would
    have been a reasonable thing to do.
        And, finally, the third point that I would like to make,
    because this is a very serious problem, is the situation where
    we are right now, what we really--Senator Kaufman was talking
    about democracy and capital markets. I believe the situation we
    have right now is really bad because what we have right now, it
    is really a marriage made in hell. You have a situation in
    which nobody believes in the ratings, and at the same time, the
    ratings are part of the regulatory framework. So nobody
    believes in these. Still, you have played by the rules.
        Now, I cannot tell you how critical that is because the
    situation right now is that the securitization market is
    paralyzed, the ABC commercial paper market is more or less
    paralyzed, or it is a shadow of what it used to be. It is about
    one-third of the size. And that has significant effects on the
    fixed-income market.
        There is a perception--and I am going to stop here--that
    this market is not regulated. Actually, I would say that this
    is probably the most regulated market in the world. It is just
    that it is regulated by the rating agencies, and it did not
    work out that well.
        So I think I am going to stop here, and then I am going to
    be happy to answer any questions that you might have. Thank you
    very much.
        Senator Levin. Thank you very much, Dr. Cifuentes.
        What we will do is have 20-minute rounds. We can have more
    than one round if we need them.
        If you all would take a look in the exhibit book at Exhibit
    94b,\1\ this is a CDO known as Vertical ABS CDO 2007-1. S&P
    analysts in 2007 complained about how the Vertical's issuer,
    UBS, was not cooperating with them, and the deal was unlikely
    to perform. In a 2007 email, the one that you are looking at
    there, Exhibit 94b, one analyst for S&P wrote, ``Vertical is
    politically closely tied to B of A--and is mostly a marketing
    shop--helping to take risk off books of BoA. Don't see why we
    have to tolerate lack of cooperation. Deals likely not to
    perform.''
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        \1\ See Exhibit No. 94b, which appears in the Appendix on page 599.
    ---------------------------------------------------------------------------
        Now, despite that judgment that the CDO was unlikely to
    perform, S&P rated it. Several months after that deal was
    rated, the loans began to show delinquencies, and a little
    later on, S&P and Moody's downgraded it. Those securities, by
    the way, are now below investment grade. They are in junk
    status.
        One of the purchasers of the Vertical securities is a hedge
    fund called Pursuit Partners. They sued S&P, Moody's, and UBS
    over the quick demise of the security. As I mentioned before,
    S&P and Moody's annuities were dropped from the lawsuit because
    of the lack of the ability under our current law to sue the
    rating agencies. But the court ordered UBS to set aside some
    funds to pay a possible award to that investor.
        Now, the investor had also uncovered an internal email at
    UBS in which a banker wrote, ``Sold some more crap to
    Pursuit,'' referring to the Vertical securities which were then
    rated as investment grade. That is Exhibit 94n,\2\ by the way.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 94n, which appears in the Appendix on page 644.
    ---------------------------------------------------------------------------
        So, first, Mr. Raiter, let me ask you: Is it common for an
    S&P analyst to rate a deal even though the analyst thought, as
    we looked at Exhibit 94b, that the deal was ``not likely to
    perform''?
        Mr. Raiter. Senator, I have to say that I was not in CDOs
    and really do not know how they did things down there. On the
    residential side, at the time that I was involved, it was not
    unusual to turn down deals if we did not think they were going
    to perform or if they did not meet our criteria. But as I think
    as has been pointed out in your opening statements, things got
    dramatically more haywire after 2004 and 2005. But I honestly
    could not tell you what they did in CDOs.
        Senator Levin. All right. But where you worked, if
    something was expected not to perform, you would not be rating
    it, I assume, as being expected to perform?
        Mr. Raiter. No, sir, we would not. As I say, there were
    occasions where we had some real concerns about collateral, and
    we just would put such high levels on the transaction, it was
    not economic for them to do it and we would not rate it. In the
    late 1990s, Prudential Mortgage changed their waterfall
    structure, which did not meet our criteria, and for a number of
    years we would not rate any of their deals because they did not
    meet the standards that we had set.
        Senator Levin. OK. Now, Mr. Kolchinsky, you have had years
    of experience, I think, with CDOs. Should a CDO which is
    expected not to perform be given a AAA rating?
        Mr. Kolchinsky. Absolutely not. If the analyst was
    convinced that the deal would not perform, that deal should not
    be rated.
        Senator Levin. Take a look, if you would, Mr. Kolchinsky,
    at Exhibit 94e.\1\ Exhibit 94e shows that some of the assets
    that were included in the CDO had already been downgraded at
    the time that they were included. Do you see that downgrade?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 94e, which appears in the Appendix on page 614.
    ---------------------------------------------------------------------------
        Mr. Kolchinsky. Yes, I do.
        Senator Levin. Both on pages 1 and 2. A lot more, actually,
    on page 2 than there was on page 1. But, anyway, there are a
    lot of those that had already been downgraded at the time they
    were included so they were not performing as expected.
        Now, if a downgraded asset is included in a CDO, is that
    something that an analyst would note?
        Mr. Kolchinsky. We had rules that if an asset was on watch,
    it would be taken down a few notches. Once an asset was
    downgraded, under these rules it would be used at that rating
    and no more or no less unless it was on watch.
        Senator Levin. And would that be a warning sign about the
    quality of the assets in the CDO?
        Mr. Kolchinsky. It would have been a qualitative warning.
    Quantitatively, I do not think that left an analyst, under the
    then prevailing rules, much room because at that point the RMBS
    Group has said this is our new view and this is our best view.
        Senator Levin. And should it affect the credit analysis?
        Mr. Kolchinsky. Oh, absolutely. With hindsight, I think
    this is something I tried to do later as we saw that once you
    take the path down to downgrade, that is not likely to stop.
    And so securities, we try to implement something where the
    securities that have been downgraded already but not currently
    on watch be stressed more severely.
        Senator Levin. It should affect the analysis, as you
    indicate, but it did not affect the analysis here. The S&P
    analyst there, Mr. Halprin, said in his email that Bank of
    America was using the CDO to take risk off its books. Now,
    Vertical is a company that was partly owned by Bank of America
    and was run by several former Bank of America employees. And if
    an analyst thinks that what is going on with a CDO is taking
    bad assets off a company's books, should that affect the rating
    process?
        Mr. Kolchinsky. I think so.
        Senator Levin. Now let me ask all the panelists, how long
    is it expected that a AAA rating should hold?
        Mr. Raiter. It should hold for the life of the transaction
    and the life of the tranche, as you pointed out, Senator. The
    waterfall typically pays the higher-rated bonds off first, and
    as they pay down, then the bonds that are underneath it start
    receiving the flows. But it should last the life of the
    transaction, for mortgage-backed, 7 or 8 years.
        Senator Levin. Would you all agree with that?
        Mr. Kolchinsky. Yes.
        Mr. Michalek. I wouldn't.
        Senator Levin. So, in this case, these ratings were
    downgraded within a year and are now below investment grade.
    These are junk.
        Mr. Michalek. Senator, if I could respond.
        Senator Levin. Mr. Michalek, I am sorry. You did not agree.
        Mr. Michalek. No, I did not.
        I think that we are touching on something that you are
    likely to hear later in the day, that, in fact, the common
    perception of what a AAA rating is and means is not necessarily
    what the definition of a AAA rating is. This is something of a
    legal distinction, but at the same time, I think it is very
    important that this is not lost on the Subcommittee.
        In fact, there is published by Moody's the migration rates
    and history of the different ratings that are assigned, and
    those migration rates represent an average migration for a
    particular rating. But it is simply an average from a
    population of which there are tails at either end. Some AAAs
    never get downgraded, and there are others that are downgraded,
    unfortunately, quite quickly. And I do think that there is an
    expectation in the market and there is a proper expectation
    that AAAs are not going to be issued on Monday and on Friday
    downgraded to anything else.
        That debate as to whether or not there should be or is a
    necessary element of stability in the rating, at least at
    Moody's, was one that was ongoing.
        Senator Levin. OK, thank you. Let us take a look at another
    failed rating, this time involving mortgages issued by Fremont.
    Take a look at Exhibit 93b.\1\ In January 2007, S&P was asked
    to rate an RMBS with subprime loans issued by Fremont
    Investment, a subprime lender known for poor-quality loans. At
    that time an S&P ratings analyst sent an email to a supervisor
    saying the following: ``I have a Goldman deal with subprime
    Fremont collateral. Since Fremont collateral has been
    performing not so good, is there anything special I should be
    aware of?''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 93b, which appears in the Appendix on page 589.
    ---------------------------------------------------------------------------
        Now, one of the supervisor's response was, ``No, we don't
    treat their collateral any differently.'' And the other one
    wrote back, in Exhibit 93c,\1\ that as long as we had current
    FICO scores for the borrowers, the analyst was ``good to go.''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 93c, which appears in the Appendix on page 590.
    ---------------------------------------------------------------------------
        So we got S&P employees now that know there is a problem
    with Fremont loans, but treated those loans like any other.
        In Exhibit 93d,\2\ there is an email in which S&P analysts
    were circulating an article about--and this is January 29--how
    Fremont had stopped using 8,000 brokers because of loans with
    high delinquency--with some of the highest delinquency rates in
    the industry coming from those brokers.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 93d, which appears in the Appendix on page 592.
    ---------------------------------------------------------------------------
        Now, in March, a couple months later, Fremont announced in
    an 8-K filing that the court of appeals had found sufficient
    evidence in a lawsuit filed by the California Insurance
    Commissioner that the company, among other things, was
    ``marketing and extending adjustable-rate mortgage products to
    subprime borrowers in an unsafe and unsound manner that greatly
    increases the risk that borrowers will default on the loans or
    otherwise cause losses.'' And the suit then could proceed
    against the company. Just a few days later, Fremont entered
    into a publicly available cease-and-desist order with the FDIC
    regarding fraud and lax underwriting standards.
        Despite that information, Fremont RMBS securities were
    rated by both S&P and Moody's in late February and early March.
    Before the ratings were done, they knew of those facts which I
    just described. By the end of the year in 2007, both companies
    began substantially downgrading the Fremont RMBS securities.
        Does either S&P or Moody's take into account an issuer's
    reputation for issuing either good loans or bad loans and
    incorporate that into their credit analyst? Mr. Raiter.
        Mr. Raiter. The answer is yes, they do. At the time that
    this occurred, the policy had been in the past that when
    information was provided to the analytical staff by investors
    or other originators, they would look into the matter, and if,
    in fact, it was justified, it would have resulted in a visit to
    them and a review of their practices and procedures. It could
    ultimately have resulted in their deals being put on Credit
    Watch or, in fact, being held up for ratings until the
    information could be worked out.
        At this time, in fairness to what was going on, there were
    rumors rampant about the quality of appraisals and the quality
    of underwriting standards that could have been quite
    overwhelming for the staff to try and track them down. But it
    routinely would have been investigated----
        Senator Levin. Should have been.
        Mr. Raiter [continuing]. And factored in. It should have
    been.
        Senator Levin. It should have been. So when the analyst
    said no special measures with Fremont, that was not what was
    supposed to happen.
        Mr. Raiter. It was the manager's responsibility to say this
    is a problem, we are going to get to the bottom of it, because
    the analysts took their marching orders from the managers that
    were in control of the criteria and the process.
        Senator Levin. So, again, when they said in that email no
    special measures, there should have been special measures
    taken?
        Mr. Raiter. There should have been, yes, sir.
        Senator Levin. Mr. Michalek.
        Mr. Michalek. I do not know if I feel competent to comment
    too much on how the RMBS team would have responded to those
    particular allegations. I know that with respect to collateral
    managers, and at the CDO level, if there was an issue that was
    raised regarding the reliability of the origination that the
    collateral manager was involved with, we might explore it and
    would definitely send a team to the collateral manager to do
    what we call an ops review to evaluate those procedures. The
    information that was obtained from those reviews would be used
    in our analysis in rating the transaction. But as to the
    underlying collateral, I am not competent to comment on.
        Senator Levin. OK. Mr. Kolchinsky, should there have been
    measures taken in those circumstances?
        Mr. Kolchinsky. I think so. As Mr. Michalek said, I am not
    competent on what occurred in the RMBS group, but had this
    information come on the CDO side, we certainly would have
    looked into it, or should have looked into it.
        I would also say I was not involved in 2007, as this
    information went through with the folks who rated subprime
    directly. But there was almost a feeling when dealing with them
    that there was a ``see no evil, hear no evil'' sort of
    attitude, and partly I think it is because people who had done
    these deals, rated these deals, did not want to believe what
    was going on, partly profit motivated, partly because they were
    part of this market, and it just should not be happening.
        Senator Levin. Part of that culture.
        Mr. Kolchinsky. Part of that culture. Closed eyes.
        Senator Levin. Dr. Cifuentes.
        Mr. Cifuentes. I can comment on what happened at the CDO
    group when I worked at Moody's. On many occasions, for example,
    we were presented with transactions that either did not make
    any sense or that had a particular peculiarity that made us
    nervous. The response was either no, you cannot do that, or the
    rating is going to be very low. It is not going to be a AAA; it
    is going to be way below. Or we took into consideration when
    analyzing the transaction or when modeling all the
    peculiarities that were applicable to that particular
    transaction. So that is the way it was done at the CDO group. I
    did not work mortgages, but----
        Senator Levin. When you were there, that is the way it was
    handled?
        Mr. Cifuentes. Yes. I remember many situations, as I said,
    in which we encountered a transaction, for example, that was
    done for the first time. We did not have enough data, for
    instance, so we had to make conservative estimates about
    certain things, and that is the way we did it.
        Senator Levin. And that is the way you believe it should
    have been done?
        Mr. Cifuentes. I believe so, because I can give you an
    example. For example, at Moody's I rated the first emerging
    market CDO that was done. That was in 1996, and we rated
    emerging market CDOs probably between 10 and 15 deals in that
    time frame. One of the problems with emerging markets was we
    did not have enough data. So the way we handled that--we were
    conscious of that--we made conservative assumptions regarding
    certain pieces of information that we did not have, and we did
    something--at the risk of sounding too technical, but I think
    you are talking about a trillion dollar problem, you better get
    the technical thing right. So we did something called stability
    analysis to see how the impact of uncertainty in the data would
    affect the ratings, and I have to say that all those emerging
    market deals did very well, actually.
        Senator Levin. Take a look at 93a.\1\ This says volumes
    about Fremont and what was known. This is a Moody's email,
    December 2006. They were talking about delinquency rates for
    issuers. If you look at page 2, ``Here is a chart of the top 10
    issuers'' that have high delinquency rates, and then on the
    bottom of the next email, it says, ``Holy cow - is this data
    correct? I just graphed it and Fremont is such an outlier!!''
    In other words, they are one of the worst when it comes to
    delinquency rates. More evidence about Fremont, by the way,
    about as bad as it gets. They had those articles about the
    8,000 brokers and the other information that I mentioned.
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        \1\ See Exhibit No. 93a, which appears in the Appendix on page 587.
    ---------------------------------------------------------------------------
        But just in terms of the deals, I wanted to talk about an
    email, Exhibit 95a.\2\ This was an email from July 2007, in
    which an investment banker described a deal called Delphinus.
    This was rated AAA by both S&P and Moody's. Exhibit 95a
    described Delphinus as having a lot of cushion, they needed a
    lot of cushion to protect against losses. Despite that cushion,
    by the way, Delphinus was downgraded 6 months after being
    rated. That may not be Monday to Friday, Mr. Michalek, but it
    is not the way it is supposed to be, right?
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        \2\ See Exhibit No. 95a, which appears in the Appendix on page 646.
    ---------------------------------------------------------------------------
        Mr. Michalek. That is correct. It is not.
        Senator Levin. Now look at Exhibit 95b.\3\ This is an S&P
    email chain from August 2007. An S&P analyst wrote here
    regarding Delphinus, ``[I]t appears that the closing date
    portfolio they gave us for analysis and the effective date
    portfolio . . . were not the same. It appears the 25ish
    assets''--and we are looking at, again, Exhibit 95b--``that
    they included in our closing date portfolio that were dummies
    were replaced in less than 24 hours with assets that would have
    been notched and made the portfolio worse.''
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        \3\ See Exhibit No. 95b, which appears in the Appendix on page 647.
    ---------------------------------------------------------------------------
        Now, if I read this right, the CDO had given S&P dummy
    assets that S&P used to come up with its rating, and then at
    the last minute replaced those dummies with new assets less
    than 24 hours before the closing, and the new assets, if I read
    this correctly, made the portfolio worse. And if that had been
    acted on, the rating would have been worse
        Mr. Raiter, is that a correct reading of that email, would
    you say, the way you read it, too?
        Mr. Raiter. These are relating to CDO analyses, and CDO,
    and it suggests that they pulled--they put dummy deals in the
    original run, and then they substituted them with loans or CDO
    credits that did not meet the standards that the original run
    was completing, or completed on or contemplated, and it looks
    like a bait and switch and that it did not meet the criteria.
    But I do not know who addressed it because if I follow the
    email stream, they were waiting for a manager to get back to
    them.
        Senator Levin. Yes. I tell you, these emails are, I think,
    just devastating as to the kind of culture that was going on
    here. It is incredible that you could have this kind of dummy
    assets being put into a CDO, then substituted at the last
    minute with even poorer assets.
        Mr. Raiter. Well, I would like to point out, if I could,
    Senator, there were a lot of very good analysts that were
    writing these memos and asking for guidance, and the guidance
    was not forthcoming from the top.
        Senator Levin. I could not agree with you more. But that is
    the culture that existed here, and I am going to now turn this
    over to Senator Kaufman.
        Senator Kaufman. Thank you, Mr. Chairman.
        To follow up on that question, in your opening remarks, you
    attributed this to bad incentives, which clearly has gone on,
    the incentives were wrong, quality was gone, quantity,
    competition. Mr. Raiter, you mentioned the SEC oversight. How
    much of this was just outright fraud? I understand this about
    the business, and I am going to get into this a little bit. But
    it seems to me the things that were going on here, because of
    the incentives, because of the lack of oversight, people were
    actually doing stuff that they knew absolutely totally was
    wrong. Mr. Raiter.
        Mr. Raiter. Well, it is clear from a lot of these emails
    people were making very poor calls in terms of the analytics.
    But whether that is fraud or not, it was wrong, it did not look
    good. They certainly would not want it to have the headline
    risk in the Wall Street Journal. But there was no one over
    there watching over them to tell them this is not the right
    thing to do.
        Senator Kaufman. No. I understand that, and I am very
    sympathetic to that. And if you heard any of the speeches I
    have given on the floor, I pretty much beat up on the
    regulators for what they did not do. But I spent a lot of time
    in business. I worked for corporations. There were always
    incentives of some kind to make the quarterly earnings, push
    the stuff out the door, do the rest of it. But when you have
    the incredible amount of--the chart that he put up there on the
    number of RMBSs that were rated AAA and ended up turning to
    junk, many of them you were going after. And maybe ``fraud'' is
    too strong a word, but things that just are not common business
    practice no matter what the incentives are, no matter whether
    you are being regulated or not.
        Mr. Raiter. Well, they were not good business practices,
    and it is my opinion that there was a huge disconnect between
    management. Senior management thought that they were
    responsible for all these wonderful things and that the
    analysts were just the soldiers in the trenches doing what they
    were told.
        Senator Kaufman. You talked about a disconnect, and I want
    to get into it, between the people doing the rating and the
    surveillance. But talk a little bit about--I have been in
    organizations, not just government organizations, private--
    where there is a disconnect, but a disconnect that this is a
    pretty incredible disconnect if you keep turning out products,
    and Mr. Michalek, I will get to the idea of what AAA really
    means or not. But you are turning out product because of the
    incentives, because of the regulators, because of the
    disconnect between management, all those things happen. But you
    are turning out product that is just really not good product,
    and how much of it is because of the emails, as Senator Levin
    said, where people just said, OK, and because of incentives,
    because of regulators, I am going to do something here and try
    to rearrange this thing.
        Mr. Raiter. Senator, if you have been in business, the
    choices that you face in a dilemma like this is you can quit.
        Senator Kaufman. Right.
        Mr. Raiter. If you have a family to support, that might be
    a little bit tenuous. And some of us chose to do just that. I
    retired because I got tired of the frustration. But a lot of
    the analysts that left tried to fight the good fight. Many of
    them have subsequently been laid off.
        Senator Kaufman. Right.
        Mr. Raiter. And when you bang your head against the
    management wall and ask for the money and give them
    presentations and show them the benefits of the higher-quality
    rating criteria and they come back and say, ``But revenues will
    go down,'' you are faced with just that choice. Either you
    continue to work there and fight, or you quit.
        Senator Kaufman. I am very sensitive to this, and I
    understand this. I have been there. But how much do you think
    the management really knew what was going on down in the
    trenches because of the pressures they were putting on the
    people down there in the trenches? Do you think they were
    oblivious to this, that they----
        Mr. Raiter. You have Kathleen Corbet, the former President,
    on the docket for the third panel.
        Senator Kaufman. Right.
        Mr. Raiter. She could possibly shed some light. Budgeting
    and the whole process of making requests and sending them up
    the line was a mystery. We never sat down and were explained
    why we did not get things, why they would not make the changes
    recommended. They just did not respond. They did not
    communicate down, from the top down.
        Senator Kaufman. Right. Mr. Michalek.
        Mr. Michalek. I can tell you at Moody's, while I was there,
    it was frequently the case that in a particularly sensitive
    issue, the information did travel upward. I was involved in one
    transaction where I was asked to consult with somebody in
    Public Finance. They had a ratings problem that was leading to
    litigation. And the general counsel for Moody's was at the
    table. We were on conference calls together. We were talking to
    the client. We were trying to resolve this.
        Brian Clarkson--at the time, I think he was president of
    Moody's Investors Service--was on the call, and this was for a
    relatively small matter. In terms of the total amount of
    issuance, it was probably a quarter of a billion dollars [$250
    million]. It was not as large as one of our CDOs.
        So from that alone, I would infer that the information
    regarding some of the much larger conflicts and potential
    problems was definitely reaching upwards.
        Senator Kaufman. Mr. Kolchinsky.
        Mr. Kolchinsky. Thank you. First, before I answer your
    question, I want to quickly come to the defense of the analyst
    mentioned in Exhibit 95a.\1\ In fact, that analyst that was
    mentioned was extremely bright and the reason that she was not
    wanted on that deal is because she asked a lot of very good
    questions. I wanted to come to her defense.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 95a, which appears in the Appendix on page 657.
    ---------------------------------------------------------------------------
        Senator Kaufman. Sure. No problem.
        Mr. Kolchinsky. Second of all, I do not believe in the
    cause of the crisis there was a lot of instances of outright
    fraud, legal fraud. There may have been some on the front end
    with the mortgage brokers in filing applications that were
    clearly fraudulent. But the way the system worked, you had a
    chain--it was almost like a game of telephone where you pass
    some information down the line, and everybody changes it just a
    little bit--not enough to jump over the fraud, but because the
    length of the chain from the mortgage broker to the originator
    to the aggregator to the CDO, by the time everybody takes a
    little cut, changes it a little bit, by the time you got to the
    end of the line, the information or the product was garbage. So
    that is why you have not seen a lot of cases of outright fraud
    because everybody pushed the envelope, clearly pushed the
    envelope. But because of everybody pushing the envelope, the
    end product was garbage.
        Senator Kaufman. Yes, but, I can see that in 1 day, I can
    see it 2 days, I can see it 5 days, I can see it a month, I can
    see it 2 months, I can see it 3 months. I just find it--these
    are very smart people. I mean, when you look and see you are in
    the middle of a chain and you see what is happening, at some
    point you say, there is something really going on here. And
    maybe it is nonfeasance. It is not malfeasance. They are not
    doing it to be bad. They just do not go back and look to find
    out what they do not want to know, what actually happened.
        Mr. Kolchinsky. I think that is right. Yes, sir, I think if
    you were going to sort of talk about sins, it is sins of
    omission because of the market, because of the incentives.
    There was really no incentive to look, to look under the rocks.
    If the rocks kind of looked polished and nice, OK, we will pass
    it on.
        Senator Kaufman. This is the third hearing we have had, and
    this is kind of a common theme. No one knew what was happening.
    It just rings to me of other cases where no one knew what was
    happening. But people knew--these are not really dumb people.
    These are not people that just come in to work, sit in their
    cubicle, look at what they are doing, they are not reading the
    newspaper, they are not picking up the Wall Street Journal or
    Barron's and reading about what is going on with the housing
    market or mortgage-backed securities or any of this kind of
    stuff. They are just coming to work, doing their job, getting
    pushed, and have these incentives. As Mr. Raiter said, good
    people. And they are stuck. And I do not think it is the good
    people, frankly, in my experience, like the analyst you
    mentioned, that were the problem. I think this is a systemic
    problem here that was not--we talk about it in kind of surgical
    terms, like incentives and regulation and all that stuff, which
    are all absolutely totally on the mark. It was the incentives,
    and it was the regulatory environment, and it was a flawed
    business strategy, and it was competition, and it was quality
    over quantity.
        When you put all those things down, somebody in the middle
    of this thing would have to be totally, completely--they had to
    put together the big picture. Somebody had to say, look, we are
    putting incentives on here, we got this quantity problem, we
    got the competition problem, we are not having very much
    regulation and oversight. There is a potential here for
    something really bad to happen.
        Mr. Cifuentes.
        Mr. Cifuentes. I think you bring up a good point, Senator.
    In fact, you referred to your experience in the private sector.
    The thing to keep in mind here is that this is a very peculiar
    sector in the private market. I mean, to be perfectly blunt, if
    you are in the private business and you do a lot of things
    wrong, eventually you go out of business. I mean, that might be
    evident. Arthur Andersen does not exist anymore, for example.
        In the rating business, because of some really flawed
    regulatory framework, there is no penalty for giving bad
    ratings. In fact, we are having this conversation 2 years after
    my first--and the rating agencies, they keep issuing ratings
    and they keep collecting fees for that.
        So, in my opinion, one of the problems is the regulatory
    framework. Today the barriers to entry into the credit rating
    business are tremendous. There was a law that was passed by
    Congress, the Rating Agency Act. If you want to start a new
    rating agency, you have to show that you have been in operation
    for 3 years giving ratings and collecting fees. Now, who is
    going to pay you for a 3-year period to give ratings that do
    not have any validity?
        So, in my opinion, that is something that needs to be
    changed because one of the problems we have right now, there is
    no penalty for getting out ratings that are unreliable. I mean,
    basically the rating agencies were giving a free gift, and you
    cannot blame them for that. I mean, they are taking advantage
    of a very unique opportunity to bring money in.
        Senator Kaufman. Mr. Michalek, I think you have got at the
    other key point in this whole discussion, especially on the
    hearing today, and that is that you want to make sure that the
    Subcommittee understands what AAA really means.
        Mr. Michalek. Correct.
        Senator Kaufman. And I think there is such an incredible
    disparity between what everyone reads AAA to be and what AAA
    means.
        Mr. Michalek. To the rating agencies, in the disclosure
    documents, I think there is a disparity--Senator Levin used the
    term ``safe,'' and I do not think that ``safe'' is correct, as
    a description--it is definitely the commonly understood
    adjective that you would use, but to be perfectly honest, I can
    think of an illustrating example--when this first debate first
    came up, there was a transaction that I was working on with an
    analyst that there was problematic--because of the particular
    assets that were in the pool--and they were not yet placed on
    negative Credit Watch, so quantitatively we could not take the
    haircut that we knew was going to be coming. And through some
    other measures, we were able to anticipate that there was going
    to be a likelihood that this would not hold its rating for a
    very long period of time.
        However, on the closing date, it did meet the published
    criteria. It did reach that particular quantitative number, and
    we could not say no--this was sort of at the beginning of the
    cultural change. We could not say it is a ``different'' AAA.
        Senator Kaufman. And, by the way, I am very sensitive to
    that. It is hard to give ratings to agencies. It is hard to
    figure out what is going to happen. And in cases like that, if
    what transpired after that had not happened, I would be sitting
    here as the most sympathetic man in the room to what you are
    saying.
        The question is at some point it went from that--which was
    a tough decision. And when you talk to the rating agencies or
    listen to what the rating agencies say, they still think it is
    like that. You just do not understand. We have these very
    difficult questions that we have to deal with. So AAA does not
    mean that it is going to be here forever, and AAA does not mean
    this and AAA does not mean that.
        Yes, AAA does not mean thousands of securities that are
    rated AAA that 2 years later are junk. So this is not a
    discussion--we are not having the first discussion, the
    discussion that I always learned about in business school, and
    also about what rating agencies are. I know what rating
    agencies are. And that is what they used to be. But when you
    are faced with a situation where because, again--because of not
    regulating the rating--so what is it that rating agencies are?
    AAA does not mean AAA. It does not mean AAA based on your very
    good definition of what it used to be. But AAA does not mean
    the same. So how do you deal with this, the fact that you had
    this systemic--is it fair to say a systemic problem?
        Mr. Michalek. I think so.
        Senator Kaufman. And how do you get at that so that
    specific problem--and we are going to have all kinds of new
    problems. We do it around here all the time. But how do you
    deal with that systemic problem?
        Mr. Michalek. In my opinion, I think that we would really
    have to begin with what we are disclosing. I personally believe
    that there are products that deserve a commonly understood
    rating, that the public can say this is safe, because the
    rating is saying that it is safe. And I think that for a large
    number of the highly complex structured products, it is a
    different ball game. And I think that to the extent that you
    are able to distinguish between those products that are clearly
    in the different ball game, then the caveat of buyer beware is
    more appropriately applied. But for that portion of the
    products that I think the enormous public good that comes from
    having an independent arbiter of risk apply a commonly
    understood and accepted measure of that risk, I think that is
    something that we should seek to preserve, and so that it would
    eliminate that bleed, if you will, from the extreme debate or
    debatable conversation that goes on with respect to the highly
    complex products, into what really should be beyond debate with
    respect to what is safe and what is definitely contributing to
    the public good.
        Senator Kaufman. And do you think you could do that? I
    mean, realizing that there would be some securities in the
    middle that would be--but having the idea that for what is
    commonly known as AAA corporate bonds you have one thing; for
    credit default swap you have something different.
        Mr. Michalek. I think that it would require an impetus from
    outside. Clearly, the rating agencies do not, as it has already
    been demonstrated, have an internal incentive given the way
    that they are structured to pursue market share and to pursue
    profits, to install that kind of change, at least not to be the
    first one to install that kind of change.
        I had the somewhat naive idea when I joined Moody's that
    there was a particular quality that Moody's was offering, and
    that was something that the company was going to seek to defend
    over time, and that effectively our brand meant something, and
    that I expected people to step in much earlier to say we are
    diluting our brand. And if we had this 96 or 98 percent market
    share, once our brand becomes absolutely equivalent to the
    other three, mathematically we are not going to stay there.
        Senator Kaufman. Mr. Michalek, you have just defined this
    whole thing. I mean, in my opinion, everybody just decided to
    go for the fastest possible money they could ever possibly make
    and not worry about the brand and not worry about anything. I
    think it goes to the whole thing where we--and we did not have
    this, as Mr. Raiter pointed out, and the big thing that was
    missing was the referees on the field. We just pulled the
    referees off the field not just in the rating agencies but with
    everybody else, and we said we do not need referees anymore.
    And I think just like in football, or here or anywhere else,
    just like why we need police on the beat, not because people
    are crooks, but because police should be on the beat because
    potentially they will become crooks if, in fact, the
    temptations are so great.
        Mr. Raiter, how do you think we deal with problems going
    down the road in terms of rating?
        Mr. Raiter. Well, I think you have to have some rules.
    Actually, you have to have some penalties for not doing the
    right thing, and there are none, and there are no measures of
    whether you are doing the right thing.
        Senator Kaufman. What would you define as not doing the
    right thing, for instance?
        Mr. Raiter. Well, I would say if you have developed a model
    in the house that shows that it is much better than anything
    you are running and it shows that you have been too optimistic
    with the ratings you have assigned, and you do not immediately
    start to use it and go back and re-rate the old deals so you
    can warn the investors that we have been wrong, then that is
    not doing the right thing. And I will point out from a cultural
    perspective, there were two mantras that we heard at Standard &
    Poor's all the time after I joined, and I am sure they went on
    before that. One was a AAA is a AAA is a AAA, and it did not
    matter if it was a corporate, a municipal, or the new
    structured products. And they used the transition studies to
    prove that by saying, look, here is the transition of a AAA
    corporate, what is the probability it might be downgraded? What
    is the probability it might go from AAA to default, as in Penn
    Central? There had never been a AAA mortgage-backed that had
    gone to default from AAA until this latest debacle. In the
    transition of AAA mortgage-backed's compared to AAA corporates,
    it was much better. All right? So AAAs were all the same.
        The other thing that was heard constantly--and it was in
    one of these emails--if we change, everybody will think that we
    have been wrong. And that just put a real anchor on any new
    ideas quickly going through the process because they were
    afraid somebody would suggest that they had not been right
    before and they would have liability or they would lose some
    market share. That was not doing the right thing, and they do
    not have a referee or anyone to tell them when they have
    crossed that line.
        Senator Kaufman. Well, the other thing is, look,
    everybody--there is not a single thing that has been raised
    here this morning in terms of what the behavior was. As an
    elected official, you hate to change your position on anything
    because it admits that you did something wrong. I mean,
    everybody does--these are all common things. I think the fact
    that there are no penalties is key, and I would like to get at
    least a little bit of questions in the second round about
    grandfathering, and exactly what you said, why there was not
    more grandfathering with all the witnesses.
        So with that, I yield to the Chairman.
        Senator Levin. There is always going to be a debate on how
    to cure a system, but we know there are a lot of things that
    should not have happened that did happen, and we are going to
    debate those cures as to what the remedies are legislatively in
    the week coming up.
        But I want to go back to some of the things that it is
    pretty obvious to me were wrong, wrong at the time, and as
    complex as some of the remedies are, some of these issues are
    not complex at all. Market share should not be driving ratings.
    Would you all agree with that?
        [Witnesses nodding affirmatively.]
        Senator Levin. Let us take a look at what drove the ratings
    here. Let us look at some more evidence. Exhibit 5, an email
    dated March 23, 2005, between S&P employees that I think you
    worked with, Mr. Raiter. Here is Exhibit 5.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        ``When we first reviewed 6.0 results `a year ago' we saw
    the sub-prime and Alt-A numbers going up and that was a major
    point of contention which led to all the model tweaking we've
    done since. Version 6.0 could've been released months ago and
    resources assigned elsewhere if we didn't have to massage the
    sub-prime and Alt-A numbers to preserve market share.''
        Should those numbers be massaged to preserve market share?
    Does anyone believe that? Mr. Raiter.
        Mr. Raiter. No, sir. They should not have been massaged. I
    think I stated earlier that as the models were developed by our
    consultant and they were tested in-house to verify that they
    were accurate and that their predictiveness was an improvement
    over the model that was currently running, the models were
    immediately put into force. We ran out of financing and funding
    in our budgets in 2003 to put this Version 6.0 model in place.
    But the preliminary analysis, as Dr. Frank Parisi suggested,
    was that we were not adequately rating the transactions. That
    model was delivered I believe in September 2006. They did an
    accuracy evaluation. It was determined to be accurate, better
    than what they were running, and the consultant was paid. But
    they also performed what was called an impact analysis on the
    ratings. We had never done that before, so I do not know where
    the order came to start doing impact analysis on the
    effectiveness new models had on market share. But it is
    apparent that is what happened.
        Senator Levin. And what was your reaction when you read
    that email?
        Mr. Raiter. I was pretty amazed. I mean, Frank Parisi was
    one of the Ph.D.s that worked on these models. He is very
    knowledgeable. He is one of the best analysts they have and
    very outspoken.
        Senator Levin. Were you bothered by it?
        Mr. Raiter. Certainly.
        Senator Levin. Mr. Michalek, should market share be
    preserved by massaging numbers?
        Mr. Michalek. No.
        Senator Levin. Is it troubling when you see that kind of an
    email?
        Mr. Michalek. It is troubling in the sense that it is one
    more piece of evidence of what I was observing while I was at
    Moody's. One of the comments that might be somewhat
    illustrative of this is when I had some discussions with Brian
    Clarkson about the process, his perspective was, yes, we could
    effectively produce perfect ratings, but we would not be on the
    deals. And if we are not on the deals, then we are not able to
    add any value whatsoever. So in some sense, it is like, yes, we
    take a little bit of this poison, but we are going to save the
    patient because you have the opportunity to get in there and
    fight the good fight.
        Senator Levin. Right, and make profit.
        Mr. Michalek. He did not mention that.
        Senator Levin. He may not have mentioned it, but
    obviously----
        Mr. Michalek. It was definitely a part of that. It was
    clearly--I mean, this was in the context of a discussion where
    my job was on the line, and it had already been said earlier in
    the conversation that if you are difficult in the transactions,
    there is no choice but to replace you.
        Senator Levin. That is pretty devastating, I tell you. Mr.
    Kolchinsky, what is your reaction to this kind of an email
    here?
        Mr. Kolchinsky. It is very disturbing, and as the folks on
    this panel said, this is something we witnessed. Market share
    did drive the credit analysis, and I think that is why I was
    also let go from the rating agency.
        Senator Levin. Because you objected to it being the driver?
        Mr. Kolchinsky. I objected to it being the driver. I went
    ahead and tried to prevent us from what I believed was
    committing securities fraud.
        Senator Levin. Dr. Cifuentes, what is your reaction when
    you see an email like this?
        Mr. Cifuentes. Well, I do not think I have a lot of
    original thoughts to add after what my colleagues have said,
    but it is kind of obvious. It is really a little bit troubling.
        Senator Levin. Take a look, if you would, at Exhibit
    24a.\1\ Mr. Kolchinsky, by October 2007, Moody's had downgraded
    hundreds of RMBS securities, and was in the process of
    downgrading billions of dollars of CDOs. Yuri Yoshizawa wrote
    to you, ``Can you take a look at the deals that we didn't rate
    from the spreadsheet that Ivy sent out last night to double
    check the information and to let me know of any of the
    `stories'?''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24a, which appears in the Appendix on page 318.
    ---------------------------------------------------------------------------
        And an earlier email in that chain says, ``Market share by
    deal count dropped to 94 percent. . . . It's lower than the
    98+% in prior quarters.''
        Is this something you got frequently, this kind of
    reference to market share, up, down, as being a driver?
        Mr. Kolchinsky. Yes, sir. These emails were sent out, the
    market share emails were sent out at least quarterly, but
    occasionally on a monthly basis. They were sent out to just the
    managing directors in a given group.
        Senator Levin. I will tell you something. For a firm that
    is supposed to have a reputation of high quality right in the
    middle of a financial crisis to be looking at the market share
    issue instead of whether their ratings are decent and whether
    or not what happened, how could our ratings have been so wrong,
    how do we improve it. What is on their mind: Market share,
    market share, market share.
        Mr. Kolchinsky and Mr. Michalek, let me ask, at Moody's did
    employees understand that the amount of market share that was
    maintained or increased by the RMBS and CDO groups influence
    the size of the employee year-end bonus?
        Mr. Kolchinsky. It was certainly the case in terms of the
    revenues impacted the stock, and most employees owned either a
    lot of options or restricted stock in the company, as well as
    the profitability of the group did influence the size of the
    bonus, yes.
        Mr. Michalek. It was even more pointed than that. I think
    that we underwent a revision in the compensation structure--I
    am not going to be able to remember exactly the date; I think
    it was in 2006--where a larger percentage of our compensation
    was going to be delivered in terms of deferred compensation. So
    it became more important to see that what we were looking at
    was whether or not we were reaching our revenue numbers on a
    quarterly and annual basis which would allow us to, ``maximize
    our--or max out our bonuses.''
        Senator Levin. And that meant that the ratings that you
    would give or not give to the banks could affect your bonuses?
        Mr. Michalek. Could affect your bonus. Clearly, if for any
    reason you were stopping a deal or delaying a deal or creating
    an issue with the relationship between the banker and Moody's,
    that was a problem.
        Senator Levin. And this is the fundamental conflict of
    interest that we need to do something about in the legislation.
    Would you agree, Mr. Kolchinsky?
        Mr. Kolchinsky. Yes, sir. that is correct.
        Senator Levin. Mr. Michalek, would you agree?
        Mr. Michalek. Absolutely.
        Senator Levin. Mr. Raiter, would you agree with that?
        Mr. Raiter. Yes, sir.
        Senator Levin. Dr. Cifuentes.
        Mr. Cifuentes. Yes, I do.
        Senator Levin. And it is legislation which is hopefully
    going to be allowed to be debated. We will find that out Monday
    night. But this is an issue which is not in the bill yet, and
    it has to be somehow or other put in that bill. There has got
    to be a way that the regulators are going to find to eliminate
    this conflict of interest. It is shocking that whether or not
    something is rated AAA or whatever--and that means something to
    people. I mean, it may mean too much to some people, by the
    way. It may mean more than technically it should mean. But it
    means a great deal, and legally means probably too much in
    terms of where some entities are allowed to invest or not
    invest. But that fact of life, it should not be dependent
    upon--the credit rating; it should not determine a bonus of
    somebody who is giving the rating. It is so clear, it is so
    obvious, there is such a fundamental conflict here to me. Your
    testimony is going to be very helpful to us in hopefully
    getting rid of that conflict and directing the regulators in
    whatever the new regulatory regime is to end that conflict of
    interest. It goes right to the heart of a rating, which is
    supposed to be an honest, objective, independent assessment of
    the likelihood of an investment paying off. And it is not
    performing that function when you have this kind of pressure on
    people to rate a certain way in terms of their own pay.
        Now, we had a situation, Mr. Raiter, I believe when you
    were head of RMBS, when you helped develop a model that was
    used to rate the RMBS securities. Then there was a period where
    S&P was doing very well in terms of revenue, and you asked
    senior management to buy mortgage data on the new types of
    mortgages so that you could improve that model. Is that
    correct?
        Mr. Raiter. Yes, sir.
        Senator Levin. And did you get the money?
        Mr. Raiter. No, sir, not while I was there.
        Senator Levin. OK. So this was supposed to keep models
    current and to do surveillance, so-called. Is that correct?
        Mr. Raiter. Well, predominantly to build models, but to be
    made available for surveillance at the loan level detail.
        Senator Levin. All right. Do you know why S&P did not spend
    the money on better analytics?
        Mr. Raiter. No, sir, I do not.
        Senator Levin. Now, there are also some things that should
    not happen regardless of the complexity of how you design a
    better system. There are some things, it seems to me, that are
    clearly wrong that happened and should not happen.
        In the subprime loan deals, a number of loans in which
    borrowers paid a low initial rate, sometimes interest-only
    payments, and then after a specified number of months or years,
    switched to a higher floating rate that was often linked to an
    index. Did you have any data at the time as to how those
    subprime loans would perform? Mr. Raiter, did you have data?
        Mr. Raiter. The model that is referenced in a number of
    these exhibits that we have looked at, the Version 6.0 was the
    first data set that we had that had a significant amount of
    information on those hybrid pay option type of loans. And it
    was the analysis of those loans that suggested that we were
    underenhancing or being overly optimistic and was the primary
    reason for trying to push that model into production as soon as
    possible in 2004 or at the most 2005.
        Senator Levin. Because you were trying to test as to
    whether or not that kind of a product would increase the risk
    of nonpayment. Is that correct?
        Mr. Raiter. Well, the products started to appear in 2003,
    but in very small numbers, and by 2004, when we built this
    database, we had more significant information on those types of
    products that indicated that what we thought--how we thought
    they were going to behave in the initial versions were--it was
    behaving worse than that, and we needed to get the new model in
    place because it had more data and gave us a better look at how
    these things might perform.
        Senator Levin. Was there a delay in putting that new model
    in place?
        Mr. Raiter. Well, we had some preliminary results in early
    2004. I left in April 2005, and I believe the model was
    delivered in September 2006. And I do not know if it was ever
    implemented.
        Senator Levin. All right. Now, some of the subprime loans
    also used stated income loans in which the lender just accepted
    a borrower's oral presentation of his income and did not verify
    it. In your judgments, would that make loans riskier to have
    unverified income in these loan applications?
        Mr. Raiter. Yes, sir, they were considered riskier.
        Senator Levin. All right. Would you all agree with that, it
    would be riskier if there was no verification of income?
        Mr. Michalek. Absolutely.
        Senator Levin. OK. Mr. Kolchinsky.
        Mr. Kolchinsky. Yes.
        Senator Levin. Would you agree with that, Dr. Cifuentes?
        Mr. Cifuentes. Yes. Actually, the real point is what you do
    about that. I mean, if you know it is riskier, you take
    precautions and you do your analysis with much more
    conservative assumptions. That is really to me the bottom line.
        Senator Levin. All right. Mr. Raiter, going back to you
    again, you had insufficient data to predict how a new loan
    would perform. Was there something assigned called a magic
    number?
        Mr. Raiter. When we could not get the data in order to do a
    full analysis on a major revision to the model, they would come
    up with a multiplier that could be applied to the model results
    that were being run, which were inadequate in order to beef
    that number up. And it was always intended that those magic
    numbers would be replaced with full-blown analytics when the
    data came in. And it is my understanding that there were some
    magic numbers installed in early 2005, when they made
    adjustments to the existing model, and if they were massaging
    information on the 6.0 model when it came out, it would
    typically be in the form of these multipliers that they would
    use.
        Senator Levin. Was there a fee charged for surveillance?
        Mr. Raiter. Yes, sir. Surveillance was a profit center.
        Senator Levin. And there was a fee, perhaps a large amount,
    that was supposed to last for the life of the security. Is that
    correct? Were surveillance fees smaller than the initial rating
    fees?
        Mr. Raiter. Yes, very much smaller.
        Senator Levin. But they were supposed to pay for ongoing
    ratings and re-ratings, were they not?
        Mr. Raiter. Right, the ongoing review of the rating.
        Senator Levin. Let me ask you, Mr. Cifuentes, perhaps. If a
    ratings model changes its assumptions or criteria, for
    instance, if it becomes materially more conservative, how
    important is it that the credit rating agency use the new
    assumptions or criteria to re-test or re-evaluate securities
    that are under surveillance?
        Mr. Cifuentes. Well, it is very important for two reasons:
    Because if you do not do that, you are basically creating two
    classes of securities, a low class and an upper class, and that
    creates a discrepancy in the market. At the same time, you are
    not being fair because you are giving an inflated rating then
    to a security or you are not communicating to the market that
    the ratings given before were of a different class. So I think
    the right thing to do is to analyze or actually re-analyze all
    the transactions with the new parameters.
        There is no revenue involved in that, as you probably
    suspect.
        Senator Levin. Mr. Raiter, were there discussions within
    S&P about using rating models to conduct surveillance?
        Mr. Raiter. Yes there were.
        Senator Levin. And were those discussions heated at times?
    Were there disagreements over that?
        Mr. Raiter. Yes, there were disagreements. Yes, sir.
        Senator Levin. What was the argument about?
        Mr. Raiter. Well, there was a certain number of analysts on
    our side that thought that it would make a lot of sense to
    protect the investors, go back and look at exactly how these
    deals were performing with new criteria and with the marks that
    were available in the model to mark the properties when the
    prices went down or up. And there was the other side of the
    argument that it would increase ratings volatility which might
    make us look bad in the eyes of the investor and could cost us
    market share.
        Senator Levin. So the market share was a factor there as
    well as to whether or not you would use the new available
    information to re-rate the existing securities?
        Mr. Raiter. Yes, sir.
        Senator Levin. Mr. Michalek, was there a restricted list
    for rating analysts at Moody's who were prohibited from working
    with certain banks?
        Mr. Michalek. I do not know if there was such a list.
        Senator Levin. Were you on a restricted list where you
    could not work for Goldman or Credit Suisse?
        Mr. Michalek. There were quite a number of banks that had
    previously requested that I not be assigned to their
    transactions.
        Senator Levin. And they were complaining about you?
        Mr. Michalek. There was a variety of complaints, that I
    would be either too aggressive, too abrasive, or that I was
    asking for things that were not being asked for by other
    analysts in the transactions.
        Senator Levin. Was that in your mind because at least in
    some of the cases you were asking too many questions which
    would negatively affect the rating?
        Mr. Michalek. Absolutely. It was a case that I attempted to
    provide the same analysis to every transaction that came into
    my view, and, unfortunately, we were not facing the same set of
    bankers on the other side of the phone.
        Senator Levin. Let me just ask a couple questions quickly
    about synthetic CDOs. There was a huge increase in those. I
    think everyone knows the numbers or at least knows of the large
    numbers that were being rated. Did those synthetics cause any
    problems for credit rating agencies? Mr. Kolchinsky.
        Mr. Kolchinsky. Yes, sir. The synthetics, the key element
    of synthetics is their complexity as well as their flexibility.
        Senator Levin. And were they being used to short the market
    a lot?
        Mr. Kolchinsky. From news reports I understand yes.
        Senator Levin. And if they were being used to short the
    market, would that be saying something about the quality of the
    reference to the assets? Logically, would it be saying
    something about the assets being referenced?
        Mr. Kolchinsky. I think if you hear all the stories of
    folks shorting not just a few securities but in size and
    massively, I think they obviously had a view that these
    securities were not that good and the whole market was going to
    collapse.
        Senator Levin. And is it correct that you supervised the
    staff at Moody's that rated the transaction known as Abacus?
        Mr. Kolchinsky. That is correct. That was under my business
    line. I think you are referring to the ABACUS AC1.
        Senator Levin. That is correct.
        Mr. Kolchinsky. In the 2007-AC1. That was under me. I
    staffed the transaction. I was not involved in it day to day.
        Senator Levin. Were you aware that the bank that presented
    the deal to Moody's was Goldman Sachs?
        Mr. Kolchinsky. I was.
        Senator Levin. And have you seen reports that the Paulson
    firm shorted the ABACUS transaction using Goldman Sachs as its
    agent?
        Mr. Kolchinsky. I have seen the recent reports on the SEC
    complaint.
        Senator Levin. And have you also seen reports that Paulson
    played a role in selecting referenced assets for the ABACUS CDO
    that he expected to perform poorly?
        Mr. Kolchinsky. I have seen those.
        Senator Levin. And were you or your staff aware at the time
    that Moody's was working on the ABACUS rating that Paulson was
    shorting the assets in ABACUS and playing a role in selecting
    referenced assets expected to perform poorly?
        Mr. Kolchinsky. I did not know, and I suspect, I am fairly
    sure, that my staff did not know either.
        Senator Levin. And are these facts that you or your staff
    would have wanted to know before rating ABACUS?
        Mr. Kolchinsky. From my personal perspective, it is
    something that I would have wanted to know, because it is more
    of a qualitative not a quantitative assessment if someone who
    intends the deal to blow up is picking the portfolio. But, yes,
    that is something that I would have personally wanted to know.
    It changes the incentives in the structure.
        Senator Levin. Are people usually putting deals together
    that want the deal to succeed? Isn't that the usual assumption?
        Mr. Kolchinsky. That is the basic assumption, yes.
        Senator Levin. And if the person wanting the deal to blow
    up is picking the assets, that would run counter to what the
    usual assumption is?
        Mr. Kolchinsky. It just changes the whole dynamic of the
    structure where the person who is putting it together, choosing
    it, wants it to blow up.
        Senator Levin. Well, I could not agree with you more.
    Senator Kaufman.
        Senator Kaufman. Thank you. I would just like to touch on a
    few things here. Grandfathering. What are the factors in
    deciding whether you grandfather or not, Mr. Raiter?
        Mr. Raiter. Can you define the term ``grandfather''?
        Senator Kaufman. In other words, finding out--going back
    and you look at securities, things you have already rated, and
    deciding whether you are going to apply a grandfather to that.
        Mr. Raiter. Well, you do not grandfather them. They do get
    surveilled. There are just different levels of criteria that
    you can apply in taking a look at how a deal is performing. One
    way is to look at the pool level and decide that we are just
    going to track the delinquencies, the foreclosures, and the
    losses. Another way is to use the loan level on the
    transaction. If you can get updated loan level files, then you
    can basically re-rate the transaction based on today's
    economics, today's house prices, and changes in the credit
    quality of the borrowers and get a better look at how it would
    perform today if you were going through the process.
        Those two different ways to surveil can produce
    dramatically different results.
        Senator Kaufman. Mr. Michalek, after you changed the model
    that you were using, you decided whether to go back and use the
    new model to older loans, is that correct?
        Mr. Michalek. Again, I think this is outside of my
    expertise.
        Senator Kaufman. OK. Mr. Kolchinsky.
        Mr. Kolchinsky. In the CDO world, a lot of times deals that
    were out there and closed ended up being grandfathered. For
    some practical purposes, some of the models that the deals
    used, for example, a diversity score model or a CDO model which
    were provided by Moody's were almost baked into the deal. And
    as a result, when that model changed--and that model had
    actually a positive effect in terms of for the deal's
    compliance--a positive meaning that there is a direct line that
    you have to comply with this test. There was no way for us to
    say now you have to stop using that old model, use the new
    model. We could have applied the new model on the portfolio. We
    had the portfolio. But that step was not taken. Usually we let
    deals who used old models continue using those models.
        Senator Kaufman. Mr. Cifuentes.
        Mr. Cifuentes. I left Moody's in 1999.
        Senator Kaufman. OK.
        Mr. Cifuentes. But we did not really have that issue. At
    that time the market was really very small compared to what it
    is today.
        Senator Kaufman. Mr. Raiter, did you have an indication
    that stated income loans were being used in any of the
    instruments that you were dealing with?
        Mr. Raiter. Yes. stated income loans were there. They were
    known as ``liar loans,'' ``NINAs.'' When they started using the
    stated income loan concept in the late 1990s, it was applied to
    the highest credit borrowers--doctors, lawyers, self-employed
    people. As they started developing in the subprime arena,
    again, you started out with the top of the subprime market with
    the initial loans that were coming into the bonds.
        By 2004 and 2005, with the new hybrids and the stated
    numbers, you were stepping down to much lower FICO scores, much
    lower credit quality of the borrower, and there was evidence
    starting to bubble up that brokers were impacting the way
    stated income was put on the various applications, that there
    were questions about appraisals, whether they were accurate or
    not.
        So when they first started out with the no-income, low-doc
    kind of loans, we did have modeled in the ratings process
    higher credit enhancements for those loans, and as we tried to
    collect data on the new products that were developing and how
    they performed or were expected to perform, we were factoring
    that into the models. And, again, I hate to beat a dead horse,
    but we had a 2.8 million loan set that was used to build the
    Version 6.0 of the model, and at that time it had the most
    information we had collected on the hybrid loans. And the next
    data set that we were trying to collect had almost 10 million
    loans in it, and it was even more powerful.
        Senator Kaufman. Right.
        Mr. Raiter. So we were always looking forward to getting
    that additional information to make a better judgment as to how
    things were performing without waiting for those portfolios to
    start going bad.
        Senator Kaufman. Do you think the decision not to move with
    the more advanced models was a financial decision, or do you
    think it was a decision made with the fact that it was going to
    make things more difficult to give higher ratings and,
    therefore, be not as competitive?
        Mr. Raiter. I think the initial decisions not to fund it
    were because of resource constraints and the desire to maintain
    higher profits. I think the decisions that were made when it
    was finally developed and available for implementation would
    indicate whether they were starting to take a more serious look
    at what the impact on market and profitability was than just
    the analytics. I was gone by then.
        Senator Kaufman. Mr. Michalek.
        Mr. Michalek. Senator, I wanted to just bring to the
    attention of the Subcommittee that what you are in part drawing
    out is an extreme reliance on modeling and on the quantitative
    analysis that was going on. To the extent that you had a stated
    income loan or a NINJA loan, effectively it was simply another
    data input for which you could make some assumptions.
        So there was necessarily a stepping back on some level, in
    my mind, of the qualitative analysis of what was going on down
    below, and instead you were saying, ``Can we model it? Yes. Do
    we need to adjust our assumptions? Perhaps.'' And the debate
    would then be around: Is this the correct adjustment to the
    assumption?
        Senator Kaufman. Right. But at some point, if, as Mr.
    Raiter said, it starts out being a very small problem at the
    very top for people with high income and now it is getting
    wider and wider and wider use, because I can understand,
    modeling works great because those stated income loans, from
    everything I gather, when they first started, high income, they
    had very few defaults. But it was clear to everyone that early
    on, Mr. Raiter, when you were still there, stated income loans
    were becoming a larger and larger part of the portfolio.
        Mr. Raiter. Well, they were growing, but in 2004 and early
    2005, they had not reached the numbers that were on your slide.
    And, again, we had a data set that told us that we needed to
    increase the numbers in our model, and the fact that it did not
    get implemented in a timely manner, those increases were just
    postponed.
        Senator Kaufman. Right.
        Mr. Raiter. But the other side of it is, in all candor--and
    I do not want to get into an analytical debate. But when you
    have pools coming in with 1,000 to 10,000 loans, each one with
    about 85 to 100 data points, it is difficult to have an
    individual sit there and look at a printout and come up with
    some qualitative decision on what is a five-basis-points
    difference in enhancement at the AAA. You cannot do these
    products without models. And if there is an area that you might
    address, the Fair Credit Reporting Act prevents the rating
    agencies from getting the kind of in-depth information on
    borrowers that would help them gauge the credit performance
    expectations.
        Senator Kaufman. Right.
        Mr. Raiter. It is post the loan being made, so it is not
    going to be a disparate impact on----
        Senator Kaufman. Good point.
        Mr. Raiter [continuing]. People trying to get a loan, but
    it gives the credit rating agencies that additional amount of
    information to help them track and determine how they will
    behave. We did not get the income. We had to back into the
    income numbers with the ratios they gave us for the mortgage in
    the front and back end, because we were not allowed to collect
    it.
        So there were some issues there with just the information
    being made available that would take us out of the box.
        Senator Kaufman. Mr. Kolchinsky----
        Mr. Cifuentes. If I could add something----
        Senator Kaufman. Yes.
        Mr. Cifuentes. For example, in that situation, clearly you
    receive 10,000 loans, there is no way you can examine each one
    of those, and I would not expect a rating agency or anybody to
    do that. However, having said that, if a banker comes to you
    and he tells you, look, I have 10,000 loans, these are the
    characteristics of the loans, one reasonable thing you can do
    is you take a random sample, see if what you find agrees with
    what the banker tells you, and that gives you an idea. We did
    that many times when I was there at the CDO Group, not in the
    context of mortgages but in the context of different things. So
    that would be a way to handle the situation.
        Senator Kaufman. Mr. Kolchinsky.
        Mr. Kolchinsky. On this issue, I am actually more in Mr.
    Michalek's camp because I believe models are important and you
    cannot do these without models. But models are--you need a
    human being to have a quality judgment of what the results are
    and what the input is into a model.
        A financial model is like a weapon. You really have to--it
    could be useful if you are holding it, not so useful if it is
    being pointed at you. And my experience has been once the model
    is out there, once it has been published, bankers, originators
    understand how to game that model.
        Senator Kaufman. Exactly.
        Mr. Kolchinsky. And they will--anecdotally, I understand
    there is some good data on some of these no-income loans
    because most of the early borrowers, the loan officer knew the
    borrower, was driving around--was the plumber who worked off
    the books, had that information. But to extend that information
    to the whole universe of borrowers is maybe statistically
    workable, but does not make sense. And that is where you need a
    sort of qualitative judgment--I know why this was happening,
    but the model does not make sense to me anymore.
        Senator Kaufman. And I think one of the classic examples--
    anybody who has read Michael Lewis' ``The Big Short''--was
    barbelling. Are you familiar with barbelling?
        Mr. Kolchinsky. Yes. It is layering of poor assets with
    good assets in the same portfolio.
        Senator Kaufman. And isn't it almost a perfect example of
    what you were just saying, where people now begin to game the
    model? They are not trying to figure out what the best product
    is. They are trying to put together a product that meets with
    the model.
        Mr. Kolchinsky. One of the lessons learned for me
    personally is that averages lie. So if you have a model rolling
    by an average, it is not telling you all the information.
        Senator Kaufman. Mr. Michalek, do you have any comments on
    barbelling?
        Mr. Michalek. It was an early example of how we had to
    respond in what became an aggressively or an increasingly
    aggressive game of cat and mouse, that effectively once we had
    published some criteria and this was the established
    requirement, we would quickly see that here was a set of
    reactions--here was a portfolio that presented some compliant
    averages, as Eric was referring to. And so then there was our
    response to that, in which case that generated yet another
    response to that. And so it goes.
        Senator Kaufman. Mr. Raiter, was barbelling a problem when
    you were still----
        Mr. Raiter. I think it may have been raising its head, but
    you can fight the concept of barbelling only by maintaining the
    models as accurately and based on the most amount of data you
    can get. And that just requires that--frankly, as the market
    exploded and the new products arrived, we really should have
    been looking at coming out with new models every 6 months, a
    year at the worst. Anybody is going to try and game it, and the
    only way you can avoid gaming is to keep improving it and
    changing it so you capture the nuances that allowed the gaming.
        Senator Kaufman. Did you have any indication management was
    concerned about this? This has come up as another one of the
    problems, just this massive flood of new business. I mean,
    business just exploded based on the chart we saw earlier, and
    it is a little like having a restaurant and tripling the number
    of people eating there without keeping the same kitchen. Did
    you see any indication by management they were concerned about
    the fact that we were not doing these new models, we were
    getting a massive influx of new business, this could be a real
    problem?
        Mr. Raiter. No, we did not get any indication that it
    really bothered them because they were turning us down for
    staff, they were turning us down for the resources we needed.
    And what they were looking at was you must not have been
    working very hard because your volume has doubled and nobody is
    quitting, so I guess you had slack down there.
        Senator Kaufman. Right.
        Mr. Raiter. And they were just enjoying the revenue, and by
    2005, when I left, we were getting calls from corporate
    monthly: How much money are you going to make this month?
    Structured was driving the whole ratings business, and RMBS was
    the fastest-growing unit.
        Senator Kaufman. Mr. Michalek, it was 2005 when Mr. Raiter
    left. I think by 2007, 2008, people must have been getting--
    there must have been some understanding by the management that
    this was not all going well.
        Mr. Michalek. Absolutely. There had to be.
        Senator Kaufman. Did you ever see any indication of that?
        Mr. Michalek. Certainly one good example would be in the
    effort to try to catch up, it was clear that from 2004 on, we
    were playing a game of catch-up in terms of staffing, in terms
    of systems. We were trying to transfer a lot of the input for
    our monitoring process to sources offshore to try to speed up
    the quantity that was being driven through. We were working on
    developing a model for doing the monitoring. But effectively
    all of the resources were being directed backward trying to fix
    what was acknowledged to be broken as opposed to trying to get
    ahead of what was coming. All the energy that was directed
    forward effectively was how do we survive this onslaught of
    work.
        Senator Kaufman. Did you ever philosophize about what they
    were thinking in management? Clearly, the brand was not doing
    well. You could see an erosion of the quality.
        Mr. Michalek. Sure. I think that it was common to
    commiserate, particularly amongst the rear guard, those that
    had been there longer, and the culture changed the most
    dramatically, that the place is not what it once was, I do not
    know what they are thinking. Personally I was anticipating a
    steady erosion until there was just a pure equivocation between
    the rating agencies. So it was a matter of just throwing a
    three-sided dice and you would pick that rating agency, it did
    not matter anymore.
        It was disappointing, but for those that did want to try to
    continue to pursue the good fight, if you will, I think we did
    our best under the circumstances.
        Senator Kaufman. Mr. Kolchinsky.
        Mr. Kolchinsky. I think the drive for market share was
    front and center, and any other resources did not really matter
    as much, and the focus was how much revenue we made.
        Senator Kaufman. I got that. Did you have any indication
    that management was aware of the fact that the incentives--all
    the things we talked about, the lack of regulation, the
    incentives, market share, profit, that they realized that there
    was an erosion of the product and that this was not a good
    long-term strategy?
        Mr. Kolchinsky. I do not know. They must have understood
    that this is not something that could continue, but I am not
    sure if they did or not.
        Senator Kaufman. All right. Mr. Cifuentes, from your
    vantage point far away from this, how did it look to you?
        Mr. Cifuentes. Well, my view here is a little bit from an
    outsider because, as I said, I left in 1999.
        Senator Kaufman. Right.
        Mr. Cifuentes. But being in the market until recently--to
    some extent I am still in the market--I know this--and I could
    not claim that I was the only person who did--a few funny
    things going on regarding the rating assumptions and the models
    at both Moody's and S&P.
        For example, I remember I gave a talk at the CDO conference
    at the end of 2006, and I made the point that there were many
    changes to many things--default probabilities, correlations,
    things that might sound too technical here. But the speed of
    the change was a little bit suspicious. There were some changes
    at that time to something called correlation, which would
    probably do not have the time to discuss what it means here,
    but basically it amounted to a relaxation of the standards.
        So anyone looking at the rules of the game from the outside
    would have noticed that certain assumptions that were being
    made in the past, now they were a little bit relaxed, and
    certain transactions that were receiving AAA ratings probably,
    with just a quick back-of-the-envelope calculation, you could
    come to the conclusion that they were probably not.
        Senator Kaufman. I am just going to end my questions now.
    Just anybody--we have been here for a while talking about this.
    Is there anything you can say to kind of sum up what you think
    went on during this period?
        Mr. Cifuentes. Thank you, Senator. I would like to add a
    brief point here, if I may, because I think it is relevant. It
    might sound like a too academic or subtle point, but I think it
    is very profound, because the problem that we have here, I
    believe, is a little bit more serious than what we think it is.
        We have been talking here about AAA, BBB, and the rating
    agencies clearly were given the right to determine whether
    something is AAA or BBB or whatever. Fine. But there is another
    level of complexity here. Congress has given the rating
    agencies also the right to define what AAA means, or BBB for
    that matter. So, in effect, Congress has given the rating
    agencies the right to legislate, and this is a little bit crazy
    because let me give you an example, and I think I am going to
    finish my statement here. But I think sometimes an example is a
    little bit more clear than a lengthy explanation.
        Suppose you pass a law stating that, say, in Washington,
    DC, you cannot build a tall building, but you forget to define
    what ``tall'' means. And now there is a private company that
    will decide what ``tall building'' means. So that company might
    decide that it is a five-story building. Next year they might
    change, and it is a ten-story building. So that remains
    undefined.
        So that is the situation we have right now. Nobody knows
    what BBB means. The only thing that is known is that, for
    example, if you are a particular company, you cannot buy
    anything with a rating below BBB. If you are a pension fund and
    you buy a BBB asset and it is downgraded, you might be forced
    to sell. But who knew what BBB means? Well, it does not really
    matter because the rating agencies not only determine whether
    something is BBB, but they can change the definition of what
    BBB means. And I think that is a very extraordinary state of
    affairs. I mean, it is really--it is very screwed up at a very
    fundamental level.
        Senator Kaufman. Because essentially the ratings are used
    by the regulatory agencies to make decisions and, therefore,
    you are right, I mean, I never thought of it that way, but
    essentially the rating agencies are determining on their own--
    --
        Mr. Cifuentes. Exactly.
        Senator Kaufman [continuing]. What these ratings actually
    are, and then the ratings are used----
        Mr. Cifuentes. Legislating all the time.
        Senator Kaufman. Right. Thank you very much, Mr. Chairman.
        Senator Levin. I just have a couple more questions for this
    panel. Did investment bankers apply pressure in connection with
    rating analysts during the rating process? We have already seen
    some evidence of pressure, but in terms of, for instance,
    getting deals done quickly, increasing size of the tranches to
    make additional money, were those kind of pressures put on the
    analysts during the rating process? Mr. Kolchinsky.
        Mr. Kolchinsky. Yes, all the time.
        Senator Levin. Mr. Michalek.
        Mr. Michalek. It was part of the daily workload.
        Senator Levin. Mr. Raiter.
        Mr. Raiter. Well, it was not particularly prominent in
    residential because our model was distributed. Everybody got
    the same answer. We could not have Bear Stearns run a deal and
    bring it in and get a structure and have Goldman bring the deal
    in and get something else. People would say, ``Well, how did
    they get a different transaction?'' So we were somewhat
    insulated.
        Senator Levin. In your particular area.
        Mr. Raiter. In this particular area, yes, sir.
        Senator Levin. And in terms of that kind of pressure that
    you felt, let me ask you, Mr. Kolchinsky. Did you ever hear the
    phrase IBG-YBG?
        Mr. Kolchinsky. Not until today, sir.
        Senator Levin. Mr. Michalek, did you ever hear of that?
        Mr. Michalek. That was quoted to me.
        Senator Levin. When you worked there?
        Mr. Michalek. I was working on a transaction, and I think
    it was--well, the name of the bank is not relevant. It was a
    large bulge bracket bank.
        Senator Levin. It was a large?
        Mr. Michalek. Bulge bracket bank.
        Senator Levin. What does that mean?
        Mr. Michalek. A bulge bracket bank is describing one of the
    largest banks that has a large balance sheet.
        Senator Levin. All right. What bank is that?
        Mr. Michalek. I think it was Deutsche Bank.
        Senator Levin. OK. And then, what does it mean?
        Mr. Michalek. IBG-YBG was explained to me to mean, ``I'll
    be gone, you'll be gone. So why are you making life difficult
    right now over this particular comment?'' Effectively--I mean,
    he said it laughingly as if you are losing perspective here.
        Senator Levin. Did it mean to you that basically you ought
    to think short term because everybody would be gone before the
    chickens came home to roost?
        Mr. Michalek. When it was originally told to me, I did not
    realize how that thinking really was driving much of what was
    going on, actually.
        Senator Levin. Short-term thinking.
        Mr. Michalek. Short term, get this deal done, get this
    quarter closed, get this bonus booked, because I do not know
    whether or not my group is going to be here at the end of next
    quarter, so I have to think of this next bonus.
        Senator Levin. Who basically did your agency think was the
    client? Was it the investment banker or was it the investor?
    Mr. Kolchinsky.
        Mr. Kolchinsky. It was the banker. The bankers were
    typically referred to as clients. If an investor called, they
    would be clients, but they never did. It was just simply the
    bankers, and they were the clients.
        Senator Levin. Do you have any more?
        Senator Kaufman. No.
        Senator Levin. Thank you. You have been very helpful, all
    of you. Some of you have come a long distance. We greatly
    appreciate it.
        Mr. Kolchinsky. Thank you.
        Mr. Cifuentes. Thank you.
        Senator Levin. We will now move to our second panel of
    witnesses: Susan Barnes, currently Managing Director for
    Mortgage-Backed Securities and former North American Practice
    Leader of Residential Mortgage-Backed Securities at Standard &
    Poor's; Yuri Yoshizawa, Group Managing Director for Structured
    Finance at Moody's Investors Service; and, finally, Peter
    D'Erchia, currently a Managing Director of U.S. Public Finance
    and former Global Practice Leader of Surveillance at Standard &
    Poor's. We thank you for being with us today.
        We have a rule here, which I think you are familiar with,
    Rule VI. I believe you were here when I said that it requires
    us to ask all of our witnesses to please stand and be sworn in.
    Raise your right hand, if you would. Do you swear that the
    testimony you are about to give will be the truth, the whole
    truth, and nothing but the truth, so help you, God?
        Ms. Barnes. I do.
        Ms. Yoshizawa. I do.
        Mr. D'Erchia. Yes.
        Senator Levin. Was that a yes?
        Mr. D'Erchia. Yes.
        Senator Levin. The timing system we will be using today,
    again, you may have heard it, but there will be a red light
    that will come on about 5 minutes from after you begin. A
    minute before that light comes on, it will be changing from
    green to yellow, which will give you a chance to conclude your
    remarks. We will print your entire testimony in the record, of
    course. We would ask you to try to limit your oral testimony to
    no more than 5 minutes.
        Ms. Barnes, we will have you go first, and then follow that
    testimony by Ms. Yoshizawa and then Mr. D'Erchia. So, Ms.
    Barnes, please proceed.

       TESTIMONY OF SUSAN BARNES,\1\ CURRENT MANAGING DIRECTOR,
      MORTGAGE-BACKED SECURITIES, FORMER NORTH AMERICAN PRACTICE
      LEADER, RESIDENTIAL MORTGAGE-BACKED SECURITIES, STANDARD &
                                 POOR'S

        Ms. Barnes. Thank you. Mr. Chairman, Members of the
    Subcommittee, good morning. I am Susan Barnes, a Managing
    Director of Standard & Poor's Rating Services. From 2005 to
    2008, I was the North American Practice Leader for Residential
    Mortgage-Backed Securities (RMBS). I have been asked to appear
    today to discuss S&P's ratings for RMBS products.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Ms. Barnes appears in the Appendix on
    page 155.
    ---------------------------------------------------------------------------
        I want to begin by saying that at S&P we have learned hard
    lessons from the difficulties in the subprime residential
    mortgage area. Although the subprime mortgage market improved
    access to credit and homeownership for millions of Americans,
    apparent abuses in that market have had a reverberating impact
    on the economy.
        S&P began downgrading some of its ratings in this area in
    2006 and had warned of deterioration in the subprime sector
    long before that. We were watching this market. But at the end
    of the day, the assumptions and criteria underlying our ratings
    simply did not anticipate the extent of the collapse of the
    housing market, which has been more severe and more precipitous
    than we, along with so many others, had anticipated.
        Although my focus today is on S&P's process for rating RMBS
    securities, it is helpful at the outset to discuss the nature
    of our credit ratings. At their core, S&P's credit ratings
    represent our opinion of the likelihood that a particular
    obligor or financial obligation will timely repay owed
    principal and interest. Ratings do not speak to whether an
    investor should buy, sell, or hold rated securities or whether
    the price of the security is commensurate with its credit risk.
        While evaluating the credit characteristics of the
    underlying mortgage pool is part of our RMBS ratings process,
    S&P does not rate the underlying mortgage loans made to
    borrowers or evaluate or regulate whether making those loans
    was a good idea in the first place.
        Originators make loans and are responsible for verifying
    information provided by borrowers. They also make underwriting
    decisions. In turn, issuers and arrangers of mortgage-backed
    securities bundle those loans, perform due diligence on those
    loans, structure transactions, identify potential buyers, and
    underwrite the securities.
        Our role in the process is to reach an opinion as to the
    ability of the underlying loans to generate sufficient proceeds
    to pay the purchasers of securities issued under stress
    scenarios that correspond to our rating levels. In doing so, we
    rely on the data coming from issuers, arrangers, and servicers
    that other market participants also rely on. For the system to
    function properly, the market must be able to rely on these
    participants to fulfill their roles and obligations, to verify
    and validate information before they pass it on to others,
    including S&P.
        S&P's analysis of an RMBS transaction evaluates the overall
    creditworthiness and expected cash flow of a pool of mortgage
    loans by, among other things, using models that embody and
    reflect our analytic assumptions and criteria. The models apply
    those criteria to particular loan pools using up to 70
    different data points regarding each loan provided by the
    arranger of the securitization. The assumptions and analysis
    embodied in our models are under regular review and are updated
    as appropriate.
        After reviewing the relevant information, the lead analyst
    then presents the transaction to a rating committee. The
    qualitative judgments of the committee members are an integral
    part of the rating process as they provide for consideration of
    asset- and transaction-specific factors, taking into account
    the judgment and experience of the committee members.
        A key component of our analysis is assessing the amount of
    credit enhancement available to support a particular rating--in
    other words, how much cushion there is in a transaction to
    account for potential losses. For example, subprime loans are
    expected to perform worse than prime loans, so a transaction
    backed by subprime loans would have significantly more credit
    enhancement than a similarly rated transaction backed by prime
    loans. Thus, it is not the case that through securitization
    poor credit assets magically become solid investments. Rather,
    the question is what amount of AAA-rated securities can a
    particular pool of collateral support.
        Once a rating is determined by the rating committee, S&P
    notifies the issuers and disseminates the rating to the public.
    Along with the rating, we frequently publish a short narrative
    for information to the public.
        The Subcommittee has asked me to speak to S&P's awareness
    of deteriorating conditions and reports of fraud in the
    subprime mortgage market. S&P was aware of these reports, and
    from 2005 to 2007 S&P consistently informed the market of its
    concerns about the deteriorating credit quality of the RMBS
    transactions as set forth in more detail in my written
    testimony. We also revised our models and took action when we
    believed action was appropriate.
        I thank you for the opportunity to participate in the
    hearing today, and I would be happy to answer any questions you
    have.
        Senator Levin. Thank you very much, Ms. Barnes. Ms.
    Yoshizawa.

       TESTIMONY OF YURI YOSHIZAWA,\1\ GROUP MANAGING DIRECTOR,
             STRUCTURED FINANCE, MOODY'S INVESTORS SERVICE

        Ms. Yoshizawa. Good afternoon, Mr. Chairman and Senator
    Kaufman. I am Yuri Yoshizawa, Senior Managing Director of the
    Derivatives Group at Moody's Investors Service. My group rates
    various types of derivative securities, including
    collateralized debt obligations, better known as CDOs. I would
    like to thank you for the opportunity to provide our views
    today.
    ---------------------------------------------------------------------------
        \1\ The joint prepared statement of Ms. Yoshizawa and Mr. McDaniel
    appears in the Appendix on page 186.
    ---------------------------------------------------------------------------
        Moody's plays an important but narrow role in the
    investment information industry. We offer reasoned,
    independent, forward-looking opinions about credit risk. We
    publish credit rating opinions and credit research about
    entities, including corporations and governments active in the
    debt capital markets globally. Our credit ratings are opinions
    about the future likelihood of full and timely repayment of
    debt obligations, such as notes, bonds, and commercial paper.
        In rating debt securities, regardless of whether the debt
    is issued by a CDO or by a corporation, Moody's analysts follow
    established analytical methodologies and adhere to established
    procedures. I will discuss these as they pertain to CDOs, but
    first I would like to give a brief overview of what CDOs are.
        CDOs have been around since the early 1990s. CDOs cover a
    wide range of instruments and can have in their collateral
    pools various types of assets, including securities issued by
    financial institutions, corporations, and other structured
    finance securities. Additionally, CDOs may either be static or
    managed transactions. In static transactions, the collateral
    pool typically is not subject to change. In managed CDOs, the
    collateral manager can buy and sell assets based on a set of
    covenants spelled out in the CDO's governing documents.
        As with all securities that Moody's rates, our methodology
    for rating CDOs incorporates qualitative and quantitative
    factors. The quantitative factors include the credit risk
    associated with the collateral backing the CDO and its
    structure. Some of the qualitative factors that we also
    typically evaluate include the governing documents of the CDO,
    the collateral manager, and the trustee. The relevance of these
    and other factors will vary depending on the specifics of
    individual transactions.
        Moody's runs its rating process through a committee system;
    that is to say, rating committees decide the ratings rather
    than any one individual. After the analyst obtains relevant
    information from the issuer through meetings and other
    communications, he or she incorporates information from public
    sources as well as Moody's own macroeconomic and sector-
    specific perspective.
        The analyst then formulates a view and presents it to a
    rating committee. Rating committee members are selected based
    on relevant expertise and diversity of opinion. Each member is
    encouraged to express dissenting or controversial views and
    discuss differences in an open and frank manner. Once a full
    discussion takes place, the members then vote, with the most
    senior members voting last so as not to influence the votes of
    the junior members. Each committee member's vote carries equal
    weight, and the majority vote decides the outcome.
        Once a credit rating is published, we monitor the rating on
    an ongoing basis, and we will modify it as appropriate to
    respond to changes in our view of the relative creditworthiness
    of the issuer or obligation.
        One common misperception is that our credit ratings are
    derived solely from the application of a mathematical process
    or model. This is not the case. Models are tools sometimes used
    in the process of assigning ratings, but the credit rating
    process always involves much more--most importantly, the
    exercise of independent judgment by the members of a rating
    committee.
        Our committee system is at the core of everything we do at
    Moody's and is designed to protect the quality, integrity, and
    independence of our ratings. Having said that, we recognize
    that we must continue re-evaluating all of our methodologies
    and processes to determine how they might be enhanced further
    in order to respond to the evolving market.
        Let me make clear we at Moody's are not satisfied with the
    performance of our ratings in RMBS and structured finance CDOs
    over the past several years. In light of the recent crisis, we
    have made a number of enhancements, some of which have been
    highlighted in Moody's written testimony.
        Thank you, and I would be happy to take your questions.
        Senator Levin. Thank you very much, Ms. Yoshizawa. Mr.
    D'Erchia.

    TESTIMONY OF PETER D'ERCHIA,\1\ CURRENT MANAGING DIRECTOR, U.S.
     PUBLIC FINANCE, FORMER GLOBAL PRACTICE LEADER, SURVEILLANCE,
                           STANDARD & POOR'S

        Mr. D'Erchia. Mr. Chairman and Senator Kaufman, good
    afternoon. I am Peter D'Erchia, a Managing Director of Standard
    & Poor's Ratings Services. During 1997 through 2008, I was the
    Global Practice Leader for Structured Finance Surveillance at
    Standard & Poor's.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. D'Erchia appears in the Appendix
    on page 173.
    ---------------------------------------------------------------------------
        As the head of that group, I supervised surveillance for
    five rating and ranking categories: residential mortgage-backed
    securities, RMBS; commercial mortgage-backed securities, CMBS;
    collateralized debt obligations, CDOs; asset-backed securities,
    ABS; and servicer evaluations.
        Each of those groups was headed by a separate manager who
    reported to me as a member of my management team. S&P's
    structured finance surveillance portfolio grew substantially
    during my time as the group's head. Our resources expanded to
    meet this increasing workload, and our growth with respect to
    RMBS in particular outpaced the increase in Standard & Poor's
    monitored transactions. Standard & Poor's RMBS surveillance
    team increased in size by 75 percent from the beginning of 2003
    through 2006. In 2007, responding to the unprecedented
    deterioration in RMBS deal performance, the group's head count
    increased an additional 57 percent.
        In order to understand the context for Standard & Poor's
    surveillance work in 2006 and 2007, it is important to consider
    the basic process behind Standard & Poor's surveillance review.
    After a rating is assigned on an RMBS transaction, a new
    transaction, it is transferred to the Surveillance Group for
    monitoring. Standard & Poor's surveillance analysis takes
    information related to the actual performance of the rated pool
    over time, and it uses that performance data to assess whether
    Standard & Poor's rating remains appropriate in light of our
    evolving view of the deal's current credit support.
        Standard & Poor's surveillance process differs somewhat
    from a new rating review. This difference reflects the
    practical reality of different pre- and post-rating deal
    metrics, but it also serves an important function in providing
    a form of analytical check and balance. Therefore, each deal
    rated by Standard & Poor's is subjected to two analytical
    processes, providing for a more robust analysis than a simple
    reapplication of the same initial method over time.
        As I noted, the volume of RMBS rated transactions under
    surveillance at Standard & Poor's increased throughout the
    years 2003 to 2007. In the past, Standard & Poor's looked for
    at least 12 months of performance data, or seasoning, in this
    analysis and used a variety of internal monitoring tools to
    identify and track individual deals for closer review. In late
    2006, as the performance of recent vintage U.S. RMBS
    transactions experienced broad deterioration out of line with
    our expectations, Standard & Poor's Surveillance Group began a
    process of vintage reviews to prioritize the review of 2005 and
    2006 RMBS transactions and to monitor those entire annual
    vintages on a monthly basis as each month's actual data came
    in.
        Starting in late 2006 and through the first half of 2007,
    delinquency data coming in each month did not resemble anything
    seen before. At that point, however, no significant realized
    losses had been reported for the deals under review. Moreover,
    historically delinquencies did not always lead to losses.
    Accordingly, there was a lot of analyses and debate at Standard
    & Poor's to determine what that data meant.
        As we received more data throughout early 2007, Standard &
    Poor's new issue, surveillance, and criteria personnel all
    worked together to understand what was happening and how to
    respond. During our ongoing analyses in early 2007, Standard &
    Poor's took numerous significant steps to react to the
    deteriorating RMBS performance and to inform the market of our
    analyses. Standard & Poor's recognized the unprecedented nature
    of the early delinquencies occurring in the 2006 vintage, and
    it fundamentally changed its practice in February 2007 to place
    issues on Credit Watch without waiting for losses to develop.
        Standard & Poor's continued to downgrade ratings as
    appropriate on an ongoing basis. By July 2007, Standard &
    Poor's had adapted its methodology sufficiently to issue a
    substantial number of further downgrades. That evolution
    continued after July 2007, resulting in further downgrades as
    the subsequent performance data and criteria warranted.
        Finally, I would like to thank the Members and the staff of
    this Subcommittee for giving me the opportunity to participate
    in this hearing. In my experience at Standard & Poor's, we have
    always been committed to doing the best we can to develop and
    maintain appropriate ratings, and I am proud of the hard work
    that our team put in trying to understand and respond to
    historic market disruption to the best of our abilities. I have
    set forth additional information about my own work and Standard
    & Poor's public discussion of the RMBS market in my written
    statement, and I am happy to answer any questions you may have.
        Senator Levin. Thank you very much, Mr. D'Erchia.
        Let me start with some of the failed deals that we went
    into with the first panel. First, the Vertical deal, if you
    will look at Exhibit 94b.\1\ This is a CDO known as Vertical
    ABS. An S&P analyst in 2007 complained about how Vertical's
    issuer, UBS, was not cooperating with them and how the deal was
    unlikely to perform. And this is what one S&P analyst wrote in
    that 2007 email at the top: ``Vertical is politically closely
    tied to [Bank of America]--and is mostly a marketing shop--
    helping to take risk off books of [Bank of America]. Don't see
    why we have to tolerate lack of cooperation. Deals likely not
    to perform.''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 94b, which appears in the Appendix on page 599.
    ---------------------------------------------------------------------------
        Despite that judgment that it was unlikely to perform, S&P
    rated it--so did Moody's, by the way. Both rated the top three
    tranches as AAA. It defaulted within a few months thereafter.
        Ms. Barnes, S&P's own analysts were uncomfortable with
    rating the deal, yet it was rated. Should it have been rated?
    Should that have been taken into consideration that there was
    no cooperation there?
        Ms. Barnes. Well, I can't speak to this specific example,
    but----
        Senator Levin. But you can speak to the question of whether
    or not if there is a lack of cooperation and a deal is not
    likely to perform, should it be rated?
        Ms. Barnes. Well, I would say the analyst would take that
    into account, and it would be part of their presentation and
    discussion in the rating committee for all of the members to
    consider.
        Senator Levin. But if an analyst concludes, the analyst on
    the deal, that a deal is not likely to perform, should you be
    giving AAA tranches to that deal?
        Ms. Barnes. Right. I guess, Mr. Chairman, what I am trying
    to emphasize is the committee process at Standard & Poor's.
        Senator Levin. I understand.
        Ms. Barnes. No one person determines a rating, so they can
    have an opinion, and you have differing opinions that will come
    to committee.
        Senator Levin. How about if the committee decides the deal
    is not likely to perform?
        Ms. Barnes. If the committee decided that, then it would
    either take action or change the ratings that it would assign
    at that time.
        Senator Levin. All right. And if an analyst says that the
    Bank of America is using the CDO to take the risk off its
    books, should that be a factor? In other words, if the analyst
    thinks that what is going on with the CDO is taking bad assets
    off the company's books, does that affect the rating process?
    Should it affect the rating process?
        Ms. Barnes. Right. I mean, I cannot speak to the aspects of
    a transaction that the CDO criteria considers, but whatever the
    committee thinks is appropriate, and if they think it was
    material from a credit perspective and it could impact the
    performance of the transaction, then I would expect that they
    would consider it, yes.
        Senator Levin. So that it should affect it?
        Ms. Barnes. If they believe that it would affect it, then
    it should be an aspect that they should consider, yes, Mr.
    Chairman.
        Senator Levin. Well, I am asking you not if they think
    something, then something should happen. I am asking you for
    your opinion.
        Ms. Barnes. I would think--yes, I would agree that it would
    be an aspect from a credit perspective.
        Senator Levin. Let me ask you, Ms. Yoshizawa. This is
    Exhibit 94e.\1\ In this 2007 CDO, securities were included that
    had previously been downgraded the year before, so they had not
    been performing as expected. Is that common for a CDO to
    include downgraded assets?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 94e, which appears in the Appendix on page 614.
    ---------------------------------------------------------------------------
        Ms. Yoshizawa. A CDO can include assets that have been
    downgraded in the past, yes.
        Senator Levin. That is common?
        Ms. Yoshizawa. It could be common, yes.
        Senator Levin. Could be common. All right. Take a look, if
    you would, at 93b.\2\ In January 2007, S&P was asked to rate a
    RMBS with subprime loans issued by Fremont. Now, Fremont was a
    subprime lender that was known for poor-quality loans. At that
    time an S&P rating analyst sent an email to his supervisor
    saying, ``I have a Goldman deal with subprime Fremont
    collateral. Since Fremont collateral has been performing not so
    good, is there anything special I should be aware of?'' One
    supervisor said, ``No, we don't treat their collateral any
    differently.'' So that is Exhibit 93b.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 93b, which appears in the Appendix on page 589.
    ---------------------------------------------------------------------------
        The other one wrote in Exhibit 93c \3\ that as long as he
    had current FICO scores for the borrowers, the analyst was
    ``good to go.''
    ---------------------------------------------------------------------------
        \3\ See Exhibit No. 93c, which appears in the Appendix on page 590.
    ---------------------------------------------------------------------------
        Two days later, an article was circulated within S&P noting
    that Fremont was not now using 8,000 brokers, because their
    loans had some of the highest delinquency rates in the
    industry. That is Exhibit 93d.\4\
    ---------------------------------------------------------------------------
        \4\ See Exhibit No. 93d, which appears in the Appendix on page 592.
    ---------------------------------------------------------------------------
        And, by the way, Fremont had also announced in an 8-K
    filing that the California Court of Appeals found that
    marketing and extending adjustable-rate mortgage products to
    subprime borrowers in an unsafe and unsound manner greatly
    increased the risk that borrowers will default on the loans or
    otherwise cause losses. The suit against Fremont was allowed to
    continue. Then there was a cease-and-desist order that Fremont
    entered into with the FDIC regarding fraud and lax underwriting
    standards.
        Now, despite all this information, we have Fremont RMBS
    securities rated by both S&P and Moody's in the spring of 2007.
    Should they have taken those factors into account? Ms. Barnes.
        Ms. Barnes. Well, I would take from this email, Mr.
    Chairman, that they are considering it and discussing it, and
    the analyst is bringing up the points, as we would expect and
    encourage them to do. And the manager is discussing and sharing
    their views that they believe--I guess the criteria at the time
    was appropriate and it should not be modified.
        Senator Levin. Well, that may be what they believed, but I
    am asking you what should be the case. Fremont's collateral has
    been performing ``not so good.'' That does not make any
    difference.
        Ms. Barnes. Right.
        Senator Levin. According to this email, it does not make
    any difference. Should it make a difference?
        Ms. Barnes. Well, Mr. Chairman, I guess when we look at the
    models, as we were discussing on the prior panel, the data that
    is used in those models is used from an array of originators
    and performance and used to establish the expected performance.
        Senator Levin. I am just asking a simple, straightforward
    question. You have an analyst who is saying their collateral
    has been performing not so good. The supervisor says that does
    not make any difference. Should it make a difference?
        Ms. Barnes. Well, I would say it----
        Senator Levin. Do you folks care whether the collateral
    makes a difference?
        Ms. Barnes. Yes, Mr. Chairman, the collateral should make a
    difference.
        Senator Levin. So why does he get an answer back from his
    supervisor saying it does not make a difference?
        Ms. Barnes. Well, again, because it goes in the context of
    what the criteria is including. If you are looking at the
    overall performance of the industry and how far is it
    deviating, what they are reporting back to this analyst is that
    they do not think an outside adjustment or change to the
    assumptions is appropriate at that time.
        Senator Levin. It is not assumptions. It is having to do
    with a deal. I have a Goldman deal with subprime Fremont
    collateral. Fremont is not performing well. There are all kinds
    of problems with Fremont.
        If Fremont does not get a higher credit risk, I am trying
    to figure out who does. I do not understand how you can just
    simply say it does not make any difference. You folks are
    supposed to be assessing credit risks here. Does it not make
    any difference that their collateral is not performing? That is
    what the email says. We do not treat their collateral any
    differently. Shouldn't their collateral be treated differently
    if it is not performing? That is a simple question.
        Ms. Barnes. Well, Mr. Chairman, I guess you mean different
    than the industry standard. If it is performing differently
    than what our models projected for that type of loans, then,
    yes, they should----
        Senator Levin. Is the fact it is not performing well
    relevant?
        Ms. Barnes. It would be relevant to the analysis, but if
    the----
        Senator Levin. It was not relevant to that supervisor.
        Ms. Barnes. I guess you have to look at it, Mr. Chairman,
    in the context of how the assumptions are built, and the
    assumptions are built on an array of data. So it would depend
    how far off and where that performance is expected to perform.
    And just because the performance is poor, it does not mean that
    a deal was underenhanced. We can have poor-quality loans put
    into transactions that have an array of credit enhancement that
    could reflect that poor credit quality. So just because
    delinquencies necessarily are high at that time for that
    particular vintage.
        Senator Levin. It is irrelevant?
        Ms. Barnes. I would not say it was irrelevant. What I would
    say that it was ignored.
        Senator Levin. He was told to ignore it. Ms. Barnes, take a
    look at 93a.\1\ I mean, this is the thing which, it seems to
    me, is going to shake up folks that are listening to this
    testimony as to how much these credit ratings can be relied on.
    Here you have a chart. This is at the top of page 2, 93a. Now,
    this is a Moody's deal, so I am going to ask Moody's as well.
    ``Here is the chart of the top ten issuers'' of high
    delinquencies. It comes back: ``Holy cow--is this data correct?
    I just graphed it and Fremont is such an outlier!!'' In other
    words, they are terrible. Is that relevant?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 93a, which appears in the Appendix on page 587.
    ---------------------------------------------------------------------------
        Ms. Barnes. It is definitely relevant.
        Senator Levin. So why doesn't the supervisor say, ``You are
    damn right it is relevant''?
        Ms. Barnes. Well, I guess I am trying to make a
    differentiating point----
        Senator Levin. You are trying not to answer the question.
    Should the supervisor have said, ``Yes, it is relevant. You
    better dig into this''?
        Ms. Barnes. It should be relevant in looking at the
    collateral characteristics and estimating the performance, yes.
        Senator Levin. Thank you.
        Ms. Yoshizawa, this is Moody's. Should that have been
    relevant? Is that a factor that there are big delinquency folks
    that Fremont is such an outlier, they are one of the worst when
    it comes to delinquency? Is that relevant to your credit rating
    or should it be relevant to your credit rating?
        Ms. Yoshizawa. Well, I am not part of the RMBS group.
        Senator Levin. You are not what?
        Ms. Yoshizawa. I am not responsible for the RMBS area. I
    have not worked in that area. However, my understanding is that
    the originator and servicer and their collateral quality is a
    factor in the analysis, yes.
        Senator Levin. And should be?
        Ms. Yoshizawa. Yes, it should be.
        Senator Levin. I am glad to hear that.
        We took an in-depth look in the early hearings into home
    loans being issued by Washington Mutual, and they were riddled
    with lax lending standards, fraud, borrowers whose income had
    not been verified, appraisal problems, loan errors. They had
    among the worst delinquency rates in the country right there
    along with Fremont.
        It seems to me it is obvious that you ought to distinguish
    between lenders when you do these kind of analyses, and I am
    glad that Moody's does. I do not know if you were at the time.
    But it seems to me that it is so obvious that you should that I
    am just kind of stunned at the reluctance of S&P to just say
    obviously they ought to be a factor. But I think at the end of
    the eighth time I asked the question, I think we got the answer
    that it ought to be a factor.
        Let us take a look at, if you would, Exhibit 95. This is
    Delphinus. I am not sure what the pronunciation is of this.
    Exhibit 95 is a Moody's deal, so I will address this to you,
    Ms. Yoshizawa. This also was rated, then downgraded within 6
    months by both Moody's and S&P. First, in July 2007 it was
    rated, then in January 2008, both of you downgraded it, and it
    became junk status.
        In Exhibit 95a,\1\ an investment banker wrote to a Moody's
    analyst that ``Delphinus was a mezzanine deal with a lot of
    cushion, so we did not really care that much.'' That is July
    2007. Well, that cushion obviously was not big enough.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 95a, which appears in the Appendix on page 646.
    ---------------------------------------------------------------------------
        And then you look at Exhibit 95b,\2\ which is an email in
    August 2007. This is an S&P analyst. He is writing the
    following--or she is writing the following: ``Regarding
    Delphinus, it appears that the closing date portfolio they gave
    us for analysis and the effective date portfolio . . . were not
    the same. It appears that the 25ish assets that they included
    in our closing date portfolio that were dummies were replaced
    in less than 24 hours with assets that would have been notched
    and made the portfolio worse.''
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 95b, which appears in the Appendix on page 647.
    ---------------------------------------------------------------------------
        Why are dummies being used in this way? I think this is
    Exhibit 95b, since this is a Standard & Poor's document, I will
    ask you again, Ms. Barnes. The dummies----
        Ms. Barnes. I am sorry. I cannot speak to the CDO practice.
    I am not in that area.
        Senator Levin. OK. Mr. D'Erchia, do you have an idea about
    the CDO practice?
        Mr. D'Erchia. No. This would be discussing the individuals
    on the new transactions side, and it would----
        Senator Levin. Well, do you know anything about the use of
    these dummies generally? Have you head about that practice,
    substituting assets shortly before the rating comes out? Have
    you heard about that at all? You are not familiar?
        Mr. D'Erchia. I am not familiar with that.
        Senator Levin. Are you familiar with the practice, Ms.
    Barnes?
        Ms. Barnes. Not with respect to CDOs.
        Senator Levin. Do you use dummies in RMBSs?
        Ms. Barnes. Not in this manner, but at times, banks--I do
    recall, Mr. Chairman, where people could submit statistical
    pools that they think would be representative of the collateral
    that they would submit finally for rating. But it would not be
    a substitution, so to speak. It would be once the collateral
    was originated from a timing perspective.
        Senator Levin. All right. It would not be a substitution of
    one asset for another.
        Ms. Barnes. No.
        Senator Levin. OK. Do you know anything about the use of
    dummies, Ms. Yoshizawa?
        Ms. Yoshizawa. I do not. As I mentioned in my opening
    testimony, CDOs can either be static or managed transactions. I
    do not know about this transaction, but to the extent that it
    was a static transaction, then we would expect that the
    portfolio that was provided to us at closing would be the same
    portfolio as of the effective date.
        Senator Levin. Take a look at Exhibit 1i.\1\ This is what
    happened to the AAAs. We ask all of you to take a look at this.
    BlackRock Solutions made an assessment in February of this
    year, and they looked at the entire universe of AAA ratings
    that have been given to RMBS securities from 2004 to 2007.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1i, which appears in the Appendix on page 244.
    ---------------------------------------------------------------------------
        First, subprime RMBS securities--91 percent of the AAA
    ratings handed out in 2007 are now junk. Ninety-three percent
    of the AAA ratings in 2006 are now junk. Option ARM securities,
    these are securities that they looked at--we looked at these,
    actually, in our first hearing, full of negatively amortizing
    loans that are issued to borrowers with initial low interest
    rates but with a much higher loan payment that kicks in later.
    These are high-risk loans because nobody knew how many of the
    borrowers would default if they couldn't refinance and had to
    pay the higher loan payments. We examined at that hearing email
    traffic showing that Washington Mutual wanted to sell its
    Option ARM loans starting in early 2007, because it had already
    decided that they were likely to fail, so they had better get
    rid of them, get them off their inventory, securitize them, and
    get them out there, put them in the stream of commerce.
        And then later, in 2007, they securitized billions of
    dollars of its Option ARM loans in several mortgage pools that
    resulted in dozens of securities. These pools won AAA ratings
    for their senior tranches, and this chart shows that 97 percent
    of the AAA ratings given to Option ARM securities in 2007 and
    2006 have now been downgraded to junk status.
        The numbers for other high-risk loans on the chart are
    equally shocking. Alt-A, fixed, and variable loans, and these
    are the loans with little or no documentation, their AAA
    ratings have fallen to junk status 96 to 98 percent of the
    time. Prime fixed and variable loans are not included in the
    chart.
        So, does that chart shock you, to look what happened to all
    the AAA loans? Mr. D'Erchia.
        Mr. D'Erchia. Yes, Mr. Chairman, it does shock--it is
    shocking, 98 percent, but my group would have been responsible
    for lowering these ratings, and in doing so, it is a tremendous
    amount of work, so----
        Senator Levin. We will get to that. It took you quite a bit
    of time to downgrade the ratings, but we will get to that
    later.
        Does this shock you, Ms. Yoshizawa?
        Ms. Yoshizawa. Yes. It is certainly not what we would have
    expected, how our ratings would perform.
        Senator Levin. Now, Ms. Yoshizawa, the first panel of
    witnesses raised a lot of concerns about Moody's handling of
    the CDOs, and here are some of the things that they said.
    Pressure by the investment bankers on your analysts. Pressure
    applied by managers at Moody's to maintain market share. Over
    and over and over again, that is what we heard. Pressure to
    maintain market share in RMBs and CDOs.
        Next, managers felt like they would lose their job if they
    lost market share. Next, drive for market share led to
    deterioration of credit standards applied by Moody's. Next,
    emphasis on keeping the investment banker customer happy,
    keeping them appeased. Next, lack of adequate resources to rate
    deals effectively or to re-rate them effectively. Change in
    culture. Great importance placed on meeting the investment
    bankers' demands. Next, the quality of assets assumed by
    Moody's model was not the same as the collateral provided by
    the investment bankers. Next, bankers were aggressively pushing
    the CDO to get done in the summer. Well, we didn't get into
    that one, so I won't ask you that.
        But is all that you heard, does that trouble you?
        Ms. Yoshizawa. Yes, all those statements are troubling.
        Senator Levin. And were you surprised to hear them, or have
    you heard them before?
        Ms. Yoshizawa. I have heard statements such as those
    before, yes.
        Senator Levin. Senator Kaufman.
        Senator Kaufman. Thank you, Mr. Chairman. To continue the
    testimony, I would like to, just for the record, kind of go
    through--thousands of RMBSes rated AAA in 2006 and 2007 are
    rated now as junk. Ms. Barnes, can you just give me what you
    think are the one, two, or three reasons why that happened?
        Ms. Barnes. Well, Senator, the assumptions that we use in
    our criteria have obviously not panned out the way we had
    expected and the market deteriorated more precipitously and
    dramatically than we had expected.
        Senator Kaufman. The assumptions didn't work out and the
    overall market went down?
        Ms. Barnes. Yes.
        Senator Kaufman. That is why an organization like yours,
    with a long and honorable tradition of rating AAA, all of a
    sudden had a massive failure--I think that is fair to say--and
    your assumptions were wrong and it was just a market thing
    because the housing market just went bad. Nobody could ever
    foresee that was going to happen, clearly. If you look at the
    housing market, it would seem that it was going into areas that
    it had never gone in before. I mean, there was no discussion at
    S&P about the fact that there was--I will just show this chart
    \1\--you had a chart like this to describe the housing prices,
    that might be a factor?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1j, which appears in the Appendix on page 245.
    ---------------------------------------------------------------------------
        Ms. Barnes. Well, Senator, there are many assumptions that
    we use in the rating process, market value decline being one of
    them, ultimate default rates, things that impact the defaults
    and the severity. So in looking at how market appreciation
    impacts people's equity positions and defaults, those would be
    things that we did consider, yes.
        Senator Kaufman. OK. Ms. Yoshizawa, why do you think that
    there was this thousands of RMBSes that were graded AAA that
    are now--in 2006 and 2007--rated as junk?
        Ms. Yoshizawa. Once again, I am not in the RMBS area.
        Senator Kaufman. Well, I just used that as an example--I
    think you have the flavor----
        Ms. Yoshizawa. We strive for and we believe we have
    achieved historically a long history of accurate and reliable
    ratings. And even outside of those structured transactions and
    others that have been affected by the housing crisis and the
    knock-on effects, we have ratings that have performed in
    structured as well as other parts of Moody's. I think that we
    certainly did not predict when we were rating these instruments
    and we were looking at the long-term credit expectations on
    these instruments, we did not predict the magnitude of the
    housing crisis. We did not predict the velocity and we did not
    even predict the length of time over which this crisis would
    extend. I think that is the main reason.
        Senator Kaufman. Mr. D'Erchia, do you have any opinions of
    why it happened?
        Mr. D'Erchia. Again, well, from a surveillance perspective,
    we had the value of seeing the actual delinquencies and we had
    never seen that precipitous a rise----
        Senator Kaufman. Sure.
        Mr. D'Erchia [continuing]. On a comparative basis with the
    previous vintages in that period of time.
        Senator Kaufman. Yes. So this is 2006, 2007. You are doing
    surveillance, though. You are not really rating. You are not
    anywhere involved in the actual rating of these being AAA. You
    are just looking back and trying to see whether they should be
    re-rated or changed, right?
        Mr. D'Erchia. Yes--well, Senator, we are trying--one
    singular goal is to make sure that rating is appropriate, yes.
        Senator Kaufman. But in 2005, S&P was already talking about
    the deteriorating market. In your testimony on page six, you
    talk about an article entitled, ``Subprime Lenders Basking in
    the Glow of a Still Benign Economy With Clouds Forming on the
    Horizon.'' Following the internal housing market simulation
    conducted in 2005, S&P had published a study concerning the
    potential impact of a housing downturn on RMBSes using the
    following assumptions: A January 19, 2006 article entitled,
    ``U.S. RMBS Markets Still Robust But Risk Increases and Growth
    Drivers are Softening.''
        So it wasn't like a shock. In 2005, you were already
    discussing the fact that this is a real problem. But then in
    2006--and I guess maybe you are the wrong person--I guess I
    should be talking to you, Ms. Barnes, in terms of you are just
    doing surveillance. You are not actually doing the ratings.
        So I guess I will switch over to you, Ms. Barnes, and also
    just add to this, in your testimony, on page 11, you recount
    the same thing. So in 2005, now, you knew that there was a
    serious problem in the housing market. Take a look at that.
    There is the chart I was holding up there, which shows the fact
    that by 2006, we were now operating--June 2006, the housing
    bubble was twice the--anyway, it is just going through the
    roof.\1\ So you knew in 2005 that this is a really big problem,
    yet through 2006 and 2007, you were still giving AAA ratings to
    a whole series of RMBSes which then ended up being junk.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1j, which appears in the Appendix on page 245.
    ---------------------------------------------------------------------------
        Ms. Barnes. Yes, Senator. Through that time period, we were
    looking at the market and trying to understand the developments
    and what was happening, so the study in 2005 that you are
    discussing about the housing bubble, people were discussing
    that in the marketplace, so we were informing our opinions and
    then did an analysis to see what impact that would have on the
    ratings should that scenario occur.
        So from 2005 on, we were looking at the different
    developments, the different types of collateral we were
    seeing----
        Senator Kaufman. No, I got all that, but during that
    period, the main thing that I am interested in about these
    instruments is you didn't give them a lower rating. They still
    got the solid gold rating, which I understand, and I think it
    doesn't mean what everybody thinks it means, which is another
    problem which we can talk about today. So you are not
    indicating any kind of--I am really concerned about this
    subprime market and maybe I ought to take a look and not give
    every single one of these things, or the vast majority--not
    every single one--so many AAA which then turn out being junk.
        Ms. Barnes. Well, Senator, through that time period, we did
    release and update our criteria--in many cases, which you would
    see that did increase our credit enhancements. So we did expect
    defaults and losses to occur through those periods and did
    increase our credit enhancement, which we believed at that time
    would be reflective of the ultimate exposure and default
    experience of those deals.
        Senator Kaufman. Ms. Yoshizawa, I know in your testimony,
    page 18, by you and Mr. McDaniel, you go back to 2003. We
    identified and began commenting about the loosening of
    underwriting standards starting in 2003. And that was 4 years
    before 2007, if my math is right. So there had to be some
    knowledge in the management of Moody's that there is trouble
    here, and it didn't all of a sudden happen then in 2007, there
    is a housing problem here of massive proportions and we are
    still rating everybody AAA--not everybody, excuse me. We are
    still putting out a good portion of AAA bonds, which in
    retrospect was just----
        Ms. Yoshizawa. Our RMBS group from 2003 on, as we mentioned
    in the testimony----
        Senator Kaufman. Sure.
        Ms. Yoshizawa [continuing]. Wrote about various concerns
    that they had in the market. At the same time, my understanding
    is that they were increasing enhancement levels required to get
    certain ratings. So there were changes being made to the
    methodology as well as requirements for reaching certain
    ratings. I don't know about the specific practices in terms of
    when they took certain actions or how much enhancement they
    changed, for example. It was not my area. However, I am aware
    that they had been continually identifying and adjusting their
    methodology.
        Senator Kaufman. Did all three of you hear the previous
    panel?
        Ms. Yoshizawa. Yes.
        Senator Kaufman. Were you here for the previous panel?
        Ms. Barnes. Yes, Senator.
        Mr. D'Erchia. Yes, Senator.
        Senator Kaufman. OK. Ms. Barnes, the previous panel said
    that is not it at all. The previous panel said it was lack of
    regulation. They said that there were the incentives given to
    folks within the organization. They said it was a search for
    profit. They said it was market share. Can you comment on any--
    I mean, did you have any firsthand experience of any of those
    things having an impact on what happened? Or it just didn't
    happen to folks you knew?
        Ms. Barnes. Are you directing it----
        Senator Kaufman. Yes.
        Ms. Barnes. Well, Senator, I have no personal knowledge of
    people's incentives being directly tied to the number of deals
    they rate or rated. But overall financial performance of the
    organization did impact people's----
        Senator Kaufman. But you don't think anybody in your
    organization you knew felt that the incentives distorted what
    decisions they were making?
        Ms. Barnes. Not on the deal level, no.
        Senator Kaufman. OK. Ms. Yoshizawa.
        Ms. Yoshizawa. Well, first, from the personal incentives,
    the analysts were not compensated based upon the performance of
    an individual group or----
        Senator Kaufman. No, I am not talking about the analysts. I
    am talking about everybody up the chain. You just went through
    the whole thing that the analysts--when Chairman Levin
    mentioned analysts, you said, wait a minute. There is a whole
    process here that we go through.
        Ms. Yoshizawa. Right.
        Senator Kaufman. Management is involved with that, is it
    fair to say, Mr. Chairman? So we are not talking about the
    analysts now, just the analysts. We are talking about the whole
    chain that you had, that both of you went into great detail to
    explain how this works. Do you think folks in that chain felt
    like there were incredible incentives for them to get as many
    deals out the door as they possibly could and with the highest
    possible rating?
        Ms. Yoshizawa. I personally did not feel any undue pressure
    for market share.
        Senator Kaufman. All right.
        Ms. Yoshizawa. I had for a very long time been responsible
    for the synthetic CDO area. We had very low market share in the
    20 and 30 percent range. It was an area that I was expected to
    explain why our market share may have been lower in terms of
    our methodologies----
        Senator Kaufman. Right.
        Ms. Yoshizawa [continuing]. In terms of could it be fees,
    but I was expected to know why that was the case. At no time
    was I told that my mandate was to increase that market share--
    --
        Senator Kaufman. Sure.
        Ms. Yoshizawa [continuing]. Or to even maintain the market
    share.
        Senator Kaufman. So you didn't feel any pressure to
    increase business at all. So what the other panel was talking
    about was something that happened with them but didn't happen
    with you? Everybody in the organization, that we want to be a,
    yes, we can organization, we want to expect as many deals as we
    can, the more deals the better, that happened to the folks that
    were on the first panel, but you didn't feel--and people around
    you, when you went out to lunch, people didn't talk about this,
    this pressure on us to do more business, to make deals work, to
    do whatever it took to make the deals work, to increase market
    share? You didn't feel any of that?
        Ms. Yoshizawa. I did not feel the pressure to do deals at
    the cost of credit, not at the cost of everything else.
        Senator Kaufman. How about pressure just to do deals?
        Ms. Yoshizawa. We were expected to be able to rate the
    deals that we could rate----
        Senator Kaufman. Right.
        Ms. Yoshizawa [continuing]. Those that we could understand
    or those that we could come up with methodologies for.
        Senator Kaufman. Right.
        Ms. Yoshizawa. We were expected to rate them at the levels
    that we thought that they should be rated.
        Senator Kaufman. Right.
        Ms. Yoshizawa. So it is not a black or white as to whether
    you can or cannot rate something. Sometimes it is. Sometimes
    you don't have enough information.
        Senator Kaufman. Sure.
        Ms. Yoshizawa. Sometimes you think that the transaction
    complexity may not allow you to come up with an analysis for it
    a couple times----
        Senator Kaufman. You were in a different environment than
    the first panel, clearly, right?
        Ms. Yoshizawa. I was in the same----
        Senator Kaufman. No, I mean, the environment they talked
    about was something that didn't impact on you. Didn't they--I
    mean, you were here when they said that there were incentives--
    --
        Ms. Yoshizawa. I did hear that. I never felt that my job--
    --
        Senator Kaufman. But you never felt--I am just trying to--
    basically, they were working in the same company, but they were
    just seeing things differently from what you did, which is
    perfectly--Mr. D'Erchia, what do you think?
        Mr. D'Erchia. My plate was full. I had 100 percent market
    share.
        Senator Kaufman. Right.
        Mr. D'Erchia. My workload came from the new deal side, so
    that was a factor. I would be in a different place.
        Senator Kaufman. Yes. I can perceive that.
        I think, Mr. Chairman, I am going to turn it back to you.
        Senator Levin. Ms. Yoshizawa, take a look, if you would, at
    Exhibit 24a.\1\ It is an internal Moody's email chain from
    early October 2007. The second email is from Sunil Surana to
    you. Who is Sunil Surana, if I am pronouncing her name
    correctly?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24a, which appears in the Appendix on page 318.
    ---------------------------------------------------------------------------
        Ms. Yoshizawa. Sunil was a business analyst reporting to my
    boss at that time.
        Senator Levin. Reporting to your boss?
        Ms. Yoshizawa. Yes.
        Senator Levin. And here is what she wrote in Exhibit 24a.
    ``Market share,'' and she is writing to you, ``Market share by
    deal count dropped to 94%, though by volume it's 97%. It's
    lower than the 98+% in prior quarters. Any reason for concern,
    are issuers being more selective to control costs (is Fitch
    cheaper?) or is it an aberration.'' What was your answer to
    that?
        Ms. Yoshizawa. We were expected to know why we were not on
    deals that we were not on. There were multiple reasons for
    that. It could be because of price. It could be because of
    credit enhancement. It could be because of other relationship
    issues, and we were----
        Senator Levin. So market share mattered? Isn't that what
    that email says?
        Ms. Yoshizawa. Market share mattered in that we were
    expected to know what the story was----
        Senator Levin. Yes.
        Ms. Yoshizawa [continuing]. And so I passed that on to my
    managing directors to find out. I am assuming there was a list
    of transactions and I was asking them to let me know what the
    story was for the transactions.
        Senator Levin. So market share----
        Ms. Yoshizawa. There was no mandate to rate those
    transactions. There was no punishment for not being on those
    transactions. But we were expected to know why we were not on
    those transactions.
        Senator Levin. And so market share mattered, in a nutshell.
        Ms. Yoshizawa. For various reasons.
        Senator Levin. And to various people, higher up?
        Ms. Yoshizawa. Yes. They wanted to know why we were not on
    certain transactions.
        Senator Levin. And then if you will look at the email, Mr.
    D'Erchia and Ms. Barnes, look at Exhibit 5 talking about market
    share.\1\ There is an S&P email chain, March 2005, and this is
    an email from Frank Parisi to you, Ms. Barnes. Who is Mr.
    Parisi?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        Ms. Barnes. Oh, Frank Parisi at that time--I am trying to
    look at the time frame, because he performed different roles.
        Senator Levin. Oh, I see. OK. March 2005.
        Ms. Barnes. I believe he was part of our research group at
    that time----
        Senator Levin. OK. Here is what he had to say. He said,
    ``When we reviewed the 6.0 results a year ago, we saw the sub-
    prime and the Alt-A numbers going up and that was a major point
    of contention which led to all the model tweaking we've done
    since. Version 6.0 could've been released months ago and
    resources assigned elsewhere if ''--and listen to this--``we
    didn't have to massage the sub-prime and Alt-A numbers to
    preserve market share.'' Market share mattered to him, wouldn't
    you agree, Ms. Barnes?
        Ms. Barnes. Mr. Chairman, I would say yes. He was saying
    that was a point he believed was being considered for the
    implementation of the model at that time.
        Senator Levin. Yes. It mattered. Preserving market share
    mattered, isn't that what he is saying, point blank?
        Ms. Barnes. He is saying that was his interpretation, yes,
    Mr. Chairman. Could I clarify for----
        Senator Levin. Well, you can try to clarify. I am just
    reading the words. It says here something could have been
    released months ago, which should have been released months
    ago, and resources assigned elsewhere if that had happened,
    ``if we didn't have to massage the subprime and Alt-A numbers
    to preserve market share.'' Isn't that pretty clear?
        Ms. Barnes. Right. Well, I guess there are two points I
    would make related to this. I mean, one, there are people with
    a client focus on the email and market share would have an
    impact in relation to them. But also, from a----
        Senator Levin. It mattered to them.
        Ms. Barnes. Yes.
        Senator Levin. And that was transmitted, was it not, to the
    staff?
        Ms. Barnes. This email is to the analytic managers of the
    mortgage group.
        Senator Levin. Yes, to the analysts. It was transmitted to
    the analysts that market share was important.
        Ms. Barnes. It was a factor at that time for people to
    consider, yes, Mr. Chairman.
        Senator Levin. OK. How about you, Mr. D'Erchia. Pretty
    clear?
        Mr. D'Erchia. Well, I am reading the words and I can't
    pretend to know what Frank is thinking when he is saying this.
        Senator Levin. Well, just about what he is saying. Forget
    what he is thinking.
        Mr. D'Erchia. Well, the words itself, I mean----
        Senator Levin. Pretty clear, aren't they?
        Mr. D'Erchia. You just repeated them----
        Senator Levin. Would you say they are pretty clear?
        Mr. D'Erchia. With the caveat that I don't know what he is
    thinking when he says it. But just the words themselves, yes,
    they are clear.
        Senator Levin. We heard from Mr. Michalek this morning, Ms.
    Yoshizawa, that there was a dramatic change in culture at
    Moody's led by Brian Clarkson, and that Moody's moved away from
    a more analytical, academic environment to an environment which
    is aimed more at satisfying the investment bankers who are
    paying Moody's for the ratings. Did you hear that testimony?
        Ms. Yoshizawa. I did.
        Senator Levin. Did that trouble you?
        Ms. Yoshizawa. It troubled me that was his view, yes.
        Senator Levin. And he testified that some of the bankers
    had complained to Brian Clarkson that Mr. Michalek was asking
    too many questions, he was doing too thorough of a review. They
    wanted him removed from their deal reviews, and they got their
    wish. Did you hear that?
        Ms. Yoshizawa. I don't think I heard him say that they got
    their wish.
        Senator Levin. Well, he said that he was not with two
    banks. He was taken off the case, right?
        Ms. Yoshizawa. I don't know of a case where he was, no.
        Senator Levin. You didn't hear him say that he was no
    longer allowed to work with a couple banks?
        Ms. Yoshizawa. No. In fact, to my knowledge, he worked with
    at least one of those banks that I know of----
        Senator Levin. But did you hear him say that he was taken
    off the case with those two banks, taken off the client list
    with those two banks?
        Ms. Yoshizawa. I did listen to his testimony. I don't
    recall----
        Senator Levin. No, I am saying, did you hear him testify--
    --
        Ms. Yoshizawa. I did hear him testify----
        Senator Levin. And was it true that he was, in fact, told
    not to work with one or more banks?
        Ms. Yoshizawa. I am not aware of that.
        Senator Levin. Were you there at the time?
        Ms. Yoshizawa. I was there at the time.
        Senator Levin. OK. So you were not aware that he was
    restricted in any way from working on CDO deals with certain
    banks? You were not aware of that?
        Ms. Yoshizawa. I was not aware of that, no. We had a quite
    contentious relationship with most of the investment banks that
    were out there, and there were many times that we would be
    requested either to remove an analyst from a transaction or
    that they not be put on the next transaction because it was
    that contentious relationship. That happened quite commonly. We
    did not make it a practice to remove people from transactions.
        Senator Levin. Did you ever do that? Did you ever remove a
    person from transactions with particular banks because of
    complaints from that bank?
        Ms. Yoshizawa. Not because of the complaints, because of
    timing, because of----
        Senator Levin. Following conversations with banks--where
    they asked for the removal of somebody from the relationship,
    did you ever accommodate that?
        Ms. Yoshizawa. There would be cases where they would ask,
    because the timing that the analyst told them that they needed
    in order to be able to work on a transaction, because their
    plate was full or because they had other things on their
    transaction, that at that time that I would say that I would
    see if I could get somebody else on the transaction.
        Senator Levin. It was only a complaint that the analyst was
    not moving quickly enough?
        Ms. Yoshizawa. No, it would be because they were not able
    to start or work on the transaction, so----
        Senator Levin. And that complaint came from the banks?
        Ms. Yoshizawa. It could come from--it usually would come
    from the banks. However, it could also come from the analyst
    who comes back and says, I have a vacation or I have a conflict
    in terms of my time and so I would not be able to work on this
    transaction.
        Senator Levin. But you never heard from a bank that they
    really would prefer you to remove somebody, it is just not
    working out well with that person? It always related just to
    the person not having enough time?
        Ms. Yoshizawa. No, we did get complaints from banks that
    they wanted people removed because they were unhappy with the--
    --
        Senator Levin. But you never accommodated that?
        Ms. Yoshizawa. No, we did not. We may add other people to
    the transaction. However, we would emphasize that the decisions
    were made on a committee basis, and so we would keep that
    analyst on. I may go to the analyst to find out what the issues
    were. However, I do not remember an instance where I took
    somebody off because the bank complained about their
    performance or because they were upset about some of the things
    that they may have said.
        Senator Levin. And you are telling us under oath that you
    never removed somebody because of a conflict between that
    person and the bank?
        Ms. Yoshizawa. I cannot remember an instance where I did.
        Senator Levin. You don't remember? So you are not denying
    that happened, is that correct?
        Ms. Yoshizawa. I cannot remember an instance where I did
    that.
        Senator Levin. How about personality conflict?
        Ms. Yoshizawa. There were cases where transactions would
    occur--as I mentioned, a lot of transactions could be very
    contentious. We typically had a couple of analysts who would
    work on transactions with us or arrangers so that they
    understood the transactions. But sometimes those relationships
    could get very contentious and very abusive and so sometimes
    for the next transaction, I would not put them on it, both from
    the perspective of protecting the analyst, because sometimes,
    as I said, the relationships could get very contentious and
    very abusive and----
        Senator Levin. So it wasn't just a matter of there wasn't
    adequate time. Now you are protecting the analyst from abuse,
    is that it?
        Ms. Yoshizawa. To the extent that we thought that the
    discussions could get very--if somebody was being yelled at or
    if we thought that the discussions were getting very
    aggressive, it was a very difficult situation, and so we did
    not necessarily want to put them on the next transaction or----
        Senator Levin. Or if the bank got mad enough at an analyst
    and it was contentious enough, then you might tell the analyst,
    we are removing you for your own sake.
        Ms. Yoshizawa. Not during a transaction. It would be for
    the next transaction----
        Senator Levin. Yes, for the next transaction with that
    bank. We are removing you for your own sake.
        Ms. Yoshizawa. We could do that. In other cases, I have
    brought in more senior people into the transaction.
        Senator Levin. Yes, but you could removed analysts. You
    might have remove analysts for that reason.
        Ms. Yoshizawa. Not removing them from the transaction----
        Senator Levin. No, from the next transaction with that
    bank.
        Ms. Yoshizawa. We may assign it to another person.
        Senator Levin. Yes.
        Ms. Yoshizawa. We didn't necessarily have the same analysts
    working on every transaction----
        Senator Levin. Right, but you may have decided not to put
    that analyst with a particular bank because there was that kind
    of a personality conflict.
        Ms. Yoshizawa. That could be the case, yes.
        Senator Levin. That, you do remember?
        Ms. Yoshizawa. Yes.
        Senator Levin. Why would you not just tell the banker,
    knock it off?
        Ms. Yoshizawa. We did.
        Senator Levin. So you stopped your relationship with
    bankers----
        Ms. Yoshizawa. We would----
        Senator Levin [continuing]. Based on their abuse?
        Ms. Yoshizawa. We would ask them to knock off the----
        Senator Levin. Did you ever tell them, we are not going to
    do any more credit rating for you with this kind of abuse of
    our analysts?
        Ms. Yoshizawa. I do not remember whether we did. I don't
    think we did.
        Senator Levin. Would you consider that pressure from banks?
        Ms. Yoshizawa. There was always pressure from the banks.
        Senator Levin. That type of pressure, to remove analysts?
        Ms. Yoshizawa. There was always pressure from banks,
    including----
        Senator Levin. Including that?
        Ms. Yoshizawa. Including that type of pressure, yes. It was
    our job as managing directors to push back against that.
        Senator Levin. I want to let you know, in your testimony
    you are shifting around here a little bit. I want to let you
    know that. First, you were saying you only would do it because
    of time, that you only would not have somebody assigned to a
    particular bank. Then you are saying, well, you didn't
    remember. Now you are saying that, yes, you might have not
    assigned a particular analyst to a particular bank in the next
    transaction because of that kind of heated conflict between the
    two. So I just want to let you know the way your testimony
    comes across. It is very unsatisfactory and----
        Ms. Yoshizawa. If I can clarify, there----
        Senator Levin. Sure.
        Ms. Yoshizawa. To me, when you say ``remove,'' I think of
    removing----
        Senator Levin. That you did not assign somebody to that
    bank for the next transaction because of that conflict.
        Who are you talking to here?
        Ms. Yoshizawa. I am sorry. It is our legal----
        Mr. Ross. I am her counsel and I am handing her a note,
    just like your counsel handed you a note.
        Senator Levin. I just want to know who.
        Mr. Ross. I am Stephen Ross from Akin Gump.
        Senator Levin. Thank you.
        Mr. Ross. Thank you.
        Ms. Yoshizawa. I am sorry. I just wanted to clarify the
    difference between removing someone in the middle of a
    transaction----
        Senator Levin. I understand.
        Ms. Yoshizawa [continuing]. Because we were being--versus
    assigning somebody to the next transaction----
        Senator Levin. OK. You did not assign that person to a
    particular bank for the next transaction because of that
    conflict.
        Ms. Yoshizawa. Because there could be--because of the
    conflict or what happened during that in terms of the
    relationship.
        Senator Levin. All right.
        Ms. Yoshizawa. However, I wanted to make clear----
        Senator Levin. The bank got their way. Don't assign that
    person to me from now on. The bank got their way for the next
    transaction.
        Ms. Yoshizawa. I think that was something that was asked of
    us quite often----
        Senator Levin. And you sometimes did it.
        Ms. Yoshizawa [continuing]. It would depend on how we felt
    about how that analyst----
        Senator Levin. Right.
        Ms. Yoshizawa [continuing]. Felt about that--the pressure
    and the relationship.
        Senator Levin. And you sometimes then did what the bank
    asked you to do, which is not to assign that person for the
    next transaction.
        Ms. Yoshizawa. Not for the benefit of the bank, no. It was
    for the benefit of--because we felt that our analysts were
    being abused and we did not want that to happen. We want to
    have--we may have assigned a more senior person that we felt
    could push back better.
        Senator Levin. And the bank got their way, though. That
    person would not have been assigned to the next transaction. So
    they succeeded.
        Ms. Yoshizawa. They may have succeeded in that instance,
    but it was not a practice and it was not for their benefit.
        Senator Levin. There was at Moody's, I believe--a man named
    Andy Kimball, is that correct?
        Ms. Yoshizawa. Yes.
        Senator Levin. Does that strike a bell? If you would take a
    look at Exhibit 24b,\1\ this is attached to the cover sheet
    from Mr. McDaniel to himself for his file. This is a long memo
    about credit policy issues at Moody's. It looks like it came at
    about October 2007, Exhibit 24b. We understand this is a memo
    that Mr. Kimball wrote. Are you familiar with this?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24b, which appears in the Appendix on page 319.
    ---------------------------------------------------------------------------
        Ms. Yoshizawa. I am not.
        Senator Levin. You are not? OK.
        Ms. Yoshizawa, we were advised by Moody's Chief Credit
    Officer that it was common knowledge that ratings shopping
    occurred in structured finance. In other words, investment
    bankers sought ratings from credit rating agencies who would
    give them their highest ratings. Would you agree with that?
        Ms. Yoshizawa. I agree that credit shopping does exist,
    yes.
        Senator Levin. Ms. Barnes, would you agree that the same
    thing existed in your area?
        Ms. Barnes. Yes, Mr. Chairman.
        Senator Levin. And Mr. D'Erchia?
        Mr. D'Erchia. No. There would be no reason to shop----
        Senator Levin. OK. So because you were doing surveillance,
    right, it would not be applicable.
        Mr. D'Erchia. That is correct.
        Senator Levin. OK. Mr. D'Erchia, whenever S&P made a
    criteria change to its RMBS model and that change was more
    conservative than the previous model, did S&P retest the old
    deals to see if their structure still passed for rating
    purposes?
        Mr. D'Erchia. Traditionally, no.
        Senator Levin. And if you would take a look at that exhibit
    we talked about before, Exhibit 5,\1\ this is a March 2005
    memo. I don't think I asked you about this memo. I think I
    talked to Ms. Barnes about it. Are you familiar with this
    email?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        Mr. D'Erchia. Well, not really, Senator. I am just reading
    it now with you.
        Senator Levin. OK. Well, let me read it. ``When we first
    reviewed 6.0 results a year ago, we saw the sub-prime and Alt-A
    numbers going up and that was a major point of contention which
    led to all the model tweaking we've done since. Version 6.0
    could've been released months ago and resources assigned
    elsewhere if we didn't have to massage the sub-prime and Alt-A
    numbers to preserve market share.'' Are you familiar with
    Version 6.0?
        Mr. D'Erchia. Not really, Mr. Chairman.
        Senator Levin. OK. That was not something that you had any
    dealings with?
        Mr. D'Erchia. The situation is different on the new deal
    side. They are rating a transaction by looking at certain
    information and making projections and assumptions. I had the
    luxury of getting monthly runs and seeing what the actual
    delinquencies were----
        Senator Levin. All right.
        Mr. D'Erchia [continuing]. And so I could measure against
    the actual information.
        Senator Levin. So this was not relevant to your work doing
    the surveillance?
        Mr. D'Erchia. I wouldn't say that. There is certain
    information you can get when you are doing new transactions
    that you just don't have once the transaction has been issued.
    A FICO score, you would get from the banker, I would assume, on
    the deal side, which I couldn't get current consistently. It
    was a difficult thing to get on a regular basis. If the home
    was sold and refinanced, it was very difficult to get current
    loan-to-value information, and the like.
        Senator Levin. OK. Ms. Barnes, if you would take a look at
    Exhibit 45,\2\ please. This was an email sent to you in June
    2005. This is a mortgage broker who was writing you saying, ``I
    saw you today on CNBC and the reason for my email is that I am
    extremely afraid of the seeds of destruction the financial
    markets have planted.'' This is now June 2005. ``I have been a
    mortgage broker for the past 13 years and I have never seen
    such a lack of attention to loan risk. I am confident our
    present housing bubble is not from supply and demand of
    housing, but from money supply.''
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 45, which appears in the Appendix on page 383.
    ---------------------------------------------------------------------------
        ``In my professional opinion the biggest perpetrator is
    Washington Mutual.'' And then listing what Washington Mutual
    was all about--``no income documentation loans;'' ``Option
    ARMs, negative amortization on over-leveraged collateral;''
    ``Interest income on negative amortization is not taxed,''
    going down to 2C, or 3, ``Option ARMs make up 90% of Bay Area
    loans in California.'' ``4, ``WaMu's recent bid for Providian
    is the purchase of another highly leveraged/securitized bank.''
    5, ``100% financing loans. I have seen instances where WaMu
    approved buyers for purchase loans; where the fully indexed
    interest only payments represented . . .''--these are interest
    only payments--``100% of the borrower's gross monthly income.
    We need to put a stop to this madness!!!''
        Did you know the person who wrote about that madness,
    Michael Blomquist? Did you know that person?
        Ms. Barnes. No, not that I recall.
        Senator Levin. This was just an email that you got from
    somebody?
        Ms. Barnes. I believe so. Yes, sir.
        Senator Levin. All right. He sure put his finger on WaMu.
        So S&P, you raised credit protection for investment grade
    RMBS securities because of issues that were raised like this,
    however, is that correct? Did you not----
        Ms. Barnes. Yes, we did, sir----
        Senator Levin. You did?
        Ms. Barnes. In the middle of 2005, what precipitated my
    appearance on CNBC was that we increased our credit enhancement
    requirements for the Option ARM loans.
        Senator Levin. All right. And so you also had data showing
    that the subprime was not performing in the first part of 2006,
    as well, is that correct?
        Ms. Barnes. It started to perform a little differently, but
    from a delinquency perspective.
        Senator Levin. That meaning worse?
        Ms. Barnes. Worse, yes, sir.
        Senator Levin. Now, these were some of the factors that led
    to a major model change to levels in July 2006. According to
    the testimony, I believe, that you gave to the Senate Banking
    Committee in April 2007, this model change resulted in more
    protection against loss, so-called credit enhancements. ``They
    were increased by 50 percent in the average subprime ratings as
    compared to deals rated in the first half of 2006 and during
    2005.'' Is that correct?
        Ms. Barnes. Yes, it is, Mr. Chairman.
        Senator Levin. And, Ms. Yoshizawa, Moody's also increased
    its credit enhancement for its model by 30 percent during that
    time frame, is that correct?
        Ms. Yoshizawa. I don't know about the RMBS model, sir.
        Senator Levin. OK. But your model that you were using, was
    that increased by 30 percent?
        Ms. Yoshizawa. I am not aware of how the RMBS model was
    changed.
        Senator Levin. OK. Let me go back, then, to you, Ms.
    Barnes. The model changes to Levels was finalized in July 2006.
    You had better data. You had improved assumptions about how
    subprime would behave in the future and that would allow you to
    better predict how deals would behave. It was a better model
    than the previous model. If you had used the new model to
    reevaluate existing RMBS securities, it would have resulted in
    downgrades for many of those securities, is that correct? If
    you had used that model?
        Ms. Barnes. If we had used that model at that time?
        Senator Levin. Yes. It would have resulted in downgrades
    for many of the RMBS securities.
        Ms. Barnes. Well, if we had rated them at the point of
    issuance, it would have ended up with different ratings being
    issued at that time, yes.
        Senator Levin. OK.
        Ms. Barnes. Possibly.
        Senator Levin. Mr. Barnes, your company did not use that
    revised model to reevaluate the existing RMBS securities, is
    that correct?
        Ms. Barnes. I am sorry. I didn't understand your question.
        Senator Levin. You did not use this revised model to
    reevaluate existing RMBS securities, is that correct?
        Ms. Barnes. We did not, Mr. Chairman.
        Senator Levin. Even though those were all under
    surveillance, is that correct?
        Ms. Barnes. That is correct.
        Senator Levin. OK. And were you familiar with that
    decision, Mr. D'Erchia?
        Mr. D'Erchia. Yes. As I said, Mr. Chairman, we had the
    luxury, if you will, of receiving the current information on a
    monthly basis.
        Senator Levin. Right. And you did not have resources, as
    well, is that correct, to apply those revised models to
    reevaluate all the existing RMBS securities? It was also a
    resource issue, is that correct?
        Mr. D'Erchia. No, Mr. Chairman.
        Senator Levin. That is not correct? It was not a resource
    issue?
        Mr. D'Erchia. No. Having the ability to look at the actual
    delinquencies and monitor them to see what percentage, if any,
    turn into losses was something that I didn't have to be
    predictive. I can see what was happening.
        Senator Levin. OK. Now, take a look at Exhibit 62.\1\ At
    the top of page two, this is a Standard and Poor's memo from
    Roy Chun, is that correct?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 62, which appears in the Appendix on page 471.
    ---------------------------------------------------------------------------
        Mr. D'Erchia. Yes.
        Senator Levin. Did you ever see this memo before, or this
    email before? Disseminated to surveillance----
        Mr. D'Erchia. I haven't seen it since 2005.
        Senator Levin. OK. ``How do we handle existing deals
    especially if there are material changes that can cause
    existing ratings to change?'' Who is Mr. Chun again?
        Mr. D'Erchia. Mr. Chun worked in the surveillance group and
    reported to me.
        Senator Levin. All right. ``How do we change existing deals
    . . . if there are material changes that can cause existing
    ratings to change? I think the history has been to only re-
    review a deal under new assumptions . . . when the deal is
    flagged for some performance reason.'' And then he said, ``I do
    not know of a situation where there were wholesale changes to
    existing ratings when the primary group changed assumptions or
    even instituted new criteria. The two major reasons why we have
    taken the approach is, (i), lack of sufficient personnel
    resources.'' That wasn't the reason? What he said was the
    reason, one of two, is not the reason, lack of personnel
    resources?
        Mr. D'Erchia. Mr. Chairman, I can't speak to the
    specifics----
        Senator Levin. No, but you disagree with that, is that
    correct? That was not a reason why that new model was not
    applied to the existing deal.
        Mr. D'Erchia. In 2005, I did not know that resources was--
    --
        Senator Levin. Did you ever have a problem in existing
    resources when it came to your job of surveillance? Did you
    ever raise the issue?
        Mr. D'Erchia. Oh, yes----
        Senator Levin. You needed more resources?
        Mr. D'Erchia. Yes, I did.
        Senator Levin. OK. Tell us about that.
        Mr. D'Erchia. Well, when we started to see the increased
    delinquencies, we switched to doing vintage reviews on the 2006
    and 2007 transactions. We worked in conjunction with a number
    of people throughout the organization, criteria, data,
    management, the new deal side, and also in New York. I had the
    luxury, if you will, again, it was moving targets with
    attrition and new hires and terminations, etc., anywhere from
    100 to 125 people reporting to me in New York. So when I would
    have a particular area that needed additional resources, I
    would shift people around to cover that. At the same time, I
    would make requests for additional resources for the future so
    that I could adequately cover all of our workload.
        Senator Levin. Right. And you didn't get those resources,
    did you?
        Mr. D'Erchia. I got resources.
        Senator Levin. Were they adequate to do your job?
        Mr. D'Erchia. I would say they were adequate to do the job
    at the time it needed to be done.
        Senator Levin. Take a look at Exhibit 86,\1\ if you would.
    Who was Ernestine Warner?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 86, which appears in the Appendix on page 531.
    ---------------------------------------------------------------------------
        Mr. D'Erchia. Ernestine Warner was the head of the RMBS
    surveillance area.
        Senator Levin. And she was asking for help?
        Mr. D'Erchia. She is asking for resources.
        Senator Levin. Yes. And you told her, I believe, is it not
    true, that they would be coming later on?
        Mr. D'Erchia. Well, I was identifying a potential avenue
    where we can get additional resources.
        Senator Levin. She was asking for additional resources, was
    she not?
        Mr. D'Erchia. Yes.
        Senator Levin. To do the surveillance job, and right in the
    middle of that Exhibit 86, you write, ``[Y]ou should be getting
    4 or 5 new Associates from the 2007 Associate class for 12 and
    continuing to get them going forward. That might help.'' Her
    response, I believe, was at the top----
        Mr. D'Erchia. That is right.
        Senator Levin. ``They will be a great help but they . .
    .''--and this is February 2007, this is a critical time--``They
    will be a great help but they will not start until August,
    right?'' So she needs help now, she is telling you, and now
    being February, and you are telling her she will get a few in
    August. And then she says, ``Let's talk about anything we might
    be able to do in the interim. I talked to Tommy yesterday and
    he thinks that the ratings are not going to hold through
    2007.'' Your ratings, your surveillance, you are supposed to
    make sure those ratings stay.
        Mr. D'Erchia. Yes, sir.
        Senator Levin. And she has talked to Tommy--I am not sure
    who that is--but he thinks the ratings are not going to hold
    through 2007. ``He asked me to begin discussing taking rating
    actions earlier on the poor performing deals. I have been
    thinking about this for much of the night. We do not have the
    resources to support what we are doing now.''
        You kept saying to my questions, you thought the resources
    were adequate now. But she is telling you, we do not have
    resources to support what we are doing now. A new process
    without the right support would be overwhelming. What was your
    response?
        Mr. D'Erchia. Oh, my response was to request resources, but
    here is----
        Senator Levin. Did you get them?
        Mr. D'Erchia. I got some, as I said----
        Senator Levin. Did you get what you needed?
        Mr. D'Erchia. Well, it depends on the job. On this
    particular job, I feel we were adequately covered and I think
    that was----
        Senator Levin. Were there some jobs you weren't adequately
    covered? In your judgment then?
        Mr. D'Erchia. I would triage according to volatility.
        Senator Levin. Triage? That means something was being
    shorted. That is the meaning of triage. If you have two sick
    patients, you are going to deal with the one that can live. I
    mean, come on. Triage means you were not providing adequate
    resources where they were needed.
        Mr. D'Erchia. Well, if I could, Mr. Chairman----
        Senator Levin. Sure. Go ahead.
        Mr. D'Erchia. Ernestine Warner is in charge of the
    Residential Mortgage Group. Her job is to inform me when she
    needs resources and what those resources are. This email is her
    doing her job.
        Senator Levin. Right.
        Mr. D'Erchia. What I am doing is trying to address that
    request. I am looking to move the entire associate class over.
    I understand we are talking February to August, and she is
    asking about the interim. The ``Tommy'' she is referring to is
    the head of the Criteria Group. In the interim, I am looking
    for help. I am also shifting people over from other areas where
    they can help support me. This is in addition to and including
    the data area and the deal side if there was the luxury of
    people available, because to go out and hire, you are looking
    at at least a 6-month learning curve but she needs the help
    now. And so I had to address this situation at that time by
    shifting people over and making sure that we can help now.
        Senator Levin. Did she get the resources that she needed
    when she needed them?
        Mr. D'Erchia. I think, sadly enough, your chart shows that
    with the amount of downgrades that we had to do to make that
    rating, to make the ratings be appropriate--and at that
    particular time, I would say I was never satisfied with
    anything, and that typically was the budget process, is where I
    would go and I would request and document the need for those
    requests and then we would get them. But at this particular
    time, and knowing what I did in shifting over personnel, this
    particular issue, yes, this was resolved.
        Senator Levin. It was resolved. Were the resources
    adequate? She was warning you, the storm is coming. The ratings
    aren't going to hold. You are going to need to start
    downgrading. We need people. We need resources now. And you are
    telling me she got the resources that she needed? That is what
    your testimony is, under oath?
        Mr. D'Erchia. Yes. We increased our staff--as I said, I had
    about 100--over 115 people to 125 people at any given time.
        Senator Levin. All right. Now take a look at Exhibit 84,\1\
    if you would, the third page. This is Ernestine Warner again
    writing. ``In light of the current state of residential
    mortgage performance, especially sub-prime, I think it would be
    very beneficial for the RMBS surveillance team to have the work
    being done by the temps to continue. It is still very important
    that performance data is loaded on a timely basis as this has
    an impact on our exception reports. Currently, there are nearly
    1,000 deals with data loads aged beyond one month.'' Was that
    satisfactory, to have that kind of a backlog?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 84, which appears in the Appendix on page 526.
    ---------------------------------------------------------------------------
        Mr. D'Erchia. No, and that is what we did. Also, we used--
    for data loading and data collection, I would in addition use
    our affiliate company--CRISIL--and have them do a lot of the
    data loading and data collection. The people she is talking to
    are people in the data group, and she is seeking additional
    help in loading data.
        Senator Levin. And, Ms. Barnes, you had to borrow staff for
    new ratings, I understand, from surveillance, is that correct?
        Ms. Barnes. Yes, Mr. Chairman. At different times, we
    shifted resources between the two.
        Senator Levin. How about at that time, at that time that we
    are talking about?
        Ms. Barnes. In December 2006?
        Senator Levin. Yes.
        Ms. Barnes. I don't think so in December 2006, but in
    February, we were working jointly.
        Senator Levin. Jointly, but you were short of staff at the
    same time they were short of staff, is that correct? You were
    both short of staff?
        Ms. Barnes. Yes, Mr. Chairman. Everyone was working very
    hard and----
        Senator Levin. I know everyone was working hard. Were you
    both short of staff?
        Ms. Barnes. Right. As a manager, you are always asking for
    more resources to do more things----
        Senator Levin. This is just a routine time, right?
        Ms. Barnes. Right.
        Senator Levin. This was all routine.
        Ms. Barnes. No, not at all.
        Senator Levin. There wasn't a collapse, or a calamity that
    was about to hit us. It was just ordinary, bureaucratic,
    everyone can always use more staff. Everybody is working pretty
    hard. You needed more staff. You saw something coming, didn't
    you?
        Mr. D'Erchia. Yes.
        Senator Levin. And didn't you also need more staff, and
    didn't you make requests for more staff? Didn't you have to
    pull staff from other parts of the operation?
        Ms. Barnes. Yes, we did, Mr. Chairman.
        Senator Levin. February 2007, we need to talk about getting
    more resources in general. I see evidence that I really need to
    add staff to keep up what is going on with subprime and
    mortgage performance in general. And the company was doing
    well, wasn't it, pretty well profit-wise at this time, S&P at
    that time?
        Ms. Barnes. I can't speak to the financial performance.
        Senator Levin. Can you speak to that?
        Mr. D'Erchia. No. We, as I said, had our hands full with
    monitoring delinquencies to see if they would lead to realized
    losses.
        Senator Levin. And in 2006, delinquency rates for loans
    supporting subprime securities were hitting record levels, is
    that true, Mr. D'Erchia?
        Mr. D'Erchia. In 2006, yes.
        Senator Levin. And they outpaced any previous year for
    subprime RMBSes, is that correct?
        Mr. D'Erchia. To my knowledge, yes, Mr. Chairman.
        Senator Levin. And by the end of 2006, delinquencies in the
    high-risk subprime securities, RMBS securities, were
    approaching 10 percent and the vintage was not even a year old,
    is that correct?
        Mr. D'Erchia. The specific numbers sound correct.
        Senator Levin. There were a lot of reasons for the 2006
    loans that were going bad so quickly. Fraud in mortgage
    applications was up substantially. Low and no doc loans were
    prevalent. stated income loans, in which a bank doesn't verify
    the borrower's income, were everywhere. Combined loan-to-value
    was pushing 90 percent for subprime. Housing prices had peaked
    and were beginning to fall, making refinancing difficult. Is it
    correct that by late 2006, that you were of the opinion that
    subprime was rapidly deteriorating? Is that correct, Ms.
    Barnes?
        Ms. Barnes. I am sorry, which month?
        Senator Levin. What time?
        Ms. Barnes. I am sorry, I didn't catch the last part of
    your----
        Senator Levin. Is it correct that by late 2006, you were of
    the opinion that subprime was rapidly deteriorating?
        Ms. Barnes. I would say it was deteriorating at a pace that
    was higher than the previous vintages, yes.
        Mr. D'Erchia. Yes, I agree.
        Senator Levin. How about you, Ms. Yoshizawa?
        Ms. Yoshizawa. I think our RMBS group was publishing that
    it was higher than previous vintages, but it was still tracking
    with some of the previous downturn years.
        Senator Levin. OK. In late 2006, I believe that Standard
    and Poor's advised the head of structured finance was a person
    named Joanne Rose?
        Ms. Barnes. Yes, it was, sir.
        Senator Levin. That subprime was rapidly deteriorating and
    that you felt that Standard and Poor's should start downgrading
    subprime, is that correct?
        Mr. D'Erchia. We were downgrading subprime.
        Senator Levin. So that you felt Standard and Poor's should
    downgrade subprime, significantly.
        Mr. D'Erchia. At this time period.
        Senator Levin. Yes.
        Mr. D'Erchia. Yes.
        Senator Levin. And you continued to bring that up in 2007,
    is that correct?
        Mr. D'Erchia. Your charts show----
        Senator Levin. And was she resistant at all?
        Mr. D'Erchia. I wouldn't say resisted. She would want us to
    work more in conjunction with the deal side and others,
    including Frank and our research and our criteria groups, in
    order to ascertain whether or not we are seeing an anomaly
    where the delinquencies are front-end loaded, and the reality
    over the life of the transaction, if that became true, then we
    wouldn't be seeing such large losses and downgrades. When it
    became apparent that those losses were being realized, yes, we
    made those ratings appropriate.
        Senator Levin. Yes. But you had kind of a bone of
    contention, was there not, between you and Joanne Rose? Isn't
    that a fair statement? There was a disagreement between you and
    Joanne Rose on this issue, was there not? I mean, people have
    disagreements. Was there a disagreement about this issue?
        Mr. D'Erchia. About this issue?
        Senator Levin. Yes.
        Mr. D'Erchia. Yes.
        Senator Levin. OK. And as a matter of fact, it became such
    a bone of contention that she gave you a bad performance
    evaluation, didn't she? You had strong convictions on this
    subject, about the rapid deterioration of subprime mortgages
    and the need to downgrade, is that not true?
        Mr. D'Erchia. Yes, but it wasn't clear to me that the
    evaluation was personal issues or related to this issue.
        Senator Levin. But it may have been related to this issue,
    is that what you are saying? It wasn't clear to you----
        Mr. D'Erchia. It wasn't clear to me why she wrote that.
        Senator Levin. All right. It followed, however, some
    continued disagreements about the issue of the rapid
    deterioration of the subprime mortgages and the need to
    downgrade. Is that fair, that bad performance evaluation came
    at that time?
        Mr. D'Erchia. I guess I am not clear on what the exact
    question is.
        Senator Levin. You made a comment about her evaluation, I
    believe, is that not true----
        Mr. D'Erchia. My evaluation.
        Senator Levin. Yes.
        Mr. D'Erchia. Yes.
        Senator Levin. Of you.
        Mr. D'Erchia. I responded.
        Senator Levin. Who evaluated you?
        Mr. D'Erchia. Who evaluated me?
        Senator Levin. Was she evaluating you?
        Mr. D'Erchia. She wrote that evaluation.
        Senator Levin. That is what I am saying. And you had
    previously had a disagreement with her about the issue of
    downgrading subprime mortgages and the rapid deterioration, in
    your judgment, which was occurring, and she and you had a
    disagreement about that, and you have acknowledged that you did
    have a disagreement. Did you not write in your comment about
    her evaluation that you had a disagreement over subprime debt
    deterioration? Did you not write that in your reaction?
        Mr. D'Erchia. Yes, Mr. Chairman.
        Senator Levin. OK. The bottom line is that the credit
    rating agencies continued to issue AAA ratings on new subprime
    RMBS and CDOs in 2007 despite warnings, despite a large
    percentage of the 2007 vintage turning out to be problematic
    and downgraded, and it is a pretty sad story. A sad chapter in
    the history of credit rating agencies, folks. People put a lot
    of reliance, maybe too much reliance, on what you do, but that
    is a fact and it is no longer as much of a fact as it was a
    couple of years ago and there was a real failure here.
        How we deal with it, we will know in the next few weeks.
    There are some structural problems here in terms of conflict of
    interest, but there are some other issues, as well. We, I
    think, see some of it in the history which are in these
    exhibits. As much as exhibits can come to life, these problems
    are coming to life.
        I thank you all.
        Mr. D'Erchia. Thank you, Mr. Chairman.
        Ms. Yoshizawa. Thank you, Mr. Chairman.
        Ms. Barnes. Thank you, Mr. Chairman.
        Senator Levin. We are going to recess for 10 minutes.
        [Recess.]
        Senator Levin. OK. We will come back to order.
        Our third and final panel of witnesses for today's hearing
    is Raymond McDaniel, Jr., Chairman and Chief Executive Officer
    of Moody's Corporation, and Kathleen A. Corbet, the former
    President of Standard and Poor's from 2004 to 2007.
        I don't know if you were with us before when we said that
    under Rule 6 of our Subcommittee, all of our witnesses are
    required to be sworn. So I would ask you both to stand, raise
    your right hand, and answer the following question. Do you
    swear that all the testimony you are about to give will be the
    truth, the whole truth, and nothing but the truth, so help you,
    God?
        Mr. McDaniel. I do.
        Ms. Corbet. I do.
        Senator Levin. Thank you. And under our timing system, we
    will give you one minute notice. The light will turn from green
    to yellow. It will become red in 5 minutes, so we would ask
    that you try to limit your oral testimony to no more than 5
    minutes. I know that sometimes that goes over, and if it does,
    it does, but we would ask you to make that effort.
        Mr. McDaniel, I think we will have you go first, followed
    by Ms. Corbet, and then we will turn to questions. Thank you
    both for being here today. Mr. McDaniel.

     TESTIMONY OF RAYMOND W. MCDANIEL, JR.,\1\ CHAIRMAN AND CHIEF
                 EXECUTIVE OFFICER, MOODY'S CORPORATION

        Mr. McDaniel. Thank you, Mr. Chairman and Senator Kaufman.
    I am Ray McDaniel, Chairman and CEO of Moody's Corporation, the
    parent of the credit rating agency Moody's Investor Service. I
    want to thank you for the opportunity to contribute Moody's
    views today.
    ---------------------------------------------------------------------------
        \1\ The joint prepared statement of Mr. McDaniel and Ms. Yoshizawa
    appears in the Appendix on page 186.
    ---------------------------------------------------------------------------
        The global financial crisis has sparked a necessary debate
    about the role and performance of numerous participants in the
    financial markets. With respect to credit rating agencies, many
    market observers have expressed concerns that ratings did not
    better predict the deteriorating conditions in the subprime
    mortgage market.
        Let me assure you that Moody's is not satisfied, and I am
    not satisfied, with the performance of our ratings during the
    unprecedented market downturn of the past 2 years. We did not
    anticipate the extraordinary confluence of forces that drove
    the unusually poor performance of subprime mortgages. We were
    not alone in this regard, but I believe that we should be at
    the leading edge for predictive opinions about credit risk.
        Some key issues influencing the unanticipated performance
    included the steep and sudden nationwide decline in home prices
    and the sharp contraction that followed in credit available
    from banks for mortgage refinancing. Moody's did observe a
    trend of loosening mortgage underwriting and escalating home
    prices. We highlighted that trend in our reports and
    incorporated it into our analysis of mortgage-backed
    securities. And, as conditions in the U.S. housing market began
    to deteriorate beyond our expectations, we took the rating
    actions that we believed at the time were appropriate based on
    the information we had.
        Let me summarize our actions during the 2003 to 2007 time
    frame. First, starting in 2003, we identified and began
    commenting on the loosening of underwriting standards and
    escalating housing prices through our sector publications.
        Second, we tightened our ratings criteria in response to
    these loosening standards. In fact, between 2003 and 2006, we
    steadily increased our loss expectations and the levels of
    credit protection required for a given rating level. In
    practical terms, this meant that by 2006, half the mortgages in
    a pool would have to default and provide a recovery of just
    half the appraised value of the home before a subprime RMBS
    bond rated AAA by Moody's would suffer its first dollar of
    loss. This is a level of anticipated loss that far exceeded the
    losses that actually occurred in the past four real estate
    recessions. But even these conservative assumptions proved
    insufficient.
        Third, we took steps to watch and analyze the unprecedented
    market conditions and the behavior of various market
    participants as the crisis continued to unfold. For example,
    one question before the market was how borrowers, servicers,
    and banks would respond to the resetting of mortgage interest
    rates and how that behavior would affect default rates. Faced
    with extraordinary conditions, we saw market participants,
    including borrowers, mortgage servicers, mortgage originators,
    and the Federal Government, behave in historically
    unprecedented ways.
        Fourth, we took rating actions when the mortgage
    performance data warranted. Moody's monitors the actual
    performance of the mortgages and the securities that we rate
    throughout the life of the security. The early performance of
    the 2006 loans was, in fact, comparable to the performance of
    similar subprime loans during the 2000 and 2001 recession. And
    not until performance data from the second quarter of 2007 was
    available did it become clear that many of the 2006 vintage
    bonds might perform worse than those from the prior recession.
        In short, Moody's did see the loosening of some prime
    lending standards. We reported our observations to the market
    and we incorporated our increasingly unfavorable views into the
    ratings we assigned. However, let me emphasize again that we,
    like most other market participants, did not anticipate the
    severity or the speed of deterioration that occurred in the
    U.S. housing market, nor did we anticipate the behavior of
    market participants in response to the housing downturn,
    including the speed of credit tightening by financial
    institutions that followed and exacerbated the situation.
        The unprecedented events of the last few years provide
    critical lessons to all market participants, certainly
    including us. At Moody's over the past 2 years, we have
    undertaken a wide range of initiatives to strengthen the
    quality, transparency, and independence of our ratings. Some of
    these measures include establishing common macroeconomic
    scenarios for rating committees, publishing volatility scores
    and sensitivity analysis on structured finance securities,
    consolidating surveillance activities and structured finance
    under one leadership, and further bolstering the independence
    of and resources for our credit policy function.
        Moody's is firmly committed to meeting the highest
    standards of integrity in our rating practices. We
    wholeheartedly support constructive reforms and we are eager to
    work with Congress, regulators, and other market participants
    to that end.
        I am happy to respond to your questions.
        Senator Levin. Thank you very much, Mr. McDaniel. Ms.
    Corbet.

      TESTIMONY OF KATHLEEN A. CORBET,\1\ FORMER PRESIDENT (2004-
                       2007), STANDARD AND POOR'S

        Ms. Corbet. Thank you, Mr. Chairman and Senator Kaufman.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Ms. Corbet appears in the Appendix on
    page 210.
    ---------------------------------------------------------------------------
        My name is Kathleen Corbet and my career spans over 25
    years of experience within the financial services industry. For
    a 3-year period during my career, I served as President as
    Standard and Poor's, a division of the McGraw-Hill Companies,
    from April 2004 until my voluntary departure in September 2007.
        Before turning to the substantive issues raised by the
    Subcommittee's investigation, I would like to acknowledge the
    important work of the Subcommittee and Congress more broadly in
    its examination of the causes and consequences of the financial
    crisis.
        It is difficult not to feel personally touched by the pain
    experienced by many as a result of the turmoil in the subprime
    market and the financial crisis that followed. Many people feel
    anger, and in my view, that anger is understandable.
    Accordingly, I believe strongly that we should collectively use
    the lessons from this crisis to focus on effective reforms,
    stronger investor protections, better industry practices, and
    accountability.
        As background, I was recruited to join the McGraw-Hill
    Companies as an Executive Vice President of its Financial
    Services Division in April 2004 and served as President of
    Standard and Poor's until my successor, Deven Sharma, took over
    that position in September 2007. During my 3-year tenure, I led
    an organization of 8,000 employees based in 23 countries which
    provided financial information and market analysis to its
    customers and the broader market as a whole.
        The company was organized across four primary business
    units, including Rating Services, Equity Research Services,
    Index Services, and Data and Information Services. Each
    business unit was led by a seasoned executive having direct
    operating responsibility in the respective area and reporting
    directly to me.
        One of those units was Rating Services, which issued credit
    ratings on hundreds of thousands of securities across the
    globe, including corporate securities, government securities,
    and structured finance securities. Rating Services was led by
    an Executive Vice President for Ratings, an executive with over
    30 years of experience in the ratings business, who had day-to-
    day operational responsibility for that business. Among her
    direct reports was the Executive Managing Director of
    Structured Finance Ratings, who was responsible for the day-to-
    day operations of the Structured Finance Ratings Group, the
    group that issued the ratings that are the subject of this
    Subcommittee's focus.
        Consistent with S&P's longstanding and publicly disclosed
    practice, ratings decisions were and are solely the province of
    committees comprised of experienced analysts in the relevant
    area. This practice is based on the principle that the highest
    quality analysis comes from the exercise of independent
    analytical judgment free from both undue external or internal
    pressure. Accordingly, during my tenure, I did not participate
    in any rating or analytical criteria committee meetings
    regarding ratings on any type of security, including mortgage-
    backed securities.
        All that said, I do hope to be able to provide a business
    perspective that is helpful to the Subcommittee, and in my
    view, it is clear that many of the ratings S&P issued on
    securities backed by subprime mortgages have performed
    extremely poorly. S&P has publicly stated its profound
    disappointment with that performance, and I deeply share that
    sentiment.
        From my personal perspective, I believe the primary reason
    for these downgrades is that, despite its efforts to get the
    rating right and despite rooting its analysis in historical
    data, S&P's assumptions did not capture the unprecedented and
    unexpected outcomes that later occurred with respect to the
    housing market, borrower behavior and credit correlations.
        S&P, along with others, has been criticized for its failure
    to predict what happened in the subprime market, and in many
    ways, that criticism is justifiable. Moreover, the subsequent
    outcome of the severe economic downturn and downgrades of
    securities backed by subprime mortgages highlight the
    challenges inherent in the nature of ratings. At their core,
    ratings are opinions about what may happen in the future,
    specifically, the likelihood that a particular security may
    default.
        I think that most people agree that predicting the future
    is always challenging and outcomes can often turn out very
    differently than even the most carefully derived predictions
    anticipate. The key from my perspective is to learn from these
    experiences and to take specific actions to improve. The credit
    rating industry has begun to respond in a constructive fashion,
    but there is much more to be done.
        Through the course of history and through many market
    cycles, the credit rating industry has played an important role
    in the financial system for nearly a century, and I do believe
    that it has the opportunity to continue to do so through the
    commitment to continual improvements and from appropriate
    regulatory reform.
        Again, I appreciate the goals of the Subcommittee's work
    and would be glad to answer any questions that you have.
        Senator Levin. Thank you, Ms. Corbet. Thank you both.
        Before we start with questions, let me put into the record
    a statement of the Attorney General of the State of
    Connecticut, Richard Blumenthal. He has made a very powerful
    statement about the topic of the hearing today, which is ``Wall
    Street and the Financial Crisis: The Role of Credit Rating
    Agencies,'' and that will be made part of the record at an
    appropriate place.\1\
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Blumenthal appears in the
    Appendix as Exhibit 109, on page 1201.
    ---------------------------------------------------------------------------
        Were you both here earlier?
        Ms. Corbet. Yes, I was.
        Senator Levin. Mr. McDaniel, were you here, too?
        Mr. McDaniel. I was here for the second panel.
        Senator Levin. The second panel.
        Mr. McDaniel. Yes.
        Senator Levin. OK. Well, in that case, I may have to repeat
    some of the questions.
        The first exhibit that we have used is Exhibit 94b,\1\
    where a Standard and Poor's analyst wrote--maybe, Ms. Corbet,
    you could take a look at Exhibit 94b--``Vertical is politically
    closely tied to Bank of America and is mostly a marketing shop
    - helping to take risk off books of Bank of America. Don't see
    why we have to tolerate lack of cooperation. Deals likely not
    to perform.'' This deal was rated by Standard and Poor's
    anyway, even though the analyst said that the deal was not
    likely to perform.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 94b, which appears in the Appendix on page 599.
    ---------------------------------------------------------------------------
        Then the next transaction that I want to look at with you
    was Fremont, which is Exhibit 93b.\2\ Standard and Poor's was
    asked to rate an RMBS with subprime loans issued by Fremont
    Investment. This was a subprime lender known for poor quality
    loans. An email was sent by an S&P ratings analyst to his
    supervisor saying, ``I have a Goldman deal with subprime
    Fremont collateral.'' He says, ``Fremont collateral has been
    performing not so good. Is there anything special I should be
    aware of?'' One supervisor says, ``No, we don't treat their
    collateral any differently.'' Another one says, ``if the
    current FICO scores are there, the answer is good to go.''\3\
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 93b, which appears in the Appendix on page 589.
        \3\ See Exhibit No. 93c, which appears in the Appendix on page 590.
    ---------------------------------------------------------------------------
        Now, there was a whole lot of evidence, a whole lot of
    evidence beside evidence right inside of S&P that Fremont
    collateral was problematical, to put it mildly. Fremont had
    stopped using 8,000 brokers--that is Exhibit 93d\4\--due to the
    loans that those brokers were forwarding, which had some of the
    highest delinquency rates in the country. As a matter of fact,
    there was an exhibit where--Exhibit 93a\5\--a Moody's analyst
    in late December 2006, before the Fremont deal was rated, said,
    ``Holy cow . . . Fremont is such an outlier,'' talking about
    their delinquency rates being one of the worst in the country.
    That is Exhibit 93a at the bottom. This analyst almost couldn't
    believe it. ``Holy cow--is this data correct? I just graphed it
    and Fremont is such an outlier!!''
    ---------------------------------------------------------------------------
        \4\ See Exhibit No. 93d, which appears in the Appendix on page 592.
        \5\ See Exhibit No. 93a, which appears in the Appendix on page 587.
    ---------------------------------------------------------------------------
        It was well known, publicly, inside of the credit rating
    agencies, that Fremont collateral was problematical. There had
    also been a California Court of Appeals decision described in
    an 8(k) filing by Fremont where there was sufficient evidence
    in a lawsuit by the California Insurance Commissioner talking
    about Fremont. There was a cease and desist order at the FDIC
    involving Fremont. But all we get internally here is, you are
    good to go. The fact that we know that they are problematical
    does not affect us.
        And I am just wondering--first, let me start with you, Ms.
    Corbet. Your own employees know that Fremont issued poor
    quality loans, high delinquency rates, and yet they handle
    Fremont loans the way they do any other loans. Shouldn't that
    kind of a history be taken into account by S&P?
        Ms. Corbet. Well, first of all, Mr. Chairman, I am not
    familiar with this particular transaction or the people that
    wrote this email or corresponded with this email. I would say,
    however, that in the analysis of any transaction in terms of
    both the quantitative analysis and qualitative model, that all
    factors are considered in the consideration of a rating.
        Senator Levin. Should be.
        Ms. Corbet. All factors should be considered, yes.
        Senator Levin. So that Standard and Poor's assigns lower
    ratings to lenders that are known for poor quality loans with
    high delinquency rates? Does Standard and Poor's assign lower
    ratings to lenders that are known for poor quality loans?
        Ms. Corbet. I would suggest to you that in this particular
    case, in terms of discussing the collateral, again, this is
    perhaps just one piece of a larger discussion around a
    transaction, but I think the question was, should anything be
    considered about the FICO scores, and that is something that
    has nothing to do necessarily with, in this particular case,
    the provider of this transaction, and I believe that whoever
    this person was that was responding said that shouldn't make a
    difference. That is another element of data. It doesn't mean
    that not everything was considered. It is just that means that
    it shouldn't be changed in terms of treating it any
    differently. That would be my observations. Again, I don't know
    anything specific about this transaction.
        Senator Levin. Well, I am asking you generically. In this
    transaction, you have got an analyst who says, ``I have a
    Goldman deal with subprime Fremont collateral. Since Fremont
    collateral has been performing not so good, is there anything
    special I should be aware of?'' Answer, ``we don't treat their
    collateral any differently.''
        My question, when you got Fremont, which has been not only
    publicly, but now internally an analyst says Fremont collateral
    has not been performing good, was that the right answer, don't
    treat their collateral any differently?
        Ms. Corbet. I am not sure what they were referring to,
    whether they are treating it in a model, whether they are
    considering it in any other context, so I couldn't say----
        Senator Levin. Is that the right answer?
        Ms. Corbet. Again, I think it is----
        Senator Levin. That is the whole answer.
        Ms. Corbet [continuing]. In a small context. It is not
    clear whether he is suggesting that it should be different in
    any other kind of model. It is the underlying collateral that I
    think he is referring to.
        Senator Levin. Should the collateral be treated differently
    where the collateral is coming from a company that is not
    performing so good?
        Ms. Corbet. Again, in the context of all the different
    variables that need to be considered, I could not comment as to
    whether or not the particular query that he is asking about----
        Senator Levin. No, I am asking you a generic question.
    Should collateral that is coming from a company whose
    collateral in general is not performing so good, should that
    collateral be treated differently?
        Ms. Corbet. I think that certainly should be taken into
    consideration.
        Senator Levin. It wasn't here. That is all I can tell you.
    It is your company, and I don't know if anyone cares to do
    anything about it when you get that kind of an answer, but I
    would think that the message ought to go from the leadership of
    an agency--that is something which should be looked at, not, it
    doesn't make any difference. The answer is here from a
    supervisor, it doesn't make any difference that their
    collateral is not performing well.
        Ms. Corbet. No.
        Senator Levin. You just said finally, after the fourth time
    I asked, it should be looked at differently.
        Ms. Corbet. And it doesn't mean that it wasn't.
        Senator Levin. You don't know that it wasn't. I don't know
    that it wasn't.
        Ms. Corbet. I don't----
        Senator Levin. All we know is what the response was, and
    you are saying it was the wrong response. It should be a factor
    in how it is treated, right?
        Ms. Corbet. And it very well might have been.
        Senator Levin. I am not asking you whether it might have
    been or was. It got a AAA rating. My question is, should it be
    treated differently?
        Ms. Corbet. I would expect it would be considered----
        Senator Levin. And should?
        Ms. Corbet. I would expect that it would be considered,
    yes, sir.
        Senator Levin. And would you believe it should be
    considered differently?
        Ms. Corbet. I would expect that all of the different
    provisions of the transaction should be considered, yes,
    Senator.
        Senator Levin. Thank you.
        Now let me ask you, Mr. McDaniel, does Moody's assign lower
    ratings to lenders that are known for poor quality loans with
    high delinquency rates?
        Mr. McDaniel. Do you mean to the lenders themselves?
        Senator Levin. No, to the loans of those lenders.
        Mr. McDaniel. Clearly, pools of lower-quality loans versus
    higher-quality loans is a credit factor, absolutely.
        Senator Levin. No, I am not asking you that. I am asking
    you whether or not you assign a lower rating if you know that
    the lender involved is known for poor quality loans with high
    delinquency rates. Is that something you look at when you rate
    their loans?
        Mr. McDaniel. It absolutely is something we look at, yes.
        Senator Levin. Senator Kaufman.
        Senator Kaufman. Thank you very much.
        Just so I get it clear, it is in your statements, I mean,
    but just to kind of concentrate on what it is, we know that
    thousands of RMBSes that were rated AAA in 2006-2007 are now
    rated as junk. Mr. McDaniel, what would you give precisely as
    what you think are the main reasons why that happened?
        Mr. McDaniel. I think there were a number of reasons. Among
    the principal or the most proximate reasons would be that we
    went from a period where there was a long period of home price
    appreciation. There was low interest rates and low credit
    spreads so that there was a lot of credit availability. We had
    the introduction of--when we had the introduction of a
    softening in the housing market, the loose credit that had been
    available tightened very rapidly and that curtailed refinancing
    opportunities for many borrowers who were anticipating that
    they were going to be able to refinance their mortgages.
        Senator Kaufman. OK. Ms. Corbet.
        Ms. Corbet. I would concur with all of that statement.
    Indeed, it was predicting what the likely outcome would be, not
    only in terms of the housing market, but also unemployment,
    borrower behavior, also credit correlations. All of those in
    terms of the forecast were certainly not as great as the
    outcome that actually transpired.
        Senator Kaufman. So essentially it was the housing market.
    I mean, it was the housing market, all the things that were
    happening----
        Ms. Corbet. It was the confluence, many factors----
        Senator Kaufman [continuing]. The meltdown of all the
    things.
        Ms. Corbet. Yes.
        Senator Kaufman. Mr. McDaniel, is that----
        Mr. McDaniel. That was it.
        Senator Kaufman. Mr. McDaniel, as you said in your
    testimony, and as you mentioned here earlier, as early as 2003,
    you were talking about the housing market. You were saying that
    the housing market--on page 18 of your testimony. So you knew
    as early as 2003 this was going to be a problem. This just
    didn't come on you in 2006 and 2007 like I think sometimes it
    is characterized by certain people, as kind of like a natural
    disaster. It was like a volcano or a hurricane. This housing
    thing happened, and you have just got to understand when things
    like that happen. We had years and years and this never
    happened before. Therefore--I mean, this is a constant theme we
    are hearing in these hearings.
        But as early as 2003, you knew the housing market was a
    problem and you lay out what your concerns are. So you are now
    at 2006 and 2007, and I understand you have tightened your
    standards, but when it is all over, an incredible number of
    these thousands--they said something like 10,000 RMBSes from
    2002 to 2007, the majority of AAA ratings are now rated as
    junk. How does that happen?
        Mr. McDaniel. First, Senator, we did not identify a housing
    bubble in 2003. We certainly----
        Senator Kaufman. No. I mean you saw the oncoming.
        Mr. McDaniel. Yes, we saw loosening underwriting
    standards----
        Senator Kaufman. Right.
        Mr. McDaniel [continuing]. And we were certainly aware that
    home price appreciation was occurring through this period.
        Senator Kaufman. So, it is hard--Ms. Corbet, I will get
    back to it and maybe the two of you can work together. There is
    the chart. Oh, that bubble just came on.
        Look, I am not saying we are all victims of our own
    personal experience. In 2005, I sent my children a printout
    from Merrill Lynch of essentially that chart, and I sent with
    them what Merrill Lynch said. People say that this is because
    there are so many more people buying houses, but if that was
    true, they showed another chart and it showed then rental use
    would go up, too, and rental use was rock solid. So we have a
    housing bubble. That is what Merrill Lynch sent out to me as a
    Merrill Lynch investor and I sent it to my kids.
        The fact that we were coming onto a bubble, as you say, you
    didn't say it in 2003, but you are talking about it generally
    and you are still--do you see my point? These products are
    still rolling off the assembly lines with AAA on them.
        Mr. McDaniel. That is exactly why we were raising the
    credit protection levels associated with the highly-rated
    securities. I acknowledge they proved to be insufficient upward
    adjustments in credit protection. Those adjustments were
    overwhelmed by the actual performance of the mortgages that
    were created in the 2006-2007 period.
        Senator Kaufman. Ms. Corbet, does that agree with some of
    your position?
        Ms. Corbet. Yes. In fact, Standard and Poor's was reporting
    on what they saw was the increasing risks of the housing
    bubble, and throughout the course of 2004, 2005, through 2007,
    those analyses and research vis-a-vis publications and
    teleconferences were provided to the market, as well as what
    the expected impact might be on subprime mortgages.
        Senator Kaufman. But you must admit, and I understand and I
    have understood for a long time that what most people think is
    AAA and most people think is what you do is not what you do,
    but it is fair to say that if you are sending out all kinds of
    advisories and putting all kinds of prints, but the AAAs are
    still rolling off the assembly line, that is really what
    affects investors, right? I mean, we have a problem here, but
    by the way, I am just going to send another group of AAAs down
    the old pike. And the argument is kind of like, well,
    historically, we really did well. This never happened before.
        But you had to have some kind of seeing that there is a
    dark cloud on the horizon, and you didn't see those in the
    corporation. You get up every day kind of thinking about it.
    How am I going to make this work? How am I going to protect my
    brand? How am I going to make money? How am I going to make all
    this work?
        And, Ms. Corbet, I know you don't take any part in doing
    the ratings, but was there any--I mean, did either of you feel
    a little bit uncomfortable? Did you get up in the morning and
    say, we are still rating these things AAA and it doesn't look
    good, Mr. McDaniel? Let me put it this way, when did it hit you
    that maybe we ought to really take a hard look at what we are
    rating AAA, not what we are sending out, not that we are
    setting up credit backup, but what we are actually--RMBSes that
    we are rating AAA? About when did you start feeling, there is a
    problem here and I am the CEO. I am going to have to address
    that.
        Mr. McDaniel. We endeavor to take a hard look at everything
    we rate----
        Senator Kaufman. No, but, I mean----
        Mr. McDaniel [continuing]. Regardless of the rating level--
    --
        Senator Kaufman. No, I know, but there are some----
        Mr. McDaniel [continuing]. Including AAA.
        Senator Kaufman. But somewhere in here, there was a point
    at which you did something differently, didn't you? Or did this
    just kind of peter out on its own? Was there any modification
    of behavior as you--did you ever go to any of the people on
    your board or people that were working for you and say, look,
    this is a bad situation. We ought to start doing something a
    little different than what we did yesterday.
        Mr. McDaniel. We certainly were aggressively monitoring the
    market and looking at the performance of mortgages and
    associating that performance with the credit protection levels
    in these deals. If you are asking what was probably the most
    important point in time, at least for me----
        Senator Kaufman. Yes.
        Mr. McDaniel [continuing]. It was when we saw that the
    delinquency and default trends for the mortgages originated in
    2006 departed from the delinquency and default trends that we
    had seen in prior recessions, most recently the 2000-2001.
        Senator Kaufman. And when would you think that was?
        Mr. McDaniel. That was in the second quarter of 2007. Until
    then, they had been tracking almost identically to the default
    and delinquency trends we saw in the previous recession, and we
    knew that the transactions had more than sufficient credit
    protection to withstand that kind of a downturn.
        Senator Kaufman. So if I went back and looked, the number
    of AAAs rolling out the door as a percentage after the first
    quarter of 2007 would have begun to change?
        Mr. McDaniel. The credit protection levels were raised, and
    then the market shut down very quickly after that.
        Senator Kaufman. Ms. Corbet, when did you first pull your
    management team together and say, I don't think this is like
    what has happened in the past. We are producing products--way
    too many of our AAAs are defaulting. We should really change
    the way things are going.
        Ms. Corbet. Well, I think Standard and Poor's, concurrent
    with its own research and publications of some of the stresses
    that they were beginning to see in the marketplace back in
    2005, they began to make, as earlier testified by the S&P
    folks, that they began to make changes in their criteria and
    their credit enhancement levels in 2005 and in 2006, as well.
    In fact, in 2006, the number of downgrades exceeded the number
    of upgrades for subprime residential mortgage-backed
    securities. So the actions were following the research and the
    findings that were being reported to the marketplace.
        In 2007, following again the two previous credit
    enhancement increases, again, the performance data was
    suggesting that it was even more serious than was previously
    contemplated, and so, therefore, in February 2007 S&P made
    another change and announcement of downgrades to--credit watch,
    excuse me, for subprime mortgages.
        In March, we reported also in a teleconference about what
    our outlook was in terms of expectations for the housing market
    and what the impact may be in terms of downgrades----
        Senator Kaufman. And again, this reporting is great, but
    really, the key----
        Ms. Corbet. Is actions, yes.
        Senator Kaufman. Yes. But, I mean, the key is how many AAAs
    are we sending out the door that in retrospect, when you look
    back on it 2 years later, are not AAA but they are junk? I
    mean, that is really the key. I think--and, Ms. Corbet, were
    you here for the first panel?
        Ms. Corbet. I was in and out, yes.
        Senator Kaufman. OK. That is not what they said in the
    first panel. They said a number of things, and what I would
    like to do is kind of go through them and see what you say.
    They said it was incentives.
        Ms. Corbet. Yes.
        Senator Kaufman. Mr. McDaniel, they said that there were
    incentives in the organization, in Moody's, to get more
    business out the door, to not worry so much about what the
    rating is going to be, just move it out there, quantity over
    quality, I think, is the term that one of the gentlemen used.
    Clearly, you haven't raised that as one of the problems.
        Mr. McDaniel. Ratings quality is paramount at Moody's. It
    has been, I think, throughout our history and it continues to
    be. We rate according to published methodologies. Our thinking
    is as transparent as we can make it, to provide the market the
    opportunity to----
        Senator Kaufman. So, basically, you just think that there
    was no incentive problem inside Moody's, that essentially
    everything went just exactly as you just said. This is an
    operation that was smoothly functioning and there was no--the
    incentives--to the extent there were incentives for people to
    do things other than what you said, to take a cold eye view at
    everything, you just didn't see it and you had no reports of
    anyone in your organization saying, maybe we are incentivizing
    people to maybe move the process a little bit one way or the
    other.
        Mr. McDaniel. We have many business objectives at the firm.
    None of those objectives are permitted to compromise ratings
    quality. People actively talk about whether our protocols and
    procedures are sufficient, whether they are best practice,
    should they be changed, and if they can be and we can improve
    ourselves, we do.
        Senator Kaufman. Yes. So I am just saying, in terms of what
    these four gentlemen were up here saying uniformly is something
    that you didn't hear about at the time, don't see it being a
    problem in terms of incentives, and that, essentially,
    everything was working smoothly from your view as CEO?
        Mr. McDaniel. I was not aware of any incentives being
    misaligned----
        Senator Kaufman. When you talked about incentives in
    business meetings, did you ever say, look, we had better be
    careful that we don't create too many incentives for market
    share and profits, that maybe someone down in the organization
    might get the wrong message and begin to kind of--especially
    when you had the explosion of business that you had during this
    period? Can you put the chart up that shows how much business
    grew?\1\ I mean, this was literally an explosion of business.
    And what they said was, this was a market. This is great. Look
    at this.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1g, which appears in the Appendix on page 242.
    ---------------------------------------------------------------------------
        Mr. McDaniel. Well----
        Senator Kaufman. That usually happens in every business
    organization I have been involved in, management comes to me
    and says--let us get it out the door. Let us watch our profit
    line. Let us get this business. Let us be competitive. There
    were stories about market share where managers were in trouble
    if their market share dropped, and when they checked on why the
    market share dropped, the person said, look, these were just
    bad loans. We didn't do them. And the manager came back and
    said, well, look, other people are doing it. You have dropped
    three points. We can't have that. Do you believe any of that
    went on at Moody's?
        Mr. McDaniel. I have been with Moody's 23 years. I am
    unaware of any employee at Moody's ever being removed or
    terminated for a market share----
        Senator Kaufman. Or how about just basically said, get with
    the program?
        Mr. McDaniel. As I said, we are interested in----
        Senator Kaufman. What would you attribute the incredible
    growth during this period to, great management practices?
        Mr. McDaniel. The growth in the debt markets.
        Senator Kaufman. Right.
        Mr. McDaniel. That is what I attribute that growth to.
        Senator Kaufman. OK. Ms. Corbet, in S&P, did you----
        Ms. Corbet. In S&P, certainly the growth in the credit
    markets, but also in the three other businesses that S&P is
    involved in. The index services business is a very large and
    growing business with indices and ETFs, the data and
    information business, and, as well as equity research, and all
    four contributed to the growth at S&P.
        Senator Kaufman. Mr. McDaniel, I am not asking about this
    specific email because it was a long time ago, it was October
    2007, but it says, analysts--this is from Moody's Chief Risk
    Officer--``Analysts and managing directors are continually
    pitched by bankers, issues, and investors, all with reasonable
    arguments. These views can color credit management judgments,
    sometimes improving it, other times degrading it. We call it,
    drinking the Kool-Aid. Coupled with strong--and this is a
    market share, market focus--this does constitute a risk to
    ratings quality.''\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24b, which appears in the Appendix on page 319.
    ---------------------------------------------------------------------------
        And I am not asking you about this specific thing, but you
    still say that you never had any feelings in the organization
    that the incentives and desire for short-term profits had any
    impact on your ratings?
        Mr. McDaniel. I am aware of the passage that you just read
    and the author of that passage was talking about the fact that
    we are gathering information from many different sources in the
    marketplace, issuers, investors----
        Senator Kaufman. Yes.
        Mr. McDaniel [continuing]. Bankers, all with point of
    view----
        Senator Kaufman. Right.
        Mr. McDaniel [continuing]. And that runs the risk of having
    our thinking match the consensus thinking in the marketplace--
    --
        Senator Kaufman. Right.
        Mr. McDaniel [continuing]. And that the strength of the
    work that we do is to have independent points of view.
        Senator Kaufman. Sure. No, I got that.
        And, Ms. Corbet, I didn't get a chance for you to answer
    the question. When you were CEO of Standard and Poor's, did you
    ever run into someone coming to you and saying, I feel under
    pressure to do some things, maybe in order to build business,
    in order to increase profitability? Never once, right?
        Ms. Corbet. No.
        Senator Kaufman. OK. One of the men on the first panel who
    had been there for a number of years said the whole time he is
    worried, aren't they going to see that they are destroying our
    brand? Aren't they seeing by doing these short-term things we
    are destroying our brand? Mr. McDaniel, you never felt any
    problem during this period that what was going on--clearly,
    since you don't think anything was going to hurt the Moody's
    brand.
        Mr. McDaniel. The ability to run a successful business in
    the credit ratings industry is first and foremost dependent on
    having predictive ratings. And so business success is very
    tightly aligned with the quality of the ratings, which is----
        Senator Kaufman. That is the point he was making. He is
    saying that our whole business depends on this.
        Mr. McDaniel. And that is why the performance of the
    subprime mortgage securities, particularly in 2006 and 2007, is
    so frustrating to me as a CEO, among other reasons.
        Senator Kaufman. Well, I don't see why it would be
    frustrating, because basically, what happened was we had this
    housing market blow-up, and through no fault of our own,
    everything went south. There was nothing--you have not
    identified a single thing that was going on at Moody's other
    than just you guys got caught in a bad housing market, not in a
    bad business market, a bad housing market.
        Mr. McDaniel. There are a number of things that, in
    hindsight, I wish we had done differently, absolutely.
        Senator Kaufman. That is really what I was trying to get at
    with the first question. What are some of the things that, in
    hindsight, you would have done differently?
        Mr. McDaniel. There are a number. I think at the macro
    level, we were insufficiently rigorous in thinking about trends
    in housing at an overall system level, and even more
    importantly, having thought about that, pushing that
    macroeconomic, macro housing perspective down into the rating
    committee deliberations.
        Senator Kaufman. How would you have done that? I mean, the
    system that you have laid out was, as Ms. Corbet even said--I
    didn't have anything to do with this rating thing. I think your
    testimony is essentially--how would you have done that? How
    would you have, in this system, been able to communicate down
    and you say, look, we are not being rigorous enough in this
    analysis? What would you do mechanically? Would you send a memo
    to everybody and say, while we are doing this thing, let us
    take a look at these?
        Mr. McDaniel. What we are doing now is a formal macro risk
    perspective series. It is updated every 6 months. This is done
    on a global basis. And we are taking the relevant components of
    that macro risk perspective and the stress scenarios around
    that and delivering those to--not only to our own employees,
    but to the marketplace, as well, and instructing the managers
    and rating analysts that they should utilize the relevant parts
    of that macro analysis.
        We are also using, particularly in the mortgage sector, we
    are relying much more heavily on work done by a company that we
    purchased back in, I think it was late 2005, perhaps early
    2006, Moody'seconomy.com, which provides housing analysis
    nationwide, housing demographic and econometric analysis.
        Senator Kaufman. Is there anything else just short, any
    other thing you think in retrospect----
        Mr. McDaniel. Yes. As I said, there are a number of things.
        Senator Kaufman. Right.
        Mr. McDaniel. In addition, we determined that we had to
    have more cross-disciplinary expertise in the rating
    committees, that there are other elements operating in the
    credit markets that may affect housing, that bringing different
    disciplines to bear in the rating really brings a richer
    perspective.
        We have changed governance practices in the ratings
    business. We have changed our methodologies and our
    enhancements. We have added different types of research to try
    and communicate our views as clearly as possible. There is a
    very long list and I am trying to hit on----
        Senator Kaufman. I have got it. No, that is not good
    enough.
        Ms. Corbet, is there anything in retrospect that you would
    have done differently?
        Ms. Corbet. Well, similarly to Moody's, Standard and Poor's
    has taken increased steps in terms of governance, in terms of
    including in their forecasts and ratings elements of stability,
    the stability of ratings, the comparability of ratings----
        Senator Kaufman. How about have you thought at all about
    the way you incentivize people within the organization? Has
    that been a concern at all?
        Ms. Corbet. Well, historically, and I believe that is the
    case today, that analysts have never been incentivized based
    on----
        Senator Kaufman. No, I am not talking about analysts. I am
    talking about people from top to bottom in the organization,
    the business part of the organization.
        Ms. Corbet. At Standard and Poor's throughout--certainly
    during my tenure--it has always been about the analytical
    quality and independence of the ratings being first and
    foremost and not being compromised.
        Senator Kaufman. Yes. I am sorry you didn't hear the first
    panel because it was pretty unanimous that it stopped at some
    point and moved to a situation where the business part of--and
    by the way, just so you don't feel bad, the hearing we had last
    week, Washington Mutual, exactly the same discussion went on,
    is it fair to say, that people that were involved in it feel
    that the incentives were such and the disincentives were such
    within the organization that things were done that they wish
    they hadn't done, that quality was overlooked, that it was more
    about quantity than quality.
        So it is not just at Standard and Poor's and Moody's, and I
    am sure we are going to find, from everything I can see, it has
    happened in loads and loads of organizations. Things are going
    great. Let us do it. We know what we are doing. Let us just get
    the stuff out the door. So anyway, I am just saying, it is of
    concern, that also at Washington Mutual, the head of Washington
    Mutual had no idea this was going on while many people in the
    organization felt that was going on, so----
        Ms. Corbet. Well, to the extent that was, and again----
        Senator Kaufman. And I am going to ask you to comment
    later.
        Ms. Corbet [continuing]. I think that it is important that,
    and certainly was the case, I believe, at S&P, is that they
    should have had the ability to raise those concerns with their
    management team----
        Senator Kaufman. Sure.
        Ms. Corbet [continuing]. And hopefully those would have
    been addressed if those were----
        Senator Kaufman. Yes, I know, and they did and they
    weren't. A lot of people think it is CEO pay that makes
    Americans so upset. I have my own opinion that the CEO pay
    thing is. The average pay of a CEO as compared to the average
    working person has grown quite exponentially, and I know people
    are concerned about that.
        But I think it is more that when these things happen. I
    mean, the idea that one of the smartest people I ever met,
    Robert Rubin--one of the smartest people I ever met, I am not
    overstating that, smart from a standpoint of knowledge, smart
    in terms of politics, smart in everything else--is making $30
    million a year as the Vice Chairman of Citigroup and says, I
    didn't know there was this $49 billion bomb down in the bottom
    of my business. I mean, that is what I think people are really
    upset about. They are upset about the pay, but then they are
    upset that when these things are going on and when things are
    going on down in their business, as these four--and they seem
    to me dedicated employees, they are not disgruntled employees.
    They said it almost like they were as upset as anyone else. And
    I know the companies I worked at, people would have been upset
    if they felt like the brand was being hurt, because people live
    it.
        But do either one of you want to comment a little bit on
    barbelling, the idea that FICO scores--that the way that you
    calculated FICO scores and used averages allowed ne'er-do-wells
    to kind of pick mortgages so that they could take advantage of
    the averages? Are you familiar with barbelling?
        Mr. McDaniel. As far as barbelling by taking strong and
    weak FICO scores----
        Senator Kaufman. Right.
        Mr. McDaniel [continuing]. And averaging those out, we do
    not look at FICO scores on an average basis, so that
    barbelling, I don't----
        Senator Kaufman. And you never have?
        Mr. McDaniel. I don't believe so, so I don't think that
    would have achieved what someone might have wanted to achieve.
        Senator Kaufman. And, Ms. Corbet, do you----
        Ms. Corbet. I am unfamiliar with the term.
        Senator Kaufman. Unfamiliar with the term. How about stated
    income loans? Mr. McDaniel, you are familiar with what a stated
    income loan is, aren't you?
        Mr. McDaniel. Yes.
        Senator Kaufman. And, Ms. Corbet, are you familiar with
    stated income loans?
        Ms. Corbet. Yes.
        Senator Kaufman. Did you feel at any point there was like
    an explosion of stated income loans throughout the business?
    With the explosion of the business went the explosion of stated
    income loans, and from the data we have, there are many
    companies that were going--it started out as just a small part
    of the business and becoming more. At any point, did you get
    concerned or would you be concerned, or is that part of the
    calculation of the ratings, that there were a lot of stated
    income loans in a particular security?
        Mr. McDaniel. Yes, that would absolutely be a credit factor
    for an analyst or rating committee to consider.
        Senator Kaufman. Do you know if any was, if it was?
        Mr. McDaniel. I have not participated in the rating
    committees----
        Senator Kaufman. Right.
        Mr. McDaniel [continuing]. But I would be extremely
    surprised if they hadn't.
        Senator Kaufman. Ms. Corbet.
        Ms. Corbet. I would expect the same.
        Senator Kaufman. Yes. OK. Mr. Chairman.
        Senator Levin. Thank you so much, Senator Kaufman.
        I think it is all well and good to look back and figure out
    what we would have done differently if we had known. Part of
    the responsibility is to look at what happened at the time.
    When we look at what happened at the time, we see the huge
    impact on the drive for market share on these companies, and
    there is just no getting away from it. The testimony this
    morning was very powerful about it.
        Just take a look at a few of the exhibits, Exhibit 3,\1\
    first, in your book, if you would. It is August 17, 2004,
    importance, high. ``Rich, We are meeting with your group this
    week to discuss adjusting criteria for rating CDOs of real
    estate assets this week because of the ongoing threat of losing
    deals.'' Now, that is a Standard and Poor's exhibit, August
    2004, an ``ongoing threat of losing deals.''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3, which appears in the Appendix on page 250.
    ---------------------------------------------------------------------------
        Then you look at the next exhibit, Exhibit 2.\2\ This is
    Standard and Poor's, as well. ``We just lost a huge . . . RMBS
    deal to Moody's due to a huge difference in the required credit
    support level.'' Down a paragraph, ``Losing one or even several
    deals due to criteria issues, but this is so significant that
    it could have an impact in future deals. There's no way we can
    get back on this one but we need to address this now in
    preparation for future deals.'' That is Exhibit 2.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 2, which appears in the Appendix on page 249.
    ---------------------------------------------------------------------------
        Then you look at Exhibit 5,\3\ the new S&P ratings model
    could have been released months ago, which is called Version
    6.0, and ``resources assigned elsewhere if we didn't have to
    massage the sub-prime and Alt-A numbers to preserve market
    share.'' Preserve market share. We could have done the right
    thing, in other words, months ago if we didn't have to massage
    the subprime and Alt-A numbers to preserve market share. This
    is contemporaneous. This isn't looking back. This isn't looking
    in the rearview mirror. This isn't benefit of hindsight. This
    is what is going on at the time.
    ---------------------------------------------------------------------------
        \3\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        Then you look at the testimony of Mr. Michalek this
    morning, a former analyst at Moody's, pretty compelling
    testimony. He testifies that the President of Moody's and the
    former head of Structured Finance, Brian Clarkson, who he
    believed was leading a change in culture at Moody's away from
    the more analytical environment to a profit-driven one, more to
    their customer, the investment bank, instead of the real
    customer, the investing public, but nonetheless what he says is
    that a number of bankers complained to Mr. Clarkson that Mr.
    Michalek was asking too many questions, doing too thorough a
    review. They wanted him removed from their deals, and they got
    their wish on future deals.
        Instead of rewarding Mr. Michalek for asking the probing
    questions and doing his job, he testified that Mr. Clarkson
    suggested that he provide an explanation for what he was doing
    and he ultimately was then not allowed to work on deals with
    certain banks. That message is a pretty clear message to
    employees. It is contemporaneous. It is at the time.
        Then you have another exhibit, Exhibit 11,\1\ email, May
    2006. A UBS banker writes to S&P, ``heard you guys are revising
    your residential [mortgage-backed securities] rating
    methodology - getting very punitive on silent seconds. [h]eard
    your ratings could be 5 notches back . . . [g]onna to kill your
    [residential business]. [m]ay force us to do moodyfitch only
    cdos!'' So, an S&P employee forwards the email to a colleague
    and he says, ``Any truth to this?'' The colleague responds,
    ``We put out some criteria changes a couple of weeks ago that
    we will begin to use for deals closing in July. . . . We
    certainly did not intend to do anything to bump us off a
    significant amount of deals.'' God forbid we do something which
    bumps us off a significant amount of deals.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 11, which appears in the Appendix on page 287.
    ---------------------------------------------------------------------------
        So, you want to look backwards, and we all do. When
    mistakes are made, we all love to just say, let us look
    forward. Don't look in the rearview mirror. But folks, there
    was huge pressure, according to these documents and testimony,
    to preserve market share contemporaneously at the time this
    happened.
        And one of the reasons according to testimony and according
    to the exhibits that there was not downgrading of existing
    RMBSes and CDOs, despite existing delinquencies, was you have
    got to hold on to market share. Analysts didn't have the data
    or the resources needed to do the volume of high-risk deals
    that they were asked to rate. You guys were making a lot of
    money. They didn't have enough resources. Investment bankers
    had excessive influence. Why? You needed their business.
        Now, I want to give some other testimony. The manager of
    the CDOs, a guy named Gus Harris, used to tell staff that if
    they lose market share, they are going to be fired. And we have
    that testimony, contemporaneous testimony. Were you troubled by
    it when you heard it? I don't know if you heard it all.
        Mr. McDaniel. As I said, no employee at Moody's has ever
    been fired for market share issues, ever.
        Senator Levin. Have they been threatened that they would be
    fired?
        Mr. McDaniel. Not that I am aware of.
        Senator Levin. Is there any evidence that market share
    drove ratings? Have you seen it? Have you looked at these
    exhibits? Have you listened to what I just told you?
        Mr. McDaniel. As I testified earlier, ratings quality is
    paramount.
        Senator Levin. Of course. It is supposed to be paramount.
        Mr. McDaniel. We look at other things that are relevant to
    running a business. That includes market share, and in
    particular in ratings includes market coverage, whether we are
    paid for that coverage or not because we are operating a system
    in which the comparative elements are important. So being able
    to compare one security to another with a common view of credit
    or a common language for credit as expressed in the rating, I
    do think is important. That is different from market share for
    financial purposes.
        Senator Levin. Ms. Corbet, are you surprised to hear
    testimony and exhibits about the impact of market share at the
    time?
        Ms. Corbet. Well, also, let me say, Mr. Chairman, that
    indeed, one of the things that Standard and Poor's, I think
    early on, recognized, that to mitigate any pressure if it came
    from externally, as some of the emails indicated, was really to
    separate the commercial from the analytical process, and so I
    think that was important in terms of--and exists today in terms
    of there is separation of the business from the ratings.
        Market share in many different ways can be a measure of the
    market's acceptance of the quality of the ratings, and so to
    the extent that market share declined, it could be many
    different things that would be looked into in terms of whether
    or not--and first and foremost, in any respect, that the
    quality of the ratings was in any way not useful to the
    marketplace.
        Senator Levin. If you look at Exhibit 24a,\1\ this is a
    Moody's exhibit. This is the one we talked about before.
    ``Market share by deal count dropped to 94%.'' Any lower--
    ``It's lower than the 98+% in prior quarters. Any reason for
    concern . . .?''
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24a, which appears in the Appendix on page 318.
    ---------------------------------------------------------------------------
        And then you have this Exhibit 24b.\2\ If you look at that,
    Mr. McDaniel, I think that exhibit was put together by your
    Chief Credit Officer, is that correct, Mr. Kimball?
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 24b, which appears in the Appendix on page 319.
    ---------------------------------------------------------------------------
        Mr. McDaniel. Yes. That is correct.
        Senator Levin. He says that--he disputes that quality is
    king. He says it is at risk due to pressure from bankers.
    ``Analysts and managing directors are continually `pitched' by
    bankers, issuers, investors--all with reasonable arguments--
    whose views can color credit judgment, sometimes improving it,
    other times degrading it. (we drink the `kool-aid'). Coupled
    with strong internal emphasis on market share & margin focus,
    this does constitute a `risk' to ratings quality.'' That is his
    analysis.
        And then he says--I don't know if you followed what I was
    reading on page two, ``Analysts and MDs are continually pitched
    by bankers, issuers, investors.'' Continually pitched. This
    constitutes ``a risk to ratings quality.'' Do you agree with
    that?
        Mr. McDaniel. As I had commented before, the observation
    that our information sources oftentimes have points of view,
    whether it is issuers or investors, they have the risk of
    causing us to think on a consensus basis with the market and we
    want to have independent views. So I appreciate that Chief
    Credit Officer is thinking about these issues. I appreciate
    that he is raising them to my attention. And I have reacted by
    implementing many of the recommendations and thoughts that are
    included in his comments.
        Senator Levin. When you say, you shouldn't operate from
    consensus, it says that there is a strong internal emphasis on
    market share.
        Mr. McDaniel. Yes. That is--as I said, we have market
    coverage.
        Senator Levin. And that constitutes a risk to ratings
    quality. Does your emphasis on market share constitute a risk
    to ratings quality?
        Mr. McDaniel. If we are not attentive----
        Senator Levin. That is what he is saying. He says it is
    coupled with an emphasis.
        Mr. McDaniel. He is saying----
        Senator Levin. He is not saying if. He is saying, coupled
    with an emphasis. ``With a strong internal emphasis on market
    share . . . this does constitute a risk to ratings quality.''
    That is him.
        Mr. McDaniel. Those are risks and they must be managed
    properly so that the rating system is not compromised in any
    way.
        Senator Levin. It says it is coupled with a strong internal
    emphasis, and you are saying that there is no such coupling?
        Mr. McDaniel. I am saying that is a risk and it must be
    managed properly so that the ratings are not compromised.
        Senator Levin. You say there is a strong internal emphasis,
    then, on market share? You agree to that?
        Mr. McDaniel. I pay attention to market share----
        Senator Levin. I know you pay attention to it, but do you
    agree there is a strong internal emphasis on market share?
        Mr. McDaniel. I believe he thinks there is----
        Senator Levin. Did you agree with him when you read that?
        Mr. McDaniel. I believe that attention to market share is
    one thing we must pay attention to in running the business.
        Senator Levin. Well, that is not my question.
        Mr. McDaniel. It is not as important as ratings quality,
    but I pay attention to it and I care about it.
        Senator Levin. But that wasn't my question.
        Mr. McDaniel. I apologize, Mr. Chairman, I am trying to
    answer----
        Senator Levin. Well, let me try again. Was he right that
    there is a strong internal emphasis on market share?
        Mr. McDaniel. There is a strong internal emphasis on market
    coverage, yes.
        Senator Levin. So you would not word it the way he does?
        Mr. McDaniel. I would not, but I understand that market
    coverage and market share can be conflated.
        Senator Levin. Can be what?
        Mr. McDaniel. Conflated.
        Senator Levin. Does that mean confused?
        Mr. McDaniel. No, used interchangeably.
        Senator Levin. But you would not phrase it that way?
        Mr. McDaniel. No. As I said, I think the market coverage
    issue is the more important issue.
        Senator Levin. Did he prepare this at your request?
        Mr. McDaniel. I actually don't remember if he prepared it
    at my request or independently, but I do remember receiving it.
        Senator Levin. Ms. Corbet, were you familiar with an FBI
    report that came out in 2004 that said that mortgage fraud was
    becoming more prevalent?
        Ms. Corbet. I am not specifically aware of that particular
    report.
        Senator Levin. Were you aware that the FBI in 2006 reported
    that the number of suspicious activity reports surrounding
    mortgage fraud rose by 700 percent?
        Ms. Corbet. Again, I am not familiar with that specific
    report.
        Senator Levin. And in the period 2004 to 2006, were you
    aware of the growth of interest-only loans, the broad use of
    interest-only loans? Do you know what I mean by interest-only
    loans?
        Ms. Corbet. I believe so, yes.
        Senator Levin. Were you aware that there was a large use of
    interest-only loans during that period?
        Ms. Corbet. I don't know that I was aware of the amount,
    but I was aware that there were different types of loans being
    offered in the marketplace, yes.
        Senator Levin. Were you aware that there was a large growth
    in the utilization of interest-only loans during that period?
        Ms. Corbet. I am not aware of what percentage of growth. I
    was aware that those loans existed.
        Senator Levin. Were you aware that there was a large
    growth? I am not asking you for a percentage. Were you aware?
        Ms. Corbet. Yes. I was aware that those were new products
    in the marketplace, yes.
        Senator Levin. Were you aware in 2004 to 2006 of the
    growing use of no doc and low doc loans?
        Ms. Corbet. I am aware of that, yes.
        Senator Levin. Do you know what silent seconds are?
        Ms. Corbet. Honestly, I do not.
        Senator Levin. That is OK. I didn't know a few months ago,
    either. Were you aware of the second liens? Do you know what
    second liens are?
        Ms. Corbet. I am familiar with the term----
        Senator Levin. Second mortgages?
        Ms. Corbet. Yes.
        Senator Levin. This is Standard and Poor's, an email--this
    is Exhibit 14\1\--from Richard Koch to Michael Gutierrez. Do
    you know who those folks are or were?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 14, which appears in the Appendix on page 293.
    ---------------------------------------------------------------------------
        Ms. Corbet. No, I don't.
        Senator Levin. OK. That email says, ``[T]here has been a
    rampant appraisal and underwriting fraud in the industry for
    quite some time as pressure has mounted to feed the origination
    machine.'' Would you agree that there was great pressure to
    feed the origination machine?
        Ms. Corbet. I am not aware of this specific email----
        Senator Levin. No, I know that, but in general, were you
    aware that there was a huge demand for mortgages, to securitize
    mortgages?
        Ms. Corbet. I was certainly aware of the growth in
    securitized mortgages, yes.
        Senator Levin. And the great demand for mortgages for that
    purpose?
        Ms. Corbet. And the demand from investors to invest in
    those securities, yes.
        Senator Levin. And from Wall Street to securitize----
        Ms. Corbet. Yes.
        Senator Levin. You were aware of that?
        Ms. Corbet. Yes.
        Senator Levin. Were you aware of this Exhibit 5?\1\ I don't
    know if I asked you specifically or not, Ms. Corbet. ``Version
    6.0 could've been released months ago and . . . assigned''--I
    don't know if I asked you specifically about that--if they
    ``didn't have to massage the subprime and Alt-A numbers to
    preserve market share.'' Did I ask you what your reaction is to
    that?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5, which appears in the Appendix on page 258.
    ---------------------------------------------------------------------------
        Ms. Corbet. You did not ask, but I can say----
        Senator Levin. What is your reaction?
        Ms. Corbet. I am not familiar with what the topic that they
    are referring to or the people who they are addressing.
        Senator Levin. What is your reaction now that you read
    that, that something that would have been done otherwise could
    not be done because the writer, a Standard and Poor's employee,
    had to ``massage the subprime and Alt-A numbers to preserve
    market share?'' What is your reaction now that you read that?
        Ms. Corbet. Well, it is certainly troubling, but to the
    extent--again, it is probably--in the larger context, I am not
    sure what the subject might be addressing. But to the extent
    that was a concern, I would expect that would be reviewed, and
    to the extent it wasn't addressed, it should have been raised
    to my attention.
        Senator Levin. Exhibit 87\2\ is the subject we talked about
    with an earlier panel. There was a message from Ms. Warner in
    Exhibit 87 pleading for resources. They are short-staffed,
    analyzed, overwhelmed. That is Exhibit 91.\3\ There are a
    number of exhibits that show the overwhelming shortage of
    staff, both to do the ratings, but also to do the reviews. Were
    you aware of that kind of shortfall of staff at that time?
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 87, which appears in the Appendix on page 535.
        \3\ See Exhibit No. 91, which appears in the Appendix on page 541.
    ---------------------------------------------------------------------------
        Ms. Corbet. Well, certainly in early 2007, as the number of
    securities were, again, starting to show deteriorating
    performance data, that indeed, the number of employees needed
    for this particular group needed to be increased. As I
    understand from Mr. D'Erchia's testimony, this group did
    receive the needed resources.
        Senator Levin. Well, that is not the part of the testimony
    he finally acknowledged, which is they were short of resources
    and didn't get what they requested. He tried to say that they
    shuffled back and forth, but they were short of resources.
        Exhibit 90, Mr. McDaniel, take a look at Exhibit 90.\4\
    This is a document from a Moody's employee, January 2006. ``. .
    . I think we need full functionality with M3''--that is the
    Moody's model--``first, especially if we're to remain short-
    staffed for yet another year.'' Were you short-staffed in
    January 2006?
    ---------------------------------------------------------------------------
        \4\ See Exhibit No. 90, which appears in the Appendix on page 539.
    ---------------------------------------------------------------------------
        Mr. McDaniel. Yes.
        Senator Levin. Were you aware of that?
        Mr. McDaniel. We had stress on our resources in this
    period, absolutely.
        Senator Levin. And you were making pretty good profit at
    that time, though, weren't you?
        Mr. McDaniel. We were profitable, yes.
        Senator Levin. And take a look at Exhibit 91, another
    Moody's employee in May 2007, if you would, Mr. McDaniel. The
    second paragraph. ``Our analysts are overwhelmed.'' This is Mr.
    Kolchinsky's email.
        Mr. McDaniel. As I remarked, there were definitely resource
    stresses at this point in time. People were working longer
    hours than we wanted them to, working more days of the week
    than we wanted them to. It was not for lack of having open
    positions, but with the pace at which the market was growing,
    it was difficult to fill positions as quickly as we would have
    liked.
        Senator Levin. Did Moody's reevaluate wholesale or just
    certain transactions?
        Mr. McDaniel. We monitor in our surveillance all
    transactions.
        Senator Levin. But did you reevaluate, for instance, an
    entire CDO or an entire RMBS?
        Mr. McDaniel. I apologize. I am not following----
        Senator Levin. All right. If you have a new metric, you
    have got a new model that you are using to rate new securities,
    will you go back and use that model on existing securities?
        Mr. McDaniel. It would depend.
        Senator Levin. You didn't retest the old deals, did you?
        Mr. McDaniel. In many cases, we do. In other cases, we do
    not.
        Senator Levin. And what about Standard and Poor's?
        Ms. Corbet. There are two different processes once a
    security was issued. The surveillance group was looking at
    actual loan performance data to determine whether or not there
    would be any impact to the rating.
        Senator Levin. And you didn't go and take a look at the
    entire rating for an entire issue?
        Ms. Corbet. Every issue was looked at for--in terms of the
    actual performance data.
        Senator Levin. So you went back and used the new model, or
    did you grandfather the old rating? Which one?
        Ms. Corbet. It was a different procedure for existing
    transactions, to look at actual performance data. And to the
    extent that criteria was changed on new issues, it would always
    be disclosed to the marketplace as to what extent any past
    transactions needed any criteria change or modification.
        Senator Levin. So you didn't retest your old deals. You
    just disclosed the new rating to the marketplace?
        Ms. Corbet. We disclosed the new criteria and how it would
    impact securities that were to be rated going forward, that is
    correct.
        Senator Levin. In the future, going forward.
        Ms. Corbet. That is correct.
        Senator Levin. Is one of the reasons that you didn't go
    back and apply your new model, what you now knew, to the old
    deals was because of a shortage of resources to do that?
        Ms. Corbet. No.
        Senator Levin. Was that one of the reasons that you didn't
    do that, Mr. McDaniel? When you didn't do that, was that
    shortage of resources?
        Mr. McDaniel. There are a number of reasons not to go
    back----
        Senator Levin. Was that one of them?
        Mr. McDaniel. I don't believe it would be.
        Senator Levin. OK. This is Exhibit 62.\1\ This is a
    Standard and Poor's exhibit. It is at the bottom of page one.
    ``How do we handle existing deals especially if there are
    material changes that can cause existing ratings to change?''
    And if you look at the top of page two, again, this is Standard
    and Poor's, it says, ``I do not know of a situation where there
    were wholesale changes to existing ratings when the primary
    group changed assumptions or even instituted new criteria. The
    two major reasons why we have taken this approach is, (i) lack
    of sufficient personnel resources.'' Are you familiar with that
    document, Ms. Corbet?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 62, which appears in the Appendix on page 471.
    ---------------------------------------------------------------------------
        Ms. Corbet. No, I am not. This is the first--I just
    reviewed it this week.
        Senator Levin. All right. But this is not accurate This is
    not true? You said that----
        Ms. Corbet. This is not my understanding of how securities
    were surveiled.
        Senator Levin. OK. And then if you take a look at Exhibit
    92a,\2\ Mr. McDaniel.
    ---------------------------------------------------------------------------
        \2\ See Exhibit No. 92a, which appears in the Appendix on page 543.
    ---------------------------------------------------------------------------
        Mr. McDaniel. Yes.
        Senator Levin. This is a focus group associate survey. If
    you take a look at page three, you apparently were there at a
    series of interviews and focus groups. If you look at that
    first dot. And if you look at the findings, most indicated that
    SFG business objectives included increasing market share and/or
    coverage. Do you see that?
        Mr. McDaniel. Yes.
        Senator Levin. Now, after your mass downgrades in 2007,
    during the last 6 months, Moody's rated about 500 subprime RMBS
    securities and S&P rated over 700. So you are still allowing
    these dubious mortgages to be put into the market. Hadn't you
    already decided that these securities were high-risk in July?
    Hadn't you already reached that conclusion?
        Mr. McDaniel. I don't believe there were new RMBS
    transactions in late 2007----
        Senator Levin. You don't? In the last 6 months?
        Mr. McDaniel. Not that I recall.
        Ms. Corbet. I actually departed S&P at the beginning of
    September, so I am not familiar what the last 6 months of
    transactions were.
        Senator Levin. All right. Well, Moody's did rate RMBS----
        Mr. McDaniel. OK. I apologize. I did not recall that.
        Senator Levin. And in July, I guess, there was that massive
    downgrade of securities. Were you consulted when that happened?
        Mr. McDaniel. I was aware of the downgrade, yes.
        Senator Levin. Were you consulted?
        Mr. McDaniel. I was not consulted from a credit perspective
    in terms of whether it should happen or not. I was informed so
    that I would have an understanding of the action the rating
    committees were taking.
        Senator Levin. All right. But it was not your job to be
    part of that decision?
        Mr. McDaniel. That is correct.
        Senator Levin. Did you see the impact of those downgrades,
    those mass downgrades, on the market? Were you aware of the
    huge impact it had on the market when it happened?
        Mr. McDaniel. We were observing deterioration in
    performance of mortgages. That is what had the impact on the
    market, I believe----
        Senator Levin. Yes. The subprime market just collapsed,
    right.
        Mr. McDaniel. And we were recognizing the deterioration
    with the rating downgrades, not causing the deterioration.
        Senator Levin. Well, if you would have done them a year
    earlier when you had information that the market was going
    under and was in trouble, if you would have done that over the
    year period and taken those early warning signs seriously and
    done your downgrading then, there wouldn't have been such a
    mass downgrading a year later. That is the whole issue that we
    are looking at.
        I am sure you won't agree with that, but it is,
    nonetheless, factually the case, that you had the information,
    you were applying the new model to new securities that you were
    rating. You did not re-rate the old securities, according to
    one of the documents, because you didn't want to apply the
    resources to do it and some other reasons. In any event, you
    didn't do it. And as a result, you did it in a massive way and
    it had a huge effect. If you would have done it in a different
    way when you first got the information and first had those
    storm warnings, I think the argument, which is much more
    persuasive at that point, is that you would not have had this
    massive downgrading which had such a huge impact in July 2007.
        And again, I am happy to have your comment on that, if you
    want, but I don't think you will probably want to agree with
    that. Maybe you do want to agree with it.
        Mr. McDaniel. We were managing the ratings system to react
    to actual performance data, and when it deviated from what we
    had seen in the previous recessions, that is when we took our
    actions.
        Senator Levin. In July 2007, did you know who David
    Goldstein was?
        Mr. McDaniel. No, I didn't.
        Senator Levin. OK. Do you know who Dania Corledo was?
        Mr. McDaniel. No.
        Senator Levin. How about David Oman?
        Mr. McDaniel. No. I am sorry.
        Senator Levin. That is OK. How about David Bawden?
        Mr. McDaniel. No.
        Senator Levin. OK. Ms. Corbet, take a look at Exhibit
    52c,\1\ if you would. This is an email dated March 20, 2007.
    This is an S&P employee who writes that, ``In a meeting with
    Kathleen Corbet today, she requested we put together a
    marketing campaign around the events in the subprime market''--
    now, this is March 2007--``the sooner, the better.'' Why would
    you want to put together a marketing campaign in March 2007?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 52c, which appears in the Appendix on page 439.
    ---------------------------------------------------------------------------
        Ms. Corbet. I would not use the term marketing campaign.
    What I did ask was for a more responsive communications
    campaign around the subprime market, and again, this followed
    along with a teleconference, an investor teleconference that we
    put on just about this time, shortly thereafter.
        Senator Levin. So you didn't use the term that they said
    you used?
        Ms. Corbet. I don't think that I would have used that term.
    It was clearly a communications effort.
        Senator Levin. Going back to this question of what happened
    late in 2007, in the last 6 months of 2007, after the crunch
    came, one of the last subprime RMBS deals that was rated was
    called Citigroup Mortgage Loan Trust, and both S&P and Moody's
    rated this deal in December 2007. I don't have any exhibits for
    you to look at, so I will just have to read this more slowly.
    December 2007, that was months after both of your companies had
    downgraded thousands of subprime RMBSes.
        First of all, were you aware that your agency, each of you,
    gave a AAA rating to four tranches of a $386 million Citibank
    subprime deal in December 2007? Were you aware of that?
        Mr. McDaniel. No, I was not.
        Ms. Corbet. I was no longer with the company.
        Senator Levin. OK. And the press release from your firm--
    and I will just address this to you, Mr. McDaniel--when you
    rated the Citibank deal stated that you expected heightened
    losses and had accounted for that in the structure of the deal,
    but there was a 37 percent loss. That is the actual losses as
    of today. They exceeded any expected loss, obviously, when you
    rated the deal. But does it surprise you that you were still
    rating those subprime RMBSes in December 2007, after what
    happened in July? Does that come as any surprise to you?
        Mr. McDaniel. I am surprised that there was a subprime RMBS
    security issued in the market. To the extent that we had
    updated our views and felt that those views would now be
    sufficient to provide protection for the ratings assigned, I
    can understand why the rating committee would do so.
        Senator Levin. Let me go back again to Exhibit 24b.\1\
    There are a lot of interesting things there that your Chief
    Credit Officer, Mr. Kimball, wrote in October 2007 about issues
    and weaknesses that the organization needs to address after the
    subprime market had collapsed.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24b, which appears in the Appendix on page 319.
    ---------------------------------------------------------------------------
        One of the things he wrote, and this is under market share,
    he says in paragraph five, ``Ideally, competition would be
    primarily on the basis of ratings quality''--that is ideally--
    ``with a second component of price and a third component of
    service. Unfortunately, of the three competitive factors,
    rating quality is proving the least powerful.''
        Then two lines down, he says, ``The real problem is not
    that the market does underweights rating quality but rather
    that, in some sectors it actually penalizes quality by awarding
    rating mandates based on the lowest credit enhancement needed
    for the highest rating. Unchecked competition on this basis can
    place the entire financial system at risk. It turns out that
    ratings quality has surprisingly few friends; issuers want high
    ratings; investors don't want rating downgrades; short-sighted
    bankers labor short-sightedly to game the rating agencies for a
    few extra basis points on execution.''
        Would you agree with that?
        Mr. McDaniel. In this section, he is talking about the
    issue of rating shopping, and I agree that existed then and
    exists now.
        Senator Levin. All right. He is analyzing in paragraph
    seven. He says, ``[T]he market share pressure persists'' in
    certain areas. This is near the top. ``Moody's has erected
    safeguards to keep teams from too easily solving the market
    share problem by lowering standards. These protections do help
    protect credit quality. Ratings are assigned by committee, not
    individuals. However,'' he says, ``entire committees, entire
    departments are susceptible to market share objectives.'' Do
    you agree with that?
        Mr. McDaniel. Well, in terms of financial incentive, the
    analysts would not be rewarded for market share or penalized
    for lack of market share. At management levels, there is more
    incentive associated with how the overall firm does
    financially, and so to the extent that there is a greater paid
    market share as opposed to just market coverage, that would
    have some impact on compensation at management levels, which is
    why we need appropriate safeguards and checks and balances.
        Senator Levin. Do you agree that entire committees are
    susceptible to market share objectives?
        Mr. McDaniel. Actually, no, I don't agree----
        Senator Levin. All right.
        Mr. McDaniel [continuing]. The committees are susceptible
    to that----
        Senator Levin. Fair enough.
        Mr. McDaniel [continuing]. Because they are not standing
    committees. They are ad hoc committees.
        Senator Levin. In Exhibit 24b,\1\ paragraph 7(b), he says,
    ``Methodologies and criteria are published and thus put
    boundaries on rating committees' discretion.'' Then he says,
    ``However, there is usually plenty of latitude within those
    boundaries to register market influence.'' Do you agree with
    that?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 24b, which appears in the Appendix on page 319.
    ---------------------------------------------------------------------------
        Mr. McDaniel. I am not sure what he means by market
    influence, so I don't know if I agree or not.
        Senator Levin. OK. In paragraph 23 of that same exhibit,
    ``From a credit policy perspective, we want to be in a position
    to just say no to a market opportunity when imperative to do so
    from a quality perspective. We have done that in the past.'' He
    gives some examples. ``How to do it more aggressively without
    simply exiting whole market sectors is an unsolved problem.''
    Would you agree it is an unsolved problem?
        Mr. McDaniel. It is an unsolved problem to the extent that
    the market is not rewarding ratings quality. If we don't have
    customers for the highest quality ratings, this is an ongoing
    problem.
        Senator Levin. OK. You have a Town Meeting, Exhibit 98.\1\
    It is a transcript of Moody's managing directors. You spoke at
    that Town Meeting in September 2007. On page 63, you said that
    ``What happened in 2004 and 2005 with respect to subordinated
    tranches is that our competition, Fitch and S&P, went nuts.
    Everything was investment grade. It didn't really matter. . . .
    No one cared because the machine just kept going.'' What do you
    mean by that? Pretty powerful stuff. Do you stand by that?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 98, which appears in the Appendix on page 684.
    ---------------------------------------------------------------------------
        Mr. McDaniel. I was talking about the subordinated tranches
    in the mortgage-backed securities area. We had a different
    opinion from our competitors, and we were obviously not being
    persuasive with the investor community in our more conservative
    opinion and it was having an impact.
        Senator Levin. Having an impact on what?
        Mr. McDaniel. On our business. We didn't have as much
    coverage as a result.
        Senator Levin. Does that mean as much market share?
        Mr. McDaniel. Both. But really, I was talking about
    coverage in that case. There were--and the reason I keep making
    the distinction between market share and market coverage is, I
    think, that most people would associate market share with paid
    coverage, and I am talking about the coverage necessary to
    provide a comparative rating system, comparing one security to
    another.
        Senator Levin. Well, you were part of the competition
    there, Ms. Corbet.
        Ms. Corbet. Yes.
        Senator Levin. It says here that S&P ``went nuts.
    Everything was investment grade.''
        Ms. Corbet. I don't know what he is referring to.
        Senator Levin. ``It really didn't matter. No one cared,
    because the machine just kept going.'' Is that true? I wish you
    would just say, yes, I stand by that, and that is what got us
    into trouble.
        Mr. McDaniel. For the sector I was talking about, I do
    stand by it.
        Senator Levin. Ratings kept churning out with poor models.
    Now, I will use your words. I think that the agencies really
    went overboard here and really went off the deep end, and here
    is the reason. You had poor models for these new structures.
    You had too few resources you were willing to commit. You had
    too much pressure from investment bankers. And the nuts didn't
    end until these mass downgrades of July 2007, when it cratered
    the market for structured finance.
        This is what one of your managing directors said at that
    Town Meeting, Exhibit 98, and this is what he or she wrote.
    ``[W]hy didn't we envision that credit would tighten after
    being loose, and housing prices would fall after rising, after
    all most economic events are cyclical and bubbles inevitably
    burst.'' And then he said, what happened in 2004--he asked
    then, too, for the leaders to be candid and to acknowledge what
    the problems were and what had happened, and I think you have a
    long way to go in acknowledging what happened to your agencies.
        And this is what he is saying, and I happen to agree with
    him, that ``Moody's franchise value is based on staying ahead
    of the pack.'' I would apply this, though, to both. It just
    happened you guys had a Town Meeting at Moody's. I think the
    truth of this manager applies to both. He said, ``Moody's
    franchise value is based on staying ahead of the pack on credit
    analysis and instead we are in the middle of the pack. I would
    like more candor from senior management about our errors and
    how we will address them in the future.''
        That is one of the best comments that I have seen, and I
    hope you would see it that way, but I could understand that may
    not be the case.
        The SEC, Ms. Corbet, I think is conducting an investigation
    of S&P. They conducted an investigation. They found many
    problems, including staffing levels may have impacted various
    aspects of the ratings process. Is that true, that the SEC made
    that finding?
        Ms. Corbet. I don't know, sir.
        Senator Levin. OK. They found that S&P made changes to its
    rating criteria without publishing those changes, that S&P,
    like Moody's, had undocumented policies--I am quoting here--
    ``and procedures for rating RMBSes and CDOs.'' Were you
    familiar with that finding of the SEC?
        Ms. Corbet. I am not familiar with that finding, no.
        Senator Levin. The SEC found relative to Moody's that you
    had inadequate staffing levels which impacted the rating
    process, that Moody's analysts were using unpublished models,
    that Moody's analysts could be influenced in their rating by
    the fees charged to the issuers, that they were unable to find
    all the records surrounding a Moody's rating, that Moody's
    failed to retain or document certain significant steps in the
    rating process which made it difficult for the staff to assess
    compliance with its rating policies and procedures, and to
    identify the factors that were considered in developing a
    particular rating. Are you familiar with that?
        Mr. McDaniel. I am familiar with the SEC examination and
    the overall findings, yes.
        Senator Levin. Did you agree with them?
        Mr. McDaniel. The actions that the SEC asked us to take, we
    said we would take, so we are complying.
        Senator Levin. This is going to complete this panel, but I
    just have one very brief statement.
        The Subcommittee now has completed three of its four
    hearings examining some of the causes and consequences of the
    2008 financial crisis. Last week, on Tuesday, we looked at the
    role of high-risk mortgages. Last Friday's hearing looked at
    the failures of the bank regulators. Today, we looked at the
    role of credit rating agencies. It hasn't been a pretty picture
    so far and I don't think it is going to improve, although,
    frankly, the beginning of the Senate debate on strong financial
    reform next week does give us some hope.
        The final hearing of this quartet will be next Tuesday,
    when we are going to look at the role of investment banks, with
    Goldman Sachs being the case history. Our investigation has
    found that investment banks, such as Goldman Sachs, were not
    market makers helping clients. They were self-interested
    promoters of risky and complicated financial schemes that were
    a major part of the 2008 crisis. They bundled toxic and dubious
    mortgages into complex financial instruments, got the credit
    rating agencies to label them as AAA safe securities, sold them
    to investors, magnifying and spreading risk throughout the
    financial system, and all too often betting against the
    financial instruments that they sold and profiting at the
    expense of their clients.
        I am introducing into the record now four exhibits that we
    will be using at the Tuesday hearing to explore the role of
    investment banks during the financial crisis. We will be
    putting those exhibits up on the Subcommittee's Website either
    tonight or tomorrow.
        We thank this panel. We appreciate your being here. You
    have given us a great deal of documents. You have cooperated
    with this Subcommittee and we appreciate it.
        We will stand adjourned.
        Ms. Corbet. Thank you.
        Mr. McDaniel. Thank you, Mr. Chairman.
        [Whereupon, at 3:41 p.m., the Subcommittee was adjourned.]

                                A P P E N D I X

                                  ----------

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