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1 1 2 FINANCIAL CRISIS INQUIRY COMMISSION 3 Official Transcript 4 5 Hearing on "Credibility of Credit Ratings, 6 the Investment Decisions Made Based on 7 Those Ratings, and the Financial Crisis” 8 Wednesday, June 2, 2010 9 The New School 10 55 West 13th Street, New York, New York 11 8:30 A.M. 12 13 COMMISSIONERS 14 PHIL ANGELIDES, Chairman 15 HON. BILL THOMAS, Vice Chairman 16 BROOKSLEY BORN, Commissioner 17 BYRON S. GEORGIOU, Commissioner 18 HON. BOB GRAHAM, Commissioner 19 DOUGLAS HOLTZ-EAKIN, Commissioner 20 HEATHER H. MURREN, Commissioner 21 JOHN W. THOMPSON, Commissioner 22 PETER J. WALLISON, Commissioner 23 24 Reported by: 25 PAGES 1 - 511 26 DAVID LEVY, CSR, Hearing Reporter 2 1 2 3 P R O C E E D I N G S CHAIRMAN ANGELIDES: Good morning. 4 The meeting of the Financial Crisis 5 Inquiry Commission shall come to order. 6 We have a quorum present. 7 now begin our proceedings. 8 hearing will be on the credibility of 9 credit ratings, the investment decisions And so we will Today's 10 made on the basis of those ratings and the 11 financial crisis. 12 I want to welcome all of you to The 13 New School, and now it is my distinct 14 privilege and honor on behalf of 15 the whole commission to introduce Bob 16 Kerrey, former governor, former senator 17 from the State of Nebraska, now president 18 of The New School, and our host today. 19 Senator Kerrey, thanks so much for having 20 us here. 21 terrific. 22 yours. 23 You and your staff have been And the microphone is now PRESIDENT KERREY: Well, first of all 24 Chairman Angelides and Vice-Chairman 25 Thomas and members of the Financial Crisis 3 1 Preliminary remarks 2 Inquiry Commission, both The New School 3 and New York City is -- are proud to 4 welcome you here this morning, and I 5 appreciate very much you praising the 6 staff because they have done all the work 7 to make this possible, and it is always 8 quite moving to me, the effort that they 9 make to accommodate these kinds of 10 extremely important efforts. 11 your work. 12 I don't envy This is a complicated matter. Those 13 of us who have sufficient quantitative 14 skills but not impressive qualitative 15 skills find ourselves actually quite 16 unable to comprehend exactly what was 17 going on and what went wrong. 18 Trying to manage risk today has 19 become more and more difficult, and my own 20 view of the matter is that, for what it's 21 worth, which is probably not terribly 22 relevant to your work, is that America did 23 not become a great country by trying to 24 avoid risk. 25 we'll remain a great country if we try to And I do not believe that 4 1 2 Preliminary remarks avoid and take risk to zero. 3 This city as an example, benefitted 4 enormously from a public works project 5 called the Erie Canal. 6 the start of a great recession in 1817, 7 took seven years to build. 8 member of the New York City assembly or 9 Senate delegation voted for the project It was begun at Not a single 10 because they considered it to be an 11 upstate project. 12 story, which I have acquired, having come 13 and been in this city for ten years, 14 caused me to wonder whether or not the 15 Erie Canal could be built today, because 16 we have become very risk-averse and it's 17 become more difficult to take on projects 18 with almost any kind of risk attached to 19 it. 20 But the details of that So I very much appreciate your 21 willingness to tackle this problem because 22 getting our markets and regulating our 23 markets, and many of you have had 24 experience at both regulating and having 25 difficulty doing what you believe is now 5 1 Preliminary remarks 2 clear, I'm looking at Brooksley here, was 3 the right thing in the 1990’s, regulating 4 those markets so those markets remain 5 viable, remain active and trusted by the 6 American people and the world, is an 7 extremely important task. 8 9 So I welcome you once more to The New School, to New York City, and I 10 congratulate and thank you for myself and, 11 I hope, for other Americans as well, for 12 your willingness to tackle this problem. 13 CHAIRMAN ANGELIDES: Thank you much, 14 Senator. 15 to the senator or reserve those for your 16 remarks? 17 Would you like to make a comment VICE CHAIRMAN THOMAS: No, if he's 18 leaving, I want to say it in front of him, 19 Senator Kerrey and I served on the 20 bipartisan Medicare Commission and what I 21 always enjoy is visiting old friends from 22 former battles, and I like it because you 23 haven't changed at all. 24 25 The idea of someone who is as liberal as he is, check out his voting record, 6 1 Preliminary remarks 2 understanding risk, which is the other 3 side of the coin of opportunity, and how 4 this country manages not providing a 5 guarantee for everything, which means 6 risk, but succeeding because of that, has 7 always been a theme that he presented well 8 back when we had a chance to make a big 9 difference. And it's exciting to see you 10 again in these circumstances 'cause we're 11 taking a risk getting out of Washington. 12 You know, how cocooning Washington is, in 13 terms of commissions and hearings. 14 this is our first venture out of the 15 Washington Beltway. 16 And So thank you for being receptive to 17 us, and I guess we may see you back inside 18 the Beltway. 19 PRESIDENT KERREY: You do have a 20 couple of months as I go down there to try 21 to steal money for The New School. 22 VICE CHAIRMAN THOMAS: 23 PRESIDENT KERREY: Turn it over. I guess I have 24 demonstrated physically my lack of 25 understanding of risk. I get down there 7 1 Preliminary remarks 2 actually quite often as it is on behalf of 3 The New School, trying to -- 4 VICE CHAIRMAN THOMAS: Yeah, but 5 you're queuing up asking for money rather 6 than... 7 8 9 10 11 PRESIDENT KERREY: Queuing up is all right. CHAIRMAN ANGELIDES: Thank you so much and thank you for your hospitality. Let's begin our proceedings. Again, 12 thank you, President Kerrey. 13 the Financial Crisis Inquiry Commission, I 14 want to thank everyone at The New School 15 for their hospitality, I want to thank all 16 of you for being here today. 17 want to thank Vice-Chairman Thomas and I 18 especially want to especially commend 19 Commissioners Georgiou, Graham and 20 Wallison for taking the lead on this 21 hearing. 22 On behalf of As always, I Today's hearing on credit ratings is 23 part of our larger investigation into the 24 cause of the financial and economic crisis 25 that continues to bring so much hardship 8 1 Preliminary remarks 2 to our nation. Credit rating agencies 3 have played a pivotal role in our 4 financial markets. 5 Housekeeping Seal of Approval guided 6 decisions by individuals and institutional 7 investors alike. 8 look to ratings to make determinations 9 about their capital requirements. Their Good Financial institutions And 10 these ratings enabled the issuance of 11 trillions of dollars worth of subprime 12 mortgage securities. 13 Today, we're examining Moody's 14 Corporation as a case study. We will have 15 questions about why, what things went so 16 very wrong. 17 I should add that this hearing is 18 just one aspect of our investigation. 19 staff has already combed through 430,000 20 pages of documents and interviewed dozens 21 of witnesses on Moody's alone. 22 Our To be blunt, the picture is not 23 pretty. From 1998 to 2007, Moody's 24 revenues from rating complex financial 25 instruments like mortgage securities grew 9 1 Preliminary remarks 2 by a whopping 523 percent. 3 its peak in 2007, the company stock price 4 climbed more than six-fold. 5 very well. 6 Moody's ratings did not fare so well. 7 From 2000 to Moody's did The investors who relied on From 2000 to 2007, Moody's slapped 8 its coveted AAA rating on 42,625 9 residential mortgage-backed securities. 10 Moody's was a triple-A factory. 11 Moody's gave 9,029 mortgage-backed 12 securities a AAA rating. 13 put the AAA label on more than 30 mortgage 14 securities each and every working day that 15 year. 16 In 2006 alone, That means they To put that in perspective, Moody's 17 currently bestows its AAA rating on just 18 four American corporations. 19 Berkshire Hathaway, with its more than $20 20 billion cash on hand, doesn't make that 21 grade. 22 Even We all know what happened to those 23 AAA securities. In 2006, $869 billion 24 worth of mortgage securities were 25 AAA-rated by Moody's. 83 percent went on 10 1 Preliminary remarks 2 to be downgraded. 3 university endowments to teachers and 4 police officers relying on pension funds 5 suffered heavy losses. 6 Investors from Now, many of the witnesses we've 7 heard from over the course of our 8 investigation, whether it's bankers or 9 regulators or the Chairman of the Federal 10 Reserve, have said that there was no way 11 they could have foreseen the steep 12 nationwide decline in housing prices we've 13 experienced. 14 of that today. But of course there were 15 warning signs. The attempts by many 16 states to stem the tide of deceptive and 17 predatory mortgage practices, the 2004 FBI 18 warnings about mortgage fraud, and most of 19 all the fact that housing prices had shot 20 up an unprecedented 89 percent from 2000 21 to 2006, leading to the obvious 22 possibility that what goes up might come 23 down. 24 25 I suspect we may hear more Even within the Moody's Corporation, there were warnings, including a prescient 11 1 Preliminary remarks 2 2006 report from Moodyseconomy.com about 3 the dangers of an overheated housing 4 market. 5 decline in housing prices for these 6 ratings to come unhinged. 7 had only dropped four percent from their 8 peak when Moody's began its massive 9 downgrades in July 2007. And it didn't take a 30-percent Housing prices Imagine if you 10 had a laboratory that tested the safety of 11 toasters. 12 fire, there would be an outcry about the 13 toaster inspectors. 14 halting the assembly line, you sped up the 15 production of these combustible toasters. 16 After a while, if you found that 90 17 percent of the toasters you rated safe had 18 caught fire, you'd think that something 19 was fundamentally wrong. 20 If at first a few toasters caught And yet, instead of Why did Moody's get it so wrong? Was 21 it because of fraud ratings models? Was 22 it because they were paid by the bankers 23 whose secures they rated? 24 profits and market share skew their risk 25 assessment? Did a push for Was it a failure of corporate 12 1 Preliminary remarks 2 governance and management? 3 Today, we'll be asking questions of 4 the front-line personnel at Moody's and 5 the CEO, Raymond McDaniel. 6 have Moody's largest shareholder, Warren 7 Buffet, here to answer our questions. 8 hope to learn how and if credit ratings, 9 and the companies that were bestowed them, 10 11 We'll also We contributed to the financial crisis. In closing, I would like to note that 12 the Commission has an excellent background 13 report on credit rating agencies on our 14 website at fcic.gov. 15 turn over the microphone to Vice-Chairman 16 Thomas. 17 With that, let me VICE CHAIRMAN THOMAS: Thank you, 18 Mr. Chairman. 19 from our previous hearings. 20 at a single type of product, credit 21 ratings, and focusing on a single firm. 22 This does mark a difference We're looking Admittedly, there aren't a lot to 23 choose from. It's one of those areas 24 where the expertise is narrow and deep, 25 and it's tough -- especially with 13 1 Preliminary remarks 2 decisions that the government has made in 3 recent years to get into the business as a 4 direct competitor. 5 We need to examine this area. I'm 6 interested in listening to the people who 7 tried to tackle what we now know was a 8 near-impossible job, partially with tools 9 that they created but with others looking 10 over their shoulders. 11 I do want to say, I understand how 12 easy it is after the fact to talk about 13 the fact that you should have known what 14 we now know. 15 to deal with revisionist historians who go 16 back and look at various periods using 17 their current conceptual frameworks to 18 explain situations in history and, rather 19 than adopt the conceptual framework of 20 those who were at the moment in the 21 history, they impose theirs and wonder 22 why. I also find it interesting 23 I don't think that produces a lot of 24 useful answers, except, they didn't know 25 what they didn't know. And after the 14 1 Preliminary remarks 2 fact, dealing with some of the witnesses 3 that we have today, I'm hopeful that we 4 can get an accurate look. 5 What struck me in reading one of the 6 books that are now coming out, looking at 7 that situation, Michael Lewis', I think 8 very good, The Big Short, is how few there 9 are that he could talk about who were on 10 the other side. So if all of the folk 11 were basically honest and earnest in what 12 they were doing, you would think there 13 would have been more names and a slightly 14 thicker book examining those who took the 15 other side. 16 There are very, very few who took the 17 other side and what we're trying to do is 18 understand, one, why and how they got 19 where they were, but probably more 20 importantly, where a majority, a vast 21 majority of the people were, in assuming 22 that certain things would continue to 23 occur in certain ways. 24 25 One of the things I'm most fascinated by is, in looking at Moody's and their 15 1 Preliminary remarks 2 history, and the product that they rated 3 for such a long time, and then the very 4 short interim in which they had to shift 5 significantly to what was a really 6 different product, and my questions are 7 going to focus on, did they realize how 8 different that product was, and did they 9 believe they had shifted enough to cover 10 it. 11 think? 12 And now, in retrospect, what do you The other witnesses I think are going 13 to be helpful in a broader sense. 14 it's going to be interesting to examine 15 the leadership, the executive direction of 16 Moody's at a time where bravery was not 17 abundant and some of the drop in business 18 was because they decided to change the way 19 in which they evaluated if product they 20 are paid for. 21 focus on whether or not they were part of 22 the cause of the financial crisis, or were 23 one of the victims. 24 25 I think And that is going to be a And that, Mr. Chairman, is a point I'm interested in investigating. Thank 16 1 Preliminary remarks 2 you very much and thank our witnesses for 3 being here. 4 CHAIRMAN ANGELIDES: Thank you, 5 Mr. Vice-chairman. With that, I will ask 6 the witnesses for our first session to 7 come forward. 8 your seats at the table. 9 before you take your seats at the table, If you would please take And actually, 10 why don't you stand, because I'm going to 11 administer the oath, which is what we 12 customarily do for everyone who does 13 appear before us. 14 If you would please stand, which you 15 are already doing and raise your right 16 hand and I will read the oath. 17 E R I C 18 K O L C H I N S K Y , J A Y 19 G A R Y S I E G E L , W I T T , 20 having been duly sworn, testified as 21 follows: 22 CHAIRMAN ANGELIDES: Thank you very 23 much. We will begin now with session 1 of 24 today's three session hearing. 25 is entitled, "The Ratings Process." Session 1 It is 17 1 Kolchinsky - opening 2 our opportunity to hear from people at 3 Moody's who were involved in the ratings 4 process, both for residential 5 mortgage-backed securities and for 6 collateralized debt obligations. 7 have asked each of the witnesses who have 8 delivered written statements if they would 9 provide us with a five-minute opening And we 10 statement, or an opening statement of no 11 more than five minutes. 12 There is a timer, I see there, and I 13 don't know if there's another one here -- 14 yes, there is. 15 light will go to yellow when there's one 16 minute to go, and it will go to red when 17 your time is up. 18 you would each avail yourself of this 19 opportunity to give us a, no more than 20 five-minute opening statement. 21 There is a timer where the So I'd like to ask if And Mr. Kolchinski, we will start with 22 you, and we'll go from my left to my 23 right. 24 25 Thank you so much, Mr. Kolchinsky. MR. KOLCHINSKY: Thank you very much. I want to thank Chairman Angelides, 18 1 Kolchinsky - opening 2 Vice-Chairman Thomas and the commissioners 3 for inviting me to speak about the role of 4 the ratings agencies in the financial 5 crisis. 6 during the majority of 2007, I was the 7 managing director in charge of the 8 business line which rated subprime-backed 9 collateralized debt obligations at Moody's My name is Eric Kolchinsky and, 10 Investor Services. I spent my entire 11 career in structured finance and began 12 working on CDOs in 1998. 13 In addition to spending eight years 14 at Moody's, I've also worked at Goldman 15 Sachs, Merrill Lynch, Lehman Brothers and 16 MBIA. 17 fundamental question facing the 18 Commission: 19 agencies to assign such erroneous ratings? 20 How could renowned companies like Moody's, 21 S&P and Fitch, with a hundred years of 22 experience in credit analysis produce such 23 poor products? 24 this be prevented from happening again? 25 I hope to shed some light on the What caused the ratings More importantly, how can The answers lie primarily in the 19 1 Kolchinsky - opening 2 structure of the market for ratings 3 services. 4 ratings may be private entities, they seek 5 ratings to satisfy various regulatory 6 mandates. 7 agencies is quasi regulatory and is very 8 similar to the auditing work done by 9 accounting firms. 10 While the initial users of Thus, the nature of rating The failure of the rating agencies 11 can be seen as an example of regulatory 12 capture, a term used by economists to 13 describe a scenario where a regulator acts 14 in the benefit of the regulated and not in 15 the public interest. 16 In this case, the quasi regulators 17 were the rating agencies. The regulated 18 including banks and broker/dealers, and 19 the public interest lay in the guarantee 20 which taxpayers provide for the financial 21 system. 22 interplay of several factors: 23 mandated outsourcing of credit analysis 24 without any associated mandated standards 25 of highly complex and flexible structured This dynamic manifested itself in The 20 1 Kolchinsky - opening 2 finance instruments for private companies 3 whose managers were strongly incentivized 4 to maximize profits. 5 agencies were given a blank check. 6 In short, the rating Consider the incentives created by 7 these factors. The rating agencies could 8 generate billions in revenue by rating 9 instruments which few people understood. 10 The lack of guidance from private and 11 public users of ratings ensured that 12 there's little concern that anyone would 13 question the methods used to rate the 14 products. 15 The only negative factors to consider 16 were some amorphous concepts of 17 reputational risk. 18 rating agencies faced the age-old and 19 pedestrian conflict between long-term 20 product quality and short-term profits. 21 They chose the latter. 22 In other words, the These asymmetric incentives caused a 23 shift of culture at Moody's from one 24 resembling a university academic 25 department to one which values revenue at 21 1 Kolchinsky - opening 2 all costs. 3 public company with revenues of over two 4 billion, and one of the best equity 5 performers in S&P 500. 6 by my group had gone from financial 7 backwater to profit leader. 8 9 By 2007, Moody's was a major The products rated In 2001 a total of 57 billion of CDOs were rated. In 2006, the number had 10 reached 320 billion, a nearly six-fold 11 increase. 12 revenue represents 20 percent of the total 13 rating agency revenues earned by Moody's. 14 For senior management, concern about 15 credit quality took a back seat to market 16 share. 17 directive to lower credit standards, every 18 missed deal had to be explained and 19 defended. 20 In the first half of 2007, our While there was never any explicit Management also went out of its way 21 to placate bankers and issuers. For 22 example, and contrary to the testimony of 23 the Moody's senior managing director, 24 banker requests to keep senior analysts 25 off their deals were granted. 22 1 2 Kolchinsky - opening The focus on market share led 3 inevitably to inability to say no to 4 transactions. 5 if one rating agency said no, then the 6 banker could easy take their business to 7 another. 8 US ABS CDOs, I was able to say no to just 9 one particularly questionable ideal. It was well understood that During my tenure at the head of That 10 did not stop the transaction -- the banker 11 enlisted another rating agency and 12 received the two AAA ratings he was 13 looking for. 14 The poor performance of the 15 structured finance ratings is primarily 16 the result of senior management's 17 directive to maintain and increase market 18 share. 19 only be gained if one side has the ability 20 to walk away. 21 power to extract meaningful concessions 22 from bankers ceased to exist. 23 analysts and managers rationalized their 24 concessions since the nominal performance 25 of the collateral was often quite Leverage during negotiations can Without this leverage, the Instead, 23 1 2 3 Kolchinsky - opening exceptional. The increased use of synthetics also 4 changed the nature of the ABS CDO market, 5 the ability to go short created a new 6 class of investors whose goal was to 7 maximize losses. 8 players was never anticipated by our 9 models and assumptions. 10 The influence of these Additionally, the ability to infinitely 11 replicate any credit synthetically also 12 raised concerns about correlation between 13 any two CDOs. 14 identical bonds in two separate portfolios 15 was no longer limited to the outstanding 16 size of the issue. 17 concern was especially true with respect 18 to the bonds in the ABX index. 19 The property of to This correlation The index or its components started 20 appearing frequently in many of the CDOs 21 we rated. 22 concern and limiting CDO exposure to the 23 index was ready to be published in October 24 of 2006. 25 due to market share concerns. A methodology detailing this However, it was not published 24 1 Kolchinsky - opening 2 Synthetics also changed the dynamics 3 of the ratings process. 4 transaction would have taken months to 5 accumulate the collateral it needed to 6 close, a synthetic transaction could ramp 7 up in a week. 8 shortened the window for analysts to be 9 able to analyze their transactions. 10 While a cash This significantly Pressure from bankers -- 11 VICE CHAIRMAN THOMAS: 12 Mr. Kolchinsky, don't pay attention to the 13 light. 14 the last 30 seconds or so wasn't worth 15 anything because I was trying to follow 16 you. 17 while so that you can finish it in the way 18 in which we can understand the testimony. 19 We have it written, but there are people 20 who are interested in what you have to 21 say. 22 Because frankly, the delivery in I'll yield my time for a little CHAIRMAN ANGELIDES: If you could do 23 this, just take a minute or so to wrap up, 24 please, because we'll have lots of time 25 for questions, Mr. Kolchinsky, and we do 25 1 2 Kolchinsky - opening have your written testimony. 3 MR. KOLCHINSKY: Thank you -- 4 CHAIRMAN ANGELIDES: You just do your 5 major points in the last minute, that 6 would be good. 7 MR. KOLCHINSKY: Yes. Despite the 8 increasing number of deals and the 9 increasing complexity, our group did not 10 receive adequate resources. By 2007, we 11 were barely keeping up with the deal flow 12 and the developments in the market. 13 analysts, under pressure from bankers and 14 their high deal loads, began to do the 15 bare minimum of work required. 16 have the time to do any meaningful 17 research into all the emerging credit 18 issues. 19 the increasingly troubled market were 20 chided by my manager. 21 spent too much time reading research. Many We did not My own attempts to stay on top of She told me that I 22 As the market began to falter after 23 the collapse of the Bear, Stearns hedge 24 funds, I was asked to post senior 25 management on the developments in the 26 1 Kolchinsky - opening 2 markets. 3 concern regarding credit quality. 4 According to my manager, the CEO, Ray 5 McDaniel, was asking for information on 6 our potential deal flow prospects: 7 "Obviously, they're getting calls from 8 analysts and investors." 9 There appeared to be little What can be done to improve rating 10 quality? One solution which has been 11 proposed is to completely remove any 12 references to ratings in regulations. 13 While this proposal seems simple and just, 14 it is also impractical. 15 there's no organization ready to take the 16 rating agencies' role in the credit 17 markets. 18 incentives described above will apply to 19 any private organization charged with the 20 same task. At this point, Furthermore, the perverse 21 The only practical solution is to add 22 accountability to the system by mandating 23 minimum credit standards. 24 a floor on market-share-motivated 25 free-falls in methodologies and restrict This would put 27 1 Siegel - opening 2 competition to where it belongs -- price 3 and service. 4 5 6 Thank you very much. CHAIRMAN ANGELIDES: much, Mr. Kolchinsky. MR. SIEGEL: Thank you very Mr. Siegel? Good morning, Chairman, 7 Vice Chairman, and members of the 8 Commission. 9 worked for Moody's Investors Service for My name is Jay Siegel. I've 10 twelve years, from 2001 until 2006, April, 11 when I departed from the company. 12 one of two and then three of the managing 13 directors of Moody's responsible for its 14 work rating residential mortgage-backed 15 securities or RMBS. 16 opportunity to explain this process today. 17 I was I welcome the The role of ratings agencies in the 18 market is to provide a public opinion that 19 speaks to one aspect of the 20 securitization; specifically, the relative 21 risk of credit default associated with the 22 particular security. 23 securities that Moody's rates, the 24 methodology for rating RMBS incorporates 25 qualitative and quantitative factors that As with all 28 1 Siegel - opening 2 are weighed and assessed by Moody's 3 analysts. 4 Quantitative factors may include the 5 degree of credit enhancement provided by 6 the structure, the historical performance 7 of similar assets created by the 8 originator, and metrics relating to 9 borrowers' credit history. Qualitative 10 factors may include an assessment of the 11 bankruptcy-remoteness of the issuing 12 entity, the integrity of the legal 13 structure, and management and servicing 14 quality. 15 In the course of rating an RMBS 16 transaction, Moody's analysts do not see 17 individual loan files or information 18 identifying borrowers or specific 19 properties. 20 agencies receive from the originator or 21 underwriter credit characteristics for 22 each loan on an anonymous basis. 23 originators of the loans also make 24 representations and warranties to the 25 trust for the benefit of investors in Rather, credit rating The 29 1 2 3 Siegel - opening every transaction. Moody's runs its rating process 4 through a committee system. 5 say, rating committees, not individual 6 analysts, decide the ratings. 7 committee system is at the core of 8 everything Moody's does and is designed to 9 protect the quality, integrity and 10 11 That is to The independence of the ratings. One common misperception is that 12 Moody's credit ratings are derived solely 13 from the application of a mathematical 14 process or model. 15 Models are tools sometimes used in the 16 process of assigning ratings. 17 credit rating process involves much more; 18 most importantly, the exercise of 19 independent judgment by members of the 20 rating committee. 21 subjective opinions that reflect the 22 majority view of the committee's members. 23 Rating committee members are selected 24 based on relevant expertise and diversity 25 of opinion. This is not the case. But the Ultimately, ratings are Each member is encouraged to 30 1 Siegel - opening 2 express dissenting or controversial views, 3 and to discuss differences openly and 4 frankly. 5 place, the members then vote, with the 6 most senior members voting last so as to 7 not unduly influence the votes of junior 8 members. 9 and the majority vote decides the outcome. 10 Once a full discussion has taken Each vote carries equal weight Once a credit rating is published, 11 Moody's monitors the rating on an ongoing 12 basis and will modify it as appropriate to 13 respond to changes in its view of the 14 relative creditworthiness of the issuer. 15 As a general matter, subprime loans 16 are expected to perform materially worse 17 than prime loans; and therefore, higher 18 delinquencies and defaults are anticipated 19 and reflected in Moody's ratings. 20 Beginning in 2003, Moody's observed 21 and commented on the trends of loosening 22 mortgage underwriting processes and 23 escalating housing prices. 24 published on and incorporated these trends 25 into its analysis of RMBS. Moody's As a result, 31 1 Siegel - opening 2 Moody's steadily increased its loss 3 expectations on pools of subprime loans 4 and the levels of credit protection 5 required for a given rating so that RMBS 6 backed by subprime mortgages issued in 7 2006 and rated by Moody's had more credit 8 protection than bonds issued in earlier 9 years. 10 In practical terms, this meant that, 11 for the 2006 vintage rated by Moody's, 12 more than half the mortgages in a pool 13 would have to default and recover less 14 than half of the appraised value on the 15 property before a Moody's AAA-rated bond 16 would suffer its first dollar of loss. 17 In the end, even this increased 18 credit protection proved not sufficient to 19 maintain rating stability due to 20 unprecedented levels of mortgage 21 delinquencies, coupled with home price 22 depreciation. 23 period with the clarity afforded by 24 hindsight, many commentators think that 25 the credit rating agencies and others in In looking back on that 32 1 Siegel - opening 2 the market did not fully appreciate the 3 macroeconomic environment and anticipate 4 the magnitude of the housing market 5 downturn. 6 participants, certainly did not foresee as 7 imminent the severity or speed of 8 deterioration that occurred in the U.S. 9 housing market after that period or the Moody's, like other market 10 rapidity of credit tightening that 11 followed and likely exacerbated the 12 situation. 13 During my tenure, however, I believe 14 that Moody's ratings reflected the best 15 opinion on the future creditworthiness of 16 the debt securities based on the 17 information available at that time. 18 I understand that many changes have 19 been made to improve the performance -- 20 CHAIRMAN ANGELIDES: 21 pleads, Mr. Siegel? 22 MR. SIEGEL: Can you wrap up, -- yes, Chairman -- 23 performance of ratings going forward and I 24 believe that this and other forums can 25 play a valuable role in assessing what 33 1 Weill - opening 2 additional changes may be appropriate. 3 Thank you, I am happy to respond to any 4 questions. 5 6 7 CHAIRMAN ANGELIDES: much. Thank you so Mr. Weill? MR. WEILL: Good morning, 8 Mr. Chairman and Mr. Vice-Chairman and 9 members of the Commission. 10 My name is Nicolas Weill. I'm the 11 Chief Credit Officer for structured 12 finance in Moody's Investors Service. 13 2007, I was managing director of U.S. RMBS 14 surveillance. 15 Moody's rating monitoring processes and 16 will detail our monitoring activities and 17 the actions we took in response to the 18 challenging environment of 2007. 19 In Today, I will describe As we entered 2007, Moody's believed 20 that residential mortgage-backed 21 securities, RMBS, had sufficient credit 22 protection to withstand a market downturn 23 of similar depth and duration as the 24 previous real estate downturns. 25 Unfortunately, Moody's, like others in the 34 1 Weill - opening 2 market, did not anticipate the severity or 3 speed of deterioration that occurred in 4 the U.S. housing market, nor the speed of 5 credit tightening that followed and 6 exacerbated the situation. 7 A rating is an opinion of the 8 relative creditworthiness of a security 9 based on certain discussions that can 10 change over time. Once published, we 11 monitor it on an ongoing basis and we 12 change it as appropriate to respond to 13 changes in our original assumptions or 14 updates to our views of the relative 15 creditworthiness of the issuer or 16 obligation. 17 generally monitors its ratings on all 18 securities on a monthly basis. 19 terms, the surveillance analyst receives 20 data from regular servicers or trustee 21 reports, assesses the data and, if 22 necessary, conducts a rating analysis. With respect to RMBS, Moody's In general 23 Finally, when necessary, a rating 24 committee convenes to debate and to vote. 25 Any rating change is then published as 35 1 2 3 Weill - opening soon as practically possible. Throughout the 2007 time period, 4 Moody's aggressively monitored market 5 conditions, as the crisis continued to 6 unfold, to assess the impact of how the 7 various market participants might respond 8 to the extremely fast-changing conditions. 9 In January 2007, we published a special 10 report highlighting the rising defaults on 11 the 2006-vintage subprime mortgages. 12 was the first of a series of publications 13 in 2007 in which Moody's discussed the 14 deteriorating conditions of the U.S. 15 subprime and housing market, as well as 16 the market and economic factors that we 17 believed would be critical in determining 18 the ultimate performance of these loans. 19 This Moody's first downgrade and reviews 20 for downgrade on securities backed by 21 2006-vintage subprime loans took place in 22 November 2006. 23 occurred in December 2006 and January 24 2007. 25 Further rating actions Our first comprehensive set of rating 36 1 Weill - opening 2 actions on second tier mortgage-backed 3 transactions took place in April 2007. 4 second set of actions on first tier 5 mortgage-backed transactions followed in 6 July 2007. 7 as soon as there was sufficient actual 8 performance information to judge the 9 persistence of the early trends. 10 A We took these rating actions Indeed, as Moody's monitored the 11 actual performance of the 2006 subprime 12 RMBS, it appeared that the earliest loan 13 delinquency data for the 2006 vintage were 14 largely in line with the delinquency data 15 observed during the recession of 16 2000-2001. 17 consistent with the higher loss 18 expectations that were already anticipated 19 for the vintage. 20 This performance was Not until performance data from the 21 second quarter of '07 became available was 22 it clear that the performance of 2006 23 vintage was likely to worsen and that it 24 might deteriorate beyond that observed in 25 the 2000-'01 recession. 37 1 Weill - opening 2 In conclusion, the unprecedented 3 events of the last few years demonstrate 4 how dramatically markets can change. 5 the benefit and clarity of hindsight, many 6 commentators now think that we and other 7 market observers should have better 8 anticipated what course the market would 9 take. With Given the information available to 10 our analysts at the time and the 11 unpredictable behavior of the market, 12 Moody's undertook efforts to observe 13 closely, to comment publicly and to react 14 decisively. 15 We have implemented numerous changes 16 to our methodologies that we believe will 17 allow our ratings to perform better in the 18 future and we welcome constructive 19 dialogue that might improve the 20 performance of the credit markets. 21 you, and I'm happy to answer any 22 questions. 23 24 25 CHAIRMAN ANGELIDES: Mr. Weill. Thank you, Dr. Witt? DR. WITT: Chairman Angelides, Thank 38 1 Witt - opening 2 Vice-Chairman Thomas, members of the 3 Commission, my name is Gary Witt. 4 last two years, I have been teaching full 5 time at Temple University in Philadelphia, 6 and no longer have any affiliation with 7 Moody's. 8 participate in today's discussion. 9 opinions I express are mine alone. 10 For the I am pleased to be able to The The Financial Stability Act that 11 recently passed both houses of Congress 12 expands the powers of the SEC to regulate 13 the credit rating industry. 14 determine over the coming months and years 15 how best to use these new powers to foster 16 more accurate credit ratings. 17 find our deliberations useful. 18 The SEC will I hope they I was an analyst and then managing 19 director in the U.S. derivatives group at 20 Moody's from September 2000 until 21 September 2005, when I was reassigned 22 within Moody's away from CDOs. 23 of three team managing directors in the 24 CDO group from March '04 to September '05. 25 I was responsible for the following areas: I was one 39 1 2 Witt - opening Cash flow, ABS CDOs, market value 3 CDOs, collateralized fund obligations, 4 catastrophe bonds, and with another team 5 MD, structured financial operating 6 companies. 7 If this list of my responsibility 8 sounds intimidating, believe me, it was a 9 very big challenge. Some of these asset 10 categories are extremely complex. 11 investment bankers structuring them were 12 highly motivated to present them in the 13 most favorable light. 14 some very good people, but not enough of 15 them, considering the size and complexity 16 of the business that we were running. 17 The On our side, we had The CDO market was growing and 18 changing rapidly. 19 always lagged behind growth. 20 struggled to rate new CDO issuance but we 21 had many other responsibilities, including 22 monitoring existing transactions, and 23 keeping rating methods current. 24 25 Our staffing levels The group The biggest problem in my opinion during that time period was the absence of 40 1 Witt - opening 2 any reserve staff to develop, maintain and 3 test new rating methods. 4 in September 2005, I was transferred out 5 of the CDO group. 6 After 18 months, In addition to the details about my 7 time in Moody's, I would like to add a 8 little perspective to our discussion, if 9 you don't mind. 10 During the crisis, during the 11 financial crisis, many people have been 12 very quick to assign blame to the rating 13 agencies. 14 but up to a point. 15 with almost every major participant in the 16 capital markets, failed to grasp the 17 magnitude of the housing bubble before 18 2007. 19 that from every participant in the market, 20 but, you know, it was the same, we were 21 all in -- had the same lack of knowledge 22 about what the future held. 23 ball just didn't get passed around. 24 25 This is definitely appropriate, We at Moody's, along And I know you're tired of hearing The crystal However, there is always a strong tendency to blame rating agencies far more 41 1 Witt - opening 2 than is justified by their previously 3 mistaken opinions. 4 tendency to blame rating agencies results 5 from three reasons: 6 I believe this The first reason is that people 7 expect too much from ratings. As my wife 8 once asked me, what good is a rating if it 9 can't predict the future? Well, the 10 answer is that ratings are tools to help 11 investors manage risk. 12 meant to boil down the received wisdom of 13 the market to a single symbol. 14 for managers of large portfolios, ratings 15 are an easy organization tool for a 16 complex risk environment. 17 and publicly available to all investors at 18 no charge. 19 should always be based on much more than 20 just a rating. 21 A bond rating is Especially They are useful But investment decisions Second, rating downgrades are bad 22 news. It's bad news for the issuer, bad 23 news for investors. 24 the rating agency that is the bearer of 25 this particular bad news and they are the By definition, it's 42 1 2 3 Witt - opening messenger that is so often shot. The last reason that large rating 4 agencies like Moody's are too popular as 5 scapegoats is the glaring conflict of 6 interest at the heart of their business 7 model. 8 rate. 9 that Moody's balance competing interests They are paid by the issuers they Managing this conflict requires 10 of two groups, the investors in Moody's 11 shares, and the investors in the debt that 12 Moody's rates. 13 During my time at Moody's, management 14 did focus on market share and profit 15 margin. 16 myself is this: 17 rating agencies in the securitization 18 markets lead Moody's management to 19 overemphasize the short-term interests of 20 shareholders? 21 So a question that I often asked Did the competition among I don't know. I can say that it is difficult to 22 know where the line should be drawn 23 between these two competing interests. 24 While short-term profits are easy to 25 measure, bondholders' interests are served 43 1 Witt - opening 2 by the zealous pursuit of an elusive but 3 distant goal, the right rating. 4 In my opinion, addressing the 5 conflict between these two asymmetric 6 goals is the most important task the SEC 7 faces in its regulation of the credit 8 rating industry. 9 in addressing this issue in a published I've described my ideas 10 article that I included with my testimony. 11 Thank you. 12 CHAIRMAN ANGELIDES: Thank you very 13 much, Dr. Witt. 14 questioning of the witnesses. 15 begin the questioning today, as is custom, 16 and followed by Vice-Chair Thomas, and 17 then the members of our Commission who led 18 this investigation. 19 We will now begin with I will So I'd like to start with some 20 questions that go to really what a couple 21 of you have talked about as a flawed 22 business model. 23 which the issuer pays while in a sense the 24 supposed beneficiary of the rating should 25 be the long-term bondholder, the duopoly The very model under 44 1 Q & A - Session 1 2 in this industry, or certainly oligopoly, 3 that limits competition, the fact that 4 there are extraordinary legal protections 5 for credit rating agencies, and finally 6 that there is this tremendous tension 7 between short-term profits and quality of 8 ratings over time. 9 ask a couple of you to start the 10 11 So I'd like to just following. I think, Mr. Kolchinsky, you've 12 spoken on this, and I'm going to ask a 13 couple of the other folks. 14 2007, the SEC did a report on Moody's. 15 was part of a larger report which they did 16 on all rating agencies. 17 actually enter that SEC report on Moody's 18 into the record. 19 So if the staff would please note. In August of It And I'd like to It's, I believe, tab 1. 20 But in that report, the SEC noted a 21 number of items, and they said that the 22 ratings had suffered due to the increase 23 in the number and complexity of deals, 24 just the sheer volume; they said that, as 25 a corollary of that, that staffing had not 45 1 Q & A - Session 1 2 kept up with revenues and the number of 3 deals, in a sense there had been almost a 4 conveyer belt moving faster and faster, as 5 no revenues -- and this is not the SEC but 6 this is my notation -- revenues at Moody's 7 went from 600 million in 2003 to over 2.2 8 billion in '07, profit margins grew from 9 26 percent to 37 percent by 2007. 10 But the SEC found staffing shortages. 11 They said deals were pushed out the door 12 and that investment analysts were also 13 involved in fee negotiations and that 14 ratings had affected business interests. 15 I'm going to ask you very quickly, 16 Mr. Kolchinsky, do you think those are 17 fair characterizations of what you saw 18 there? 19 MR. KOLCHINSKY: I think that's 20 right. I think the fee negotiations in 21 many cases were limited because we had a 22 standard contract that we signed off to 23 bankers. 24 resources, in terms of the factory 25 mentality, I think that's a very fair But in terms of lack of adequate 46 1 2 3 Q & A - Session 1 characterization, yes. CHAIRMAN ANGELIDES: Dr. Witt, do you 4 think that's a fair characterization of 5 the SEC's report? 6 DR. WITT: Yes. As my opening 7 comments reflected, you know, I definitely 8 thought that we were under-resourced, you 9 know, we were always playing catch-up. We 10 didn't have an independent research group. 11 Of course, I'm talking about the period up 12 until September '05, when I left the CDO 13 group. 14 But on the other hand, you know, at 15 the time, the reason that we would hear 16 from management above us why we were 17 under-resourced was because the growth was 18 just so fast and because each year, they 19 would predict that, you know, the 20 residential mortgage-backed market and the 21 CDO market was going to flatten out, and 22 we, our hiring would be based on those 23 predictions. 24 catch up. 25 under-resourced. But we just never seemed to So we were definitely 47 1 2 Q & A - Session 1 CHAIRMAN ANGELIDES: Didn't you 3 express some concern in your interview 4 with our staff that there were some people 5 you wanted to bring on and you couldn't 6 get the approval for their salary levels 7 and the talent you needed? 8 9 DR. WITT: Yes. That was -- I mean, I thought -- you know, my remarks 10 reflected, you know, I'm kind of in the 11 middle here. 12 anymore. 13 to grind. 14 I don't work at Moody's I certainly don't have any axe But one of the things I did feel 15 strongly about at the time, and I still do 16 now, is that, you know, we just didn't -- 17 the profit margins were so wide, and 18 especially in the CDO group, and yet 19 management really stinted on hiring staff, 20 and I just couldn't understand it then and 21 I still don't now. 22 CHAIRMAN ANGELIDES: Okay, thank you. 23 Let me go to business practices here for a 24 minute, Mr. Siegel and Mr. Weill. 25 me just ask you, first of all, to your So let 48 1 Q & A - Session 1 2 knowledge, let me ask, do either of you 3 have any background in housing, housing 4 finance, mortgages, housing business, ever 5 been in the business itself? 6 MR. SIEGEL: Mr. Chairman, my 7 experience in the industry was based on my 8 twelve years at Moody's. 9 models and did research that way but -- 10 11 CHAIRMAN ANGELIDES: ground. I helped develop But not on the You, Mr. Weill? 12 MR. WEILL: No. 13 CHAIRMAN ANGELIDES: How many folks 14 in the business rating RMBS and CDOs 15 mortgage securities in your shops actually 16 had been in the business in any real way? 17 In other words, touching, feeling the 18 actual business? 19 housing? 20 MR. SIEGEL: Mortgages, lending, I would estimate about 21 ten percent at any time, but staffing, 22 there's always turnover. 23 CHAIRMAN ANGELIDES: Now, my 24 understanding is that you did do visits to 25 originators in the RMBS group, but my 49 1 Q & A - Session 1 2 understanding is, you would look at 3 originators but, beyond going to 4 originators, because I understand there 5 were some adjustments made for different 6 originators, did Moody's ever do any 7 actual due diligence on loans, borrowers, 8 go to places like Inland Empire, 9 Bakersfield, Sacramento, Las Vegas, and 10 actually do on the ground assessments of 11 the housing market, places where, you 12 know, there was a national housing price 13 increase of 89 percent from 2002-2006? 14 And in many of these markets, from which 15 many of us hail, there was extraordinary 16 price escalation. 17 sent on to the ground to assess the market 18 to your knowledge? 19 MR. SIEGEL: Were there any teams Our analysis of housing 20 market trends was based on published and 21 available research and discussions with 22 issuers, and observations they were able 23 to make from being on the ground. 24 25 MR. WEILL: Mr. Chairman, we also have a lot of dialogue within Moody's with 50 1 Q & A - Session 1 2 various teams of economists. 3 mentioned Moodyseconomy.com earlier. 4 this ongoing dialogue allows us to be 5 informed of market developments, regional 6 market developments. 7 CHAIRMAN ANGELIDES: You Any efforts, 8 systematic efforts, after the FBI and 9 others warned about mortgage fraud, to 10 detect mortgage fraud within the 11 securities you were rating? 12 MR. SIEGEL: So Mr. Chairman, we're 13 prohibited by law from looking at 14 personally-identifiable information. 15 terms of that sort of fraud, the Social 16 Security number appears on three loans, 17 there must be something wrong. 18 not be able to get that information. 19 So in We would But part of the originator review 20 would include an assessment of their 21 checks for fraud. 22 specifically that FBI report, but I do 23 recall substantial industry discussion 24 about the increased sophistication of 25 fraud availability over the internet of I don't recall 51 1 2 3 Q & A - Session 1 fake W-2s -CHAIRMAN ANGELIDES: Let me ask this 4 question, and then the Vice-Chair does 5 have a question which he wants to do as a 6 follow-up. 7 models to account for changing risk 8 profile in terms of fraud? 9 10 11 12 13 Any specific adjustments to MR. SIEGEL: If you're referring more broadly to our overall methodology -CHAIRMAN ANGELIDES: With respect to that specifically. MR. SIEGEL: -- our overall 14 methodology, we look to the reps and 15 warranties and strengthen our analysis of 16 examining the companies providing the reps 17 and warranties, which would include loans 18 that turn out not to be representative -- 19 CHAIRMAN ANGELIDES: If you would get 20 for us or provide exactly what Moody's did 21 in terms of altering its methodology to 22 account for perhaps increased fraud. 23 Mr. Vice-Chairman? 24 25 VICE-CHAIRMAN THOMAS: Just directly and specifically on your response to the 52 1 Q & A - Session 1 2 Chairman, in terms of actually getting 3 firsthand or primarily knowledge, you 4 indicated in the residential, in the 5 mortgage area, that you relied on 6 published sources, so it was secondary. 7 Did Moody's rely on secondary sources 8 in all of its rating activities or were 9 you involved in some primary pursuits in 10 terms of examining particular areas? 11 you a catcher all the time in terms of 12 data that was already out there, or did 13 you generate or pitch some of the time in 14 terms of the way you came to your 15 conclusions? 16 MR. SIEGEL: Were If I understand the 17 question, in some cases, Moody's was 18 actually a good source of data because, 19 for deals we rated, we received monitoring 20 information. 21 being primary, the service would report, 22 "Here, how many borrowers are delinquent 23 on this particular pool," "Here, how many 24 are in foreclosure." 25 primary, we used that information to So if you count that as If you count that as 53 1 2 3 Q & A - Session 1 inform -VICE-CHAIRMAN THOMAS: Did you 4 yourself sample it or was this others 5 providing material to you? 6 MR. SIEGEL: The -- we didn't open 7 the check and -- the envelope and see if 8 the borrower was making the full payment 9 or not, but the servicer would report on 10 this pool of loans, that ten borrowers are 11 delinquent and Moody's would use that information. 12 VICE-CHAIRMAN THOMAS: Last aspect of 13 the question. 14 based upon your recent experience? 15 16 17 18 Do you do sampling now MR. SIEGEL: I'm sorry, I left Moody's in -VICE-CHAIRMAN THOMAS: Ah, Mr. Weill, you're the one who is still there. 19 MR. WEILL: Yes, Mr. Vice-Chairman. 20 VICE-CHAIRMAN THOMAS: I don't mean 21 to finger you or point you out. 22 just, the answer customarily is, "I wasn't 23 there." 24 ask you directly. 25 It's So you're a live one, and I can MR. WEILL: What do you do? Appreciate the privilege. 54 1 Q & A - Session 1 2 We have published recently a lot on our 3 improved methodologies. 4 two fronts that are covering your 5 question. 6 there is a need to enhance how 7 representation and warranties are 8 implemented and enforced through 9 securitization. 10 11 I think there are One of them is the fact that And we can discuss it as part of the monitoring effort. The other part is, Moody's believes 12 that it's useful, as we don't have access 13 to loans, to have third parties sample 14 large sections, large proportion of the 15 loans to indeed check that the various 16 representations in the warranties on 17 appraisals, on occupancy or income are 18 indeed correct. 19 20 21 VICE-CHAIRMAN THOMAS: When did that start? MR. WEILL: The process on 22 representation and warranties, as stated 23 earlier, has started a long time ago. 24 have indeed published recently in 2008, I 25 think, various reports suggesting various We 55 1 2 3 Q & A - Session 1 enhancements for the RMBS markets. VICE-CHAIRMAN THOMAS: The sampling 4 of specific factors involving loan 5 delinquencies and so on, is that what 6 you're referencing, or is that a 7 secondary, and an additional sampling 8 model? 9 MR. WEILL: I'm referring to recent 10 2008 publications where we have discussed 11 sampling and -- 12 VICE-CHAIRMAN THOMAS: Okay. 13 "Recent" and 2008 to me don't connect, 14 given the fact that this is 2010. 15 that's the most recent, okay. 16 Mr. Chairman. 17 CHAIRMAN ANGELIDES: So if Thank you, Thank you. 18 Let's see, picking back up on this, so, 19 let me ask you a question. 20 discussion ever in Moody's as housing 21 prices began to escalate at an 22 extraordinary rate -- here is, by the way, 23 a graph of the Case-Shiller index, if you 24 can all see that. 25 2000, there is an historic and Was there any You'll see that about 56 1 Q & A - Session 1 2 unprecedented rise in housing prices, it 3 says 89 percent, in the last, from 4 2000-2007. 5 Was there any discussion internally 6 about fundamentally, not just 7 incrementally, but fundamentally changing 8 the models and/or sending assessment teams 9 out into the field? Was there any 10 fundamental rethinking of the models? 11 know there were calibrations done. 12 was there ever a "whoa" moment for the 13 team, Mr. Kolchinsky, you can remember? 14 15 MR. KOLCHINSKY: I But Well, I didn't work for the RMBS -- 16 CHAIRMAN ANGELIDES: 17 MR. KOLCHINSKY: 18 CHAIRMAN ANGELIDES: Or CDOs also. Not for CDOs. Was there ever 19 just, "Let's stop this for a minute, we're 20 rating nine thousand securities a year, 21 there's four AAA corporations, something's 22 out of whack here?" 23 step back? 24 25 MR. SIEGEL: No. Any kind of just a There were discussions with Moody's economist as to 57 1 Q & A - Session 1 2 what he -- his views were on national real 3 estate prices. 4 CHAIRMAN ANGELIDES: Well, when 5 Moody's.com came out with a report in 6 October 2006, saying there was going to be 7 a crash, that's the word they used, in 8 twenty metropolitan areas, did the group 9 say, "Whoa, let's stop this"? 10 11 MR. SIEGEL: I'm sorry, Mr. Chairman, I left in April of 2006. 12 CHAIRMAN ANGELIDES: Was there any, 13 in October of 2006, when Mark Zandi and 14 his crew said there was going to be a 15 crash, "Let's stop this, let's put this on 16 hold"? 17 MR. WEILL: I was part, as I said in 18 my testimony, on the surveillance team, so 19 we had a lot of dialogue with 20 Moodyseconomy.com among others, and at the 21 time my recollection is, for 2007, the 22 prediction were more for a soft landing at 23 the end of 2007, maybe for a ten percent 24 national price decline, worst case maybe 25 15. And the level of protection that the 58 1 Q & A - Session 1 2 securities had would easily take into 3 account a ten -- 4 CHAIRMAN ANGELIDES: Well, let me 5 query you on that. Then why is it when 6 prices dropped by four percent in July 7 2007, you're already downgrading? 8 models haven't withstood a ten or 15 9 percent decline. Your You're in downgrade mode 10 by July when prices have just come four 11 percent off their peak. 12 happening? 13 MR. WEILL: Why is that Our weighting situation 14 is level of certainty associated with 15 repayment. 16 rating scale from AAA all the way to C. 17 And each of them reflects the probability 18 of an obligation to be repaid. 19 downgrade reflects more a shift in this 20 probability, and as we saw delinquencies 21 ramping up in an environment that would be 22 less favorable in terms of home price 23 decline, downgrades were actually 24 reflective of changing views on the 25 probability of repayment. In other words, you have a 21 A In other words, 59 1 Q & A - Session 1 2 the -- 3 CHAIRMAN ANGELIDES: 4 expected loss, correct? 5 MR. WEILL: 6 CHAIRMAN ANGELIDES: Well, the That's correct. So by four 7 percent, you're already recalibrating 8 expected loss, not at ten percent. 9 a fact, right? 10 MR. WEILL: That's Mr. Chairman, the rating 11 actions are not based on the macro view. 12 The rating actions that we took in July 13 '07 and that we always take are based on 14 an analysis of security by security. 15 what is driving the downgrade is a lot 16 more the performance, the level of 17 delinquencies, the servicer reports 18 showing the severity of loss upon liquidation not-- 19 CHAIRMAN ANGELIDES: So But Mr. Weill, 20 let me just point out again, the 21 downgrades begin at four percent not when -- everyone is fond of 22 saying 23 that we couldn't have predicted 30 percent 24 diminution in home prices, but the 25 downgrades start well before that time 26 period. 60 1 2 Q & A - Session 1 Let me move right now to some market 3 practices. 4 report. 5 interviews, staff interviews, that there 6 was a lot of constant pressure for market 7 share. Some of you have spoken about that 8 today. And it's our understanding that 9 people leading the ratings team would 10 I referred to them in the SEC But we've heard in a lot of our regularly get market share reports. 11 In fact, I want to enter as examples, 12 routine examples, tab 26, tab 36, tab 37. 13 Those are e-mails from Michael Zoccoli, 14 Sunil Surana. 15 comments have been made. 16 who is one of the analysts, said, "If 17 business was missed, you would have to 18 answer to Brian.” 19 Mr. Witt. 20 market share was critically important, 21 “that is why Brian Clarkson's rise was so 22 meteoric, was because he was the enforcer 23 who could change the culture to have more 24 focus on market share.” 25 worked at Moody's said “they willingly A number of Jay Eisbruck, That's Mr. Clarkson, You once said that, you know, Jerome Fons, who 61 1 Q & A - Session 1 2 looked the other way, traded the firm's 3 reputation for short-term profits.” 4 5 6 I guess, Dr. Witt, what would happen if you didn't rate a deal? DR. WITT: Well, you know, like you 7 were talking about Sunil's reports, Sunil 8 was on Brian's staff, and we would get a 9 report that said the deals that you didn't 10 rate, and you would be typically asked to 11 explain why you didn't rate them. 12 were supposed to look into it and give an 13 explanation. 14 CHAIRMAN ANGELIDES: And? You But every 15 deal you didn't rate you would have to do 16 that? 17 DR. WITT: Well, no, not necessarily 18 every deal. 19 percentage were changing a lot, or they 20 may have some interest in a particular 21 deal, but you got a report that detailed 22 each transaction. 23 But if, you know, the CHAIRMAN ANGELIDES: By the way, just 24 for the record, those items I mentioned, 25 I'd like to enter into the record. 62 1 2 Q & A - Session 1 It's my understanding that 3 performance evaluations were based on five 4 items: 5 outreach, such as speeches, presentations, 6 ratings quality and development of tools. market coverage, revenue, market 7 Now, three of the five items seemed 8 to be on the profits metric, not on the 9 ratings quality metric. And of course the 10 rating quality wouldn't show up for quite 11 some time. 12 I did see an e-mail from Mr. Clarkson 13 to managers saying, it's document -- 14 that's tab 15 -- essentially saying, 15 "Here's the last market share, here's a 16 market share report, you ought to be using 17 this in your personal evaluations." 18 To what extent were personnel 19 evaluations based on the quality of the 20 rating versus your ability to move the 21 business, Mr. Kolchinsky? 22 ask Mr. Siegel. 23 MR. KOLCHINSKY: And then I'll I actually never 24 received a formal evaluation as a managing 25 director. But it was very clear to me 63 1 Q & A - Session 1 2 that my future at the firm and my 3 compensation would be based on the market 4 share that was brought in. 5 reinforced in many ways, especially with 6 these e-mails that were sent out, at least 7 quarterly, and occasionally monthly. 8 recall one e-mail that was sent out, I 9 believe in October of '07. And that was I This was right 10 around the same time that three thousand 11 tranches were downgraded by Mr. Weill's 12 team. 13 There was a question that our market 14 share dropped from 98 percent to 94 15 percent, and please explain why. 16 that's sort of the mentality. 17 clear that, whether explicit or implicit, 18 that the performance and the future of a 19 managing director in structured finance 20 really depended on keeping and maintaining 21 market share. 22 CHAIRMAN ANGELIDES: 23 MR. SIEGEL: And It was very Mr. Siegel? Mr. Chairman, I never 24 found that to be the case during my tenure 25 at RMBS. First of all, the performance 64 1 Q & A - Session 1 2 evaluation metrics you described sound 3 like they are for managing directors and 4 above. 5 based on market coverage. 6 component of the managing directors' 7 evaluation. 8 9 The analysts were never evaluated That was a It was always understood that market share was to be explained, not to be held 10 as a hard-and-fast number. 11 deal because the issuer found someone else 12 who offered higher ratings or weaker 13 standards, that was perfectly acceptable. 14 If we lost a deal because an analyst 15 wanted to leave at 3 o'clock and the 16 issuer had wanted feedback at the end of 17 the day, that would be an issue. 18 CHAIRMAN ANGELIDES: So losing a Okay. I just 19 want to point out this memo from 20 Mr. Clarkson went to Ed Bankole, Pramila 21 Gupta, Michael Kanef, Andrew Kriegler. 22 What level would they have been? 23 MR. SIEGEL: They would have been 24 team managing directors, the same as my 25 level -- 65 1 2 Q & A - Session 1 CHAIRMAN ANGELIDES: All right, well, 3 it says, "You should be using this in PEs 4 and to give people a heads-up on where 5 they stand relative to their peers." 6 7 8 9 So he's telling his managers, use this down the chain. MR. SIEGEL: But again, Mr. Chairman, that's not the number. That's the 10 explanation that's part of that file and 11 if people are losing deals because of 12 customer service, they left at 3 13 o'clock -- 14 CHAIRMAN ANGELIDES: But that's not 15 what it says. 16 you should give them a heads-up about 17 where they stand with their peers. 18 right. 19 It says you should tell -- All Let me -- last question here, before 20 I move on to the Vice-Chair, we looked at 21 a couple of specific deals that struck me. 22 Just to see how this worked, we looked at 23 a 2006 RMBS sponsored by Citigroup. 24 was a bunch of New Century loans, $948 25 million; 75 percent were adjustable rate, It 66 1 Q & A - Session 1 2 33 percent were 228 loans, balloon 3 payment. 4 year, 13 percent of the mortgaged 5 properties had been foreclosed upon. 6 June 2009, 31 percent. It was issued in '06. Within a By 7 Over fifty percent of the loans are 8 now 60 days-plus delinquent and all the 9 bonds have been downgraded to junk. 10 The other deal we looked at was a 11 Merrill Lynch deal. It's tab 70, and by 12 the way, the New Century deals is the 13 ratings memos, tab 22. 14 those both in the record. I'd like to enter 15 But Mr. Kolchinsky, I think you may 16 have worked on this Merrill Lynch deal. 17 It was a 2006 deal, 488 million. 18 Downgrades started in October '07. 19 now been all downgraded to junk. 20 value of the collateral originally 488 21 million, is now at 67 million, down 87 22 percent from its peak. 23 It's And the You know, I look at that and I think 24 when you go into a store and you get, you 25 see grade A eggs, you assume maybe one of 67 1 Q & A - Session 1 2 those eggs will be cracked. 3 twelve are cracked and it was originally 4 rated AAA. 5 Turns out all I guess my question for you, because 6 you were on this deal, and by the way, you 7 sent an e-mail about this deal, which I'd 8 like to enter into the record, to Yvonne 9 Fu and Yuri Yoshizawa, talking about how 10 this deal was, you sent the e-mail because 11 you said it was important to have, "A 12 record of transactions which have 13 grievously pushed our time limits and 14 analysts." 15 16 17 Tell me a little bit about this deal and why it went wrong. MR. KOLCHINSKY: Sure. On this deem, 18 I wouldn't even consider this one of the 19 worst performers and it's a standard 20 hybrid ABS CDO backed by mezzanine loans. 21 It was underwritten by Merrill Lynch. 22 manager was GSC, which is the old 23 Greenwich Street Capital Partners. 24 went wrong just like most others. 25 The It The severe downgrades in the subprime 68 1 Q & A - Session 1 2 area, and there's concentrated heavily in 3 subprime, drove the ratings down. 4 Eventually this deal suffered an event of 5 default, and none of the ratings there 6 actually -- the notes are at this point 7 not making any payments. 8 9 As far as the structure or the concern, this was -- this deal was fairly 10 ordinary. 11 and BAA3 collateral, primarily subprime 12 and midprime. 13 It was backed by primarily BAA2 What the trouble on this deal was, 14 and this is crucial about the market 15 share, was that the banker gave us hardly 16 any notice and any documents and any time 17 to analyze this deal. 18 the problem with not being able to say no. 19 If I could say no, and the documents came 20 outside the window, which we would have 21 appreciated, I would have said, "Look, I'm 22 sorry, I can't give you an opinion. 23 need at least three or four weeks to 24 analyze this deal more fully." 25 That was part of But because bankers knew that we I 69 1 Q & A - Session 1 2 could not say no to a deal, could not walk 3 away from the deal because of a market 4 share, they took advantage of that. 5 this deal particularly, the banker sent us 6 various documents, either a few days 7 before closing or sometimes after closing. 8 In this case, I believe in this 9 transaction, we didn't even know the deal And 10 was priced. 11 collateral manager when we visited the 12 collateral manager and they mentioned, 13 "Oh, by the way, we priced the deal." 14 that was something in the ordinary course 15 of events we would like to know. 16 We found that out from the And In the old days, we had about a 17 month-and-a-half, two months to actually 18 rate a deal. 19 got the documents. 20 and forth. 21 took advantage of the fact that we 22 wouldn't walk away from the deal and 23 started sending us documents whenever they 24 wanted to. 25 It took a lot of time. We They were sold back At this point, the bankers CHAIRMAN ANGELIDES: Am I reading 70 1 Q & A - Session 1 2 this right to say some of the documents 3 you got the day before the closing, some 4 about three or four days? 5 6 MR. KOLCHINSKY: I believe that's correct, yes. 7 CHAIRMAN ANGELIDES: Did you ever see 8 "I Love Lucy?" Have you ever seen that 9 famous episode where she's working in the 10 chocolate factory, and the conveyor belt 11 goes faster and faster? 12 like Lucy? 13 MR. KOLCHINSKY: Oh, yes, all the 14 time. 15 conveyer belt and we definitely felt that 16 way. 17 All the time. Did you ever feel We certainly had a CHAIRMAN ANGELIDES: All right. 18 reserve the balance of the time. 19 you very much. Mr. Vice-Chairman. 20 VICE-CHAIRMAN THOMAS: I'll Thank Thank you, 21 Mr. Chairman. I want to pursue a similar 22 line, but in a slightly different way. 23 You're interesting and useful to me 24 because at least in my mind, and any time 25 I make a statement that you don't feel is, 71 1 Q & A - Session 1 2 you know, accurate depicting the general 3 scene as you looked at it, let me know. 4 Because I see you as a choke point, not in 5 a negative sense, but it's a very limited 6 number of people doing what you do. 7 guess, given the volume and the history, 8 you're probably as good as any of them 9 doing it. And I So someone would want to get 10 your label, and that's one of the reasons 11 they came to you. 12 So as a choke point, especially since 13 you were there in this transition of 14 rating what, for want of a better term, I 15 guess it's been called plain vanilla, the 16 old corporate bonds, in a time frame that 17 seemed luxurious, looking back at it, and 18 then the transition to a much more complex 19 structured product in a far more 20 voluminous way in a time frame that gets 21 shortened from weeks or months to 22 literally days, and when it's the output 23 that's focused on and not necessarily the 24 quality of the output, it clearly creates 25 a dynamic. 72 1 Q & A - Session 1 2 And so I want to talk a little bit 3 about how you felt or what was the mental 4 set. 5 I'm very much struck by the comparisons 6 that you might make. 7 Wall Street or looking at investment 8 banks, it just always has, to me, a kind 9 of an auction atmosphere. Because in looking at what you do, 10 hectic. 11 bidding and so on. 12 Anybody looking at It's very There's pressure, time lines, In looking, especially in reading 13 about what you folks do, it just seemed to 14 be much more of an academic atmosphere, at 15 least earlier, about, even coming together 16 as committees to discuss how we do and 17 what does it look like and suggesting 18 changes that might be made. 19 back to that in a minute. 20 I'll come So when you say that you're 21 compensated, what did that mean? Was any 22 of it truly, in your mind, as the Chairman 23 referenced, rated to the volume of what 24 you were doing, quality versus quantity? 25 How did you think you were judged in terms 73 1 2 3 Q & A - Session 1 of compensation? First of all, and it's just open to 4 everybody depending on when you were 5 there, because I don't want an answer, 6 "I'm sorry, but I wasn't there." 7 almost all we've gotten from people higher 8 up in the structure, and that's one of the 9 reasons I like this panel because you were That's 10 actually doing it, and we've got people 11 who are there today, and back at that 12 particular period. 13 14 15 16 17 So how did you think you got paid? Anybody? What did you get paid on? DR. WITT: Well, one thing I want to point out is -CHAIRMAN ANGELIDES: One mike on at a 18 time, just because -- Dr. Witt, you go 19 ahead. 20 21 22 VICE-CHAIRMAN THOMAS: referee. You can Go ahead. DR. WITT: We got a salary and a 23 bonus which sounds like, you know, just 24 like the rest of Wall Street. 25 bonus that we got was a fraction of our But the 74 1 Q & A - Session 1 2 salary, not multiples of it like it was on 3 Wall Street. 4 component was not nearly as large as it 5 was for investment bankers. 6 vary -- 7 VICE-CHAIRMAN THOMAS: 8 an incentive. 9 DR. WITT: 10 11 12 So the variable compensation But it did Well, it was It was an incentive. VICE-CHAIRMAN THOMAS: A realistic incentive. DR. WITT: And I definitely thought 13 that, you know, making sure that we kept 14 market share as high as we could subject 15 to getting the ratings right. 16 that was definitely something that was 17 important, and that my manager looked at 18 and he thought about a lot, and talked 19 about. 20 I thought Yeah. VICE-CHAIRMAN THOMAS: Let me not get 21 ahead of myself, because one of the things 22 we found is that there's never enough time 23 and we can't ask all the questions and 24 frankly, as we go forward, we know more 25 than we did when we asked you the 75 1 2 Q & A - Session 1 questions in the first place. 3 So would all of you be willing, and I 4 would like a response to the question, be 5 willing to answer questions of you 6 submitted in writing as we go forward? 7 Would that be something each of you would 8 be willing to do? 9 MR. KOLCHINSKY: 10 11 VICE-CHAIRMAN THOMAS: He has a hard time reporting nodding of heads. 12 13 Yes, certainly. MR. SIEGEL: Yes, after my tenure there. 14 DR. WITT: Sure. 15 VICE-CHAIRMAN THOMAS: Back to this 16 catchers-and-pitchers thing. 17 basically feel that you were there and you 18 weren't active unless someone came to you, 19 or did you go out and actively seek folk 20 making pitches to them to use you for the 21 purpose of rating? 22 you catchers, pitchers or you did both? 23 In the company. 24 you? 25 Did you To what extent were Does that make sense to You're a rating company. People want 76 1 Q & A - Session 1 2 you to rate their product. 3 for them to come to you? 4 a catcher of people who came to you with 5 product? 6 MR. SIEGEL: Did you wait Were you purely Moody's does not 7 structure deals, so we would not go to 8 someone who had originated subprime 9 mortgages and say, "Oh, you could do a 10 securitization and we could be your rating 11 agency." 12 would come to us. 13 collateral would be driving the structure. 14 So in that respect the deals Someone who owned the VICE-CHAIRMAN THOMAS: And it never, 15 ever was a discussion about going out and 16 making pitches because you're seeing 17 things crossing your choke point that 18 others might not. 19 MR. SIEGEL: We did want the market 20 to appreciate the quality of the Moody's 21 ratings. 22 we would publish on trends in the market, 23 we would publish on rating methodologies, 24 we would publish on risk. 25 meet with issuers so, if an issuer did a So we would speak to investors, We would also 77 1 Q & A - Session 1 2 hundred deals and we were on 90, we would 3 inquire as to why we weren't on the 4 others. 5 service, of course we would pursue, "Oh, 6 you want us to have an analyst available 7 on Saturdays? 8 that." 9 And if it was, again, customer Let me try to arrange VICE-CHAIRMAN THOMAS: Sure, just 10 convenience. 11 level of dollar amounts. 12 they were real. 13 banks and what people were paid and the 14 amount of millions they would receive and 15 their answer was, "That was above my pay 16 grade?" 17 with that. 18 with Dr. Witt's testimony about the 19 failure to retain someone for $20,000 a 20 year. 21 impress folk in other areas. 22 I was also struck by the By that I mean, In discussing investment It's been very difficult to deal So I was especially struck There aren't enough zeros there to So I'm sure that you had people who 23 had been on the team for a long time and 24 that, having someone who had been in the 25 service of Moody's or another rating 78 1 Q & A - Session 1 2 agency would probably be a fairly 3 attractive hire for the people who were 4 going to be coming to you in the future to 5 ask for ratings; i.e., "I now have someone 6 at an investment bank under my employment 7 who knows the setup and key people and the 8 rest." 9 Did you see a frequency of people 10 moving from Moody's or others that you 11 were aware of to Wall Street? 12 MR. SIEGEL: The plurality of people 13 who left Moody's for another job would 14 have ended up on Wall Street. 15 VICE-CHAIRMAN THOMAS: 16 remember you? 17 they talk to you? 18 MR. SIEGEL: And did they Did they call you? Did Most of them knew that 19 that was not appropriate behavior; that 20 they could bring expertise on the product 21 type, but I would not look favorably on 22 someone calling and saying, "Can you do 23 something different or special for me." 24 That would not have gone over well at all. 25 VICE-CHAIRMAN THOMAS: Okay. We're 79 1 Q & A - Session 1 2 going to accept that as the statement. 3 Does anyone want to say that that sounds 4 good but it wasn't always that way? 5 Mr. Weill? 6 MR. WEILL: I would just add that on 7 my side, which was the surveillance side, 8 just because someone would have left to an 9 investment firm or another firm would not 10 create any kind of specific relationship 11 to be informed of any rating actions. 12 VICE-CHAIRMAN THOMAS: It wouldn't be 13 a specific rating relationship but you 14 knew each other. 15 All right, back to this business of 16 going from plain vanilla, rating corporate 17 bonds, and would it be fair to describe a 18 relatively rapid change of what you did as 19 a business in terms of the products you 20 were rating? 21 complex structured financial documents? 22 Moving to structured, Did it hit you as a company in terms 23 of what you were offering over the years, 24 versus what you were now asked to offer? 25 MR. SIEGEL: This goes back, I 80 1 Q & A - Session 1 2 started at Moody's around 1994. 3 before that, Moody's had developed the 4 methodology. 5 quantitative analysts and developed 6 entirely separate teams to rate structured 7 finance, separate people from the people 8 who were rating what you described as a 9 plain vanilla corporate bonds. 10 And even They pulled some of the more VICE-CHAIRMAN THOMAS: Okay. But 11 then it also sped up even faster than you 12 thought it was going to, based upon your 13 statements that it was going -- you 14 thought it was going to level off. 15 think, Mr. Weill, you made that statement. 16 I So what I'm looking at -- or Mr. Witt 17 did -- what I'm looking at are these 18 teams, the committees in making decisions, 19 as the process sped up, and obviously 20 people understood that if you're simply 21 going for the letters, if they shortened 22 the time in which you had to consider what 23 it was, notwithstanding they have made 24 significant changes in the product, if 25 they could indicate to you, or structure 81 1 Q & A - Session 1 2 it in a way that it looked like similar 3 products, you would have a tendency to 4 give it the same rating, notwithstanding 5 the fact the internal structure wasn't the 6 same? 7 were looking at products over this 8 timeline? 9 Did you have that feeling as you MR. KOLCHINSKY: I think that's 10 exactly what occurred with the products. 11 You had a sort of, an exterior that looked 12 sort of -- and this is -- I'm talking -- I 13 wasn't there, I never worked in 14 corporate -- even on the pure structured 15 products, the exterior looked like it 16 would match our models. 17 underlying mechanisms were changing and 18 the credit was deteriorating underneath 19 that. But all the 20 And the problem with the ratings 21 process was, if you had a hunch that 22 something was wrong or it was a 23 qualitative feeling things were wrong, you 24 couldn't really do anything, because you 25 couldn't say no to a deal. And therefore 82 1 Q & A - Session 1 2 they just got passed through because 3 quantitatively, the numbers, the headline 4 numbers were great. 5 goes to explain some of the factors in 6 RMBS, the quantitative numbers, the 7 performance numbers looked great. 8 Underneath that, what the originators, the 9 bankers did, they undermined credit Underneath, and this 10 quality by changing things, creating 11 different structures, new products that 12 looked like the old products but were in 13 fact different. 14 So the problems with the rating 15 agencies and what they did or didn't do 16 are omissions and sort of taking at face 17 value some of the things that came to us 18 because they looked good in the old 19 perspective while the bankers were 20 changing things around -- 21 VICE-CHAIRMAN THOMAS: Okay, going to 22 the Lucille Ball, "I Love Lucy" chocolate 23 conveyer belt, if you started out with 24 caramels, you could handle them pretty 25 quickly because they are solid, but if you 83 1 Q & A - Session 1 2 get into the creams, you've got to be 3 fairly careful as to what you do with 4 them, and as I recall, she just started 5 mashing them all. 6 7 8 9 Did you have a gut feeling that they looked the same, but weren't? MR. KOLCHINSKY: They were definitely gut feelings but, you know, the better 10 analogy is that you had a solid chocolate 11 versus something that was empty on the 12 inside. 13 going down the conveyor belt, and with 14 time and time they became more empty on 15 the inside and had less cocoa content -- 16 So they kind of looked the same VICE-CHAIRMAN THOMAS: So part of the 17 problem was, you are analyzing this, you 18 were coming up with new models. 19 met as committees. 20 more than anyone else, did you ever have a 21 session with a committee where you kind of 22 looked at each other and said, "This thing 23 is changing rapidly, it's different than 24 what we thought it was, let's go get some 25 reserve and reconvene as a committee a So you Probably, Mr. Weill 84 1 Q & A - Session 1 2 little bit later to examine what in fact 3 we have this gut feeling that it's 4 slightly different than what it was"? 5 that occur? 6 MR. WEILL: Did That's exactly what we 7 did in the first couple of months of 2007. 8 Where we published at the beginning of 9 2007 a special report on early payment 10 defaults. We saw that there was a 11 changing in borrower behavior, in 12 homeowners' behavior, and we had a lot 13 more early payment defaults. 14 did is, we paused and we convened a larger 15 group of people to think about what was 16 happening there, whether there was a 17 change, a departure from annual existing 18 trend to a new trend, whether the -- 19 whether this was a macroeconomic trend, 20 whether this was a refinancing trend, 21 whether it was a homeowner behaviors 22 trend, an originator trend, certain 23 behavior on reps and warranties, on 24 appraisals, on servicing and loan 25 modifications. And what we We put a lot of effort and 85 1 Q & A - Session 1 2 people together to try to think through 3 those issues. 4 what you are describing here. 5 VICE-CHAIRMAN THOMAS: That's exactly, I think, So, and this 6 is an attitude that I'm asking you in your 7 opinion. 8 terms of number, clearly, just the sheer 9 volume you were facing, they were also 10 11 As these products multiplied in changing in terms of structure. Was there any discussion or belief on 12 your part that these products were 13 changing in structure, clearly done so by 14 those who were structuring them for the 15 purpose of getting a rating, 16 notwithstanding the fact it was harder to 17 produce those same solid chocolates that 18 they did before? 19 MR. SIEGEL: Mr. Vice-Chairman, on my 20 team, the staffing levels did grow 21 substantially during this time period to 22 keep up with the increasing complexity in 23 the market. 24 where we had a more conservative approach. 25 So there were -- there were many cases We did walk away from deals 86 1 Q & A - Session 1 2 where the analysts would look at the deal 3 and they would be able to present an 4 analysis to committee as the structures 5 were changing. 6 it was in response to risks that we may 7 have identified. 8 risk of increasing interest rates, we 9 might see a deal come back with a swap. In some cases, we'd feel So if we identified a 10 So the investment bank would say, "We'll 11 put a swap and we'll take out that risk. 12 Now what do you think about the deal?" 13 VICE-CHAIRMAN THOMAS: Did you ever 14 think that, based upon that kind of a 15 discussion, the next time a product came 16 down the conveyor belt, that they got a 17 little more clever in terms of the way 18 they did it, to confuse, confound or in 19 fact cover up what it was that they were 20 doing? 21 part to outsmart you? 22 that feeling as you were looking at the 23 products? 24 25 Was it a learning curve on their MR. SIEGEL: Did you ever have I think it’s very important that we distinguish our 87 1 Q & A - Session 1 2 methodology from our models. We always, 3 when we would make available a model, we 4 would indicate that the rating still has 5 to go through committee. 6 where a model would come out like the 7 interest rate example. 8 stress case might be a rise of five 9 percent, and the swap might be so highly There were times We'd say our 10 engineered that it only protected against 11 that five percent case, not a case right 12 up to or right past it. 13 just change the way we analyzed the deal 14 during the committee process. 15 VICE-CHAIRMAN THOMAS: 16 17 18 19 So then we would Mr. Chairman has a question? CHAIRMAN ANGELIDES: No, I'm fine right now. MR. KOLCHINSKY: One example of that 20 occurred in about second quarter of '07. 21 We, in the CDO group, actually had a 22 methodology that prevented deals from 23 getting full credit for bonds that were 24 being priced at a discount. 25 pricing rule. A discount It worked very well with 88 1 Q & A - Session 1 2 cash instruments but because synthetics 3 were to flexible, you could change the 4 price, you could change the spread, it was 5 very hard to nail down what the actual 6 discount was. 7 market started deteriorating as evidenced 8 by the ABX index, the subprime index, we 9 always enforced this rule. 10 And as the prices in the But the bankers started getting more 11 and more clever with the ways that they 12 would try to counter that rule. 13 became almost like a chess game. 14 make a move, they would make two moves. 15 And it became very difficult. 16 where my view about saying no, at that 17 point, we should have been able to say, 18 "No. 19 doing." 20 You know what? And it And this is We see what you're And I saw some portfolios that were 21 clearly meant to game that rule. 22 should have said, "No, you're not 23 trustworthy. 24 with you." 25 We would We We don't want to do this But we couldn't do that, so we had to 89 1 Q & A - Session 1 2 play the chess game, which we kept losing. 3 So -- but that certainly occurred. 4 VICE-CHAIRMAN THOMAS: Mr. Chairman, 5 I'm going to reserve my time because some 6 want to use it, others; but I'm going to 7 ask you a series of written questions 8 around a concern that I have and I know a 9 number of others have. 10 You, as the people who created the 11 ratings, have, in your mind, what you 12 believe the AAA means. 13 ask for those ratings I think had in mind 14 what they thought a AAA rating meant, and 15 especially those people who were out there 16 purchasing the products had, in their 17 mind, what a AAA rating meant. 18 The customers who And I know only one of you is an 19 attorney, Mr. Kolchinsky, so when I ask 20 the question, I would prefer not to have 21 an attorney's answer. 22 But this is a source of confusion 23 among a number of people because AAA meant 24 something to you who delivered it, it 25 meant something to the people who were 90 1 Q & A - Session 1 2 seeking it, obviously, with the 3 game-playing, and it meant something to 4 those who purchased it. 5 in the end, the people who purchased it 6 didn't have any conception, often, what it 7 was and what it meant. 8 to focus on more. 9 the time we have. 10 And it turns out And that we need But we can't do it with Thank you, Mr. Chairman, I'll reserve 11 the balance of my time. 12 CHAIRMAN ANGELIDES: Yes, very 13 quickly as a follow-up, it seems to me 14 listening this morning so far, there's 15 kind of two big issues. 16 heck were the ratings so wrong? 17 were. 18 They weren't off by small measure. 19 know, 83 percent of the AAA in 2006 was 20 downgraded. 21 investment-grade products were reduced to 22 junk. 23 without using the legal term, without 24 casting aspersions, to the extent you're 25 providing a product, this comes as close One is, why the And they I just want to put in perspective. You In 2007, 89 percent of the I mean, this was way off. And 91 1 Q & A - Session 1 2 as you can to the very product being 3 fraudulent or of no use to the marketplace 4 in reality. 5 ratings. 6 struck but, I think what you referred to, 7 Dr. Witt, is just the structural problem 8 here. 9 you really to say no to 30 to 40 percent So one is the quality of But I'm more struck or equally The very system that didn't allow 10 of the deals. You might miss a deal or 11 two, but you really couldn't say no to a 12 whole market slice because you're paid by 13 issuers, and your profit, and that was, it 14 seemed to me always predominant, versus 15 quality of rating. 16 So in 2007, you know, you talked 17 about how things were recalibrated but I 18 want to point out in 2007, when housing 19 prices are heading south fast, Moody's 20 rated more than $500 billion in 21 residential mortgage-backed securities. 22 After July, when you really start 23 your massive downgrades, $119 billion get 24 rated as the market's in free fall. 25 these go very bad very quickly. And 92 1 Q & A - Session 1 2 I guess, I want to ask you, Dr. Witt, 3 was the model so flawed, issuer-paid, 4 profit, tension, you are an operating 5 business, that it was very hard to make 6 the fundamental shift to say, "We're not 7 going to rate these flawed products 8 anymore?" 9 DR. WITT: You know, fortunately, I 10 wasn't in the CDO group in 2007, so I 11 didn't have to make that difficult 12 judgment, you know, the -- you know, Eric 13 was. 14 had been a manager in that group, yeah, it 15 would have been -- it would have been a 16 hard decision to say, "You know, we're 17 just going to stop rating this stuff and 18 we're going to, you know, however many 19 tens of millions of dollars of revenue the 20 other rating agency is going to pick up, 21 we're just going to leave it on the 22 table." 23 difficult. 24 25 But, you know, I would think, if I I think that would have been CHAIRMAN ANGELIDES: Okay. Because I'm asking, could you have made that 93 1 Q & A - Session 1 2 decision? 3 to your superiors and say -- look, I mean, 4 if you think of United Labs for a minute, 5 they are not going to keep rating 6 defective electronic equipment if in fact 7 they don't believe that it should make it. 8 Consumer Reports has a very different 9 model, you know, no payments by products 10 11 Mr. Weill, could you have gone being rated. Is the model such that you just 12 couldn't do that, could you say, 13 Mr. Weill, could you go to your bosses and 14 could you say, "Twenty to thirty percent 15 of this stuff we ain't going to rate." 16 Could you do it? 17 MR. WEILL: Mr. Chairman, I would 18 offer you a surveillance perspective to 19 this. 20 transactions, and we were seeing an 21 increase in delinquencies or potential for 22 defaults on the mortgages, we were 23 constantly closing a feedback loop with 24 the various teams. 25 part of a great interest from senior When we were surveilling 2007 And I think this was 94 1 Q & A - Session 1 2 management to know how the pools were 3 performing in order to know what to do 4 with new ratings, potentially. 5 CHAIRMAN ANGELIDES: But you kept 6 rating. I mean, he didn't turn down -- 7 did the decline rate on new ratings shoot 8 up? 9 instead of not rating two percent, start In other words, the did you start, 10 not rating 20 to 30 percent, or again, did 11 the business model make that an 12 impossibility? 13 MR. KOLCHINSKY: It did. I said no 14 to one deal, and it was a difficult 15 undertaking. 16 questionable deal, and I had appeals from 17 my managers. 18 takes to make sure that I convinced people 19 that this deal should not be rated. 20 was a very difficult -- it was harder to 21 say no than to say yes. 22 CHAIRMAN ANGELIDES: 23 VICE-CHAIRMAN THOMAS: It was a particularly I had to go through a lot of Thank you. Just very 24 briefly, along those same lines to a 25 certain extent, and I guess primarily So it 95 1 Q & A - Session 1 2 Mr. Weill, because he's the one who was 3 there in June of '07, in the application 4 to the Securities and Exchange Commission 5 by Moody's, under the heading, 6 "Interacting with the Management of an 7 Issuer," Moody's said to the SEC, "Most 8 issuers operate in good faith and provide 9 reliable information to the securities 10 markets and to MIS. 11 issuers and their agents to do so," da, 12 da, da. 13 to exercise skepticism with respect to an 14 issuer's claims. 15 inadequate information to provide an 16 informed credit rating to the market, we 17 will exercise our editorial discretion and 18 will either refrain from publishing the 19 opinion or withdraw an outstanding credit 20 rating." 21 And we rely on "Nevertheless, our analysts seek If we believe we have What I'm going to be asking for in 22 writing from all of you from memory, but 23 especially the more recent situations, 24 what skepticism did you exercise? 25 have specific examples of exercising Do you 96 1 Q & A - Session 1 2 skepticism based upon it? And when you 3 were in the situation of having to produce 4 volume versus exercising the professional 5 skepticism that you told the SEC you were 6 going to exercise, I just want to see some 7 examples of that skepticism being 8 exercised. 9 writing and you can give me some examples. So I'll get it to you in 10 Thank you very much, Mr. Chairman. 11 CHAIRMAN ANGELIDES: Terrific. 12 will now move to Mr. Georgiou. 13 COMMISSIONER GEORGIOU: 14 We I suddenly became more senior on the committee, which is a great honor. 15 I wanted to inquire really of all of 16 you. I think I'm finally getting to the 17 point where I'm understanding how the 18 money is made in this business, and one of 19 the things we've learned in prior hearings 20 is that a significant element of fraud 21 occurred when we double-incentivized 22 mortgage brokers in the origination of 23 mortgages by paying them a higher 24 percentage of the mortgage if they put a 97 1 Q & A - Session 1 2 person into a mortgage that paid a higher 3 rate of interest, and was more valuable to 4 the lender. 5 And in many instances, we found that 6 the rates that they were paid were, for 7 example, if one percent on putting people 8 into a standard 80/20 mortgage that paid a 9 lower rate of interest, and two percent of 10 the origination fee if they put them into 11 a more expensive mortgage, which we 12 believe in certain instances led mortgage 13 brokers, because they would make twice as 14 much money, led mortgage brokers to 15 leading borrowers to loans that were more 16 expensive to them when they might have 17 qualified for a more reasonable loan. 18 Now, I learned from our staff's 19 investigation report, and I want to 20 clarify this, I want to make sure it's 21 true, that, for many years, Moody's, in 22 charging issuers on RMBS analysis, you 23 charged a certain rate, in this instance 24 4.75 basis points for the dollars that 25 were in the senior tranches, and 3.75 98 1 Q & A - Session 1 2 basis points for the dollars that were put 3 in subordinate tranches, which strikes me 4 as an incentive, creating a financial 5 incentive for Moody's to put a greater 6 percentage of the dollars in the senior, 7 superior tranches as opposed to 8 subordinate tranches, which may help to 9 explain why it is that, in these RMBS 10 structures, often some, as much as 90 11 percent of the issue of the tranches are 12 rated at the very, very high end. 13 Can anybody speak to this? Is 14 anybody aware of that or understand the 15 financial incentives? 16 MR. SIEGEL: Commissioner, I don't 17 recall the exact fee schedule. The 18 initial analysis of a deal would have 19 almost a fixed component, analyzing the 20 collateral, and then the tranching, where 21 you would get these senior classes, and 22 subordinate classes would come later. 23 in no case was there any distinction in my 24 mind, as the manager who knew about the 25 fees, that there should be a shift based But 99 1 Q & A - Session 1 2 on the potential fee income to Moody's. 3 And the analysts who constituted the 4 majority of committee would not even have 5 known about that differential. 6 COMMISSIONER GEORGIOU: 7 was it structured in that way? 8 words, if you have got a $250 million RMBS 9 that you're analyzing, why would you ask But then why In other 10 the issuers to pay you a higher fee per 11 dollar on the senior tranches than you 12 would on the subordinate tranches? 13 Dr. Witt, do you have any views on that? 14 DR. WITT: There was no practice 15 analogous to that in CDOs that I know of. 16 It was just a straight fee per rated 17 dollar in -- 18 COMMISSIONER GEORGIOU: Right, that's 19 correct. 20 paid nine basis points per dollar rated. 21 Now, CDO, of course, you got DR. WITT: It depended on the type 22 but yes, there were some that you did, 23 yes. 24 25 COMMISSIONER GEORGIOU: Which was more than double the highest rate that you 100 1 Q & A - Session 1 2 got for rating RMBS, which may also speak 3 to why people were incentivized to rate 4 CDOs significantly, because -- 5 DR. WITT: Well, I mean, we were paid 6 both times. 7 then they put it in the CDOs. 8 9 We were paid for the RMBS and COMMISSIONER GEORGIOU: Right, and paid at twice the rate. 10 Mr. Kolchinsky, did you ever note 11 this disparity or did anybody that you're 12 aware of note it? 13 MR. KOLCHINSKY: No, Commissioner. 14 Like Dr. Witt, in CDO we had a flat fee 15 with a cap. 16 17 18 We did not -- COMMISSIONER GEORGIOU: So who was in RMBS, Mr. Weill? MR. WEILL: Commissioner, I would -- 19 I wasn't aware of the fees. I wasn't a 20 manager on the ratings team that was 21 rating deals. 22 emphasize, I think, which is important to 23 provide some color here, is that if you 24 have a rating committee, you may have 25 three, five, ten people in the committee The thing I would 101 1 Q & A - Session 1 2 and none of us, when I was an analyst in 3 surveillance or an analyst in ABS rating 4 autos or aircraft or other deals, was 5 aware of the rating fees. 6 In other words, you have a debate and 7 everybody has one vote. 8 person, the managing director or the most 9 senior person votes last. 10 11 The most senior Cannot influence the process of the decision. COMMISSIONER GEORGIOU: Do you know 12 who developed that fee charging structure? 13 Does anybody know? 14 MR. SIEGEL: I don't. 15 COMMISSIONER GEORGIOU: Maybe that's 16 a question that I'll have to ask 17 Mr. McDaniel here in the next panel. 18 Mr. Siegel, are you aware of who 19 constructed the charging -- 20 MR. SIEGEL: But Again, I don't -- I 21 don't actually specifically remember there 22 being that distinction between the seniors 23 and subordinates. 24 that -- that is the case, at some point 25 the managers would have been involved in a But assuming you have 102 1 Q & A - Session 1 2 fee discussion and come up with a 3 schedule. 4 schedules, depending on whether it's 5 prime, subprime, second lien, et cetera. 6 And there were different RMBS But again, there might have been some 7 thinking that we have this fixed 8 component, so the senior bond determines 9 if you're on the deal or not, that you'd 10 want to charge to cover your collateral 11 analysis. 12 tranche it up, it isn't as expensive, as 13 time-consuming to figure out the ratings 14 on the junior tranches within the deal. 15 And then if you happen to COMMISSIONER GEORGIOU: Right. 16 Mr. Chairman, with your permission, I'd 17 like to have the staff direct a written 18 question to Mr. Weill and to Mr. McDaniel 19 to ascertain if we can find out how it 20 developed, what the etiology of this -- 21 CHAIRMAN ANGELIDES: So done. 22 COMMISSIONER GEORGIOU: -- and also, 23 it says in here in our investigative 24 report that all fees were due and payable 25 at the time the rating was issued. But 103 1 Q & A - Session 1 2 you were never paid until the actual issue 3 was sold, were you? 4 MR. KOLCHINSKY: We were generally, 5 on the CDO side, paid out of the closing 6 day waterfall. 7 securities were sold, we were paid along 8 with other supporting, the auditors, the 9 attorneys, the bankers themselves. Meaning that's when the 10 COMMISSIONER GEORGIOU: 11 MR. KOLCHINSKY: Correct. There was also an 12 annual monitoring fee, but that was 13 usually a fraction of the up-front fees. 14 COMMISSIONER GEORGIOU: Correct. But 15 the up-front fee, like if you rated an 16 issue and they didn't sell it for two 17 months, you didn't get your pay -- the 18 company wasn't paid when the rating was 19 issued, right? 20 the issue was actually sold from the 21 proceeds. 22 The company was paid when MR. KOLCHINSKY: That is correct. 23 There was, in our contracts in CDO, there 24 was a breakup fee but that was almost 25 never enforced. It was difficult -- it 104 1 Q & A - Session 1 2 was a fraction of the number. 3 difficult to actually get that fee. 4 experience, I don't believe we've ever 5 actually charged that breakup fee. 6 COMMISSIONER GEORGIOU: It was very In my So doesn't 7 that create yet another perverse incentive 8 to be sure that the ratings will support 9 the sale of the security, that you're 10 actually not paid until the security 11 itself is sold? 12 MR. KOLCHINSKY: I think more so 13 that -- I would, in my mind, it was the 14 fact that you couldn't say no in any case. 15 That created the worst incentives to the 16 deal. 17 of went down from there. 18 19 20 And after that, you know, it kind COMMISSIONER GEORGIOU: Right. Dr. Witt, do you have a thought on that? DR. WITT: Well, I don't know that 21 that had a big component to, you know, 22 people's incentives. 23 noticed there was an article in The Times, 24 I think yesterday or today, and they were 25 talking about the timing of when the But I did, I just 105 1 Q & A - Session 1 2 rating is issued. 3 issued, if you look at the prospectus, it 4 will say it's a condition of issuance that 5 the ratings be certain levels. 6 rating came out like coincident with the 7 deal. 8 to be this interchange between the rating 9 agencies and the structuring, the 10 11 The rating was normally So the And that fact meant that there had investment bank. And what this article said was that 12 they suggested that maybe there should be 13 some waiting period, that ratings should 14 be issued after the deal. 15 personally think that that's a really good 16 thing that should be considered. 17 COMMISSIONER GEORGIOU: And I Right. That 18 was Andrew Ross Sorkin's, one of his 19 suggested questions to us, was that 20 William Ackman, who is a hedge fund 21 manager, suggested that the ratings agency 22 adopt a wait-to-rate policy for 60 days 23 after the preliminary purchasers had 24 already purchased the bonds, so that they 25 would be obligated then to do their own 106 1 Q & A - Session 1 2 diligence, and the ratings wouldn't be 3 their primary factor. 4 would be advisable? 5 DR. WITT: Do you think that I think it would. You 6 know, investors wouldn't like it because 7 it introduces more risk to them. 8 somebody's got to buy those bonds without 9 a rating. But So they had a sort of 10 additional ratings risk. 11 investors to, you know, to take that risk, 12 to look at the deal more, not rely on 13 ratings so much as a crutch and not just 14 buy the rating but buy the issue. 15 But it forces And then the ratings themselves could 16 be more of a, you know, an objective 17 analysis and you wouldn't have the 18 close -- you wouldn't have the need for 19 the close interaction between the rating 20 analyst and the investment bank. 21 could have more of a distance, hands-off 22 relationship. 23 COMMISSIONER GEORGIOU: You Mr. Kolchinsky, 24 in one of your prior testimonies, or 25 perhaps it was here today, you suggest 107 1 Q & A - Session 1 2 that in many ways, the incentives for 3 rating agencies have become worse since 4 the credit crisis. 5 more rating agencies and they are all 6 chasing significantly fewer transaction 7 dollars. 8 place by regulators are too weak to 9 significantly alter this dynamic. 10 11 That there are now And the new controls put in Can you elaborate on that, please? MR. KOLCHINSKY: The changes in 12 incentives were, before you had, I think, 13 three major, four major rating agencies. 14 At this point, I think ten or eleven are 15 regulated as NSROs. 16 transactions that are going around just 17 because, frankly, the market has died out. 18 There are much fewer The rating agencies, any large rating 19 agency that wants to run a structured 20 finance business has a lot of fixed costs, 21 very high fixed costs. 22 as a private business, you have to justify 23 those fixed costs, and you have ten people 24 you're competing with. 25 So at some point, So the incentives to play around with 108 1 Q & A - Session 1 2 your methodology are much greater. If you 3 want to maintain your business, you want 4 to maintain your title, you want to 5 maintain your position in the company, you 6 have to compete a lot more. 7 lot less business you're competing for. 8 And frankly, the structural, up to that 9 point, and probably true going forward, so You have a 10 far, that have been put in place, have 11 been fairly weak on that, in terms of 12 maintaining, improving ratings quality. 13 So again, you have a lot more rating 14 issuers competing for a smaller pie. 15 COMMISSIONER GEORGIOU: Let me, I 16 want to read into the record one portion 17 of a letter we just received yesterday 18 from the executive director of the Montana 19 Board of Investments, which was a major 20 purchaser of bonds, in reliance to some 21 significant extent on ratings. 22 said here: 23 And it "As more complex exotic investments 24 have been created and sold to investors, 25 the rating agencies 'got it wrong,' either 109 1 Q & A - Session 1 2 because their vetting was superficial or 3 they were unduly influenced by the 4 creators of the investment and needed to 5 get the deal done. 6 agencies chose to rate complex and 7 market-sensitive instruments such as 8 structured investment vehicles as 9 risk-free as U.S. Government bonds, they When the rating 10 failed the investors who were depending 11 upon their independent, thorough analysis. 12 This board and other public investors are 13 still living with the impacts of that 14 failure." 15 If I could ask, Mr. Weill, just one 16 question real quick, just as a final, how 17 much, how present in your mind as you did 18 your analysis was the fact that many, many 19 public and private pension funds and other 20 investors responsible for funding the 21 retirement benefits of beneficiaries, how 22 present was that consideration in your 23 mind as you did your ratings? 24 25 MR. WEILL: I would say that every rating committee feels significant 110 1 Q & A - Session 1 2 responsibility when they assign a rating, 3 whether they downgrade or upgrade a 4 rating, and they have in mind all the 5 users of the ratings in a very significant 6 way. 7 8 9 10 11 COMMISSIONER GEORGIOU: All right. Thank you, Mr. Chairman. CHAIRMAN ANGELIDES: Mr. Georgiou. Thank you, Mr. Wallison? COMMISSIONER WALLISON: Thank you, 12 Mr. Chairman. 13 all are talking about the same thing. 14 we're talking here about subprime and 15 Alt-A loans securitization. 16 talking about prime securitizations. 17 any of you know what the record of Moody's 18 was for prime securitizations? 19 say, did you have many downgrades of prime 20 securitizations? 21 MR. WEILL: I want to just be sure we And We're not Does That is to Commissioner, are you 22 referring to the recent period or are you 23 referring to -- 24 25 COMMISSIONER WALLISON: We'll talk about the same period that we've been 111 1 2 3 Q & A - Session 1 talking about here from 2005 to 2007. MR. WEILL: We have indeed have had 4 significant ratings transition downgrades 5 on the prime mortgage-backed securities. 6 We have a team that publishes on a 7 frequent basis, I think twice a year in a 8 very transparent way, the performance of 9 our rated bonds. I don't have the exact 10 numbers with me. That's something we can 11 provide the Commission with. 12 13 COMMISSIONER WALLISON: I think we'd like that information. 14 MR. WEILL: Absolutely. 15 COMMISSIONER WALLISON: Let me just 16 say this, that I'm listening to all of you 17 and I think you're all well-intentioned 18 people. 19 regard as a terrible failure here. 20 my inclination always is to wonder whether 21 there was not an information problem more 22 than anything else. 23 are going to be about the information that 24 was available to you and the extent to 25 which this information was or was not We've had what anyone would And so And so my questions 112 1 Q & A - Session 1 2 sufficient for you to make the kinds of 3 judgments that you were making. 4 So the first question I would like to 5 ask here is, and I think this is obvious, 6 the ratings depend, do they not, on 7 assumptions about housing prices? 8 Mr. Siegel? 9 MR. SIEGEL: Yes. Ratings depend, 10 the performance of mortgages depends very 11 much on home price movements and at 12 different rating levels, you would be 13 looking at different stresses to possible 14 future home price movements. 15 16 17 18 19 COMMISSIONER WALLISON: disagree with that? MR. WEILL: one input. Does anyone Mr. Weill? Home price movements are You have other inputs like -- COMMISSIONER WALLISON: But that is 20 one of the significant issues, what you 21 expect home prices to be, is that -- 22 that's correct? 23 MR. SIEGEL: It's what you expect, 24 like the expected best guess, and it's 25 what you might expect as a range of stress 113 1 Q & A - Session 1 2 off of that best guess. 3 CHAIRMAN ANGELIDES: 4 DR. WITT: Mr. Witt? You know, I was in the CDO 5 group. We used the ratings from the RMBS 6 group as an input. 7 correlations and, you know, if we had, you 8 know, if we had a crystal ball and we'd 9 foreseen a really large decline in house But we did establish 10 prices, we would have raised correlations 11 as a result. 12 COMMISSIONER WALLISON: Okay. I'm 13 going to get to the correlations question, 14 I hope, if I have time. 15 Okay, so housing prices depend on an 16 assumed number of delinquencies, you’re 17 believing that there will be an assumed 18 number of delinquencies. 19 out, if I understand what you've said up 20 to now, it turned out that your estimate 21 of the number of delinquencies was wrong. 22 There were actually many, many more than 23 you expected. 24 25 MR. SIEGEL: And it turned Is that true, Mr. Siegel? Yes. Nicolas would have more of the performance information after 114 1 Q & A - Session 1 2 the deals close. But the delinquencies 3 were far above the most likely path of 4 delinquencies. 5 COMMISSIONER WALLISON: 6 MR. WEILL: Mr. Weill? Commissioner, the way I 7 would phrase the question, I would divide 8 it, there are two components to it. 9 one of them is how the macro trends of And 10 home price, whether they increase or 11 decrease, and then you have the borrower's 12 behavior. 13 more a borrower's behavior than a macro 14 trend. 15 And delinquencies is definitely At some point, they do connect. And I think you need the third 16 component to really connect them together 17 which is, as home prices decline and 18 refinancing opportunities dry up, then it 19 does magnify the delinquency issues. 20 In other words, if borrowers are 21 feeling that they are underwater on their 22 mortgage because they see home price 23 declining, their first reaction would be, 24 try to get out of this financial 25 obligation in a way that would be ideal, 115 1 Q & A - Session 1 2 i.e., selling the properties and avoiding 3 foreclosure and a default. 4 As refinancing opportunities dry up, 5 and home prices suddenly decline, it does 6 magnify the delinquency trends. 7 COMMISSIONER WALLISON: And this 8 would be especially true, I would presume, 9 for subprime and Alt-A loans. 10 MR. WEILL: They are more sensitive 11 to the various accounting factors and the 12 refinancing opportunities. 13 COMMISSIONER WALLISON: 14 15 Mr. Siegel, the same? MR. SIEGEL: Yes, I agree. That's 16 how prime borrowers are statistically more 17 sensitive to these trends. 18 COMMISSIONER WALLISON: Now, when you 19 are constructing your evaluation of a 20 particular securitization of a pool, do 21 you take into account the number of 22 subprime and Alt-A loans that are actually 23 outstanding in the market as a whole? 24 just in this portfolio or pool or 25 securitizations, but rather, the market as Not 116 1 Q & A - Session 1 2 a whole throughout the country? 3 Mr. Siegel? 4 5 6 MR. SIEGEL: Sorry, Commissioner, I'm not sure I understand the question. COMMISSIONER WALLISON: If you are 7 assigning a rating to a pool, the pool is 8 in front of you, it has a certain number 9 of subprime and Alt-A loans in it, in fact 10 that's what we're talking about -- 11 MR. SIEGEL: Right. 12 COMMISSIONER WALLISON: -- now, is it 13 important to you to know not just about 14 the loans in the pool but, rather, if 15 loans that are subprime and Alt-A 16 throughout the country, so that you are 17 placing this pool in effect in a context 18 of all mortgages that are subprime or 19 Alt-A throughout the country? 20 MR. SIEGEL: Well, when we would 21 analyze the collateral performance on 22 expectation, performance expectations on a 23 particular pool, we would compare it to 24 other pools that we had committed and 25 historical data, and then indirectly, 117 1 Q & A - Session 1 2 there might be an effect in saying, "Well, 3 here are general market shifts. 4 going to have an impact on future 5 performance" -- 6 COMMISSIONER WALLISON: Is this Indirectly. 7 Did you have information about where the 8 market was in terms of the number of 9 subprime or Alt-A loans that were 10 11 outstanding? MR. SIEGEL: Moody's published on the 12 number of Alt-A and subprime loans that 13 had been securitized. 14 the -- we saw an increasing -- 15 substantially increasing number of 16 subprime mortgages that were included in 17 securitizations leading up to 2006. 18 So we -- and we saw COMMISSIONER WALLISON: Only the ones 19 that had been securitized by Moody's or 20 those that had been securitized by all -- 21 not securitized by Moody's, but rated by 22 Moody's -- 23 MR. SIEGEL: We published based on 24 rated by Moody's. That was information 25 that we had factual and to the dollar. 118 1 Q & A - Session 1 2 But there's also a sense of 3 securitizations that we did not rate. 4 we had a feel for that number, too. 5 So But in terms of spending a lot of 6 time looking at whether FHA and Ginnie Mae 7 deals included subprime, that was -- 8 9 10 11 COMMISSIONER WALLISON: What about Fannie Mae and Freddie Mac, did you include those? MR. SIEGEL: Fannie Mae and Freddie 12 Mac do not originate loans, right? 13 buy loans -- 14 COMMISSIONER WALLISON: They They 15 certainly do not originate, that's right. 16 But they do securitize. 17 four trillion dollars in subprime and 18 Alt-A loans were securitized by Fannie Mae 19 and Freddie Mac at the time you were 20 looking at these things in 2007. Actually about 21 So did you take into account the fact 22 that there were this number, it turns out 23 to be about twelve million of Fannie Mae 24 and Freddie Mac, were in fact outstanding 25 at that time? 119 1 2 Q & A - Session 1 MR. SIEGEL: I don't recall that 3 being a factor that came up in any 4 particular deals committee as material. 5 COMMISSIONER WALLISON: 6 MR. WEILL: Mr. Weill? Well Commissioner, on 7 the monitoring side, I don't recall who 8 would use this information. 9 10 COMMISSIONER WALLISON: MR. WEILL: I'm sorry? On the monitoring side, 11 on the surveillance side of the RMBS 12 securities, I don't recall that we would 13 use this information. 14 COMMISSIONER WALLISON: And what 15 about the rating side? 16 monitoring side occurs afterward. 17 what about the rating side, did you have 18 this information at the time that you made 19 the ratings? 20 I take it the But No, is the answer -- MR. SIEGEL: Commissioner, I answered 21 as to the ratings side, and -- 22 COMMISSIONER WALLISON: I understand. 23 I understand. And this basically is my 24 question. 25 subprime or Alt-A pool when you actually How can you make a rating on a 120 1 Q & A - Session 1 2 don't know the effect that the total 3 number of outstanding subprime and Alt-A 4 loans might have on that particular pool? 5 Actually, let me give you some 6 background because it's, maybe I 7 haven't -- I've left out perhaps a logical 8 step. 9 correlations among mortgages. And the logical step is the Correlation 10 is exceedingly important in the rating 11 process, as I understand it. 12 If a mortgage fails in an area, if a 13 house has to be foreclosed, it drives down 14 the prices in that area, at least in that 15 neighborhood and in that area. 16 MR. SIEGEL: Yes. 17 number. 18 of a thousand, but yes. 19 True? It depends on the I wouldn't say, you know, one out COMMISSIONER WALLISON: Exactly. And 20 so when you have a large number of 21 subprime or Alt-A loans, there are likely, 22 especially as you've pointed out, when a 23 bubble begins to top out and people can't 24 refinance, then you're going to have many, 25 many more failures of subprime and Alt-A 121 1 2 Q & A - Session 1 loans, will you not? 3 MR. SIEGEL: It would follow, yes. 4 COMMISSIONER WALLISON: And if you 5 have many such failures of subprime and 6 Alt-A loans, that would affect the loans 7 that are in the pool that you're rating, 8 true? 9 10 11 12 13 MR. SIEGEL: Yes, that would follow as well. COMMISSIONER WALLISON: So this is the question: Since there was tremendous 14 correlation among mortgages in the sense 15 that a mortgage fails, it has an effect on 16 the housing prices in the area, many 17 mortgage failures produce sharp declines 18 in housing prices in the area, and as 19 those failures multiply, housing prices 20 dive and actually, we've seen that. 21 MR. SIEGEL: Yes. 22 COMMISSIONER WALLISON: So my 23 question then is, how could you possibly 24 have rated a pool without knowing the 25 number of subprime and Alt-A mortgages 122 1 Q & A - Session 1 2 that were outstanding in the market at 3 large, not just in that pool? 4 MR. SIEGEL: Commissioner, we had 5 commented on the fact that some of the 6 riskier loan types were having, could have 7 been having an impact on home prices. 8 that magnitude and the severity of decline 9 in the real estate market after 2006 was 10 11 But not anticipated. COMMISSIONER WALLISON: So you didn't 12 have the data, if I understand correctly, 13 about the total number of subprime and 14 Alt-A mortgages in the market at the time 15 you were doing these ratings. 16 true that there is correlation in the 17 sense that large number of mortgage 18 failures do in fact produce declines in 19 housing prices. 20 I fully understand how you were actually 21 doing these ratings. 22 Yet, it is And so I'm not sure that How did you make these judgments 23 without the information from, say, Fannie 24 Mae and Freddie Mac, or FHA through Ginnie 25 Mae, how could you possibly do that, then? 123 1 2 Q & A - Session 1 MR. SIEGEL: That was -- it was not 3 viewed by us as imminently going to drive 4 a never-before-seen housing price decline. 5 COMMISSIONER WALLISON: Okay. Then 6 we've heard all of you say at one point or 7 another, as we've heard in every one of 8 these hearings, "We couldn't possibly have 9 foreseen what happened. This was 10 completely unprecedented," is the way many 11 people have expressed it, and we accept 12 that. 13 seen housing declines like this. 14 It was unprecedented. We've never But what is also unprecedented, I 15 think, is the number of subprime and Alt-A 16 loans that were outstanding at the time, 17 of which, as I understand it, you were 18 unaware, and the number, as at least the 19 Commission has received information that 20 the number is approximately one half of 21 all mortgages outstanding in 2007 and 2008 22 were subprime and Alt-A. 23 Wouldn't it then suggest that the 24 enormous number of failures that would 25 come out of this nationwide context would 124 1 Q & A - Session 1 2 affect substantially the way your 3 particular pools perform? 4 MR. SIEGEL: Commissioner -- 5 VICE-CHAIRMAN THOMAS: We're going to 6 yield the Commissioner an additional two 7 minutes. 8 9 MR. SIEGEL: Commissioner, I believe that the specific data we had on the 10 securitized subprime market was a good 11 proxy for trends in the overall market. 12 It reflects the percentage increase of 13 subprimes. 14 number, but we certainly saw that the 15 proportion compared to the Moody's 16 securitized prime product and Moody's 17 securitized subprime product, had -- we 18 had that information available and that 19 sounds like a proxy for the topic you're 20 discussing. 21 So we did not have the exact COMMISSIONER WALLISON: You had a 22 proxy for half of all mortgages 23 outstanding in the country at that time? 24 25 MR. SIEGEL: I would have to check the figures, but subprime grew, subprime 125 1 Q & A - Session 1 2 and Alt-A grew to exceed the prime 3 securitized markets of Moody's rated 4 deals, so half sounds about right. 5 COMMISSIONER WALLISON: I really 6 would like to see the data that you had 7 available at the time and how you 8 analyzed it from that point of view. 9 Thanks very much. 10 MR. SIEGEL: Sure. 11 VICE-CHAIRMAN THOMAS: 12 DR. WITT: Dr. Witt? If I could, I think this 13 speaks to a larger problem. I talked 14 about the absence of independent research 15 staff. 16 like, really bigger issues. 17 to put words in Jay's mouth, but I believe 18 that he was, you know, managing director 19 in charge of rating new deals at the same 20 time he was sort of the lead guy on, you 21 know, methodology and trying to think 22 about those bigger issues, like you said. That's just like one of those, I don't want 23 It's very difficult to wear both 24 those hats in a market where you're just 25 so busy, you're rating so many deals. You 126 1 Q & A - Session 1 2 need an independent research function that 3 is, you know, thinking about those kinds 4 of issues. 5 COMMISSIONER WALLISON: Well, you 6 know, I understand your point, perfectly 7 reasonable point. 8 that the issue was significant, you could 9 have as many people on the staff doing If someone had thought 10 research on the market. 11 the people who are doing the ratings 12 believing that that information is 13 important. 14 You have to have I don't think it's the fact that you 15 didn't have enough people looking for that 16 information. 17 been obtained by one person who thought it 18 was important. 19 just not thought to be important. 20 DR. WITT: That information could have And I gather that it was You know, I agree with 21 that. But when you have somebody whose 22 job it is to be thinking about bigger 23 issues all the time, to be reading about 24 them and thinking about them, I think 25 you're a lot more likely to come to the 127 1 2 Q & A - Session 1 conclusion that it's an important issue. 3 4 5 CHAIRMAN ANGELIDES: you. All right, thank Senator Graham? COMMISSIONER GRAHAM: Thank you, 6 Mr. Chairman and thanks to each of you for 7 your very illuminating testimony. 8 going back to a comment that was made by 9 President Kerrey in his generous I'm 10 introductory comments in which he said 11 that America could not turn away from risk 12 and continue to be a great nation. 13 agree with that, but with a couple of 14 caveats. 15 One is, risk to whom? I What seems to 16 have been happening is that those who were 17 creating the increasing risk were also 18 finding ways to hand that risk off to 19 other entities. 20 might be the Montana Pension Board, they 21 might be the United States Government, and 22 they have turned out to be the people of 23 America, in terms of lost homes, lost jobs 24 and lost hope. 25 Those other entities The second caveat is that risk is a 128 1 Q & A - Session 1 2 different concept than recklessness. One 3 of the things that, and I'm going to 4 probe, is the recurring pattern in 5 American society where we see bright 6 warning lights going off which are ignored 7 until they mature into a catastrophe. 8 have one of those happening today in the 9 Gulf of Mexico where there were warning We 10 signals that that type of extraction had 11 dangers that were not being adequately 12 mitigated or prepared for, and we see it 13 in the subject that we are dealing with 14 today. 15 I think there were significant 16 warning signals that appear to have been 17 ignored. 18 I would start with the fact that, 19 beginning as far back as the early 1990s, 20 there was a significant change in what 21 constituted a mortgage. 22 increase in loan-to-value ratios, an 23 increase in mortgages to borrowers with 24 poor credit history, an increase in 25 mortgages for purchases of investor rather There was an 129 1 Q & A - Session 1 2 than resident-owned properties; and 3 increase in the number of cash-out 4 refinancing loans that lowered the 5 borrower's home equity. 6 changes were significantly altering what 7 the word "mortgage" meant in America. 8 9 All of those Then, beginning in 2000, and the Chairman has already shown the chart of 10 the increase in housing prices that began 11 in the year 2000, running up to the year 12 2005. 13 14 Could we have our chart? I can't -- is there a chart? 15 CHAIRMAN ANGELIDES: 16 COMMISSIONER GRAHAM: A big chart. Oh, here comes 17 the chart. 18 see the big chart, but I'm going to be 19 referring to a smaller version. 20 put -- okay, we're going to put the 21 chart -- 22 23 24 25 I'm not going to be able to CHAIRMAN ANGELIDES: Can you You can put it in front of me. VICE-CHAIRMAN THOMAS: smaller version. I have a 130 1 2 Q & A - Session 1 COMMISSIONER GRAHAM: While the chart 3 is being mounted, the chart shows 4 basically three things: 5 6 7 First is the dollars expressed in billions of dollars issued -CHAIRMAN ANGELIDES: All right, can 8 we do this? Ms. Born objects. Can we 9 move this over just a little so that we 10 can -- let's stop the clock here for a 11 minute. 12 13 14 Move it over to -- VICE-CHAIRMAN THOMAS: Can you put it at an angle in front of the lights? COMMISSIONER BORN: My position is 15 that the commissioners should be able to 16 see the witnesses as they are testifying. 17 Thank you. 18 CHAIRMAN ANGELIDES: Let's do this: 19 And we'll just move those chairs out of 20 the way. 21 It's a big chart. VICE-CHAIRMAN THOMAS: I want people 22 to know this is a totally spontaneous and 23 unrehearsed program. 24 25 26 COMMISSIONER GRAHAM: The chart demonstrates three – VICE CHAIRMAN THOMAS: Excuse me. Angle it 131 1 Q & A - Session 1 2 slightly so the cameras can look at it. 3 It makes no sense to have that big a chart 4 if people at home can't see it. 5 CHAIRMAN ANGELIDES: Let's move it 6 over, and pull it over a little so you 7 don't obscure Ms. Born, please. 8 COMMISSIONER BORN: 9 see all the witnesses. 10 CHAIRMAN ANGELIDES: I'm fine. I can All right, good. 11 We're all happy, now let's get back to 12 substance. 13 again. 14 You play start the clock COMMISSIONER GRAHAM: First, the blue 15 mountain reflects in billions of dollars 16 of issuance of RMBS; the red mountain, 17 billions of dollars of issued CDOs; and 18 then the yellow boxes, historic events, 19 starting with an event in October of 2006, 20 when the Moody's research unit issued a 21 study called, "Housing at the Tipping 22 Point," the introductory paragraph in the 23 executive summary reading, "The U.S. 24 housing market downturn is in full swing. 25 New and existing home sales and single 132 1 Q & A - Session 1 2 family housing construction are sliding. 3 Inventories of unsold homes are surging to 4 new record highs and house prices are 5 falling in an increasing number of areas." 6 That was in October of 2006. And 7 you'll note that immediately thereafter, 8 the red line goes into ascent with the 9 number of CDOs jumping in a period of less 10 than 90 days from $20 billion to over $40 11 billion. 12 Then, in January of 2007, Moody's 13 issued a special report detailing 14 abnormally high rates of early default in 15 mortgage securitizations issued in late 16 2005 and early 2006. 17 after that, another sharp incline in both 18 the RMBSs and the CDOs; in the case of the 19 CDOs, going from less than ten billion to 20 approximately 55 billion in 60 days. 21 Almost immediately Then in March of 2007, Moody's issues 22 a special comment noting that CDOs 23 containing large concentrations of RMBSs 24 as collateral were likely to experience 25 steep downgrades in the event that the 133 1 2 3 Q & A - Session 1 subprime collateral defaults. After a short downturn, both the RMBS 4 and the CDO line again goes upward. 5 in April of 2007, Moody's releases a 6 report projecting cumulative losses of six 7 to eight percent for loans backed in 2006 8 subprime RMBSs. 9 and the red line go up. 10 Then And again, both the blue Finally, in July of 2007, Moody's and 11 S&P downgrade hundreds of RMBSs totaling 12 5.3 billion in value, and place CDOs 13 backed by RMBSs on watch for possible 14 downgrades. 15 My question is, and Mr. Witt, you 16 said you needed research, more research to 17 better understand the environment in which 18 the ratings were being offered, it seems 19 to me as if your own organization was 20 issuing sharp warning signals. 21 Why was this research inadequate and 22 why was it not, apparently, taken into 23 account? 24 25 DR. WITT: I was wondering the same thing, you know. I was out of the CDO 134 1 Q & A - Session 1 2 group. 3 before this graph starts. 4 I left in September '05, a year So... COMMISSIONER GRAHAM: So that 5 explains your -- what about those who were 6 here? 7 Mr. Siegel, what did you do with this 8 information? 9 10 What did those of you, Mr. Weill, MR. WEILL: Should I take the question, Commissioner? 11 COMMISSIONER GRAHAM: 12 MR. WEILL: Yes. Over the course of 2007, 13 we had a lot of dialogue with a lot of 14 economists, including Moodyseconomy.com, 15 and the discussion at the time was not on 16 a crash but was more primarily on a soft 17 landing. The actual predictions of -- 18 CHAIRMAN ANGELIDES: 19 COMMISSIONER GRAHAM: Can I just -Did you read 20 your own report? This was issued in 21 October of 2006. "The U.S. housing market 22 downturn is in full swing. 23 existing home sales and single family 24 housing construction are sliding. 25 Inventories of unsold homes are surging to New and 135 1 Q & A - Session 1 2 new record highs and house prices are 3 falling in increasing numbers of areas." 4 5 6 Did that information not get to those responsible for ratings? CHAIRMAN ANGELIDES: Can I add on my 7 time one item, since you used the word 8 "crash?" 9 of the nations metro will experience a Here's what it said: Nearly 20 10 crash in housing prices." 11 since you mentioned "crash," I thought I'd 12 put that on the record. 13 MR. WEILL: So I just -- My team and myself, we 14 read the research we get, including the 15 research from Moodyseconomy.com. 16 more detailed reports with actual numbers 17 on the home price declines, and we need to 18 get the actual numbers, and then when we 19 look at the numbers that were produced in 20 2007, most economic forecasters were 21 predicting a national decline of about 22 five percent. 23 five percent, then maybe ten. 24 25 We get Soft landing first, then There were some. I must say, some pockets within the country where maybe 136 1 Q & A - Session 1 2 more significant price declines were 3 envisioned. 4 if you look back at the research that was 5 produced, most economists were talking 6 about a soft landing and maybe five or ten 7 percent. 8 9 10 11 But over the course of 2007, COMMISSIONER GRAHAM: Well, that's not what your own economists were calling for. MR. WEILL: Well, I mean, I think 12 there were multiple reports and I think 13 there were a number of reports by our own 14 Moodyseconomy.com focused on this as well. 15 COMMISSIONER GRAHAM: How do you 16 explain what seems to be counterintuitive, 17 that you get very bad news and the number 18 of CDOs jumps by a factor of 60 or 70 19 percent in 90 days? 20 21 22 MR. WEILL: I mean, this is, I think, two different items. What I'm -- COMMISSIONER GRAHAM: I mean, one is 23 the warning and the other is the action 24 taken on the warning. 25 running in contrary directions. They seem to be 137 1 2 Q & A - Session 1 MR. WEILL: I think what is running 3 in a similar direction, Commissioner, is, 4 if we are warning the market -- if some 5 economists start to speak about potential 6 severe home price declines, it is very 7 much linked to what we're seeing, that we 8 are seeing early payment defaults. 9 So I think when we signal to the 10 market in early 2007 that we're seeing 11 early payment defaults, I think it does 12 match quite well with the announcement 13 that it could be severe pressure on the 14 home prices. 15 perspective, just maybe to put a number 16 here, when we discussed early payment 17 defaults in early '07 for the entire 18 subprime mortgage industry six months or 19 so after seasoning, it was about two 20 percent delinquencies, 2.5 if my memory 21 serves me well. 22 And if you put it in So if you put things in perspective, 23 as long as -- it does sort of correlate 24 quite well that there is a view out there 25 in the market, or more views that prices 138 1 Q & A - Session 1 2 are declining and early payment defaults 3 are increasing. 4 COMMISSIONER GRAHAM: Mr. Kolchinsky, 5 how would you explain the fact that you 6 get such a hair-raising report in October, 7 and immediately thereafter, the number of 8 CDOs issued by Moody's rockets up? 9 MR. KOLCHINSKY: It's actually, what 10 you mention, it's actually an interesting 11 dynamic. 12 of 20-20 hindsight, there were very few, 13 what you would call real money investors 14 in CDOs. 15 taking down the super-senior structures 16 from these deals. 17 were going into the warehouses of these 18 same banks, into other CDOs. 19 of it was being sold to other structured 20 vehicles that were being, the economic 21 risk of which was taken by the banks. 22 By this time, and this is sort The bankers themselves were The mezzanine pieces So the bulk From the bankers' perspective, and 23 this is where you get the bad incentives, 24 there were some price declines in the ABX 25 at this point. No ratings declines, but 139 1 Q & A - Session 1 2 price declines. 3 perspective, as opposed to the taxpayer 4 who provides the guarantee for the bank, 5 these were arbitrage opportunities. 6 made the economics better. 7 something we saw in the first quarter of 8 '07, second quarter of '07. 9 stepped on the gas and they issued as many 10 11 From the bankers' They So that's People deals as they could. From our perspective in the CDO 12 group, we used ratings, just plain old 13 ratings as determinants of the default 14 probability of the underlying securities. 15 We did have this discount purchase rule to 16 sort of look at scenarios where prices 17 were really showing something very 18 different than ratings; but as I said 19 before, the bankers had a lot of ways to 20 get around that rule and they did. 21 But this shows -- the incentives were 22 very perverted in this case. 23 were trying to do more deals. 24 25 COMMISSIONER GRAHAM: The bankers Did the rating agencies, were you aware of this perverse 140 1 2 Q & A - Session 1 incentive and actions by the bankers? 3 MR. KOLCHINSKY: I mean, I mean we -- 4 I understood but I didn't know the extent 5 of the fact, how much of the collateral 6 was being put on the banks' balance sheet, 7 how much was going to other warehouses. 8 That's one area that the bankers would not 9 tell us, is where they were sold into. 10 COMMISSIONER GRAHAM: Are you not 11 able -- are you not able to command that 12 kind of information? 13 14 MR. KOLCHINSKY: no. Oh, absolutely not, That was -- 15 COMMISSIONER GRAHAM: 16 MR. KOLCHINSKY: Why not? That bankers viewed 17 it as proprietary information where they 18 sold these bonds. 19 COMMISSIONER GRAHAM: Does this go 20 back to the fact that you couldn't walk 21 away from a deal because you were so 22 concerned with market share? 23 MR. KOLCHINSKY: Some it does. I 24 think in some ways that is a legitimate 25 position for bankers to take, that -- 141 1 Q & A - Session 1 2 3 COMMISSIONER GRAHAM: You're putting your reputation on the line -- 4 MR. KOLCHINSKY: That's correct. 5 COMMISSIONER GRAHAM: -- that these 6 securities are going to perform against 7 the rating that you're going to give them. 8 Isn't that an important factor? 9 MR. KOLCHINSKY: In general, I would 10 say. 11 where bankers, what I believe, lied to me 12 about where these were being placed and 13 there was nothing I could do about it. 14 You know, there's no penalty for lying to 15 a rating agency analyst. 16 since I couldn't say no, I kind of had to 17 take my lumps, but absolutely. 18 19 20 21 22 But in some cases, I have had cases COMMISSIONER GRAHAM: So I couldn't, Could I take another minute? CHAIRMAN ANGELIDES: Yes, just one minute. COMMISSIONER GRAHAM: The Chairman 23 asked in his opening comments some 24 questions relative to, did you have 25 anybody on your committees that were 142 1 Q & A - Session 1 2 making the judgment who had actually had 3 experience in housing, and the answer was 4 no. 5 Did you have anybody on your 6 committee who had actually had some 7 experience working in one of these banks 8 or investment houses that were putting 9 these deals together so that you would be 10 alert to efforts that might be designed to 11 deceive you? 12 MR. KOLCHINSKY: I actually, myself, 13 I worked at banks but I was one of the few 14 people who had worked for an investment 15 bank and, to be honest with you, the 16 nature of the market from the time that I 17 worked at a bank had changed by '06-'07. 18 In the beginning of the market, there were 19 placements to investors, to actual 20 real-money investors. 21 But the nature of this market 22 changed. As more and more structured 23 vehicles, you know, the RMBS collateral, a 24 lot of it went into CDOs or into SIVs. 25 The CDOs themselves were repackaged and 143 1 Q & A - Session 1 2 sold into other CDOs or into SIVs, and the 3 super seniors were held on the balance 4 sheet. 5 changed the nature of banking from even 6 the time I was there. 7 So that factory structure really COMMISSIONER GRAHAM: And you're 8 saying that even though you'd had some 9 background, you would not have picked up 10 on that? 11 MR. KOLCHINSKY: No. 12 COMMISSIONER GRAHAM: And that you 13 were an exception in that you'd had some 14 experience in the industry. 15 MR. KOLCHINSKY: That is correct. 16 And I could not have imagined that 17 actually, the risk management was so poor 18 at banks that this was allowed to go on. 19 So I, if I was at part of, at least the 20 early market where the bankers actually -- 21 you actually had to sell the deal. 22 live investors with real money to actually 23 buy the deal. 24 work. 25 just went into a perpetual factory and Real Otherwise, the deal didn't That changed by '06-'07, where this 144 1 2 3 4 5 Q & A - Session 1 packaged it into other securities. CHAIRMAN ANGELIDES: much. Thank you very Ms. Born? COMMISSIONER BORN: Thank you very 6 much. 7 Let me just follow up, Mr. Kolchinsky, 8 with something that you just said. 9 And thank you all for appearing. You said that there was no penalty if 10 an issuer or an investment bank who was 11 working with you lied about aspects of the 12 deal. 13 Is that correct? MR. KOLCHINSKY: That is correct. 14 For practical purposes, we would not walk 15 away from a deal. 16 that would be the most obvious penalty, 17 that you do in any normal business, if you 18 find that your trading partner is not 19 being truthful to you, you say, "I'm not 20 going to do any business with you." 21 We couldn't say no, so So once that avenue is closed off 22 because you want to increase market share, 23 there's no penalty. 24 position of being a quasi regulator, which 25 means we had no power to compel people to We were in the 145 1 Q & A - Session 1 2 give us information. We had no power to 3 check the veracity of their statements. 4 So that, without the -- without the 5 ability to say no to a deal, without the 6 ability to compel, you just were left in 7 this sort of limbo where you tried very 8 hard, and many people tried very hard to 9 force the information out. But at the end 10 of the day, with push comes to shove, 11 people could lie to you without a penalty. 12 COMMISSIONER BORN: And there would 13 be no repercussions with, under the 14 securities laws, for example? 15 that means an issuer can go to a rating 16 agency, provide false information 17 resulting in a false AAA rating, for 18 example, and there would -- you would 19 not -- if you found out that that 20 information was false, would you consider 21 going to the SEC with information about, 22 you know, these misrepresentations that 23 misled investors? 24 25 MR. KOLCHINSKY: I mean, I had never considered that, but I think it would 146 1 Q & A - Session 1 2 be -- it would take a chain of events 3 to -- which were of very low probability. 4 We would have had to find out, which could 5 be difficult. 6 material; and, to be perfectly honest with 7 you, you would have to get the management 8 to agree to take action against large fee 9 providers, which probably is the most 10 difficult. 11 occur. 12 It would have to be So that probably would not Even if -- even if we did have 13 evidence, direct evidence, it would 14 probably be handled on some higher level 15 between the two parties instead of taking 16 it to a regulator. 17 18 19 COMMISSIONER BORN: Mr. Siegel, do you disagree? MR. SIEGEL: I've been operating, 20 when I was at Moody's, and not having done 21 the legal research in particular, I was 22 operating under the impression that it was 23 a violation of securities law to lie to 24 the rating agencies that had been 25 published in the general media. 147 1 Q & A - Session 1 2 When Moody's got information from 3 colleges and if -- it turned out to be -- 4 who needed a rating -- turned out to be 5 more truthful than information they 6 provided to Newsweek when they were trying 7 to tout how strong their schools were, and 8 there was commentary that they couldn't 9 lie to the rating agencies. 10 11 So we operated under that assumption. If I had found someone intentionally 12 misleading, my belief is, I would have 13 taken action. 14 person at an institutional level at a bank 15 said, "Our policy is to lie to the rating 16 agencies, do anything you can." 17 I rarely would say a senior But if it were an individual banker 18 who sent information that was wrong a 19 couple of times, we'd call a more senior 20 person and tell them, "You know, we want 21 the information to come, you know, some 22 other way," or, to "make sure you get the 23 right person checking this data before we 24 get it," on the RMBS team. 25 COMMISSIONER BORN: Thank you. 148 1 Q & A - Session 1 2 Mr. Kolchinsky, I take it from your 3 testimony, from your written testimony, 4 that you feel that Moody's quest for 5 market share, market coverage and revenues 6 tended to undermine the quality of the 7 credit ratings, at least in the structured 8 finance area, is that correct? 9 10 MR. KOLCHINSKY: That is correct. COMMISSIONER BORN: So a profit 11 motive corrupted the -- 12 MR. KOLCHINSKY: Short-term profits 13 versus long-term product quality. 14 very pedestrian, very -- nothing unusual 15 about this conflict. 16 in every industry. 17 It's It occurs probably It's very standard. COMMISSIONER BORN: Certainly, we're 18 finding it occurring in the financial 19 services industry. 20 view, was the credit, the quality of the 21 credit ratings undermined in any respect 22 by the search for market coverage and 23 market share? 24 DR. WITT: 25 Mr. Witt, in your I don't know of any, like, cases where there was a really bright line 149 1 Q & A - Session 1 2 that anybody crossed that I knew of where 3 it was really obvious that somebody was 4 changing standards or inventing standards 5 to get a deal or to get market share. 6 7 8 9 COMMISSIONER BORN: gradual erosion? DR. WITT: I wouldn't -- if somebody said that, I wouldn't doubt their 10 veracity. 11 myself, but... 12 Was there a I probably wouldn't say that COMMISSIONER BORN: Mr. Kolchinsky, 13 let me ask you, you testified in your 14 written testimony, but not in your oral 15 testimony, you talked about your ratings 16 of CDOs, collateralized debt obligations, 17 when they began to contain credit default 18 swaps, as at least a portion of the 19 underlying assets. 20 MR. KOLCHINSKY: Yes. 21 COMMISSIONER BORN: And as I 22 understand it, the credit default swaps 23 began to replace some of the residential 24 mortgage-backed securities. 25 MR. KOLCHINSKY: That is correct. By 150 1 Q & A - Session 1 2 '07, most of the deals, instead of having 3 cash assets, had credit default swaps that 4 referenced the subprime and Alt-A 5 collateral, yes. 6 COMMISSIONER BORN: And did you 7 experience particular issues or 8 difficulties in rating the synthetic or 9 hybrid CDOs? 10 MR. KOLCHINSKY: They were much more 11 difficult to rate. 12 number of new factors, a number of new 13 risks including counterparty risk, 14 collateral risk because it all had to be 15 funded. 16 mechanics in the deal were essentially 17 doubled. 18 They introduced a The number of waterfalls and the On top of that, even credit default 19 swaps would be customized. And by that I 20 mean, like the things that I mentioned 21 with the discount purchase option, the 22 only thing that made it possible to do 23 that for a banker is the fact that the 24 credit default swap was so flexible. 25 could adjust certain things in it. You The 151 1 Q & A - Session 1 2 degrees of freedom in a credit default 3 swap were much higher than the degrees of 4 freedom in a normal cash bond where you 5 only had price. 6 risks. 7 credit default. 8 items. 9 So you could hide certain You could create a different So that in itself changed I think I mentioned that the ability 10 to short created a new -- new type of 11 investor who wanted to see the market 12 deteriorate. 13 14 15 COMMISSIONER BORN: They wanted to see these bonds fail. MR. KOLCHINSKY: Fail. And the point 16 from the rating agency perspective, we did 17 not anticipate that sort of investor in 18 our deals, in our modeling, in our 19 approaches, so that was something new. 20 And finally, it really changed the 21 dynamic of the rating timeline. When I 22 started, we probably had one-and-a-half to 23 two months to look at a deal. 24 forth with a banker while they actually 25 had to -- actually gather that collateral, Go back and 152 1 Q & A - Session 1 2 either in the primary or secondary, which 3 took some time. 4 that could be done in a week. 5 When you had synthetics, So we had the time pressure, we had 6 this deal. The bankers don't want to hold 7 the warehouse risk, especially when the 8 market was going down. 9 it off or get it into a different form, They wanted to get 10 but still keep it on -- so the time 11 pressures and the pressure on the banker 12 increased tremendously. 13 14 15 16 17 So those were all changes as a result of the deals becoming much more synthetic. COMMISSIONER BORN: I also think -- may I have two more minutes? CHAIRMAN ANGELIDES: Just because 18 we're running, sure, just if you could ask 19 one -- 20 COMMISSIONER BORN: Well, if I am 21 limited to one question, how did the 22 ratings on the synthetic CDOs perform? 23 you agree with Mark Froeba, who has 24 testified in his written testimony that 25 they were the worst ratings in all of Do 153 1 Q & A - Session 1 2 Moody's once-distinguished history? 3 MR. KOLCHINSKY: I, without the data, 4 I would say, my guess is yes. I mean, all 5 these deals performed poorly. But because 6 many of the synthetic deals were, as we 7 know now, we didn't know then, were 8 actually done in the portfolios selected 9 by parties who wanted to see the deals -- 10 maximize the losses, they would have 11 probably performed worse. 12 any data, but I wouldn't -- 13 14 COMMISSIONER BORN: Since they were designed to fail, they did fail. 15 MR. KOLCHINSKY: 16 COMMISSIONER BORN: 17 CHAIRMAN ANGELIDES: 18 So I don't have Yes. Thank you. Thank you, Ms. Born, Mr. Holtz-Eakin? 19 COMMISSIONER HOLTZ-EAKIN: Thank you, 20 Mr. Chairman. Thank you, gentlemen, for 21 taking the time to be with us today. 22 I want to reiterate what I think were 23 some information requests by Commissioner 24 Wallison and hope that we can come back to 25 you. I am particularly interested in not 154 1 Q & A - Session 1 2 just the absolute level of performance of 3 your ratings in these structured products 4 running mortgages, which I think the 5 record has indicated is not outstanding, 6 but how they performed versus other 7 ratings done by Moody's, in structured 8 finance, not mortgage-related. 9 this a problem endemic to structured 10 finance or was it a mortgage-related 11 problem? 12 So was I'm also interested in any 13 comparative information you might have on 14 your performance relative to market 15 competitors, whether it be S&P, Fitch, 16 whoever. 17 carefully, I think it would be useful to 18 the Commission and I look forward to your 19 help in doing that. 20 I think to frame this more It seems to me that there are three 21 levels of questions involved. One is, 22 what exactly is it that you did in rating 23 these various securities; the second is 24 the nature of the business model in which 25 your activities were embedded and the 155 1 Q & A - Session 1 2 degree to which that shaped your actions; 3 and the third is the role the ratings 4 themselves played in market dynamics and 5 what was ultimately an enormous financial 6 crisis. 7 A better questioner would be able to 8 distinguish among them and lead you 9 through it. That's not me. So you're 10 going to get questions on each of those, 11 as we go through. 12 with the bottom of this, which is 13 residential mortgage-backed securities, 14 and ask you, Mr. Siegel, in particular, 15 some questions about that process and how 16 it worked. But I did want to start 17 And so first and foremost, what were 18 you trying to do when you rated an RMBS? 19 MR. SIEGEL: Commissioner, when we 20 rated an RMBS, there were two primary 21 components to it. 22 collateral, so a subprime mortgage pool 23 would be substantially riskier than a 24 prime mortgage pool; floating rate loans, 25 riskier than fixed rate loans, et cetera. One is evaluating the 156 1 2 Q & A - Session 1 And after evaluating the expected 3 performance of the pool and the 4 performance at different stress levels, we 5 would lay that against a proposed 6 structure of the deal. 7 structured finance securities in general, 8 and prime versus RMBS in particular, to 9 get ratings at different levels is that, The reason 10 within the deal, investors allocated risks 11 among themselves. 12 The company, the originator might 13 agree to take like an equity position and 14 they would be the first to lose if the 15 loan performed poorly. 16 have investors at the cusp of investment 17 grade, like hedge funds might buy the 18 near-investment-grade classes. 19 know that if losses exceeded protection 20 from the company, they would take the 21 loss. Then you might And they 22 In turn, the most senior investor 23 would be protected by about 20 percent of 24 subordination below them. 25 assessing whether the collateral dynamics So it was 157 1 Q & A - Session 1 2 projected forward compared to the 3 protection provided within the structure, 4 what level of risk that resulted in to 5 buyers of the security. 6 COMMISSIONER HOLTZ-EAKIN: So your 7 goal was to look at alternative futures 8 and look at the cash flows that the 9 underlying subprimes would generate, 10 allocate them to the different investor 11 tranches and look at the expected returns 12 they might get and the degree to which 13 they fell short, and then assign rating 14 accordingly, that's the basic process? 15 16 17 MR. SIEGEL: Yes, that's a good summary. COMMISSIONER HOLTZ-EAKIN: What would 18 I get, would I get your rating or a full 19 analysis, what would be available to 20 someone using your product? 21 MR. SIEGEL: For each RMBS deal we 22 strove to publish what we called a New 23 Issue Report, which would give our 24 ratings, along with a summary of the pool 25 statistics, so investors could see 158 1 Q & A - Session 1 2 what the collateral was, a summary of the 3 structure and our rating rationale. 4 It would give an explanation, again, 5 not each individual person's, but the 6 committee would come up with a rational, 7 why do we think 20 percent protection is 8 enough for a AA II rating on this tranche. 9 COMMISSIONER HOLTZ-EAKIN: So into 10 that process went some quantitative 11 analysis, some modeling, as well as the 12 other inputs from members of the committee 13 on a more qualitative basis? 14 15 16 MR. SIEGEL: Exactly, our ratings were -COMMISSIONER HOLTZ-EAKIN: So let me 17 ask you a couple of questions about each. 18 How did you build the quantitative 19 analysis? 20 price data? 21 was used to determine the performance of 22 the subprime loans, the prepayments, the 23 delinquencies, defaults, the entire range 24 of behaviors you had to model? 25 What was the historical house What was the information that MR. SIEGEL: Well, the models were 159 1 2 3 4 5 Q & A - Session 1 shifting over time, so I'll speak as to -COMMISSIONER HOLTZ-EAKIN: How often were they updated? MR. SIEGEL: Well, I just want to be 6 clear on that question. 7 we do an entire revamp with new data, like 8 a million loans of data, and look at that? 9 That tended to be about every five years, 10 11 How often would but -COMMISSIONER HOLTZ-EAKIN: So in 12 particular, as you got more information 13 about house prices declining, mortgages 14 performing poorly, which we've heard a lot 15 about today, there was not an effort to 16 re-estimate the basic modeling underneath 17 the ratings? 18 MR. SIEGEL: Again, it would not be 19 the major revamp. 20 came in, there were new loan types, and 21 Moody's then just say, "Oh, sorry, we 22 didn't have that in our dataset, we can't 23 assign a rating." 24 25 But as any information Rather, we would analyze the additional risk. So an interest-only loan 160 1 Q & A - Session 1 2 we didn't have historical performance on 3 interest-only loans but everyone can 4 imagine that if the borrower is not 5 amortizing their loan, if they're simply 6 paying interest over time, it's going to 7 be risk. 8 9 So we actually had some indirect data on what would happen when payment goes up, 10 what happens when equity doesn't go down. 11 So we applied that to the I-O loans, not 12 waiting five fears to get data on the 13 actual performance on interest-only, but 14 analytically projecting out increased risk 15 as data came in, such as an interest-only 16 loan. 17 COMMISSIONER HOLTZ-EAKIN: So I'm 18 interested in two pieces of what I 19 understand to be the quantitative process. 20 One was reports we received that there was 21 an effort to lower the sensitivity to 22 house price increases because in fact, the 23 models were not performing well in 24 predicting losses. 25 to be too small. Losses were predicted Is that a fair 161 1 2 Q & A - Session 1 characterization of what went on? 3 MR. SIEGEL: 4 frame for that? 5 Do you have the time I don't -- COMMISSIONER HOLTZ-EAKIN: -- the 6 development of your basic subprime RMBS 7 model -- 8 9 10 MR. SIEGEL: Let's—it’s going back to the 1996, thereabouts, model? COMMISSIONER HOLTZ-EAKIN: I'll 11 follow up with a -- I mean, this was, as I 12 understand it something that happened in 13 the 2000s leading into the development of 14 a new model for assessing subprime RMBS. 15 The M3. 16 MR. SIEGEL: M3 in around 2001 was a 17 model being built for prime, so is that 18 what you're referring to? 19 20 21 COMMISSIONER HOLTZ-EAKIN: And the subsequent for subprime, M3 subprime? MR. SIEGEL: That was later on. I 22 was not as directly involved with that. 23 In fact, it was rolled out after I left 24 the company. 25 being able to answer your question. So I can't -- I had trouble Now I 162 1 Q & A - Session 1 2 understand why. 3 something after I left. 4 It probably relates to COMMISSIONER HOLTZ-EAKIN: I'll come 5 back in writing to try to understand it a 6 little better; because if you make it less 7 sensitive going up, my guess is, you would 8 make it less sensitive going down. 9 the history is pretty clear on that. And 10 My second question has to do with 11 picking the worst outcome in a series of, 12 you know, 1,250 stochastic runs, doubling 13 that to assess tail risk. 14 judgment made, and how did the issuer 15 respond to your information about that? 16 MR. SIEGEL: How is that Again, if that was what 17 was done in the subprime, I'll take it 18 from the question, but I don't know that's 19 what happened in the subprime arena. 20 committee, when we did the economics for 21 the model that I worked on, which sounds a 22 similar case, we had historical home price 23 data and were able to project out, not 24 just the expected case, but the stress 25 cases and a correlation across states, A 163 1 Q & A - Session 1 2 which is critical. 3 observations available to us through that 4 date. 5 All that based on COMMISSIONER HOLTZ-EAKIN: So I want 6 to come back to that. So my understanding 7 is, when this happened, often there would 8 be an exposure in the stress test to 9 downside risk, and issuers would purchase 10 credit enhancements in order to get a 11 rating. 12 How was the credit enhancement 13 analyzed? 14 underlying collateral. 15 assess the quality of the credit 16 enhancements and the correlation of that 17 with the performance of the RMBS itself? 18 You've got cash flows on the CHAIRMAN ANGELIDES: What was done to By the way, the 19 Vice-Chair in absentia yields his 20 remaining two minutes to you. 21 COMMISSIONER HOLTZ-EAKIN: 22 the Vice-Chair. 23 legendary. 24 25 MR. SIEGEL: I thank His generosity is For the most part, it's two separate pieces of analysis. It is 164 1 Q & A - Session 1 2 looking at the collateral performance 3 through each of these different scenarios. 4 And in the prime, there are 1250 different 5 scenarios, and then comparing that to 6 credit support. 7 forms. 8 put aside in the deal, or it's 9 over-collateralization. Credit support takes many Some of that is certain, it's cash Where you have a 10 hundred of loans, 90 of certificates, a 11 ten-dollar collateral loss won't affect 12 the security holders who have 90, to pay 13 off the 90. 14 agreed-upon subordination of certain 15 investors, as I described earlier, the 16 hedge fund agreeing that they will take 17 losses first. 18 In some cases, it was the So the analysis of the type of credit 19 support was tied to, but separate from, 20 the collateral analysis. 21 COMMISSIONER HOLTZ-EAKIN: I'm going 22 to run out of time and we won't get to 23 have the long dialogue on correlations I 24 desire, but that's life. 25 two quick questions, one from Mr. Weill, Let me ask just 165 1 2 3 Q & A - Session 1 and one from the CDO perspective. It's clear you're analyzing the cash 4 flows and then going forward. 5 surveillance, what the is nature of 6 surveillance and how does it inform back 7 from the basic ratings at the issuance? 8 9 When you do And then for Mr. Witt and Mr. Kolchinsky, how is it, when you're 10 building a CDO based on the very same 11 RMBS, how do you capture that cash flow 12 information, particularly what turned out 13 after the fact to be dramatic correlation 14 in the performance of these, what was if 15 effort to identify that? 16 MR. WEILL: Commissioner, so if I 17 summarize, you're asking me two questions. 18 One of them is the process on how we do 19 that within surveillance, and how do we 20 communicate back to the -- 21 COMMISSIONER HOLTZ-EAKIN: 22 CHAIRMAN ANGELIDES: 23 24 25 Yes. Brisk answers, please. COMMISSIONER HOLTZ-EAKIN: you’re the Vice-Chairman. Imagine Go ahead. 166 1 2 Q & A - Session 1 MR. WEILL: On the first one, the 3 process is divided into two components. 4 Unlike the initial ratings side, where we 5 get a lot of information on the 6 pre-closing, like FICOs and other items 7 like that like that, the surveillance side 8 is a lot more focused on performance. 9 So what we care about primarily is 10 for example, to get how much is 30-day 11 plus 60-day, foreclosure, real estate 12 owned. 13 information on liquidation proceeds to see 14 how much is lost. We also care about getting 15 COMMISSIONER HOLTZ-EAKIN: 16 MR. WEILL: Recoveries. Recovered? How much is 17 lost when a mortgage is actually 18 foreclosed upon. 19 lot of information on deterioration of the 20 market or whether appraisals were too high 21 or other items. 22 And this is giving us a All the information we get on the 23 delinquent portion informs what our 24 thoughts are on the non-delinquent 25 portion. In other words, if we see a 167 1 Q & A - Session 1 2 significant trend of delinquencies, we do 3 increase our views on the non-delinquent 4 portion of the pools on the surveillance 5 side. 6 Beyond that -- I don't know how brisk 7 I'm supposed to be -- but beyond that, I 8 would just say that we run cash flows. 9 the extent there are complex waterfalls, To 10 we need to have information about how cash 11 would flow, depending on the timing of 12 defaults and the timing of prepayments. 13 14 15 So that's sort of a big picture. I know we can spend a lot more time on this. COMMISSIONER HOLTZ-EAKIN: I'll come 16 back to you at a later time. 17 just briefly get you, Mr. Witt and 18 Mr. Kolchinsky, to talk about the role 19 that cash flows played and the analysis of 20 those cash flows in the CDOs themselves. 21 22 23 DR. WITT: flow modeling. If I could CDOs definitely had cash You know, you had -- COMMISSIONER HOLTZ-EAKIN: Were you 24 to look through also the underlying 25 subprime mortgages? 168 1 2 Q & A - Session 1 DR. WITT: No, we definitely did not 3 look through the underlying subprime 4 mortgages -- 5 6 7 COMMISSIONER HOLTZ-EAKIN: What did you look at? DR. WITT: Okay. Well, first of all, 8 like in a CDO, let's say you've got a 9 hundred BBB RMBS tranches. In each RMBS 10 tranche you've got maybe a thousand 11 mortgages. 12 analysis would mean going through those 13 underlying one hundred thousand mortgages 14 and making some specific assumptions about 15 all those. 16 So doing a look-through We definitely did not do that on a -- 17 you know, deal -- for each deal. 18 did was, we took the rating that had 19 already been assigned by the RMBS group -- 20 21 22 COMMISSIONER HOLTZ-EAKIN: What we Did it have to be your own rating? DR. WITT: It didn't have to be but 23 if it was a rating from another rating 24 agency, we decremented it, because we 25 assumed that our ratings, you know, we 169 1 Q & A - Session 1 2 believed our ratings. We weren't sure 3 about other people's. It's called 4 notching. 5 So we, so that's what we did. We 6 didn't do the look-through analysis 7 although, you know, when I was CDO manager 8 and managing director, I really wanted to 9 do a look-through analysis as a study, as 10 a research tool, just to see -- really 11 what I was interested in was the 12 correlations that were being assumed in 13 the RMBS at the mortgage level. 14 allowed those to flow through to a CDO, 15 would you get -- would a AAA CDO be based 16 on similar correlations as a AAA RMBS? 17 That was the question. 18 19 20 COMMISSIONER HOLTZ-EAKIN: If you I think we now know the answer. DR. WITT: Well, I mean, both of them 21 were, you know, inadequate. 22 correlation levels for both were far lower 23 than they should have been. 24 25 The COMMISSIONER HOLTZ-EAKIN: Mr. Kolchinsky, I'm going to come back to 170 1 2 3 Q & A - Session 1 you in writing. I apologize CHAIRMAN ANGELIDES: No, these are 4 good lines of questioning. 5 could follow up in writing on this issue, 6 it is central, and I will say that there's 7 a lot in our research report on this. 8 this is an area in which we're 9 particularly interested. 10 11 But if we But All right, let's go to Mr. Thompson. COMMISSIONER THOMPSON: Thank you, 12 Mr. Chairman, and good morning, gentlemen. 13 Thank you for joining us. 14 I'm personally struck by the cultural 15 shifts that may very well have occurred 16 within Moody's as time progressed. 17 many little anecdotes have been spoken to 18 this morning, the fact that we could make 19 silk purses out of sows' ears in that 20 factory that you had is somewhat striking 21 to me. 22 influenced by human knowledge seems to 23 make sense to me. 24 mathematical model could ever take into 25 effect, or in effect, all of the variables While And the fact that the models were I don't know why any 171 1 2 Q & A - Session 1 that may be going on in the marketplace. 3 But the one big variable is in fact 4 the quest for market coverage or market 5 shift. 6 role as surveillance officer. 7 opine for a minute on your surveillance 8 observations about the cultural shifts 9 that occurred in Moody's post-IPO? 10 I'm struck, Mr. Weill, by your MR. WEILL: So can you My true goals as 11 surveillance managing director were to get 12 the ratings right, and to communicate 13 effectively on any rating actions. 14 were very demanding objectives, and I 15 think those were the absolute, sole 16 priorities that were set for my team in 17 surveillance. 18 COMMISSIONER THOMPSON: Those Did you sense 19 pressure on the team within Moody's to 20 drive market share rather than get the 21 ratings right? 22 MR. WEILL: I never felt this. I was 23 in charge of surveillance. No one was 24 forcing any objectives on me other than 25 getting the ratings right and 172 1 Q & A - Session 1 2 communicating effectively. 3 COMMISSIONER THOMPSON: So as the 4 surveillance officer, when much has been 5 found by our staff in e-mails and threats 6 about the quest for market share and 7 market coverage, you knew nothing about 8 that? 9 to that? 10 11 12 Your team was completely oblivious MR. WEILL: on market share. My team was not focused So -- COMMISSIONER THOMPSON: No, I didn't 13 ask that. 14 surveying what was going on within the 15 company and recognizing the quest for 16 market share and how that might effect 17 ratings? 18 I asked, was your team MR. WEILL: No. I'm not sure exactly 19 I understand what you mean by that. 20 think the only -- there is no quest for 21 market share in surveillance. 22 and the sole objective is moving ratings 23 when they deserve to be moved. 24 not part of any other objectives. 25 COMMISSIONER THOMPSON: I Obviously We were Dr. Witt, in 173 1 Q & A - Session 1 2 the business I come from, when someone 3 gets reassigned, sometimes that's a 4 euphemism for something else. 5 that mean in your language? 6 DR. WITT: What does I believe that I was 7 reassigned out of CDO group because I 8 had -- I was looking for another job. 9 got an offer from a university in Texas I 10 and I told my superiors about it. 11 ended up not taking the job because the 12 details didn't turn out to be what I was 13 expecting. 14 And I And, you know, so I stayed on. But about two months later, I was 15 asked to leave the CDO group. 16 that was the main reason. 17 I was looking for another job was the 18 types of things I was talking about in my 19 opening remarks about, I felt like we were 20 being asked, and specifically I was being 21 asked, to be in charge of something that 22 was incredibly complicated, and very 23 difficult to achieve, and I did not have 24 the resources to do it adequately. 25 I think But the reason It wasn't that I thought that we were 174 1 Q & A - Session 1 2 getting the ratings wrong or that I was 3 being pressured to get the ratings wrong. 4 It was that I thought that I didn't have 5 the resources to make sure that I was 6 getting the ratings right. 7 COMMISSIONER THOMPSON: So is that to 8 suggest that the pace of innovation just 9 overwhelmed your team or the whole 10 11 12 13 company? DR. WITT: For my team, that was definitely a big issue, yes. COMMISSIONER THOMPSON: 14 Mr. Kolchinsky, you have suggested in your 15 comments or observations that the quest 16 for market share was paramount. 17 you comment on the cultural shift that may 18 have occurred within Moody's around the 19 IPO, or post-IPO? 20 21 MR. KOLCHINSKY: And can It was a slow shift, but certainly, two stories: 22 When I first joined Moody's I was 23 asked to opine on a new deal that was 24 being brought to us by a banker that 25 contained primarily telecommunications 175 1 Q & A - Session 1 2 loans, and they wanted to convince us that 3 it was just as good as any other CMO, and 4 I was asked to look into it. 5 brand-new. 6 justify this. 7 And that was okay, "Great, thank you very 8 much." 9 I was I said, "No, we can't really We can't rate this deal." By the time I became MD, not rating a 10 deal became a very important factor, and 11 you had these e-mails, and you had market 12 share drops from 98 to 94 percent at a 13 time of credit turmoil were considered 14 great events. 15 rating every single deal or as many deals 16 as I could was critical to my job 17 performance. 18 So it was clear to me that I think it's true that no one said, 19 "Here, you have to lower standards." But 20 that was one area where it was easy, both 21 to rationalize, because prior to '07, the 22 performance of assets was so -- so good. 23 I mean, if you look at the subprime 24 performance up to that point, 25 delinquencies were extremely low, and I'm 176 1 Q & A - Session 1 2 sure Nicholas can tell you about that as 3 well. 4 concessions. 5 effectively gained and maintained market 6 share. So it was easy to rationalize And that's how people 7 COMMISSIONER THOMPSON: 8 to Mr. Weill for a moment. 9 Can I go back I would liken surveillance in your 10 environment to internal audit. 11 not true? 12 your attorneys, apparently shaking their 13 head. 14 15 16 17 18 Is that I see some guys behind you, MR. WEILL: I don't view my role as internal audit. COMMISSIONER THOMPSON: Is it similar, though? MR. WEILL: I don't think so. What 19 we do is, some call monitoring like 20 rerating. 21 Moody's assigns a rating, there are two 22 commitments to the market. 23 there's a commitment to the market to 24 inform the market over time on the rating, 25 and adjust a rating if there's any reasons And I think the way, when I mean, 177 1 2 3 Q & A - Session 1 to do so. So I think, I view my team as a team 4 of rating analysts that, instead of 5 rating, assigning initial rating, are 6 simply rating seasoned deals. 7 In other words, rating deals that are 8 enriched by the information of performance 9 and assigning new ratings. It's a 10 euphemism. 11 rating every day but we are getting 12 information every month, and based on 13 information we get every month, we are 14 reassessing those ratings. 15 an -- internal audit. 16 different ratings team. 17 18 19 COMMISSIONER THOMPSON: We're not assigning a new So it's not It's more like a Thank you very much. CHAIRMAN ANGELIDES: Very quickly, Ms. Murren, before 20 you go on, I want to enter a couple of 21 things in this record before I forget. 22 With respect to Mr. Holtz-Eakin's 23 questions, I'd like to enter into the 24 record an excerpt from a testimony from 25 Mr. Roger Stein about the ratings process 26 and the extent to which it was a matter of 178 1 Q & A - Session 1 2 human involvement, recalibrating the 3 assumptions, some of the things you talked 4 about. 5 of that excerpt. 6 I think it's an interesting part Secondly, I just want to make sure I 7 enter tab 15, and finally, the e-mail from 8 Mr. Kolchinsky to Ms. Fu and Ms. Yoshizawa 9 about the record of transactions which 10 have egregiously pushed our time limits. 11 I don't know if I did that. 12 COMMISSIONER MURREN: Ms. Murren? Thank you, 13 thanks to all of you for being here today. 14 I have a couple of questions. 15 for Dr. Witt: 16 The first You had mentioned earlier in your 17 commentary that your job was to get the 18 ratings right. 19 standpoint, does getting the ratings right 20 mean that they conform to your internal 21 modeling and that they've gone through the 22 appropriate processes through your 23 committee, or does it mean that, down the 24 road in the future, that the ratings that 25 you've assigned appear to be the ones that And I'm curious, from your 179 1 Q & A - Session 1 2 are accurate? 3 DR. WITT: The latter. You know, 4 when I say "get the ratings right," I'm 5 just trying to, it's a shorthand for, you 6 know, accurately predict, you know, what 7 percentage -- AAA should only have on 8 average losses of about a basis point, for 9 instance. 10 COMMISSIONER MURREN: And to your 11 knowledge, at Moody's, was there any 12 evaluation of performance by either the 13 analysts, the committee itself or people 14 in managerial positions that were 15 backward-looking, that would say that your 16 performance was being evaluated based on 17 what you just described, which is making 18 sure the ratings were right? 19 DR. WITT: There's definitely a group 20 that measures the performance ratings, you 21 know, by category, and they would put out 22 a report every year that would tell how 23 ratings did. 24 25 But did that affect people's pay, people's compensation? I would say in my 180 1 2 3 Q & A - Session 1 experience, no. COMMISSIONER MURREN: Okay. So it 4 was important to you, but not because it 5 was something that was rewarded 6 necessarily at the firm. 7 DR. WITT: Yes. I mean, people took 8 a lot of pride in trying to get the 9 ratings right. I mean, you know, down at 10 my level, at the analyst level and manager 11 level, it definitely did. 12 COMMISSIONER MURREN: Thank you. Did 13 all of you have contact with the issuers 14 or those that were the ones coming to you 15 for the ratings for these securities? 16 It's just a yes or no question. 17 all have meetings, conversations, did you 18 have contact with them? 19 MR. SIEGEL: 20 COMMISSIONER MURREN: 21 regular basis? 22 MR. WEILL: Did you Yes. On a pretty My contacts were, after 23 issuance of ratings on an on-going basis to have monitor 24 information. 25 COMMISSIONER MURREN: But it's again 181 1 2 Q & A - Session 1 with the issuers themselves. 3 MR. WEILL: Issuers or their agents. 4 COMMISSIONER MURREN: And yet, 5 Mr. Weill, you had said that when you were 6 in the conversations in your committee 7 deliberations, that first and foremost, or 8 at least very prominently figured in the 9 hierarchy of what was important to you, 10 was the end user of the ratings, meaning 11 the pension funds and the mutual funds 12 that ultimately would rely on these 13 ratings for their investment decisions. 14 How often did you have contact with 15 16 them? MR. WEILL: We had a lot of contacts 17 with investors. 18 participating through teleconferences. 19 had teleconferences after significant Dow 20 reactions. 21 action we discussed today, we had a major 22 teleconference where we presented our 23 slides. 24 investors. 25 Some investors were We I would say in the July 2007 We had a Q&A with hundreds of We also were participating to 182 1 Q & A - Session 1 2 investor briefing where investors would 3 either come to Moody's or come to a 4 different place where we would present our 5 methodologies and take questions from 6 investors. 7 conferences to investors. 8 were really a key contact for us in 9 monitoring. 10 We were speaking to COMMISSIONER MURREN: So investors During the 11 course of the time period that we're 12 examining, did those investors ever convey 13 to you that your ratings were overly 14 optimistic or that they felt that the 15 underlying assumptions may need to change 16 or offer up any concerns about the housing 17 market? 18 MR. WEILL: I would say two things to 19 this, to that effect, Commissioner. The 20 first one is, when you get a phone call 21 from an investor, you don't necessarily 22 know whether this investor is short or 23 long the securities; i.e., whether they 24 are happy with, let's say, the downgrade 25 or unhappy if there is a downgrade. 183 1 2 Q & A - Session 1 The second point I would say is that 3 we have an ongoing dialogue with 4 investors. 5 models. 6 information for them. 7 do actually run their own models and cash 8 flows and they express their views. 9 it's a very fruitful exercise for me and 10 11 They have views, they have Ratings is only one source of And major investors And for my team to get information from them. COMMISSIONER MURREN: So now we've 12 heard that your own internal economic 13 forecasting is something that you may not 14 always rely on for your information. 15 one of many different factors. 16 conversations that you have with 17 investors, I guess are yet another of many 18 different factors that you consider. 19 But what is the factor then that It's And the 20 would throw up a red flag where you would 21 react? 22 be that something is in the process of 23 needing to be downgraded or are there 24 ever, sort of, forward-looking types of 25 warning signals that you would heed? I mean, does it actually have to 184 1 2 Q & A - Session 1 MR. WEILL: The -- we look at -- we'd 3 look at warning signs. Like if you look, 4 for example, at early payment defaults, 5 and you see a small, even a small 6 percentage of early payment defaulters, 7 there would be a flag that we need to 8 engage in more research. 9 where we would, for example, speak to At the time 10 services, get information from them on 11 what they see in terms of revised 12 appraisals, updated appraisals, what they 13 see in terms of liquidations and 14 recoveries. 15 So we get a few data points from the 16 servicer reports and trustee reports. 17 this is -- this allows us to graph and 18 analyze trends and forces us into a lot 19 more research. 20 COMMISSIONER MURREN: And then that 21 research, at what point do you take 22 action, after the data in the model 23 changes? 24 25 MR. WEILL: And There is a significant tradeoff between, on when to take a rating 185 1 Q & A - Session 1 2 action, and I think this is a very 3 difficult question. 4 example, the early payment defaulters, you 5 see a group of homeowners that are 6 starting to be delinquent on their 7 payments. 8 different ways to analyze it. If I take, for And there could be a lot of 9 One way to analyze it would be to 10 have, to see that you have a group of 11 speculators, people who were just hoping 12 to make a quick profit, never intended to 13 live in the property, just buying a house 14 to sell it within three months, or are 15 they actually -- 16 17 COMMISSIONER MURREN: somewhat subjective. 18 MR. WEILL: 19 COMMISSIONER MURREN: 20 minutes left. 21 apologize. 22 23 24 25 So it's There is -I have two That's why I'm rushing, I MR. WEILL: There is a qualitative component to it. COMMISSIONER MURREN: Thanks. Dr. Witt, if I could return to you, you 186 1 Q & A - Session 1 2 had mentioned that there was some pressure 3 from bankers that related to what ratings 4 you assigned within your group. 5 Could you talk a little bit about 6 that? And secondarily, you had also 7 mentioned that you could go in and say 8 that you didn't want to rate something, 9 and I'm curious as to what happened to 10 those deals. I mean, how many did you not 11 rate, and did they go to another rating 12 agency or did they come to market? 13 happened to them? 14 DR. WITT: What Well, the first question 15 about the bankers, you know, they always 16 wanted higher ratings or, you know, the 17 largest -- the bigger AAA tranches, and 18 they would, you know, work hard to achieve 19 that and could be very creative in the 20 ways they would try to explain things or 21 the types of evidence they would use. 22 You know, they definitely -- they 23 would just use, pull any lever, basically, 24 that they could. 25 might mean, you know, calling one of our And, you know, pressure 187 1 Q & A - Session 1 2 superiors and, you know, describing some 3 situation in terms that wasn't really, you 4 know, accurate, to try and, you know, kind 5 of, you know, put me on the defensive. 6 7 8 9 You know, they -- that was just a part of the job. COMMISSIONER MURREN: What happened to deals that you decided -- how many were 10 there that you decided not to rate and 11 what happened to them? 12 DR. WITT: I'm not sure, when did I 13 say that we decided not to rate 14 transactions? 15 COMMISSIONER MURREN: Perhaps it 16 wasn't you. 17 else. 18 it was possible to go in and say that you 19 didn't want to rate something. 20 referenced one instance. 21 It might have been someone But there was -- someone said that MR. KOLCHINSKY: You In my case, there 22 was only one I was able to say no to and 23 it went to another rating agency. 24 wasn't -- it was theoretically possible, 25 but not advisable for your career But it 188 1 Q & A - Session 1 2 prospects and practically, very difficult 3 to say no. 4 5 6 COMMISSIONER MURREN: So did you ever say no? DR. WITT: Well, you know, there 7 definitely could be a transaction, where 8 you would be talking to the arranger, 9 investment banker, and they would end up 10 with not getting a rating because they 11 weren’t happy with the rating they were 12 going to get. 13 But I don't ever remember ever 14 saying, "We're just not going to rate this 15 deal." 16 is the rating we give," or, "We would 17 give." 18 don't like that," and they would go away. 19 But I don't remember just saying, "We 20 can't rate this." 21 It would be more like, "Okay, this And they would say, "Well, we COMMISSIONER MURREN: Of course. But 22 how many times did people walk away 23 because you would say, "We will not give 24 you the rating you want?" 25 DR. WITT: Oh, you know, I'm sure 189 1 Q & A - Session 1 2 there were many occasions, you know, over 3 the year-and-a-half. 4 COMMISSIONER MURREN: And typically, 5 those would go to another rating agency 6 and they would get the rating they wanted? 7 DR. WITT: Often, yes. 8 COMMISSIONER MURREN: 9 CHAIRMAN ANGELIDES: Thank you. All right, thank 10 you. 11 we'll ask this of Moody's Corporation, but 12 we would like, Senator Graham would like 13 some information about the backgrounds of 14 the people who sat on the ratings 15 committee, I think with an eye to seeing 16 what their expertise, knowledge, diversity 17 of background was that allowed them to 18 make assessments of the mortgage market; 19 correct, Senator Graham? 20 At the request of Senator Graham, So we will make that request of 21 Moody's and direct it to the appropriate 22 person. 23 make a comment before we close up here? 24 25 Mr. Vice Chair, you wanted to VICE-CHAIRMAN THOMAS: Well, actually, I have a couple of quick 190 1 2 Q & A - Session 1 questions as well. 3 4 5 CHAIRMAN ANGELIDES: I would not defy you. VICE-CHAIRMAN THOMAS: Well, after 32 6 years in elected office, I learned never 7 to ask for the last question. 8 is wait until you get a good one and say 9 that was the last question. 10 11 What you do So I'm having fun in this position. Dr. Witt, in reading what you wrote, 12 and listening to what you said, I know 13 you'll give me what you believe to be the 14 honest answer to the question in terms of 15 your feelings not being comfortable, which 16 finally drove you back to academia. 17 18 If you had double your pay, would you have had the same feelings? 19 DR. WITT: Absolutely. 20 VICE-CHAIRMAN THOMAS: If you had 21 triple the pay, would you have had the 22 same feelings? 23 24 25 DR. WITT: I'm telling you the truth, I would have, yes. VICE-CHAIRMAN THOMAS: Okay. And 191 1 Q & A - Session 1 2 then finally, the plea that the ratings 3 agencies weren't the cause of the 4 financial crisis, I'll accept that if 5 you'll answer this question: 6 We'll start with you, Mr. Kolchinsky 7 and go down the line very quickly, 8 preferably one word, two if you need to. 9 10 What was the major cause of the economic crisis? 11 MR. KOLCHINSKY: 12 VICE-CHAIRMAN THOMAS: 13 Actually, it's -- or two words. 14 MR. KOLCHINSKY: 15 Everybody in the chain. 16 Everybody. VICE-CHAIRMAN THOMAS: 17 attorney, I forgot. 18 MR. KOLCHINSKY: 19 Not a practicing one. VICE-CHAIRMAN THOMAS: 21 MR. SIEGEL: 23 Oh, he's an You're an attorney. 20 22 No, just one Mr. Siegel? The housing market decline. VICE-CHAIRMAN THOMAS: If that's your 24 answer. I mean, you guys are good at what 25 you do, so if that's your answer. 192 1 2 Q & A - Session 1 Mr. Weill? 3 MR. WEILL: Housing market decline 4 combined with hard refinancing 5 opportunities. 6 7 DR. WITT: decline, you could talk about -- 8 9 The housing market VICE-CHAIRMAN THOMAS: Well, the question is, what was the cause of the 10 housing market decline, was it AAA ratings 11 on stuff that weren't? 12 DR. WITT: A lot of 13 inappropriate financing, and definitely to some 14 extent -- 15 16 VICE-CHAIRMAN THOMAS: And inappropriate rating? 17 DR. WITT: -- and to some extent, 18 inappropriate rating contributed to that. 19 Yes. 20 21 22 VICE-CHAIRMAN THOMAS: All right. That is all -CHAIRMAN ANGELIDES: The only thing I 23 wanted to note is in response to 24 Ms. Murren's question, I thought you were 25 very delicate. Just for the record, in 193 1 Q & A - Session 1 2 your interview with our staff, Dr. Witt, 3 when asked about pressure from bankers, 4 you said, "Oh God, are you kidding? 5 the time. 6 mean, they would threaten you all the 7 time." 8 9 10 11 I mean, that's routine. I just wanted to note that. I But I appreciate your delicacy and nuance of words today. VICE-CHAIRMAN THOMAS: Now I 12 understand why he wouldn't do it for 13 triple the amount. 14 All CHAIRMAN ANGELIDES: All right. I 15 want to thank the panel for your time, for 16 the answers to your questions. 17 it very much. 18 Appreciate We are going to take a ten-minute 19 break, a brief ten-minute break. 20 reconvene at 11:45 for session two. 21 members, we're shortened up a little here. 22 (Recess taken.) 23 CHAIRMAN ANGELIDES: We will So We will now come 24 back into session. We are going to begin 25 the second session of today's hearing on 194 1 Proceedings 2 the credibility of credit ratings, the 3 investment decisions made based on those 4 ratings and the financial crisis. 5 second session is, "Credit Ratings and the 6 Financial Crisis." 7 The We are joined today at the witness 8 table by Mr. Warren Buffet, the Chairman 9 and CEO of Berkshire Hathaway, and 10 Mr. Raymond McDaniel, the Chairman and CEO 11 of Moody's Corporation. 12 Gentlemen, I'd like to start, thank 13 you for being here, I'd like to start by 14 doing to what is customary for all 15 witnesses in all proceedings. 16 ask you both to stand and be sworn. 17 Please raise your right hand. 18 W A R R E N 19 R A Y M O N D I'd like to B U F F E T T , M c D A N I E L , 20 Having been duly sworn, testified as 21 follows: 22 CHAIRMAN ANGELIDES: Thank you very 23 much. We will begin by offering both of 24 you the opportunity to make an opening 25 statement of no more than five minutes. I 195 1 Opening - McDaniel 2 don't know if I -- I know that 3 Mr. McDaniel has prepared a statement, I 4 don't know, Mr. Buffett, if you want to 5 avail yourself of that opportunity. 6 MR. BUFFETT: I have no statement. 7 CHAIRMAN ANGELIDES: Good. That will 8 cut five minutes off the agenda. 9 we'll do, Mr. McDaniel, we'll take your 10 opening statement and we'll go right to 11 Commission questioning. 12 MR. McDANIEL: Thank you. And what Good 13 morning, Mr. Chairman, Mr. Vice-Chairman 14 and members of the Commission. 15 the Ray McDaniel, I'm the Chairman and CEO 16 of Moody's Corporation, the parent of 17 credit rating agency Moody's Investor 18 Services. 19 My name Moody's appreciates the important 20 work this Commission is undertaking and on 21 behalf of my colleagues, I welcome the 22 opportunity to contribute our views 23 regarding the role of credit rating 24 agencies. 25 Over the past several years, we've 196 1 Opening - McDaniel 2 witnessed events who magnitude many of us 3 would have thought highly unlikely. 4 turmoil in the U.S. housing market is that 5 began in the subprime residential mortgage 6 sector led to a global liquidity crisis 7 and a loss of confidence in the U.S. and 8 global financial system. 9 created a great hardship for many The The impact has 10 Americans. 11 jobs, homes and college and retirement 12 savings as a result of this financial 13 crisis. 14 American families have lost Moody's is well aware that the crisis 15 of confidence in the market has also 16 impacted the confidence in the credit 17 ratings industry. 18 At Moody's, our reputation is our 19 single most important asset. For one 20 hundred years, Moody's employees have 21 brought their insight and integrity to 22 rating trillions of dollars of debt and 23 hundreds of thousands of obligations 24 across a broad range of sectors, asset 25 types and regions. The record for 197 1 Opening - McDaniel 2 providing predictive credit opinions has 3 earned Moody's a strong reputation among 4 capital market participants worldwide. 5 However, Moody's is certainly not 6 satisfied with the performance of our 7 credit ratings for the U.S. residential 8 mortgage-backed securities and related 9 collateralized debt obligations over the 10 past several years. 11 deeply disappointing. 12 Indeed, it has been Starting in 2003, Moody's did observe 13 a trend of loosening mortgage underwriting 14 standards and escalating housing prices. 15 We repeatedly highlighted those trends in 16 our research and we incorporated them into 17 our analysis of the securities. 18 we were requiring an unprecedented level 19 of credit protection. 20 nor most other market participants, 21 observers or regulators, anticipated the 22 severity or speed of deterioration that 23 occurred in the U.S. housing market or the 24 rapidity of credit tightening that 25 followed and exacerbated the situation. By 2006, However, neither we 198 1 Opening - McDaniel 2 And even our enhanced credit protection 3 requirements were insufficient to ensure 4 ratings stability. 5 Today with the benefit of hindsight, 6 many observers have suggested that the 7 events that ultimately came to pass were 8 inevitable and easily predictable. 9 they were occurring, however, various As 10 outcomes were considered possible. Market 11 experts in both the public and private 12 sector had differing views about the 13 ultimate performance of the U.S. housing 14 sector and its potential effect on the 15 rest of the economy. 16 persist today. These questions 17 The economic downturn exposed serious 18 vulnerabilities across the infrastructure 19 of the global financial system. 20 Moody's part, there has been an intense 21 level of self-evaluation over the past few 22 years. 23 For Members of my management team and I 24 have solicited ideas and perspectives from 25 both inside and outside the company. 199 1 Opening - McDaniel 2 We've sought to better understand what 3 caused the poor performance of our ratings 4 in this sector and we've sought to improve 5 the assessment of credit risk in a 6 fast-changing and unpredictable market 7 environment. 8 initiatives to improve the credibility of 9 our ratings and strengthen their quality We've undertaken numerous 10 transparency and independence. 11 actions are extensive and have occurred in 12 six principal areas: 13 These We have strengthened the analytical 14 integrity of our ratings, and hence, 15 consistency across rating groups, improved 16 the transparency of rating and the rating 17 process, increased resources in key areas, 18 bolstered measures to avoid conflicts of 19 interest, and we continue to pursue 20 industry and market-wide initiatives. 21 In each area, we've made good 22 progress. Still, I believe more can and 23 should be done. 24 legislative and regulatory reform efforts 25 that will reinforce high quality ratings We wholeheartedly support 200 1 Opening - McDaniel 2 and enhance accountability without 3 intruding into the objectivity and 4 independence of rating opinion content. 5 At Moody's, we are firmly committed 6 to meeting the highest standards of 7 integrity in our rating practices, quality 8 in our rating methodologies and analysis 9 and transparency in our rating actions and 10 ratings performance metrics. 11 Thank you. 12 any questions. 13 I'm happy to respond to CHAIRMAN ANGELIDES: 14 much. 15 questioning. 16 start and move to the Vice-Chair and then 17 the members who led this research and 18 investigation effort into credit rating 19 agencies. 20 All right. Thank you very We'll begin with the So, and I will, as custom, Let me start by saying the two issues 21 I'd like to probe with you gentlemen today 22 are really the following: 23 First of all, business and management 24 practices, corporate responsibility, 25 management accountability, for starters. 201 1 Q & A - Session 2 2 Second issue I'd like to look at and 3 talk with you about is the model for 4 credit rating agencies in the financial 5 market. 6 with you today, and let me ask you very 7 directly. 8 9 So, Mr. McDaniel, let me start And by the way, the reason I want to say that these issues of corporate 10 governance, leadership accountability are 11 important is, in trying to assess how we 12 had this run-up to the financial crisis, 13 we have found over the course of months 14 that there's very little -- there's a lot 15 of finger-pointing away, very little 16 self-examination. 17 you. 18 So let me start with Under your leadership, there were, in 19 the end, for whatever reasons, very 20 significant failures of Moody's. 21 product that your company offered, which 22 are ratings for the benefit of investors, 23 proved to be highly defective, and not 24 just by small measure but by a large 25 amount. The 83 percent of your AAA-rated 202 1 Q & A - Session 2 2 securities in the RMBS area in 2006 were 3 downgraded. 4 which were investment-grade rated were 5 downgraded to junk. 6 downgrades, I ought to note, started in 7 July '07, when housing prices had declined 8 just four percent from the peak. 9 Some have said that the very In 2007, 89 percent of those And massive 10 enterprise was fraudulent, if not in a 11 legal sense, but in a practical sense, 12 because the products did not closely 13 approximate what they were represented to 14 be. 15 to your 2007 ratings, it would have been 16 five times more accurate in terms of the 17 result. 18 If we'd flipped a coin with respect Your shareholders have lost 73 19 percent of the value in the stock from the 20 peak to today. 21 issuance of trillions of dollars of 22 mortgage securities which we now know were 23 rife with significant problems from fraud 24 to misrepresentation that may have well 25 fueled the housing bubbles. The ratings enabled the Investors who 203 1 Q & A - Session 2 2 relied on the ratings suffered enormous 3 losses and your company's reputation, 4 something that I know that Mr. Buffett has 5 held important, reputation within 6 business, is certainly under significant 7 criticism. 8 9 My question for you is really, who should be held accountable? We have a 10 system of capitalism in this country where 11 we have regulatory mechanisms; we have 12 owners, boards, and management. 13 should be accountable if not you? 14 MR. McDANIEL: Who The performance of the 15 housing sector and as a result of ratings 16 that are associated with housing assets 17 clearly have exhibited very poor 18 performance in recent years. 19 decades of strong performance leading up 20 to the current crisis. 21 our ratings were our best opinion at the 22 time that we assigned them. 23 obtained new information and were able to 24 update our judgments based on the new 25 information and the trends we were seeing There was We believed that As we 204 1 Q & A - Session 2 2 in the housing market, we made what I 3 think are appropriate changes to our 4 ratings. 5 So I am deeply disappointed, as I 6 said in my opening remarks, with the 7 performance of ratings associated with the 8 housing sector. 9 the reputation of the firm and to the And that is injurious to 10 long-term value of the firm. 11 regret is genuine and deep with respect to 12 our ratings in the housing sector. 13 CHAIRMAN ANGELIDES: And so the But let me probe 14 this a little further. Just as -- and 15 look, I've been certainly wrong as much as 16 I'm right. 17 peaks and valleys. 18 say, there's almost a common-sense test 19 here. I know it's hard to predict Let me just 20 Your firm rated 42,000 tranches of 21 RMBS AAA from about 2000-2007 in a context 22 where there's four corporations in the 23 country -- used to be a few more -- that 24 were rated AAA. 25 rating about 90 percent of these In that context you were 205 1 Q & A - Session 2 2 securities as AAA when, in terms of the 3 corporate debt world, where you actually 4 have more transparency, you can get in, 5 look at all the public filings, understand 6 the corporate debt, only about 1.4 percent 7 of that was rated AAA. 8 enterprise for which you were compensated 9 pretty handsomely, $39 million over this 10 11 You led an period. I guess what I'm getting to, is, if 12 American capitalism is about risk and 13 reward, rewarding success, rewarding 14 failure, should there have been a 15 management change at Moody's? 16 need to have a culture in which success 17 and failure are essentially accounted for 18 in our capitalist system? 19 MR. McDANIEL: Don't we As I remarked a moment 20 ago, we certainly believed that our 21 ratings were appropriate when they were 22 assigned. 23 ratings have not performed well in the 24 housing-related sector. 25 we did make management changes. And I recognize that those And as a result, If you 206 1 2 Q & A - Session 2 are -- 3 4 5 CHAIRMAN ANGELIDES: top. But not at the No board or CEO changes or -MR. McDANIEL: If you're asking with 6 respect to me, which I can see you are, 7 it's a fair question. 8 point where either our shareholders or our 9 board of directors or I don't believe I am And if we reach a 10 best positioned to lead the firm through 11 this period and into the future, then I 12 will not be in my job. 13 CHAIRMAN ANGELIDES: Okay. 14 Mr. Buffett, any observations on the 15 responses by Mr. McDaniel? 16 MR. BUFFETT: Well, I probably have 17 been more draconian than you have in my 18 view about the CEO’s responsibility and-- 19 20 21 CHAIRMAN ANGELIDES: I just haven't been as widely quoted. MR. BUFFETT: Well, in terms of 22 financial institutions that have failed 23 and required assistance by the federal 24 government, I think that when society has 25 to step in to save institutions for 207 1 Q & A - Session 2 2 societal reasons, that the CEO should 3 basically go away broke, and I think his 4 spouse should go away broke. 5 there should be a real downside, and I 6 think incentives are an important 7 aspect in behavior. 8 9 I think In the end, I don't know who, except for maybe John Paulsen or Michael Murray, 10 would have been running Moody's and coming 11 up with different kinds of ratings. 12 was the greatest bubble I've ever seen in 13 my life, and I've read about bubbles all 14 the way back to the tulip bubble. 15 entire American public eventually, was 16 caught up in a belief that housing prices 17 could not fall dramatically. 18 Mac believed it, Fannie Mae believed it, 19 Congress believed it, the media believed 20 it, I believed it. This The And Freddie 21 If I'd seen what was coming, would I 22 have held my Moody's stock in the 60s or 23 something of the sort? 24 people could appreciate the bubble, and 25 that's the nature of bubbles, they become Very, very few 208 1 2 Q & A - Session 2 mass delusions of sorts. 3 So I am much more inclined to come 4 down hard on the CEOs of institutions that 5 cause the United States’ government to come 6 in and necessarily bolster them than I am 7 on somebody's that made a mistake that 8 three hundred other Americans made. 9 CHAIRMAN ANGELIDES: Well, let me 10 probe that a little. 11 just want to say for the record, I do 12 think around the country, there were 13 people who thought the bubble was 14 unsustainable. 15 secret here. 16 experts, whether it was Robert Schiller or 17 Mr. Rubini or Mr. Baker, Dean Baker, there 18 were a number of people who saw this 19 bubble. 20 89 percent in home price appreciation in seven years, 21 something we had never seen historically. 22 Because, you know, I I don't think there was a There were a number of We had this unprecedented rise, But moving beyond that for a minute, 23 the rating agencies did play a fundamental 24 role in accelerating essentially the 25 securitization, therefore, some would 209 1 Q & A - Session 2 2 argue, the origination of products that 3 tended to be highly deficient. 4 talking about low teaser rates, negative 5 amortization. 6 We're There was a warning in 2004 from the 7 FBI that mortgage fraud had become so 8 epidemic that, if unchecked, it would 9 result in a crisis as big as the S&L 10 11 crisis. I mean, there were many red and 12 yellow flashing lights along the way. 13 There is a country song by Don McLean 14 where he says, "When the gates are all 15 down and the signals are flashing and the 16 whistles are screaming in vain, and you 17 stay on the tracks, avoiding the facts, 18 you can't blame the wreck on the train." 19 Wasn't the role of the rating 20 agencies, though, to be referees in a game 21 that got out of control? 22 staff that, well, gee, if they had not 23 done the ratings, they would have been 24 howled at by Congress. 25 expect referees to make the call even if You told our But don't we 210 1 2 3 Q & A - Session 2 they are going to get booed? MR. BUFFETT: Yes, and they made the 4 wrong call. 5 most of the American public did, and you 6 couldn't have had this size bubble without 7 over overwhelming -- and the Cassandras 8 were there, but who was goes to listen to 9 John Paulsen in 2005 or 2006, or Michael 10 Murray? 11 anything. 12 They basically believed, as I mean, they -- it didn't mean And look at me. I mean, I was wrong 13 on it, too. I recognized that something 14 pretty dramatic was going on in housing 15 but I actually called it in the annual 16 meeting, when I got a question on it, a 17 "bubblette." 18 term, because it was a four-star bubble. 19 And the rating agencies missed it, and, 20 you know, as I say, you could look at the 21 March 30th, 2007 report to Congress by 22 OFHEO, which had two hundred people 23 overseeing Freddie and Fannie, and they 24 basically gave them a green light on asset 25 quality. Well, that was a terrible 211 1 2 Q & A - Session 2 CHAIRMAN ANGELIDES: Well, I actually 3 think, I take a different few, if you look 4 at OFHEO's reports, which we've had access 5 to, they raised a number of issues. 6 But moving on from that, you said the 7 ratings business was a wonderful business. 8 You said that, as a matter of fact, 9 because it's a duopoly, little capital 10 required, enormous pricing power, turned 11 out to be good for a short time, not 12 necessarily, I think, the model that works 13 best for the marketplace. 14 But I want to return to this matter 15 of corporate governance and 16 accountability. 17 You are the largest shareholder, and 18 I realize by all accounts, you were not a 19 particular -- in fact, you described it 20 as, "not particularly active would 21 probably be too aggressive." 22 infrequent contact, I think only twice 23 with Mr. McDaniel, and maybe a little with 24 Mr. Rutherford during the years he would 25 come to visit you. You had very 212 1 Q & A - Session 2 2 But I want to probe the 3 responsibility of shareholders. 4 a company where 50.5 percent of the shares 5 I think are held by five large owners. 6 You had this tremendous spike in revenues 7 coming from structured products. 8 heard today from, and in the course of our 9 interviews, a lot of concerns about the This was We've 10 change in culture at Moody's, the pressure 11 for profits, sacrificing ratings quality. 12 I guess I would ask, what do you 13 think are the appropriate roles of 14 shareholders and boards of directors in 15 monitoring companies? 16 to kind of look into the culture problems 17 that are arising, and did the board and 18 the shareholders do what they should have 19 done in this respect? 20 MR. BUFFETT: What responsibility Yes, I -- in 2006, I 21 was not sitting there thinking that the 22 housing bubble was going to get as large 23 as it did, or as it was, actually, and 24 that it was going to burst. 25 say, if I had, I probably would have sold And like I 213 1 2 Q & A - Session 2 my stock. 3 CHAIRMAN ANGELIDES: So I want to 4 keep at this a little. I mean, given the 5 dramatic consequences that have happened 6 here, and I do think there has been 7 reputational damage. 8 famously said, "It takes twenty years to 9 build a reputation, five minutes to ruin I think you once 10 it. 11 something like, "You'll do things 12 differently." 13 If you actually think about that," I guess the question is, in the end 14 here, the ratings were wrong. 15 reputational issues. 16 massive loss of shareholder value and the 17 whole business model has come apart. 18 mean, should there be a new board, should 19 there be new management after this kind of 20 change? 21 MR. BUFFETT: There are There's been a I I would say that in 22 this particular case, I think they made a 23 mistake that virtually everybody in the 24 country made. 25 OFHEO report, March 30th of 2007, it was And going back to that 214 1 Q & A - Session 2 2 reported the enterprise's overall asset 3 quality is strong. 4 2007, and all they owned was mortgages. 5 That was March of CHAIRMAN ANGELIDES: Well, I will 6 just say, arguing with you about what the 7 markets were saying, I mean, this was not 8 a big secret. 9 the fall shows housing prices falling like This is The Economist after 10 a brick. 11 Even Moodys.com, Mr. Zandi is a very 12 capable man. 13 There were a lot of warnings. So I guess you're saying the 14 magnitude of the mistakes doesn't in the 15 end warrant change the management, relook 16 at the culture of the corporations? 17 MR. BUFFETT: It's not necessary, and 18 incidentally, I don't think The Economist 19 wrote an article called "Before the Fall." 20 CHAIRMAN ANGELIDES: This was 2005. 21 All right. 22 one last question of you, Mr. Buffett, and 23 then back to both of you very quickly. 24 We interviewed a member of the 25 Let me move on and ask this Moody's board, Nancy Newcomb, who 215 1 Q & A - Session 2 2 indicated the board wasn't particularly 3 involved, and didn't discuss significant 4 issues like the ratings process. 5 was a recent press account, I think in the 6 McClatchy newspapers, about the 7 disengaged nature of the board, but also 8 said that two senior executives approached 9 you with significant problems at the 10 company? 11 MR. BUFFETT: 12 CHAIRMAN ANGELIDES: 13 MR. BUFFETT: 14 CHAIRMAN ANGELIDES: 15 There No. No? No. Okay, so not accurate. 16 MR. BUFFETT: No. 17 CHAIRMAN ANGELIDES: Okay, thank you. 18 I want to talk to both of you about the 19 model for credit rating agencies in the 20 context of this marketplace. 21 me there are, you know, the worst of many 22 worlds here. 23 by its nature that creates pressure to 24 produce credit ratings that serve the 25 interest of the issuer, not the It seems to You have an issuer-pay model 216 1 Q & A - Session 2 2 beneficiary of those. 3 Munger has said, I think, as you know, 4 "Whose bread I eat, his song I sing." 5 I've seen him say that a number of times. 6 In fact, Charlie You have a duopoly with enormous 7 pricing power. 8 also, business has had a whole set of 9 legal protections, including First 10 And in the end, you have Amendment protections. 11 It seems to me like a pretty toxic 12 brew of corporate non-responsibility here. 13 Do you think radical surgery is necessary? 14 For example, Mr. Buffett, do you think we 15 ought to outlaw the issuer-pay model, do 16 you think we ought to adopt the Franken 17 positions in the Senate bill that would 18 say that rather than issuers selecting 19 rating agencies, they should be selected 20 by the SEC? 21 What kind of radical surgery might 22 have, had it been performed early enough, 23 might have helped in the sense that these 24 rating agencies would not have enabled 25 this flood of toxic mortgage securities? 217 1 2 Q & A - Session 2 MR. BUFFETT: Well, as Chairman of 3 Berkshire, I hate issuer pay. 4 pay a lot of money and we have no 5 negotiating power. 6 CHAIRMAN ANGELIDES: I mean, we As treasurer of 7 the State of California, I deeply resented 8 the model myself. 9 MR. BUFFETT: It makes for a 10 wonderful economic model for the business 11 but, as a practical matter, I have no 12 negotiating power. 13 rating, I need a Standard & Poor’s rating. 14 I need both of them. 15 many cases by the rules under which our 16 life insurance company operates or our 17 property/casualty companies. 18 I need a Moody's It's required in So if they say to me, "My bill is a 19 billion dollars," and I say, "Gee, you 20 know, I'd like it to be nine hundred 21 thousand or I'll go down the street," 22 essentially there is no "down the street." 23 Now, that's the nature of it. 24 25 Now, if you go to something other than user pay, it gets very tricky because 218 1 Q & A - Session 2 2 who am I, you know, if my daughter is 3 going to buy a ten thousand dollar 4 municipal bond, is she going to pay for a 5 rating for somebody? 6 rating someplace, or it will be published 7 in some book and -- 8 9 No, she'll hear the CHAIRMAN ANGELIDES: United Labs. But UL does it. That's a nonprofit model. 10 So you don't have the profit pressure. 11 Consumer Reports does it. 12 broken model? 13 MR. BUFFETT: Is this a Well, if Consumer 14 Reports would want to rate bonds and 15 people would accept those ratings, I 16 suppose it could happen. 17 require a pretty fair expenditure of money 18 to rate thousands of municipalities and 19 thousands of corporations, so I'm not 20 arguing that this is the perfect model. 21 I'm just saying it's very difficult to 22 think of an alternative where the user 23 pays. 24 25 But it would I'm not going to pay. CHAIRMAN ANGELIDES: What about selection of raters by other than the 219 1 2 3 Q & A - Session 2 issuers, for example, by a panel? MR. BUFFETT: Well, in effect, you've 4 got selection now by directive. 5 effect, I am told by the Nebraska 6 Insurance Department, you know, which 7 raters I have to use in terms of 8 establishing -- 9 CHAIRMAN ANGELIDES: And in Well, what about 10 that is a change? 11 obviated some problems? 12 and might it have obviated some problems? 13 MR. BUFFETT: Might that have Should it be done I don't know the answer 14 to that. 15 out raters, you know, is that going to be 16 perfect? 17 The wisdom of somebody picking I don't know. MR. McDANIEL: Well, there are 18 several alternative business models that 19 rating agencies operate under. 20 largest rating agencies you were under an 21 issuer-pays model, and I think it's 22 important for us to acknowledge and 23 recognize that any business model in which 24 the fee payer has an interest in the 25 outcome is a model that has potential The 220 1 Q & A - Session 2 2 conflicts of interest and that those 3 conflicts must be managed transparently 4 and properly. 5 CHAIRMAN ANGELIDES: But can they 6 really -- you know, if Fannie Mae and 7 Freddie Mac, since you raise OFHEO, here 8 are institutions that had this push-pull. 9 They had, you know, the mission but also 10 the profit motive. 11 pretty powerful, both on the issuer side 12 and in terms of your business model. 13 it really be overcome? 14 to say -- it's like transparency. 15 Everybody loves transparency. 16 they also say, "We can handle our 17 conflicts." 18 Because it doesn't appear to have been, 19 based on this latest period. 20 The profit motive is Can I mean, it's nice And then Is it really resolvable? MR. McDANIEL: Well, the poor 21 performance of ratings from the 2006-2007 22 period in residential mortgage-backed 23 securities and other related securities, 24 housing-related securities, has not at all 25 been replicated elsewhere in the business. 221 1 Q & A - Session 2 2 So to the extent that there is a concern 3 that we cannot have superior ratings 4 quality, even in the midst of a severe 5 economic downturn, I think is a 6 misunderstanding. 7 the parties that are willing to pay fees 8 for ratings, whether it be issuers or 9 investors or governments, have an interest And as I said, because 10 in the outcome of those ratings, I don't 11 see how to avoid potential conflicts of 12 interest. 13 And we also, under the issuer-pays 14 model, have an important public good that 15 is produced, which is the ratings are made 16 available to the general public for free. 17 There is no selective disclosure of 18 the ratings. 19 have an advantage over smaller 20 institutions or individuals in terms of 21 the access to the ratings. 22 that's an important public benefit. 23 Large institutions do not CHAIRMAN ANGELIDES: And I think But I want to 24 probe this because this goes to 25 management. This structured products 222 1 Q & A - Session 2 2 division was a cash cow. I mean, this is 3 a classic case of, if it's growing like a 4 weed, maybe it's a weed. 5 about a hundred some million dollars in revenue this 6 section to 700 million, and there are 7 questions about whether you staffed up 8 enough to do it. 9 your revenues. You went from It became 53 percent of I mean, it became a huge 10 part of your business, so to say, "We did 11 fine, we just missed here," I mean, the 12 miss was huge. 13 downgrade. 14 in the class gets ten percent on the exam. 15 It seems to me that the resources were not 16 applied to understand these products. 17 I mean, 90 percent I mean, even the dumbest kid I happen to come from the real estate 18 business. I asked your folks earlier 19 today, did you actually have due diligence 20 teams that went to the ground to places 21 like Riverside or Bakersfield or 22 Sacramento where I'm from, and take a look 23 at the borrowers, the nature of the home 24 markets. 25 in the capacity from a management It doesn't seem to me you built 223 1 Q & A - Session 2 2 standpoint to really do structured 3 products well. 4 I mean, this was a huge new industry 5 that yes, brought in revenue but it 6 doesn't seem to me from a pure management 7 perspective -- and you miss my point, 8 Mr. Buffett, it wasn't just a mistake -- 9 that the resources to understand this were 10 11 put in place. We've spent countless hours here 12 trying to understand the modeling and the 13 truth is, if you look at the modeling, 14 data was put in that was relatively, 15 frankly, incomplete, inadequate. 16 was a lot of human judgments but there 17 wasn't a lot of ground-level due 18 diligence; in fact, none other than visits 19 to originators. 20 There So isn't that a significant 21 management failure, to not have built in 22 the capacity? 23 less had you been truly on top of this in 24 terms of understanding the products? 25 Might you have missed this MR. McDANIEL: I think that we 224 1 Q & A - Session 2 2 certainly believed we were on top of this 3 and we believed that the information that 4 was being made available was adequate. 5 There are other parties in the marketplace 6 who have other roles and responsibilities 7 with respect to valuation of properties 8 and review of mortgage applications. 9 we are analysts. 10 11 So We consume that information. We believe our role is to look at the 12 information and look at the data and 13 process that as part of our rating 14 committee analytical process, not to 15 replicate or duplicate roles that others 16 in the market -- 17 18 19 CHAIRMAN ANGELIDES: Which they didn't do. MR. McDANIEL: It would appear that 20 in some cases they did not. 21 CHAIRMAN ANGELIDES: They didn't, 22 they didn't have fraud protection. 23 Underwriting standards went to hell in 24 hand basket. 25 Mr. Buffett, any observations on 225 1 Q & A - Session 2 2 whether this was just a pure modeling 3 mistake or whether in fact it was also a 4 lack of attention in terms of the depth of 5 due diligence? 6 something? 7 just -- you're a big advocate, "Do your 8 own due diligence." 9 10 I mean -- can I say You're a big advocate, let me MR. BUFFETT: Absolutely. CHAIRMAN ANGELIDES: So here you have 11 an entity that's a surrogate due diligence 12 provider in a sense, and, you know, even 13 whether people fully rely, having looked 14 at real estate investments, you can ask a 15 third party. 16 outsource due diligence, you would hope 17 your due diligence entity would be doing 18 due diligence. 19 shouldn't they have done actual 20 ground-level due diligence, sipping those blizzards 21 at a Dairy Queen, rather than just looking 22 at the revenues? 23 MR. BUFFETT: But if you're going to Shouldn't rating agencies, Looking back, they 24 should have recognized. But like I say, I 25 didn't recognize it, and most everybody I 226 1 Q & A - Session 2 2 know didn't recognize it. They should 3 have recognized that this was a huge 4 bubble. 5 something in the model, and I may be wrong 6 on this, that there wouldn't be a 7 correlation throughout the country of the 8 same experience. 9 the past, you'd have housing booms And as I understand it, they had And it's true that in 10 someplace that have been sort of 11 localized; but this was a nationwide 12 bubble, and diversification among states 13 didn't really make that much difference. 14 It was worse to be Nevada and Arizona and 15 Florida, but it happened everyplace. 16 CHAIRMAN ANGELIDES: '91 to '93, we 17 had actual national two percent decline in 18 house prices because of the big drops in 19 places, and you know there is that old 20 line, you know, one rotten apple can spoil 21 the bunch. 22 half the apples may have been rotten. 23 mean, the correlation assumptions I think 24 were not very well defined or thought out. 25 And this was an instance where I All right, I've asked you plenty for 227 1 Q & A - Session 2 2 right now. 3 Vice-Chairman. 4 Let's move on to the Thank you very much. VICE-CHAIRMAN THOMAS: Thank you, 5 Mr. Chairman. 6 notwithstanding the subpoena, I want to 7 thank you for coming. 8 9 10 11 Now, Mr. Buffett, MR. BUFFETT: I want to thank you for the subpoena. CHAIRMAN ANGELIDES: I wanted you to have a framed copy for your wall. 12 MR. BUFFETT: It's already up. 13 VICE-CHAIRMAN THOMAS: I think it was 14 good cover, because then you can tell 15 others that you don't want to go to, "If 16 you've got the power, use it." 17 18 19 MR. BUFFETT: I admire that sort of instruction. VICE-CHAIRMAN THOMAS: I also don't 20 have anything for you to sign. But when I 21 was younger, when Monday Night Football 22 began, Don Meredith and Howard Cosell were 23 the team and Don Meredith would launch in 24 at least once a game with the, "If 'ifs' 25 and 'buts' were candy and nuts, we would 228 1 Q & A - Session 2 2 all have a merry Christmas." And at this 3 point, I'm not interested in going after 4 the 'ifs' and 'buts' because there were 5 plenty to go around. 6 supporter and have tried to maintain the 7 argument that behavior has consequences. I am a very strong 8 You can do it when your ability to 9 threaten someone with something, either as 10 an incentive or as a negative, can 11 influence that behavior. 12 concerned about the amounts of money that 13 were generated in a structure that 14 provided those short-term opportunities, 15 and no long-term downside, and apparently 16 no moral angst over having done it. 17 there is to a degree, I think, an argument 18 that this is basically, you know, 19 somebody's idea of unfettered capitalism 20 to a very great extent. But I am very And 21 You've made comments in that regard. 22 How concerned are you that we're able to 23 get this genie back in the bottle to the 24 point that if behavior has consequences, 25 you want to claw back monies that they 229 1 Q & A - Session 2 2 have? 3 put that structure in place. 4 feel? 5 I don't see anybody being able to MR. BUFFETT: How do you I think it can be put 6 in place but it requires a whole new level 7 of thinking. 8 absolutely right. 9 behavior and when you run a huge financial 10 institution whose stability or instability 11 can affect the entire society, I think 12 there ought to be a tremendous downside. 13 It's fine if there's a tremendous upside, 14 too. 15 But I think you're That incentives affect I don't have a problem with that. But I think that for somebody's -- if 16 somebody's personal equation as CEO of 17 some large financial institution is that 18 if they ruin the place, they walk away 19 with a hundred million instead of five 20 hundred million, and if they succeed, 21 maybe they get a billion, I think that is 22 a crazy structure. 23 boards of directors should not sign on to 24 such a structure, and I think that the 25 boards themselves should bear heavy And I think that 230 1 Q & A - Session 2 2 penalties when an institution has to go to 3 the federal government, and I think that 4 that should not be insurable. 5 So it wouldn't be as Draconian as I 6 have with the CEO, but I would want to 7 focus the attention of somebody running a 8 huge financial institution on the fact 9 that their mistakes could cause big 10 problems for the society. 11 VICE-CHAIRMAN THOMAS: Thank you. I 12 thought I got out of the business. I did 13 32 years and I didn't think I was going to 14 be back on this side of the desk asking 15 questions of witnesses again. 16 yes to this because of the way this 17 Commission has been structured. 18 basically my belief that it's just pure 19 public service. 20 the Congress to structure us not to look 21 for answers to those 'ifs' and 'buts' in 22 terms of projecting forward what we ought 23 to do, because frankly, Congress is trying 24 to address those, and I'll have a question 25 on that in a moment. But I said It's I thought it was wise of But our job is just 231 1 Q & A - Session 2 2 basically to try to explain the financial 3 crisis and do it as accurately as we're 4 able with the resources that we have. 5 So one of the reasons I was pleased 6 to have, notwithstanding the subpoena, the 7 coincidence of you being in New York and 8 our desire to be in New York to have you 9 in front of us, so that I would hope that 10 the answer that you would give me to your 11 question isn't the one that virtually 12 everyone else has given, because it's not 13 unlike the behavior and the consequences. 14 The answer is, "somebody else." 15 And given your reputation, but 16 frankly, reputations are only as good as 17 your balance sheet, you've got a really 18 good reputation in terms -- 19 20 21 MR. BUFFETT: I'll settle for that definition. VICE-CHAIRMAN THOMAS: -- in terms of 22 understanding how things work. 23 estimation, I don't want to drag us 24 through this business of woulda, coulda, 25 shoulda, ifs and buts. We have In your 232 1 Q & A - Session 2 2 legislation moving through the House and 3 Senate that hasn't gone to conference yet 4 and isn't locked up, and I have kind of 5 preached to anyone who wants to hear that 6 committees have such narrow jurisdiction 7 that you're not going to be able to solve 8 the fundamental problems, whatever they 9 are, as we examine them, with a single 10 bill that's principally gone through two 11 committees that have roughly the same 12 jurisdiction. 13 hit it. 14 You're just not going to So what I would like you to do, and I 15 would ask both of you that if the 16 Commission provides you questions in 17 writing, would you be willing to answer 18 them, because we do not have the ability 19 in the time we have to get to what we need 20 to do. 21 Mr. Buffett, would you be willing to do that? MR. BUFFETT: Sure, I would be 22 willing to do that. And incidentally, I 23 did have a very good session with your 24 staff that was recorded for two hours 25 and -- 233 1 2 Q & A - Session 2 VICE-CHAIRMAN THOMAS: 3 that and we read it. 4 MR. BUFFETT: And we have I really think they did 5 a good job of asking both good questions 6 and good follow-up questions. 7 hope some of the material might be in that 8 record. 9 10 VICE-CHAIRMAN THOMAS: So I would And we're reviewing it to make sure it is. 11 12 MR. McDANIEL: Yes, we would do so also. 13 VICE-CHAIRMAN THOMAS: What do you 14 think the House and the Senate has gotten 15 mostly right in the legislation that's 16 moving through Congress, and where, if 17 there are obvious misses? 18 we need to deal with subtleties now. 19 might be in some follow-up written 20 questions. 21 22 23 MR. BUFFETT: I don't think It I haven't read the 1,500-page bill -VICE-CHAIRMAN THOMAS: No one has, 24 including some of the cosponsors of that. 25 That's a denial that's okay. 234 1 2 Q & A - Session 2 MR. BUFFETT: Okay. But I've got two 3 thoughts basically. I think I would 4 address if I were -- one is this question 5 of incentives. 6 important -- I think it's -- I think no 7 one has any business running a huge 8 financial institution unless they regard 9 themselves as the chief risk officer. I mean, I think it is very 10 They are responsible for the ship. And if 11 they aren't, they should be willing to 12 take that on or somebody else should be in 13 that position. 14 huge downside for the CEO and significant 15 downside for the board if government help 16 is required. So I think there has to be 17 The second thing I think is that part 18 of any huge bubble is excessive leverage. 19 And it's very hard to define leverage, 20 because you're going to have some 21 institution that's ten for one and their 22 assets are all treasury bills and it 23 doesn't make any difference, and you can 24 have somebody that's three for one and it 25 can be all second mortgages and you've got 235 1 Q & A - Session 2 2 lots of trouble, so it's not easy to 3 define. 4 But the size of the pop of the bubble 5 was accentuated in an enormous way because 6 of the leverage that existed in the system 7 and some of it was hidden, you know, 8 off-balance-sheet type things. 9 I would -- those would be two points I 10 would try very hard to address 11 intelligently. 12 VICE-CHAIRMAN THOMAS: And -- but Thank you. 13 Mr. Chairman, did you want to ask a 14 question? 15 CHAIRMAN ANGELIDES: Yes, just one on 16 the kind of incentives, upside and 17 downside, and I do want to just return, 18 because you've talked about financial 19 institutions. 20 But the very structure, again, of 21 credit rating agencies, it does seem in 22 the end, there's lots of upside, you know, 23 as a structured product business group, 24 very little downside. 25 protections -- and by the way, I think Legal 236 1 Q & A - Session 2 2 there's a fine distinction between 3 financial institutions that receive 4 federal money -- 5 MR. BUFFETT: 6 CHAIRMAN ANGELIDES: I do, too. -- and, I might 7 add, a credit rating agency that's a full 8 participant in the system that got us 9 there. 10 11 12 13 14 So wasn't this system tilted in terms of lots of upside and no downside? MR. BUFFETT: I think much of corporate America is tilted that way. CHAIRMAN ANGELIDES: But you'd say 15 that applies to credit rating agencies -- 16 I know you're an owner, but come on. 17 MR. BUFFETT: We've seen significant 18 downside. 19 that the mistakes that were made at 20 Moody's and Standard & Poor’s are have 21 affected both Moody's stock and 22 McGraw-Hill stock in a big way. 23 I mean, there's no question VICE-CHAIRMAN THOMAS: I have no 24 right to ask you this, but just as the 25 rating agencies produced whatever a 237 1 Q & A - Session 2 2 AAA was, and then investment banks and 3 others were able to take the leftovers, 4 restructure them and turn them into more 5 AAAs rated by an agency, you really need 6 to speak out even more than you have about 7 fundamentals. 8 people who can command the respect, and I 9 know you were really busy out there on a There are aren't very many 10 chair in front of a number of different 11 channels. 12 this. 13 But you've got to do more of This may be your real legacy. MR. BUFFETT: Well, I've spoken out 14 on some things, but I don't disagree with 15 you that perhaps no one spoke out enough, 16 you know, in the past years, during the 17 bubble. 18 more. 19 up for me. 20 agree with you, Mr. Thomas. 21 But certainly, I could have done My partner, Charlie Mungers, makes He speaks very loudly. VICE-CHAIRMAN THOMAS: But I Because once 22 Congress acts, the ability, as you well know, to act again, 23 to move into areas they weren't able to 24 initially, political becomes virtually 25 impossible. You only try to clean up the 238 1 2 3 Q & A - Session 2 area that you moved with first. This isn't nearly as comprehensive as 4 it needs to be. 5 to tort and other areas. 6 turn my time over to others who might want 7 to quiz you from a very particular point 8 of view. 9 It may even need to move So I'm going to Mine is simple. Capitalism has changed in your 10 lifetime. And my concern is that in those 11 who are watching, it gets better. 12 means responsibility, moral obligation, 13 and behavior has consequences. 14 MR. BUFFETT: 15 CHAIRMAN ANGELIDES: Which Thank you. Thank you. All right, thank 16 you very much, Mr. Thomas. 17 going to move to Senator Graham and yes, 18 wheel the chart. 19 20 COMMISSIONER GRAHAM: We're now Thank you very much, Mr. Chairman. 21 CHAIRMAN ANGELIDES: 22 COMMISSIONER GRAHAM: Microphone? Thank you very 23 much, Mr. Buffett and Mr. McDaniel for 24 your insightful comments. 25 Mr. McDaniel, you said that Moody's 239 1 Q & A - Session 2 2 had incorporated the research into its 3 rating process. 4 5 The chart that's about to be placed -- 6 CHAIRMAN ANGELIDES: Can we please 7 place it where we placed it before, Karen, 8 so we do not obscure Commissioners? 9 if you have to move the chairs, move the 10 chairs. Stop the clock. 11 should charge the Senator for this. Even though we 12 (A pause in the proceedings.) 13 CHAIRMAN ANGELIDES: 14 15 And All right, move on. COMMISSIONER GRAHAM: This chart 16 indicates the mountain of RMBS securities 17 that were rated by Moody's as the blue, 18 and the red are the CDOs and then in 19 yellow boxes are some important events. 20 The first of the yellow boxes is in 21 October of 2006 when, for instance, on the 22 CDO line, it was something south of ten 23 billion dollars issued. 24 Research Service issued a report, the 25 first paragraph, the executive summary When Moody's 240 1 Q & A - Session 2 2 saying, "The U.S. housing market downturn 3 is in full swing; new and existing home 4 sales and single-family housing 5 construction are sliding, inventories of 6 unsold homes are surging to new record 7 highs, house prices are falling in an 8 increasing number of areas," and the word 9 "crash" is used to describe the situation, 10 in areas of the country which represented 11 about half of the outstanding mortgages. 12 How was that information incorporated 13 into the subsequent rating processes of 14 Moody's? 15 MR. McDANIEL: The Moody's analysts 16 and Moody's rating committees have 17 information from other parts of Moody's as 18 well as information from other firms, and 19 governmental services available to 20 include in their rating committee 21 deliberations and their analysis. 22 they do use multiple sources of 23 information, including a source from 24 Moodyseconomy.com. 25 COMMISSIONER GRAHAM: So, and Recognizing 241 1 Q & A - Session 2 2 that this internal document, as well as 3 external information is available, the 4 question is how, in October of 2006, was 5 this incorporated into the rating process? 6 7 8 9 MR. McDANIEL: I don't know exactly how it was used in the rating committees. COMMISSIONER GRAHAM: The concern is that, immediately after that dire 10 prediction was issued, the number of CDOs 11 went from $10 billion a month to over $40 12 billion a month in less than ninety days. 13 It doesn't seem as if the announcement of 14 severe problems correlated with the 15 actions that were taken. 16 MR. McDANIEL: I believe that the 17 rating committees would include any 18 information that they believe relevant in 19 their deliberations. 20 COMMISSIONER GRAHAM: Could you, as a 21 follow-up, give us some more specific 22 information as to what did in fact happen 23 in terms of incorporating this research 24 into the rating process in October of 25 2006? 242 1 Q & A - Session 2 2 MR. McDANIEL: Yes. 3 CHAIRMAN ANGELIDES: On my time, 4 could I just amplify that? 5 came from obviously, Moody's.com, 6 Mr. Zandi and his team, very well 7 respected. 8 9 Because this Could you, as part of that, actually do a chronology of what management did 10 very specifically, how folks reacted to 11 that report, because it's pretty dramatic. 12 It uses the words, "The market is going to 13 crash in 20 metropolitan areas." 14 So if you could give a very specific 15 timeline about who did what when, from the 16 top levels on down. 17 MR. McDANIEL: I will do that, and I 18 should just add that I believe at this 19 time, even with the analysis that 20 Moodyseconomy.com was producing, their 21 expectations were far more moderate in 22 terms of what was going to happen in the 23 housing market than what in fact has 24 eventuated. 25 that there's no misunderstanding in the So I just want to make sure 243 1 Q & A - Session 2 2 degree of downturn that they were 3 expecting at that time compared to what 4 we've seen. 5 COMMISSIONER GRAHAM: One of my 6 concerns which is not peculiar to the 7 financial industry or to rating agencies 8 but seems to be endemic across our 9 culture, is the avoidance of warning signs 10 until the situation degenerates into a 11 catastrophe; whether it's the failure to 12 see the consequences of new technologies 13 in deep water petroleum extraction but not 14 changing safety and response capabilities, 15 or some of the signs that have led to the, 16 now, the financial collapse. 17 The first panel made up of people who 18 all had experience at Moody's gave a 19 number of reasons why these warning 20 signals were not acted upon. 21 included the desire to increase market 22 share, the lack of ability to walk away 23 from a deal, the lack of human resources 24 to keep pace with the rapid increase in 25 the number of CDOs that were being Those 244 1 Q & A - Session 2 2 evaluated, the lack of adequate 3 independent research capabilities, the 4 fact that the banks were misleading the 5 rating agencies, manipulating the process. 6 Those were some of the items that were 7 listed. 8 9 Do you concur with that list and are there other items that you would add to 10 the list of why were the warning signs 11 missed? 12 MR. McDANIEL: There were some things 13 that I would concur with, and other things 14 that I would not. 15 that I think are important, first of all, 16 we agree that having a robust, independent 17 research and credit policy function is 18 important, and we have made changes in 19 both the number of individuals and the 20 independence of the credit policy function 21 over the past three years. 22 And to highlight two COMMISSIONER GRAHAM: Excuse me, 23 could I ask, one other issue was the fact 24 that the committees that were doing the 25 rating seemed to be devoid of people 245 1 Q & A - Session 2 2 either from the real estate industry or 3 from the banking industry, and therefore 4 had little personal capacity to evaluate 5 what was happening in those areas. 6 Have you taken some steps to broaden 7 the pool of background on the rating 8 committees? 9 MR. McDANIEL: That, again, in the 10 category of lessons learned, greater 11 cross-disciplinary expertise in rating 12 committees, I think, is important, and we 13 have made important strides in 14 accomplishing that. 15 made very good progress. 16 COMMISSIONER GRAHAM: And I think we've Could you give 17 us some information on that subject, that 18 we asked the first panel for, what was the 19 status of those rating committees during 20 the period of '05 forward. 21 MR. McDANIEL: Yes. With respect to 22 being unwilling for walk away from a deal, 23 I believe was one of the comments that you 24 had related, I simply disagree with that. 25 We did not rate hundreds, probably 246 1 Q & A - Session 2 2 thousands of residential mortgage-backed 3 securities tranches, particularly the 4 junior securities. 5 at them, our opinions were not such that 6 the issuers wished to have those opinions, 7 and we did not rate those. 8 9 Even though we looked We have sat out entire market sectors for credit reasons where we have credit 10 concerns. 11 quality is paramount. 12 it right. 13 uncertain process. 14 think that there has been a 15 misunderstanding of our willingness to 16 stay out of markets where our credit 17 opinions are more conservative or we have 18 credit concerns. 19 And that is because the ratings We don't always get Predicting the future is an But I think that -- I COMMISSIONER GRAHAM: What about this 20 issue of misleading or manipulative 21 activities by banks? 22 MR. McDANIEL: Well, certainly, if 23 we're aware of anything that is misleading 24 or manipulative, we would not use that 25 information nor pursue rating a 247 1 Q & A - Session 2 2 transaction with an institution that's 3 providing that. 4 COMMISSIONER GRAHAM: Well, the 5 testimony that we had was that the banks 6 would not disclose information which was 7 requested and the analysts didn't feel 8 that they could push back against the 9 banks to make that a requirement of their 10 11 issuing the rating. MR. McDANIEL: Our methodologies are, 12 I believe, clear in terms of the 13 information that we need to rate an 14 instrument. 15 that information consistent with our 16 methodologies. 17 information that would be interesting to 18 review which may or may not have an 19 influence on our thinking on credit. 20 And I believe that we pursued There may be additional But certainly, we would look to have 21 all of the information that is consistent 22 with our methodological approach. 23 COMMISSIONER GRAHAM: Mr. Buffett, 24 this is a broader question. But I know 25 you have an excellent reputation of being 248 1 Q & A - Session 2 2 the risk manager for your firm and that 3 you feel, as you've said today, that you 4 feel that's a principal responsibility of 5 the CEO. 6 Why do you think that, as a society, 7 we seem to have missed so many signals 8 across a range of areas? 9 MR. BUFFETT: Well, rising prices and 10 discredited Cassandras from the past blunt 11 sensitivities and judgment, even of 12 people who are very smart. 13 initially, my old boss, Ben Graham, used 14 to say, "You get in much more trouble in 15 investments with a sound premise than a 16 bad premise, because the bad premise you 17 recognize immediately doesn't make any 18 sense." 19 I mean, When you have a sound premise, 20 namely, the Internet is going to be very 21 important and eyeballs are going to be 22 important and all of that, initially, it 23 makes a lot of sense. 24 rising prices of all internet stocks 25 caused people to be able to raise billions After a while, the 249 1 Q & A - Session 2 2 of dollars for things that are 3 nonsensical. 4 A home is a sound investment. I 5 mean, 66 or 67 percent of the people are 6 going to want to be in one. 7 believe house prices are going to go up 8 next year, you're going to stretch to buy 9 one this year, and the world enabled 10 11 And if you people to stretch. After a while, rising prices became 12 their own rationale and people decided, if 13 buying one house was a good idea, buying 14 three houses was a good idea. 15 house you can afford is a good idea, 16 buying a house you can't afford is a good 17 idea because it's going to go up in price. 18 If buying a And people who lent money said, "It 19 doesn't really make any difference whether 20 the guy is lying about his income, because 21 in the house goes up in price, we'll get 22 our money back anyway." 23 So rising prices are a narcotic that 24 affect the reasoning power up and down the 25 line, of people, even, that should have 250 1 2 3 Q & A - Session 2 had the experience. Isaac Newton participated in the 4 South Sea Bubble originally, got out, and 5 then he couldn't stand prices going up any 6 longer, so he went back in and got 7 cleaned, you know. 8 that generally was regarded as being 9 pretty bright. And this is a fellow So it, rising prices are, 10 eventually, we had it in farmland in the 11 Midwest and it was a worse recession for 12 us than this housing recession, because 13 people just felt, they are not making any 14 more farmland, there are going to be more 15 people, they're going to eat more, 16 farmland's going to get more productive, 17 and the rising prices eventually created 18 their own -- their own destruction. 19 CHAIRMAN ANGELIDES: On my time, just 20 quickly, okay, it's a narcotic, but don't 21 we expect that regulators, credit rating 22 agencies, not partake of the narcotic? 23 Isn't that their role? 24 25 MR. BUFFETT: Well, you would hope so, but it's not easy to avoid. 251 1 2 Q & A - Session 2 CHAIRMAN ANGELIDES: Well, still, you 3 don't want your police trading in crack. 4 You want them stepping back. 5 MR. BUFFETT: Yeah, and we had 6 Chairman Greenspan talk about irrational 7 exuberance in 1996. 8 the power of his podium and everything 9 else, we had a great internet boom after 10 11 But with all -- with that that was -CHAIRMAN ANGELIDES: That was the 12 nature of my questions about who's 13 responsible; regulators, shareholders, 14 boards, management? 15 I'll turn it back to the Senator. 16 17 18 Someone must be. COMMISSIONER GRAHAM: I want to ask a different question, Mr. McDaniel. During this period of the last five 19 years, how frequently did representatives 20 of various regulators, from financial 21 institution regulators to the SEC, visit 22 Moody's to talk about your rating 23 methodology and to inform themselves as to 24 what it was that you were doing? 25 the ones who have imposed regulations They are 252 1 Q & A - Session 2 2 requiring the use of your rating services. 3 How close a supervision or at least 4 monitoring of activities did they 5 maintain? 6 MR. McDANIEL: Pursuant to the Credit 7 Rating Agency Reform Act of 2006, which 8 became effective in, I believe it was 9 September of 2007, there's been multiple 10 inspections and reviews of our rating 11 processes and practices by the Securities 12 and Exchange Commission. 13 Prior to that period, the oversight 14 was less intensive because there was not a 15 regulatory framework that the SEC was 16 operating under for an inspection and 17 review regime. 18 COMMISSIONER GRAHAM: Prior to that 19 legislation, are you saying they did not 20 seem to think that they had some 21 responsibility, having mandated or given 22 strong incentives to use the rating 23 agencies' products as part of the 24 management of regulated activities, that 25 they had some responsibility to be aware 253 1 Q & A - Session 2 2 of what that rating constituted and how it 3 was being assumed? 4 MR. McDANIEL: I can't speak for the 5 Commission. 6 regulatory oversight opportunities were 7 more limited prior to the legislation 8 passing, and so they were not as extensive 9 in their oversight of Moody's or the 10 industry. 11 12 COMMISSIONER GRAHAM: Thank you, Mr. Chairman. 13 14 But I believe that the CHAIRMAN ANGELIDES: much, Senator Graham. 15 Thank you very Mr. Wallison? COMMISSIONER WALLISON: Thank you, 16 Mr. Chairman, and thank you both for 17 coming here, even when under compulsory 18 process, but voluntarily still. 19 you. 20 Thank Let me start with you, Mr. McDaniel. 21 You were here this morning for the earlier 22 panel? 23 24 25 MR. McDANIEL: I heard most of the earlier panel, not all of it. COMMISSIONER WALLISON: I just was 254 1 Q & A - Session 2 2 wondering whether you heard anything about 3 your company that was a surprise to you, 4 or you did not know. 5 MR. McDANIEL: The issues that were 6 raised by some of the individuals who were 7 more critical of the company, I have heard 8 before. 9 those issues previously, including through 10 use of an external law firm, and found the 11 concerns that were raised to be without 12 merit. 13 And in fact, we have investigated COMMISSIONER WALLISON: Well, there 14 was this question I thought of enhanced, 15 what you, I think, referred to when you 16 were talking about enhanced analytical 17 integrity. 18 the point that there were pressures, 19 perhaps, on the talent that you had, the 20 analytical talent, to produce ratings. 21 I think you were getting at Is that what you meant by "enhanced 22 analytical integrity?" 23 do to prevent that from happening? 24 25 MR. McDANIEL: And what did you In the context of my prepared remarks, with respect to enhanced 255 1 Q & A - Session 2 2 analytical integrity, I was referring to 3 some of the actions that we have taken 4 since 2007 to separate, for example, our 5 credit policy function from the 6 line-of-business ratings analysts; to have 7 more cross-disciplinary participation in 8 the rating committee process; and to 9 create further separation of any person 10 who is involved in commercial activities 11 for the firm from people who are involved 12 in analytical -- 13 COMMISSIONER WALLISON: Well, let's 14 talk specifically about this one issue, 15 and that is, are analysts now permitted to 16 talk to issuers or the representatives of 17 issuers? 18 19 20 Is that still permitted? MR. McDANIEL: Yes, analyst do speak to issuers. COMMISSIONER WALLISON: And you are 21 not concerned that there are pressures 22 brought on them as academics, or people 23 who are academically inclined, by people 24 who are much more ambitious and forceful? 25 don't see that as a problem? You 256 1 Q & A - Session 2 2 MR. McDANIEL: I think the 3 communication between an issuer of 4 securities and an analyst of those 5 securities is important and should 6 continue. 7 about financial information or management 8 strategy at the issuer, the issuer's 9 future plans with respect to its capital 10 The analyst may have questions structure, et cetera. 11 So I do think those communications, 12 for purposes of creating most predictive 13 credit ratings we can produce, are useful. 14 COMMISSIONER WALLISON: Is there a 15 manager who oversees the analysts and can 16 be available for discussion of these issues? 17 MR. McDANIEL: There are managers who 18 oversee our analysts, yes, and they would 19 be available. 20 COMMISSIONER WALLISON: Let me ask 21 you one final question, a very general 22 one. 23 what caused the financial crisis? 24 25 And that is, what is your view of MR. McDANIEL: In terms of direct causes, certainly the weakening of the 257 1 Q & A - Session 2 2 housing market, the softening of that 3 market. 4 rapid tightening of credit for mortgage 5 borrowers who needed to refinance, in 6 particular, greatly exacerbated the issue; 7 that the sudden tightening of credit in 8 the midst of a softening housing market I 9 think produced the kind of large and rapid 10 11 And then importantly, the very problem that we saw. COMMISSIONER WALLISON: So it's 12 principally a problem of people not being 13 able to finance, refinance, which caused 14 failures? 15 MR. McDANIEL: I think that was an 16 important contributor. 17 catalyst. 18 It acted as a COMMISSIONER WALLISON: Mr. Buffett, 19 we've had housing bubbles before, quite a 20 few, and other kinds of asset bubbles 21 before, most recently an oil price asset 22 bubble. 23 This one was really quite special. I 24 want to press you a little bit on this, 25 because I'd like to get your sense of why 258 1 2 3 Q & A - Session 2 this one was special. Why did it get so large? Why did 4 someone with your astute knowledge about 5 the economy not see that this was an 6 extraordinarily different bubble from one 7 we've had before? 8 9 MR. BUFFETT: Well, I wish I could give you a good answer to that. It was 10 really the granddaddy of all bubbles and 11 it affected an asset class of 22 trillion. 12 I mean, it hit everybody. 13 Mr. McDaniel mentioned people refinancing. 14 I mean, they were betting on the fact that 15 the following year, if they couldn't make 16 the payments, they could refinance. 17 of course, the figures show that by the 18 hundreds and hundreds of billions, that 19 happened. 20 And And But when it gathers momentum, you 21 know, the internet bubble went further 22 than I would have thought it would have. 23 We did have that farm bubble in Nebraska 24 where, you know, things went crazy for a 25 while, and the early Cassandras do look 259 1 Q & A - Session 2 2 kind of foolish as they go along. 3 when your next-door neighbor is making 4 money, you know, very easy, buying a 5 second house, you know, with very small 6 down payment, after a while it sort of gets 7 to you and maybe you figure you should be 8 doing it, too. 9 And It's been the history of bubbles. 10 never understood why tulips were worth 11 what they were, back in -- 12 COMMISSIONER WALLISON: I But for you 13 in particular, and you've had many years 14 to watch our economy, and to economists in 15 general, sharply rising prices are a 16 signal that something is peculiarly going 17 on in the economy. 18 rising very quickly but you still didn't 19 think that this was something that could 20 eventually collapse? 21 MR. BUFFETT: 22 pop like it did, no. 23 enough, in 2005 and '06, and I believe I've 24 got the time period right, I got offered 25 businesses for sale periodically. You saw the prices I didn't think it would Interestingly A 260 1 Q & A - Session 2 2 significant percentage of the 3 publicly-traded home builders one way or 4 another let it be known that they would 5 like to sell out to Berkshire Hathaway, 6 and looking back, I should have figured 7 out what I didn't figure out. 8 9 10 COMMISSIONER WALLISON: Were they asking more than once? MR. BUFFETT: It's interesting, I 11 never heard from them in many decades in 12 business, and all of a sudden, three or 13 four of them showed up on the doorstep. 14 15 COMMISSIONER WALLISON: You were once an owner of Freddie Mac. 16 MR. BUFFETT: Right. 17 COMMISSIONER WALLISON: So you are 18 familiar with how Fannie Mae and Freddie 19 Mac operate. 20 as having any role in the growth of this 21 bubble? 22 Do you see their activities MR. BUFFETT: Well, I think they were 23 doing what they were instructed by 24 Congress to do to a great degree, but I -- 25 they took on weaker forms of mortgages in 261 1 Q & A - Session 2 2 greater amounts. 3 covered in some of the reports. 4 they -- and they also bought, you know, 5 they would require twenty percent 6 down payment but then they would buy 7 mortgage insurance from other entities. 8 9 I mean, that's been And so And I've looked at the profiles of some of those loans, and material I got 10 from the mortgage guarantee organizations. 11 And frequently, the significant percentage 12 of the time, more than fifty percent of 13 the income of the borrower was going to 14 mortgage payments. 15 That's not sustainable. And -- but 16 whereas they are laying that off with the 17 mortgage guarantee insurance company, they 18 were still in effect helping people 19 participate in something that was really, 20 unless housing prices kept going up, was 21 going to lead to big trouble. 22 23 24 25 COMMISSIONER WALLISON: Why did you sell your Freddie Mac stock? MR. BUFFETT: I sold it for several reasons, but I think we were the largest 262 1 Q & A - Session 2 2 shareholders of Freddie Mac. 3 point, it became apparent they were 4 getting more and more entranced by trying 5 to report increased earnings every 6 quarter. 7 that tries to do that, in my view, is 8 going to get in trouble sooner or later. 9 And they became quite interested in that 10 11 And at one And any financial institution particular, having that happen. They also, Freddie, as I remember, it 12 was either RJR bonds or Philip Morris 13 bonds, but they had bought some bonds that 14 had nothing to do with housing at all. 15 And here they were using the government's 16 credit to enlarge the size of this 17 hedge-fund type portfolio, now with some 18 corporate bonds that had nothing to do 19 with housing. 20 And I just figure if you see one 21 cockroach there's probably a lot more in 22 the kitchen. 23 COMMISSIONER WALLISON: Did you 24 follow Fannie and Freddie enough to know 25 that they had affordable housing 263 1 2 Q & A - Session 2 requirements? 3 MR. BUFFETT: Oh, sure, yes. 4 COMMISSIONER WALLISON: And did you 5 know the size of those affordable housing 6 requirements? 7 MR. BUFFETT: Yes, and of course, they are 8 predicated on being able to use the tax 9 credits that were involved, and they set 10 them up as assets on their balance sheet, 11 and of course they have no income now. 12 those became very dubious assets. 13 COMMISSIONER WALLISON: But were you 14 aware, then, that they were buying the 15 kinds of mortgages that they were buying 16 in order to comply with the affordable 17 housing requirements that -- 18 MR. BUFFETT: So Well, I certainly knew 19 that they were -- they were mandated in 20 many of their activities by Congress, no 21 question about that. 22 trying to serve Wall Street, and that's a 23 tough balancing act. 24 25 And they were also COMMISSIONER WALLISON: do I have left? How much time 264 1 2 3 4 Q & A - Session 2 CHAIRMAN ANGELIDES: Four minutes and 51 seconds. COMMISSIONER WALLISON: You are quite 5 famous for saying, among other things, and 6 this isn't the only thing you're famous 7 for, but you said that credit default 8 swaps are financial instruments of mass 9 destruction. And yet it's recently come 10 to light that you actually participate 11 actively in that market. 12 MR. BUFFETT: Yea, I think I actually said 13 derivatives are financial -- potentially, 14 and I think that used improperly, as they 15 almost are certain to be, because of what 16 they provide people to trade in them and 17 what they provide in the way of increased 18 leverage that's not obtainable in other 19 ways, I think that they have, they pose 20 system-wide problems. 21 22 23 COMMISSIONER WALLISON: What do you use them for? MR. BUFFETT: 24 money. 25 buy them. I use them to make If I think they are mispriced, I 265 1 Q & A - Session 2 2 COMMISSIONER WALLISON: 3 credit default swaps or other kinds of -- 4 MR. BUFFETT: 5 credit default swap. 6 default swaps. 7 8 We've sold credit We sell insurance. MR. BUFFETT: We sell insurance, we sell -COMMISSIONER WALLISON: MR. BUFFETT: 14 COMMISSIONER WALLISON: 18 19 20 No. You do not hedge that? 16 17 And then do you lay that off? 13 15 You sell protection. 11 12 No, we've never bought a COMMISSIONER WALLISON: 9 10 But these are MR. BUFFETT: off. No, I never write it We sell insurance. COMMISSIONER WALLISON: like what AIG did. MR. BUFFETT: This is much Didn't they -I don't think it's much 21 like it, but we sell credit insurance. 22 And we sell auto insurance, and AIG sold 23 auto insurance, too. I mean... 24 COMMISSIONER WALLISON: 25 have no further questions. All right, I Thanks very 266 1 2 3 Q & A - Session 2 much. MR. BUFFETT: Could I bring up one 4 point? Because it gets back to a point 5 that was made earlier about the laws 6 getting on the books and never getting 7 changed. 8 1920s, we had a bubble then. 9 stocks and it was partly caused by extreme If you go back to the 19, late It was in 10 margin by people that didn't really know 11 what they were doing, ten percent margins, 12 and they had Commission hearings after 13 that, and they decided that this was a 14 societal problem, and Congress gave to the 15 Federal Reserve the authority to regulate 16 margins, and they said, "this is 17 important." 18 The Federal Reserve still has that 19 authority, as I understand it, you know, 20 70-plus years later. 21 derivatives and total return swaps, at 22 that point you could borrow a hundred 23 percent of what you owned. 24 here with the system -- and I've brought 25 this up a half a dozen times, and What we put into And we sit 267 1 Q & A - Session 2 2 sometimes people in Congress, and I say, 3 "What in the world are we doing when we 4 say the Federal Reserve should have margin 5 requirements," which I believe now are 6 fifty percent, "And you can go and get a 7 total return swap and borrow a hundred 8 percent or you can buy S&P index futures 9 with a tiny percentage down?" 10 11 I mean, it is something that should be addressed. COMMISSIONER WALLISON: I thought 12 your, maybe I've misread this in the 13 newspapers but I thought your problem with 14 some of the legislation that is going 15 through had to do with the fact that you 16 didn't want to put up the collateral which 17 substitutes for the margin. 18 MR. BUFFETT: In terms of -- in terms 19 of contracts that were negotiated several 20 years ago, there was one price for 21 collateralized contracts and another price 22 for uncollateralized. 23 Coca-Cola, Anheuser-Busch, thousands of 24 companies negotiated under that basis. 25 say, if we're required to substitute an And incidentally, We 268 1 Q & A - Session 2 2 uncollateralized contract and make it a 3 collateralized contract, before we send 4 that money to Wall Street, we should get 5 paid for the difference in those two types 6 of contracts because they are two 7 different contracts, just like changing 8 the price or changing the maturity. 9 And there's a very significant 10 difference in price. 11 hundreds of end users would be required to 12 send money to Wall Street firms, contrary 13 to the contract they originally negotiated 14 and contrary to the price differential 15 that existed between those two types of 16 contracts. 17 And not only we, but COMMISSIONER WALLISON: So you don't 18 have any objection to doing it in the 19 future -- 20 MR. BUFFETT: Oh, no, not in the 21 least, I don't -- I just -- I object to 22 selling one kind of a contract and having 23 it changed into another kind of a contract 24 without getting paid. 25 COMMISSIONER WALLISON: Okay, thank 269 1 2 Q & A - Session 2 you. 3 CHAIRMAN ANGELIDES: Thank you very 4 much. 5 you can flip that mike off, thank you. 6 7 Mr. Georgiou and Mr. Wallison, if COMMISSIONER GEORGIOU: Thank you very much, gentlemen, for joining us. 8 I'd like to start with Mr. Buffett, 9 largely because my 90-year-old mother is 10 watching and she'd be very upset with me 11 if I didn't acknowledge your seniority. 12 Here we are. 13 I take it that between AIG's selling 14 of credit insurance and yours is that you 15 charge enough to cover the risk that 16 you're undertaking, is that fair for say? 17 MR. BUFFETT: That's fair to say. 18 But additionally, we only take on risk we 19 can handle ourselves, so we only have 20 about 250 contracts or so, total. 21 everything goes wrong, we can easily 22 handle it. 23 AIG. 24 25 And that was not the case with COMMISSIONER GEORGIOU: not. And if Indeed it was I want to address the general 270 1 Q & A - Session 2 2 question which I've sort of been putting 3 at a lot of these hearings, about how we 4 might restructure the incentives in the 5 market system to try to avoid these market 6 crises in the future. 7 You said, Mr. Buffett, that you liked 8 this business at Moody's, because it had 9 pricing power, it was a natural duopoly. 10 This gentleman Kolchinsky, who testified a 11 little bit earlier today, who was a 12 subordinate of Mr. McDaniel said that, in 13 many ways, the incentives for rating 14 agencies have become worse since the 15 credit crisis. 16 agencies and they are all chasing 17 significantly fewer transaction dollars. 18 The new controls put in place by 19 regulators are too weak to significantly 20 alter this dynamic. 21 There are now more rating And then there's a quote that you 22 also had in your testimony that you gave 23 privately to our team, "Market systems 24 produce strange results in Wall Street. 25 In general, the capital markets are so 271 1 Q & A - Session 2 2 big, there's so much money, that taking a 3 small percentage results in a huge amount 4 of money per capita in terms of the people 5 that work in it, and they are not inclined 6 to give it up." 7 And then one last quote I want to 8 read to you, but I will tell you the 9 quote, "Whenever I hear the terms 10 'modernization' or 'innovation' in 11 financial markets, I reach for my wallet. 12 It's usually, what they mean is 13 revenue-producing." 14 So we've seen a number of things go 15 on in the marketplace. And you've also 16 said that everyone should have a lot to 17 lose in this marketplace. 18 in the securitization process, we've 19 discovered through the course of our 20 hearings that really, almost everybody 21 involved has nothing to lose. 22 mortgage brokers who originate the 23 mortgage get paid a percentage of the 24 mortgage they originate without regard to 25 the consequences if it succeeds or fails. Well, really, The 272 1 Q & A - Session 2 2 The bankers who put the deals together, 3 the mortgage-backed securities, are 4 getting a percentage of the deal. 5 lawyers who write the prospectuses, the 6 auditors, accountants who audit the books, 7 and the credit rating agencies who rate 8 the credits, are all basically paid in 9 cash at the conclusion of the sale of The 10 these securities, really without any 11 significant consequence to whether they 12 actually do what people represent them to 13 do or they fail. 14 And one thought that some people have 15 suggested is that, rather than pay all 16 these market participants in cash, that 17 you might increase the likelihood of 18 diligence being properly done if you paid 19 them in the securities themselves. 20 you're getting, whatever, ten basis points 21 of the dollars, give the security to 22 Moody's, so that you know that you're 23 going to live with that security for a 24 long time. 25 You can bonus the people that did the job So if You're going to be long in it. 273 1 Q & A - Session 2 2 with the same security. 3 they get seven percent interest per year 4 for ten years, then they get their money 5 back. 6 If they succeed, What do you think about that idea? MR. BUFFETT: I like it, or put it in 7 a deferred account and have an index of 8 all the things in which they participated 9 become the index factor that's applied to 10 that deferred account when it's finally 11 paid out at some point. 12 You have to, I think the most can be 13 achieved actually by getting, at the very 14 big institutions, the CEO and the boards, 15 where they've got real downside. 16 But I can tell you, I was at Salomon 17 almost twenty years ago, and trying to put 18 in a new compensation system in Wall 19 Street can be very difficult. 20 COMMISSIONER GEORGIOU: 21 MR. BUFFETT: But I don't retract any 22 of those earlier remarks. 23 them. 24 25 Right. COMMISSIONER GEORGIOU: I agree with I asked in the case of Jimmy Cayne at Bear Stearns, 274 1 Q & A - Session 2 2 he said, "That's a great idea but they are 3 not going to like it." 4 that -- and I want to go back here to what 5 happened at Moody's to some extent. 6 Because really, a hundred years ago, you 7 know, John Moody started rating railroad 8 bonds, which you know a lot about. 9 Relatively simple instruments. 10 So it seems to me Now, Moody's is rating exceedingly 11 complex instruments. 12 financial incentives, maybe I should turn 13 to Mr. McDaniel on this question, some of 14 the financial incentives, it seems to me, 15 are skewed in favor of your properly 16 rating, besides the fact, the obviously 17 glaring one that issuers pay. 18 And some of the But in your pricing, I learned from 19 our investigation that, on RMBS, on 20 residential mortgage-backed securities, 21 you charged 4.75 basis points for those 22 tranches that were rated senior of the 23 dollars in those tranches, and 3.50 basis 24 points for the tranches that were rated 25 subordinate. 275 1 2 Q & A - Session 2 Which, it seems to me, gives a skewed 3 incentive for you to put more dollars into 4 the senior tranches and less dollars in 5 the subordinate tranches because you're 6 going to make almost 40 percent more per 7 dollar rated in the higher-rated ones, 8 which is similar to a difficulty we've 9 discovered in the mortgage brokerage 10 situation, where mortgage brokers 11 sometimes were compensated at twice the 12 rate, at the percentage rate, for 13 generating a mortgage that had a higher 14 interest rate payable to the lender than a 15 traditional mortgage, which then 16 incentivized them twice as much to direct 17 borrowers into subprime mortgages and 18 high-interest-rate mortgages who might 19 otherwise qualify for regular, traditional 20 ones. 21 Mr. McDaniel, do you think that's a 22 problem? And why, if you could tell us, 23 did you actually structure the fees 24 payable to Moody's in that way, that gave 25 you more if you rated them senior than 276 1 2 3 Q & A - Session 2 they would if they were subordinate? MR. McDANIEL: I think, as you heard 4 from the panelists earlier today, first of 5 all, they were not aware of a difference 6 in pricing in their deliberations or 7 analytical work and rating committee work. 8 And secondly, although I have not had 9 an opportunity to do a comprehensive 10 check, I did go back to look at RMBS 11 applications in 2006 and 2007, and the 12 basis point fees were identical for senior 13 and junior tranches. 14 COMMISSIONER GEORGIOU: Well, our 15 people say that they changed it in 2007 to 16 flat, to 3.5 percent which, incidentally, 17 is a reduction in pricing power, 3.5 basis 18 points for all, all the way across an 19 RMBS, starting in 2007 forward, when in 20 2006 prior it was a differential. 21 MR. McDANIEL: I was able to look at 22 2006, and it was identical in 2006 as 23 well -- as I said, I did not have a chance 24 to do a comprehensive -- 25 COMMISSIONER GEORGIOU: Right. Maybe 277 1 Q & A - Session 2 2 you could check that out and report to us 3 on it. 4 MR. McDANIEL: Yes. 5 COMMISSIONER GEORGIOU: The other 6 point I think is that you got nine basis 7 points for rating a CDO which is, again, 8 more than twice as much as you got for 9 rating an RMBS, which is sort of unclear 10 11 to me how that could be. And does that then incentivize you to 12 do more CDOs because you do a 13 billion-dollar CDO, you're going to make 14 almost a million dollars in fees. 15 that -- is it really that much harder to 16 rate a CDO than it is to rate an RMBS? 17 MR. McDANIEL: And is Well, I'm not a CDO 18 analyst. So I can only respond with 19 respect to the overall approach and if 20 there is an opportunity to charge fees 21 that the market will bear, I think we 22 would do that. 23 We have fees that range from very, 24 very modest, particularly in the municipal 25 bond sector, small municipalities, to fees 278 1 Q & A - Session 2 2 that are a lot more substantial for large 3 corporations and complex securities. 4 COMMISSIONER GEORGIOU: Let me try -- 5 I want to press you a little bit -- 6 Mr. Buffett, did you have a comment on 7 that? 8 9 MR. BUFFETT: was looking for the modest ones, I haven't 10 found them yet. 11 referred to. 12 I was just thinking, I The modest fees he COMMISSIONER GEORGIOU: There aren't 13 too many. 14 either. 15 Commissioner Graham brought in front of 16 you, it strikes me that, when you look at 17 this, in the face of contradictory 18 information, the actual number of deals 19 rated in both CDOs and residential 20 mortgage-backed securities goes up 21 dramatically. 22 I haven't seemed to find them, Looking back at this chart that And really, even after you've had 23 four or five major downgrades, I mean, 24 significant downgrades, you're still 25 rating a whole bunch of deals that come 279 1 2 3 Q & A - Session 2 forward. And I think that -- I'll sort of give 4 you a pass to some extent on nobody knew 5 that the market was going to go down as 6 fast as it did. 7 basically, I don't remember what your term 8 was, Mr. Buffett, that everybody was 9 believing in this -- as this bubble. 10 And everybody was But once you get contradictory 11 information, don't you then have an 12 obligation not to go forward? 13 honest with you, it looks to me, given now 14 that there are so few transactions in the 15 marketplace, that what you were really 16 trying to do was get these deals done so 17 you could mop up the last bit of the gravy 18 before they took the plates away. 19 this is not -- these deals are not out 20 there anymore. 21 nine-basis-point fees to be made on 22 billion-dollar CDOs every day anymore. 23 And the fact that you did it in the face 24 of contradictory information seems to me 25 to be highly troubling. And to be I mean, There's not 280 1 Q & A - Session 2 2 Do you have a thought on that? 3 MR. McDANIEL: As long as securities 4 are being offered to the marketplace, I 5 think we have an obligation to try to 6 offer our best opinion on those 7 securities. 8 active and robust or whether they are 9 quiet, what is coming to market I think we 10 11 So whether the markets are should attempt to offer an opinion on. We obviously want those opinions to 12 be predictive. 13 incorporate all information that we think 14 is relevant, and incorporate our best 15 judgment. 16 to offer the opinion. 17 We want those opinions to But I do think we should try COMMISSIONER GEORGIOU: But they 18 weren't any more predictive, were they? 19 In fact, they led to downgrades as 20 significantly as they were prior to that, 21 is that not correct? 22 23 24 25 Yes, Mr. Angelides -- I know you do. So do I. There are two Greeks on this committee, gentlemen, which is a little 281 1 Q & A - Session 2 2 bit dangerous for all of us here. 3 Buffett -- 4 5 6 VICE-CHAIRMAN THOMAS: But Mr. I'm Welsh. My hands are tied. COMMISSIONER GEORGIOU: -- Mr. Buffett, 7 do you fault the management of Moody's for 8 at least that? 9 give them fault, but in the face of this I know you're reluctant to 10 contradictory information, how is it that 11 they went forward and continued to rate 12 these securities essentially no 13 differently than they had been doing in 14 the face of the bubble? 15 CHAIRMAN ANGELIDES: Can I say the 16 reason I was waving my hands? I want to 17 put this in perspective. 18 is one thing. 19 they are AAA is quite another. 20 frame this question on my time, I think in 21 2007, $500 billion of RMBS was rated AAA. 22 About a hundred-billion-plus after July 23 '07, when you began to do the downgrades. 24 So there's offering an opinion, which may 25 be that this isn't ratable, shouldn't be Offering opinion Offering an opinion that So just to 282 1 Q & A - Session 2 2 rated investment-grade, and then in 3 fact -- 4 COMMISSIONER GEORGIOU: Rating it AAA 5 and then of course they were subsequently 6 downgraded, even those later new 7 issuances. 8 9 Mr. Buffett? MR. BUFFETT: Well, I don't know what took place internally there. But just 10 from listening to this and what I see here 11 on the chart and so forth, it looks like 12 they tweaked their model when they should 13 have gone at it with a meat axe, 14 basically. 15 for people to adjust their thinking that 16 much in a short period of time, but they 17 should have gone at it with a meat axe. 18 And it is sometimes difficult COMMISSIONER GEORGIOU: Too many 19 mixed metaphors here on occasion. But I 20 guess I'd like to ask you, if I could, I 21 know you've testified in your internal 22 testimony that you thought that the 23 government made the right decision in 24 backing up these companies, that the 25 markets really needed reassurance at the 283 1 Q & A - Session 2 2 time. 3 having to do with Moody's. 4 This is a more generic question not But there are many who believe that 5 that demonstrates the breadth and scope of 6 this crisis, that, you know, we've had so 7 many other crises. 8 seventh largest corporation in America, it 9 want bankrupt. I mean, Enron was the The tech bubble happened, 10 a lot of things happened in the last 70 11 years and none of them required trillions 12 of dollars of taxpayer money at risk to 13 bolster the private sector, and yet you 14 feel that it was necessary at the time. 15 Could you elucidate? 16 MR. BUFFETT: I do. In September of 17 2008, you know, our financial system 18 basically came to a halt. 19 30 million Americans with their money in 20 money market funds comprising 21 three-and-a-half trillion with close to 22 half the deposits at the banks, and in the 23 first three days of that week following 24 Lehman, 170 billion flowed out. 25 Interestingly now, that was all I mean, you had 284 1 Q & A - Session 2 2 institutional. 3 on yet. 4 Individuals hadn't caught But when thirty million people start 5 worrying about whether their money market 6 funds are going to be -- break the buck, 7 when you've got -- when you've got 8 commercial paper stopped in terms of 9 issuance, when you have -- later we sold a 10 Treasury bill due in April of 2009, we 11 sold it in December for $5,000,090 when 12 you were only going to get five million in 13 April. 14 wasn't even good enough. 15 Treasury bill was $90 better than a 16 mattress. 17 So at that point your mattress I mean, a So it was a paralysis of the system, 18 and the American people knew that only the 19 government could pull us out. 20 trust anybody else. 21 had to act. 22 in every case, who knows? 23 important thing is they acted. 24 COMMISSIONER GEORGIOU: 25 They didn't And the government Whether they acted perfectly going forward. But the But now we're And part of what we're to 285 1 Q & A - Session 2 2 do here is to evaluate what happened in 3 the financial crisis and, although we're 4 not proposing remedies, certainly, a lot 5 of people are concerned about the debt 6 that's been taken on to finance this 7 bailout and so forth. 8 9 10 What do you do in the future to avoid this occurring? CHAIRMAN ANGELIDES: By the way, go 11 ahead and answer, Mr. Buffett, but that's 12 time -- Mr. Buffett, answer, we would want 13 your answer. 14 MR. BUFFETT: Yes. The two best 15 things I know how to attack are leverage 16 and incentives. 17 system and you can't rearrange the whole 18 thing, but you can change how people 19 behave, in one case by incentives, and 20 secondly, you just tell them how much rope 21 they can use by the amount of leverage 22 they can have, particularly when they are 23 getting the benefit of government 24 guaranteed money. 25 You've got a market COMMISSIONER GEORGIOU: Exactly, and 286 1 Q & A - Session 2 2 let me just, one little follow-up, and 3 that is, your company has a huge cash 4 cushion, which you like to keep because it 5 puts you in a protected, safe position to 6 take advantage of opportunities. 7 A lot of other people in this 8 financial institution area did not do 9 that. They ran every capital arbitrage 10 possible to avoid holding back as much 11 capital, and so that seems to me to be a 12 related problem. 13 MR. BUFFETT: Yes, well, the AIG 14 derivatives contracts you meant were to 15 get around capital requirements in Europe. 16 I mean, three hundred billion. 17 know, there's a lot of abuse, and if you 18 let those instruments exist in that form 19 and let people use them in an unlimited 20 manner, they will get used in an unlimited 21 manner. 22 CHAIRMAN ANGELIDES: 23 much, Mr. Georgiou. 24 on. 25 So, you Thank you very All right, let's move Ms. Murren? COMMISSIONER MURREN: Thank you. 287 1 Q & A - Session 2 2 Thank you both for being here. 3 Mr. McDaniel, I have a question for you 4 about the events of the crisis, and when 5 you look back at the financial crisis, I 6 wonder if the requirement, the legislative 7 requirement that asks certain investors to 8 invest only in rated securities, if those 9 requirements had not existed, how would 10 your business have been different? 11 you have had to compete on different terms 12 and would you have had to reward people 13 within Moody's differently? 14 MR. McDANIEL: Would Well, I don't know 15 exactly how the business would exist if 16 there were different or lesser regulatory 17 uses of the ratings. 18 supportive of a reduction of use of 19 ratings in regulation. 20 think the use of ratings and regulation 21 offers rating agencies a basis for 22 competing other than on the quality of 23 their ratings. 24 in effect, the certification that they 25 have as a regulatory-approved rating Nonetheless, I am I think it -- I They can compete on the, 288 1 2 3 Q & A - Session 2 agency. And I think that rating agencies 4 should either prosper or not prosper based 5 on whether market participants value the 6 ratings and value the rating opinions and 7 research that accompany that. 8 9 COMMISSIONER MURREN: With that in mind, there were comments from some of the 10 individuals that were here before this 11 panel that suggested that they could not 12 determine if there was a connection 13 between their ability to get the ratings 14 right, their words, and their actual 15 recognition within the firm. 16 Do you think that's true? 17 MR. McDANIEL: We certainly try to 18 reward people in terms of their position 19 in the firm and their compensation, based 20 on the quality of their work. 21 business in which it can take a long time 22 to evaluate the ultimate performance of 23 securities. 24 preparedness for rating committees, 25 their -- the robustness of their reasoning It is a But their research, their 289 1 Q & A - Session 2 2 are things that can be judged and we very 3 much try to do that. 4 COMMISSIONER MURREN: Those things 5 are process-oriented though, not 6 outcome-oriented necessarily. 7 MR. McDANIEL: The outcomes are able 8 to be measured at a broad level 9 statistically to, I think, a -- to a 10 strong outcome. It is more difficult to 11 judge an individual's performance, 12 especially in the short run, on a very 13 limited number of credits. 14 easier to measure this at a broad level 15 than at a narrow level. And so it is 16 COMMISSIONER MURREN: 17 Mr. Buffett, do you think that the 18 investing world would be a better place if 19 everyone had to do their own due 20 diligence? 21 MR. BUFFETT: Thank you. Well, I certainly think 22 at Berkshire Hathaway it's better. But 23 there are people that aren't equipped. 24 mean, the banking authorities, insurance 25 authorities, probably need to rely on some I 290 1 Q & A - Session 2 2 kind of standards to make sure that people 3 don't go totally hog wild in terms of how 4 they invest insurance funds which belong 5 to their policyholders. 6 But in the end, we don't use ratings. 7 From my -- what we really hope for is 8 misrated securities because that would 9 give us a chance, perhaps, to earn a 10 profit if we disagree with how the 11 agencies rate them. 12 There's one ironic point I should 13 mention. 14 agencies, all equally well regarded, all 15 acceptable to the market, and you only 16 needed one when Berkshire Hathaway issues 17 a bond, we could have any one of them, 18 those ten would compete either on price or 19 laxity or both. 20 there trying to get our business, and they 21 would try by price, but they might also 22 try by laxity. 23 If there were ten rating I mean, they would be out You can argue that if there was just 24 one rating agency, they would have no 25 reason to compete on either price or 291 1 Q & A - Session 2 2 laxity. I mean, independence can really 3 come with -- with strength in the 4 business. 5 difficult for an empty sack to stand 6 straight. 7 situation where there was a lot of 8 competition, I'm not sure that the rating 9 agencies would be as independent actually Ben Franklin said it's So if you really had a 10 in coming to their credit conclusions as 11 they are. 12 COMMISSIONER MURREN: I would hate to 13 differ with you. 14 example, equity research, there are a 15 number of boutique shops that are 16 specifically known for the quality of 17 their research and they do not engage in 18 investment banking activity, so they don't 19 have as much of a stake in the origination 20 process. 21 But if you look at, for And to me there's some parallel 22 between this area of research and some 23 others. 24 if you change the way people get paid, 25 would you get a different outcome? So I guess my question really is, So 292 1 Q & A - Session 2 2 that really was the nature of where I was 3 headed with this. 4 But I actually have an off-topic 5 question for you, Mr. Buffett, and that 6 is, I know that you've been largely a 7 hands-off investor for Moody's. 8 curious about the due diligence process in 9 your investment in Goldman Sachs, and if But I was 10 you could talk a little bit about your 11 conversations with management there and 12 how that decision was made. 13 MR. BUFFETT: Well, that decision was 14 made in September of 2008. We'd been 15 approached by just about every firm, at 16 least every firm that went under, about 17 putting money in. 18 was willing to take money on terms I found 19 satisfactory, which had not been the case 20 even the week before, I came to the 21 conclusion that, unless the American 22 financial system totally fell apart, that 23 it was going to be a sound investment. 24 And I had far more confidence in their 25 risk management than I had in some of the And when Goldman Sachs 293 1 Q & A - Session 2 2 other Wall Street firms that had come to 3 me earlier. 4 And again, if the system had fallen 5 apart, if the Federal Reserve had not 6 acted, in terms of commercial paper and 7 the money market funds and all, everyone 8 would have been toast, I think basically. 9 But I came to the, my basic 10 conclusion was that the American 11 government would do what was necessary to 12 get the engine started again. 13 was the case, Goldman Sachs was in fine 14 shape. 15 COMMISSIONER MURREN: And if that But they did 16 change the terms they were willing to 17 accept for your investment as time went 18 on. 19 MR. BUFFETT: Yeah. Prior to the 20 middle of September, you know, they would 21 not have paid us what they, remotely what 22 they did pay us for that preferred stock 23 and the warrants, whenever it was, 24 September 22nd or 23rd or some time in 25 that time frame. 294 1 2 Q & A - Session 2 At that point, they not only wanted 3 the money but they wanted a show of 4 confidence, obviously, in the fact that 5 the world wasn't going to come to an end 6 financially. 7 And I didn't think the world was 8 going to come to an end financially, 9 because I thought that the federal 10 government would act. I just thought it 11 was so obvious that it had to, and only it 12 could do it. 13 billion dollars would not be in any danger 14 at all. 15 and there were a lot of other things that 16 were attractive, then, too. 17 the decision that that was a good use for 18 the five billion. And I felt that our five And the terms were attractive, 19 COMMISSIONER MURREN: 20 CHAIRMAN ANGELIDES: 21 22 But I made Thank you. Thank you, Mr. Holtz-Eakin? COMMISSIONER HOLTZ-EAKIN: Thank you, 23 Mr. Chairman; thank you, gentlemen, for 24 spending time with us today. 25 Mr. McDaniel, in your opening remarks 295 1 Q & A - Session 2 2 you were very forthright about the 3 inherent conflict between providing 4 ratings to the market and running a public 5 company for profit, and incentives that 6 issuers have to use the outcome of your 7 rating process. 8 9 10 11 How do you manage that conflict at Moody's? What do you put in place to keep that under control? MR. McDANIEL: Well, from my office, 12 I think it's important to emphasize and 13 reemphasize the fact that we are trying to 14 create long-term shareholder value, and I 15 think the way to do that is to have credit 16 ratings that are of high quality and 17 predictive over time. 18 problems we saw in the mortgage-related 19 securities sector were so devastating to 20 the firm, in addition to the consequences 21 for the larger economy and to households 22 in America. 23 That is why the Beyond that, though, we have 24 structural components of the firm that are 25 designed to insulate and protect the 296 1 Q & A - Session 2 2 analytical process from some of the 3 financial and commercial interests of the 4 company, again, including independent 5 credit policy function. 6 recently created a separate commercial 7 organization in the firm that is separate 8 and apart from either credit policy or the 9 ratings analysts and the lines of 10 11 We have also business. COMMISSIONER HOLTZ-EAKIN: And to be 12 clear, those are two recent changes in 13 response to the problems you had? 14 MR. McDANIEL: The credit policy 15 function has existed for many years, but 16 we then enhanced that function in terms of 17 its independence in 2007. 18 commercial group is a more recent 19 introduction. 20 And the We also have formally separated the 21 rating agency from our other operating 22 businesses, non-credit ratings businesses. 23 So those kinds of actions I think are 24 useful and important, not only for our own 25 processes, but to be able to turn around 297 1 Q & A - Session 2 2 and demonstrate that those processes are 3 proper and being handled in the right 4 manner. 5 COMMISSIONER HOLTZ-EAKIN: So the 6 quality of the ratings ends up being the 7 key. 8 you want them to include all the relevant 9 information and make them as good as 10 And I think you said earlier that possible. 11 MR. McDANIEL: Absolutely. 12 COMMISSIONER HOLTZ-EAKIN: So I am 13 then very interested in this situation 14 that occurred in 2007 where you had the 15 residential mortgage-backed securities 16 clearly up for downgrade and at the same 17 time are rating CDOs based on the same 18 underlying RMBSs, and went ahead and rated 19 them AAA. 20 It doesn't seem like all the relevant 21 information was brought into the rating 22 process. 23 and the risk it placed to your reputation 24 and the quality of your ratings? 25 And how do you feel about that, MR. McDANIEL: I believe that all of 298 1 Q & A - Session 2 2 the information we thought was relevant at 3 the time was brought into the rating 4 process. 5 problem of underestimating the extent to 6 which the housing downturn was going to -- 7 its magnitude and how widely it was going 8 to affect home prices nationwide. 9 But obviously, we had the So as a result, the, even though we 10 felt we were including relevant 11 information, we felt we were using the 12 best information we had available in the 13 rating committee process, it proved to be 14 insufficient, and -- 15 COMMISSIONER HOLTZ-EAKIN: You 16 couldn't wait until you found out a little 17 bit more from your RMBS guys before you 18 went out and rated the CDOs or was the 19 short-term pressure too great? 20 MR. McDANIEL: I think the 21 information that our RMBS teams had and 22 their perspectives and opinions were 23 available to other teams as they developed 24 and evolved. 25 incorporate their changing points of view I think we were trying to 299 1 Q & A - Session 2 2 as we were looking at other securities 3 related to the mortgage sector. 4 COMMISSIONER HOLTZ-EAKIN: Well, it 5 at least appears, with the benefit of 6 hindsight, that there was a rush to get 7 this stuff done, and it strikes me as 8 central to your role, and Mr. Buffett 9 indeed said you as the CEO have to be your 10 chief risk officer; and knowing the way in 11 which these ratings were done and knowing 12 when not to do them, wait and get more 13 information, we heard from the panel 14 earlier today about a great desire to 15 learn more about the cash flows underneath 16 the CDOs, but such a study was not done. 17 And pressures from outside the 18 organization to manage the market share, 19 all of which were pretty striking 20 testimony to a real effort to move things 21 out for short-term gain as the expense of 22 what turned out to your reputation and 23 your long run value. 24 25 MR. McDANIEL: We simply, if we thought that the housing problems and 300 1 Q & A - Session 2 2 collateral consequences from the housing 3 problem, if we had thought they were going 4 to be what they in fact have turned out to 5 be, we would have had very different 6 opinions on those securities. 7 just underestimated and dramatically 8 underestimated the significance of the 9 downturn. 10 We -- we COMMISSIONER HOLTZ-EAKIN: 11 Mr. Buffett, you've said that you're 12 interested in long-run value and not 13 short-term profits. 14 problems in the structured credit, 15 housing-related structured-credit ratings? 16 MR. BUFFETT: Were you aware of the Certainly not 17 sufficiently, no. 18 don't think I've ever bought a CDO or a 19 residential mortgage-backed security. 20 Actually, we bought one recently here that 21 we thought was mispriced. 22 a field that I spent a lot of time on. 23 It's just, I was more interested in 24 straight debt and equities. 25 We, to my knowledge, I But it was not COMMISSIONER HOLTZ-EAKIN: And were 301 1 Q & A - Session 2 2 you satisfied with the risk measures, the 3 internal controls at Moody's and doing due 4 diligence on all the products they 5 provided ratings on? 6 MR. BUFFETT: I had no idea. I'd 7 never been at Moody's, I don't know where 8 they are located. 9 business model is extraordinary. 10 11 12 You know, I know their And they have the ability to price. COMMISSIONER HOLTZ-EAKIN: I want to come back to that. 13 MR. BUFFETT: Yes. 14 COMMISSIONER HOLTZ-EAKIN: But isn't 15 it at odds with being confident of their 16 long-run value to not know if they are 17 doing due diligence for the asset they 18 consider most important to their 19 reputation? 20 MR. BUFFETT: The long-run value 21 basically was in their position as part of 22 a duopoly, that arose naturally over a 23 long -- 24 25 COMMISSIONER HOLTZ-EAKIN: Independent of the quality of their 302 1 2 Q & A - Session 2 ratings? 3 MR. BUFFETT: Well, I'm in no 4 position to judge thousands of ratings. 5 think they misrate us. 6 notch below where Standard & Poors has 7 us. 8 improvement. 9 They've got us a So clearly, there's room for But no, I've watched their process. 10 They come out and spend -- and Standard & 11 Poor’s does, too -- they'll spend three 12 hours with me. 13 managers, key managers in our insurance 14 businesses, but three hours every year. 15 And any question they ask me, you know, I 16 give them the answer to. 17 thoughts about the future, which I don't 18 even with our shareholders. 19 I They will go to all our I give them my They have been diligent in terms of 20 what I have seen at the Berkshire Hathaway 21 level, and in terms of our insurance. 22 Now, they also have this incredible 23 pricing power. I think they ought to be 24 doing it at a much lower price, as far as 25 I'm concerned, and of course I think they 303 1 Q & A - Session 2 2 ought to be rating us right up there where 3 Standard & Poor’s has, but that's another 4 question. 5 6 7 COMMISSIONER HOLTZ-EAKIN: What is the source of the pricing power? MR. BUFFETT: What is the source of 8 the pricing power? The source of the 9 pricing power is that, if you're an 10 insurance company, as an example, but if 11 you're any issuer of securities, people 12 expect you to have a Standard & Poor’s and 13 Moody's rating, and it's very small, the 14 dollars spent as a percentage of the total 15 bond issue or whatever they may be doing, 16 but it's required. 17 filing fee. 18 going to come to market without it. 19 It's like an SEC I mean, basically, you're not And if the SEC doubles its price for 20 filing fees, I pay it. If they triple it, 21 I pay it. 22 that are required as part of issuing 23 securities. 24 important part of the securities that are 25 issued are required to have a Standard & And there are certainly things And in this country, an 304 1 Q & A - Session 2 2 Poor’s and Moody's rating attached to them, 3 and often it's by statute. 4 COMMISSIONER HOLTZ-EAKIN: 5 Mr. McDaniel, in your time and, to your 6 knowledge, for your predecessor, has 7 Moody's ever lobbied Congress or the 8 regulatory agency to enshrine in statute 9 or regulation a requirement for ratings? 10 MR. McDANIEL: No, not to my 11 knowledge. 12 been -- we have spoken repeatedly, 13 publicly going back at least 15 years, 14 about the risks of including ratings in 15 regulation, and offering our support for 16 the reduction or elimination of the use of 17 ratings and regulation. 18 Just the opposite. MR. BUFFETT: We have I would say that they 19 are required by regulation in many of 20 the -- 21 22 23 COMMISSIONER HOLTZ-EAKIN: It's great for pricing power. MR. BUFFETT: It is. But if they 24 weren't, we still would have to have them. 25 The world may change. It may be different 305 1 Q & A - Session 2 2 ten years from now or 20 years from now 3 but there's no way Berkshire Hathaway even 4 with a good reputation and all earnings 5 and CPA reports attesting to the fact that 6 the 20 billion in cash is really there and 7 all that sort of thing, we will not be 8 able to issue a bond without a rating. 9 COMMISSIONER HOLTZ-EAKIN: So what I 10 hear you saying is that from the long term 11 value perspective, it's that pricing power 12 that matters, not the quality of the 13 ratings, that the internal controls were 14 not a great concern to you? 15 16 17 18 19 20 21 VICE-CHAIRMAN THOMAS: May I yield the gentleman an additional two minutes? COMMISSIONER HOLTZ-EAKIN: And the conduct of Moody's -MR. BUFFETT: I'm not in a position to evaluate the internal workings -COMMISSIONER HOLTZ-EAKIN: You're the 22 majority owner. 23 be in a better position than most of us. 24 25 MR. BUFFETT: I would think you would We own a significant position in Procter & Gamble. I don't 306 1 Q & A - Session 2 2 know what their internal controls are, I 3 don't know how they make Tide, you know, 4 and whether the processes are proper. 5 We own a lot of Johnson & Johnson. 6 They had a problem at the McNeil Lab 7 recently. 8 know about that. 9 Johnson & Johnson will do fine. There's no way I'm going to Over time, I think I don't 10 think they are going to do everything 11 perfectly but I think, generally speaking, 12 their management has done a good job and 13 will continue to do a good job. 14 COMMISSIONER HOLTZ-EAKIN: 15 CHAIRMAN ANGELIDES: Thank you. I'm going to 16 take a minute or so to probe this. Don't 17 you believe that shareholders, and boards 18 who shareholders elect, have a threshold 19 responsibility for the proper conduct of a 20 corporation? 21 mean, forget the housing price mess. 22 There's now a whole set of information 23 here, SEC reports, extensive testimony, I 24 might add, not just two or three people, 25 about the culture at Moody's that may have And let me add to this, I 307 1 Q & A - Session 2 2 jeopardized the ratings quality, 3 information that there were inadequate 4 resources, inadequate pay, I don't think 5 it's any secret that pay at the rating 6 agencies that may be good for the bottom 7 line revenue, but that pay was not 8 sufficient to retain, to attract and 9 retain the kind of quality people you 10 have. 11 There's a meeting with Dr. Witt, who 12 testified this morning, talks about that 13 as the markets are coming apart in 14 '07-'08, there's a big employees' meeting 15 and Mr. McDaniel's there and talking about 16 how we're going to get it back on track, 17 be profitable, and a managing director, 18 after thirty minutes of this, finally 19 stands up and says, after about thirty 20 minutes of this, this is Dr. Witt's 21 testimony, "One of our MDs from the 22 corporate sector says, 'Are you going to 23 talk about how we're going to ever salvage 24 our reputation?'" 25 you just say, "Gee, I didn't know?" You know, why didn't 308 1 2 Q & A - Session 2 Don't you think a shareholder with 3 twenty percent coupled with three or four 4 others that have fifty percent, five 5 shareholders, and the board, have a 6 threshold responsibility in regard to 7 these kind of operations? 8 number one. 9 And that's And number two is, knowing what you 10 know today, are these matters of great 11 concern is to you as a big shareholder? 12 MR. BUFFETT: I would say in terms 13 of -- in terms of the behavior of the 14 credit agencies, recognizing all their 15 limitations, aside from the real estate 16 bubble, I do not have a record of where 17 they have been further off in their 18 ratings than I would expect normal human 19 beings to be. 20 CHAIRMAN ANGELIDES: It's not a 21 matter of ratings. Take a look at the SEC 22 report. 23 talks about threshold issues like adequacy of 24 resources, business considerations 25 affecting ratings. We'll post it on our web. It If we can't count on 309 1 Q & A - Session 2 2 corporate shareholders, who can we count 3 on? 4 MR. BUFFETT: I'll go back. We own a 5 very big chunk of Johnson & Johnson. 6 the papers in the last week, there had 7 been a lot of material about some 8 children's product, the McNeil thing. 9 I going to investigate that? No. In Am I mean, 10 overall, think I the Johnson & Johnson 11 management is going to do a fine job over 12 time and that they'll make mistakes and 13 correct them. 14 I think they are overreaching or doing 15 certain things -- 16 17 18 Now, if I see something, if CHAIRMAN ANGELIDES: If you see a cockroach. MR. BUFFETT: Yeah. I do not 19 regard -- if they have a problem at one 20 lab, I do not regard that -- they had a 21 Tylenol problem many years ago, as you 22 know. I mean, every major -- 23 CHAIRMAN ANGELIDES: 24 MR. BUFFETT: 25 I'm saying -- Let me say this: Today, we have 260,000 employees at 310 1 Q & A - Session 2 2 Berkshire. Somebody's doing something 3 wrong now. I wish I knew who it was. 4 wish I could find out. 5 CHAIRMAN ANGELIDES: There's a 6 difference between that and systemic 7 failure. 8 9 10 MR. BUFFETT: systemic failure. I don't think it's been I think they made a huge mistake on -- 11 CHAIRMAN ANGELIDES: Have you 12 reviewed the SEC report, at least the 13 pubic one? 14 MR. BUFFETT: 15 CHAIRMAN ANGELIDES: 16 I No, I haven't. Okay, thank you. Mr. Thompson? 17 COMMISSIONER THOMPSON: Thank you, 18 Mr. Chairman. 19 said about tone at the top. 20 you just tell me what outcomes or results 21 you value most from your company? 22 Mr. McDaniel, much can be MR. McDANIEL: And so would Well, it's somewhat 23 similar to a remark I made a few minutes 24 ago. 25 have a successful business. Obviously, we want to, I want to And I believe 311 1 Q & A - Session 2 2 the way to have a successful business is 3 to have high quality products and 4 services; in this case, ratings and 5 related research. 6 It does nothing for our business to 7 focus on the short run and to cut corners 8 and, as I've said, that's why it is so 9 deeply disappointing to have had the 10 experience that we've had in the 11 mortgage-related securities that we've 12 rated. 13 COMMISSIONER THOMPSON: So quality of 14 the product or service that you deliver 15 would be the one outcome that you value 16 most. 17 MR. McDANIEL: Yes, because I believe 18 that leads to the long-term prosperity of 19 the firm. 20 COMMISSIONER THOMPSON: So why, then, 21 is quality not a major component in the 22 compensation plans for the managing 23 directors who rate these securities? 24 25 MR. McDANIEL: it is. First of all, I think And we have adjusted our 312 1 Q & A - Session 2 2 compensation programs over time in order 3 to try and align high quality product and 4 service with compensation. 5 Our senior management team, the top 6 senior-most 40 individuals in our firm now 7 have, as part of their compensation 8 program, a three-year performance share 9 plan. And for everyone involved in the 10 Moody's Investor Service rating agencies business 11 in that group, there is, fifty percent of 12 that plan is based on the statistical 13 performance of our ratings over that 14 three-year period. 15 16 COMMISSIONER THOMPSON: "now." When was that change made? 17 MR. McDANIEL: 18 the end of last year. 19 20 21 You said This was introduced at COMMISSIONER THOMPSON: So this is after the crash, if you will. MR. McDANIEL: And it's really an 22 experiment. We will have to see how this 23 works. 24 statistically over a multiyear period is 25 something we can do, and we think that The ability to measure ratings 313 1 Q & A - Session 2 2 it's going to provide good incentive 3 alignment for our senior management. 4 COMMISSIONER THOMPSON: So in keeping 5 with the notion of tone at the top, you 6 would say that in your communications and 7 your most senior team's communications 8 with the rank-and-file of Moody's, it's 9 clear that quality trumps market share? 10 MR. McDANIEL: Well, from my 11 position, I have to be concerned with all 12 different aspects of trying to manage a 13 successful business. 14 But for our more junior employees, 15 their compensation, our analysts and 16 support analysts, their compensation is in 17 no way tied to the number of securities 18 they rate or the number of companies they 19 follow or anything of that sort. 20 21 22 23 24 25 COMMISSIONER THOMPSON: Or the share they gain in the market. MR. McDANIEL: Or the share that we gain or may lose in the market. COMMISSIONER THOMPSON: So the gentlemen who were here earlier were 314 1 Q & A - Session 2 2 delusional about what objectives and goals 3 they had as they were working at Moody's. 4 MR. McDANIEL: No. As I said, I care 5 about market share, I care about market 6 coverage as much as I care about market 7 share, even if that coverage is produced 8 on an unpaid basis. 9 market coverage. I still want to have But I also care deeply 10 about ratings quality, and part of my job 11 is to balance those interests properly, 12 and to communicate that balancing of 13 interests throughout the firm in a way 14 that individuals understand that the 15 long-term success of this company has to 16 start with quality of this company, 17 ratings quality, research quality. 18 COMMISSIONER THOMPSON: Mr. Buffett, 19 much has been said about regulatory or 20 supervisory failure through this debacle. 21 The SEC, OFHEO, you name the regulator 22 that was involved, any number of them 23 missed. 24 25 Other than over-the-counter derivatives, can you think of a major area 315 1 Q & A - Session 2 2 of regulatory oversight that dictates 3 major changes in our system? 4 MR. BUFFETT: Well, I would say that 5 going beyond the OTC derivatives, I think 6 that addressing the problems of disguised 7 leverage, unwise leverage, which is really 8 tough, but doing it with ratios is not the 9 answer, is not the sole answer. But 10 leverage is what gets people in trouble. 11 I mean, we've run Berkshire that way, and 12 when people stretch and they get rewards 13 for it, they are inclined to stretch more. 14 I think I heard some testimony in an 15 earlier panel you had about whether having 16 the objective of return on equity, whether 17 that might cause people to do different 18 things. 19 people to do different things. 20 easiest way to jack up return on equity is 21 to leverage. 22 Well, of course it does cause The So addressing that, addressing it 23 wisely I think is very tough. But I think 24 that that's the most important thing in 25 the regulatory world. 316 1 Q & A - Session 2 2 COMMISSIONER THOMPSON: Are you as 3 surprised as most Americans are that, 4 post-Enron, we could have 5 off-balance-sheet financing that would 6 have been perhaps at the core of this 7 collapse? 8 9 MR. BUFFETT: Yeah, I don't know that it's necessarily at the core, but I 10 certainly was surprised when Citigroup 11 turned out to have SIVs, you know, in the 12 many tens of billions, which is just a way 13 of jacking up leverage again. 14 surprised. 15 read the 10-Ks carefully enough or 16 anything, but there certainly were no 17 flashing signs that said, "We're using a 18 bunch of leverage off balance sheet." 19 I was I mean, now, I may not have So I think that -- I think we're 20 always going to be fighting the human 21 tendency to borrow more money than you 22 should. 23 they thought that houses were going to go 24 up next year. 25 made any difference what their income was, And households did it because They really didn't think it 317 1 Q & A - Session 2 2 because they'd refi in a year or two. 3 It's just such a human tendency that you 4 need something on the governmental side to 5 counterbalance that. 6 7 8 9 COMMISSIONER THOMPSON: Thank you very much. CHAIRMAN ANGELIDES: Before we go to Ms. Born, I just -- can I just ask if we 10 get supplied with a couple of pieces of 11 information? 12 to us the board's evaluation of your CEO? 13 They do an annual evaluation? 14 Can we have made available MR. McDANIEL: I submit a 15 self-evaluation which the board then 16 reviews and discusses among themselves 17 and -- 18 CHAIRMAN ANGELIDES: 19 access to that to us? 20 MR. McDANIEL: 21 CHAIRMAN ANGELIDES: Can you provide Yes. Secondly, could 22 we also have access to any internal 23 comprehensive reviews that have been done 24 about practices at Moody's to the extent 25 we haven't already received them, in other 318 1 Q & A - Session 2 2 words, reviewing systemic breakdowns that 3 might have been done? 4 comprehensive reviews, internally, in the 5 wake of all this? 6 MR. McDANIEL: Have you done Well, we've done a 7 number of reviews, and if there's anything 8 that we haven't provided that's 9 appropriate, I certainly would instruct 10 our people to do so. 11 CHAIRMAN ANGELIDES: And then 12 finally, I think the company did a review 13 with a law firm of Mr. Kolchinsky's 14 employment retaliation allegations. 15 that be made available to us? 16 17 MR. McDANIEL: I'm not sure. Can I don't know if there is a report on that or not. 18 CHAIRMAN ANGELIDES: 19 is. 20 If Mr. Kolchinsky agrees, I would hope 21 that you would also. 22 it out? 23 24 25 I believe there is. I believe there Check it out. Can you please check Thank you. MR. McDANIEL: I will check. you. VICE-CHAIRMAN THOMAS: For the Thank 319 1 Q & A - Session 2 2 record, especially since we have witnesses 3 in front of us which we say you ought to 4 know more than about your business, and 5 someone else's business, notwithstanding 6 that you were looking at it from a 7 different perspective, I would like to 8 place on the record the fact that the 9 Commission will examine the assertion that 10 we've made, which we believe to be 11 accurate, that there were various rates 12 charged for different tranches and, if 13 need be, correct the record and if not, be 14 proud that we were right. 15 to get the answer correct one way or the 16 other. 17 MR. McDANIEL: But we're going As I said, I did not 18 have the opportunity for a comprehensive 19 check on that. 20 VICE-CHAIRMAN THOMAS: And neither 21 have we, but we believe it to be accurate 22 so we're going to get to the bottom of it. 23 Thank you, Mr. Chairman. 24 CHAIRMAN ANGELIDES: 25 COMMISSIONER BORN: Ms. Born? Thank you very 320 1 Q & A - Session 2 2 much. 3 before us. 4 And thank you both for appearing Mr. Buffett, I'm going to take 5 advantage of your being here by asking you 6 about derivatives and your views of them. 7 As Mr. Wallison has said, your 2002 8 Berkshire Hathaway shareholder letter 9 famously referred to derivatives, and this 10 is, I believe, all derivatives, not just 11 credit derivatives, as, "financial weapons 12 of mass destruction, carrying dangers 13 that, while now latent, are potentially 14 lethal." 15 You also presciently said that they 16 are "time bombs, both for the parties that 17 deal in them, and the economic system." 18 And more recently, in your 2008 19 shareholder letter, you said that Bear, 20 Stearns' collapse demonstrated the time 21 bomb of counterparty risk that you had 22 earlier described. 23 these two shareholder letters be placed in 24 the record. 25 And I would ask that CHAIRMAN ANGELIDES: They will be. 321 1 2 Q & A - Session 2 COMMISSIONER BORN: I would like you 3 to describe your view of the role that 4 derivatives has played in the current 5 financial crisis. 6 MR. BUFFETT: Well, they accentuated 7 enormously, in my view, the leverage in 8 the system. 9 counterparties and one of the -- one of 10 the beauties of the Stock Exchange over 11 the years is that you've had now a 12 three-day clearing system because people 13 realize that if you have a contract, and 14 it's six months later that it settles, 15 that a lot of things can happen in those 16 six months. 17 The huge dependency on In fact, I think the Kuwait Stock 18 Exchange got into big trouble some years 19 back because they had got a very delayed 20 clearing arrangement. 21 contracts with sometimes unbelievably long 22 settlement periods. 23 And derivatives are Generally, we inherited 23,000 24 derivative contracts. I could have hired 25 the 50 smartest Ph.D.s out of MIT to 322 1 Q & A - Session 2 2 prepare some kind of report that would 3 tell me the risk I was bearing, and I 4 wouldn't have gotten the answer. 5 it was impossible to get your mind round 6 that. 7 counterparties. 8 names of a couple of hundred of them. 9 mean, they were foreign institutions I 10 11 I mean, I mean, we had nine hundred I couldn't pronounce the I never heard of. In effect, the integrity of our 12 balance sheet at Gen Re was dependent on 13 all these people behaving at times in the 14 future, which strung out to almost a 15 hundred years in a few cases. 16 So the only answer was to get out of 17 the business. I couldn't design a system 18 that would enable me to know what the hell 19 was going on. 20 So if that was my problem with 23,000 21 of them, you know, I've read about vastly 22 greater numbers that existed at Bear, 23 Stearns or at Lehman and something else. 24 I just think institutions can get out of 25 control and I don't think that's a good 323 1 Q & A - Session 2 2 thing for the system, particularly when, 3 if they are large enough, if they get out 4 of control, it means that society gets 5 interrupted in a very, very major way. 6 COMMISSIONER BORN: Well, following 7 up on that notion, I think you stated in 8 your 2008 letter that the Federal Reserve 9 rescued Bear Stearns because the 10 counterparty risk posed by its enormous 11 position in derivatives would have 12 created, "a financial chain of 13 unpredictable magnitude." 14 correct? 15 MR. BUFFETT: Is that That's correct. And 16 what happened of course, I think, in 17 Lehman was that we saw an example of that. 18 I think it was underappreciated. 19 saying I would have called it right, 20 either. 21 institution that was showing 15 or so 22 billion of book equity, some of it was 23 real estate deals and some of that; but in 24 the end, the debt of 140 million, or 25 whatever it was, is now selling for maybe I'm not But when Lehman failed, an 324 1 Q & A - Session 2 2 30 billion in the market, so that's 110 3 billion. 4 disappear overnight. 5 That kind of money shouldn't COMMISSIONER BORN: And with respect 6 to the other large derivatives dealers, 7 AIG and the large investment banks and 8 bank holding companies that needed TARP 9 money, do you think that played a role 10 11 with respect to them as well? MR. BUFFETT: Yeah, I think the 12 government did the right thing in stepping 13 in at AIG, but I don't think AIG should 14 have gotten there in the first place. 15 AIG, as you probably know better than I, I 16 think there was three hundred billion of 17 derivatives that were essentially designed 18 for something called regulatory arbitrage, 19 which was just a way of relieving the 20 capital pressures on European banks 21 because they got the AAA AIG transferred 22 over. 23 And Well, if you get enough of that sort 24 of thing going on in financial system, 25 you're going to have a problem. 325 1 2 Q & A - Session 2 COMMISSIONER BORN: Well, in light of 3 the problems that you and the other people 4 at Berkshire Hathaway experienced with the 5 general re derivatives position, what's 6 your view of the ability of these enormous 7 derivatives dealers to successfully manage 8 their companies in light of their enormous 9 positions? 10 For example, they hold millions of contracts. 11 MR. BUFFETT: Yes. 12 COMMISSIONER BORN: At year-end 2009, 13 the OCC said that JPMorgan's position was 14 $78.6 trillion in notional amount. 15 can such enormous, complex books of 16 business be successfully managed by human 17 beings? 18 MR. BUFFETT: And I think they are 19 dangerous. I would say this: I don't 20 think I could manage it. 21 to -- it's hard for me to imagine a 22 system -- it's hard for me to imagine a 23 regulatory system that could supervise 24 something like that. 25 of the ironies is that, with only four big It's hard And of course, one 326 1 Q & A - Session 2 2 auditing firms in the United States, I 3 will guarantee you that if you take two 4 big firms that are audited by the same 5 auditor, you will find different prices 6 attributed to given derivatives contracts 7 at the same time that the auditor attests 8 to. 9 I mean, it's mind-boggling, and the 10 23 -- you mentioned our getting out of it. 11 We lost $400 million in a very benign 12 period with no pressures on us, able to 13 exit, and maybe that's why Lehman lost a 14 hundred billion. 15 stuff. 16 But it's very dangerous COMMISSIONER BORN: You also pointed 17 out that, in your, I think, most recent 18 shareholder letter, the 2008 one that I'm 19 referring to, not the 2009, that it's 20 almost impossible for an investor, looking 21 at the financial statements of these big 22 derivatives dealers, to really know what 23 their financial situation is. 24 right? 25 MR. BUFFETT: Isn't that And I think if you 327 1 Q & A - Session 2 2 added a thousand pages of disclosure, it 3 would be impossible, too. 4 report, because we only have 250 5 positions, I try to tell the shareholders 6 what basically the positions are, and I 7 think I can do that. 8 there's only a couple of classes of them, 9 and I can describe them. I try in our But that's because And I think so 10 that anybody that knows accounting, at 11 least, can understand what I'm talking 12 about. 13 But I don't know how -- I don't know 14 how to read a 10-K, whether it's three 15 hundred pages long or three thousand pages 16 long, that can describe a million 17 derivative contracts. 18 COMMISSIONER BORN: Now, you're a 19 very sophisticated investor and I assume 20 in going into derivatives contracts, you 21 carefully examine what the embedded risks 22 are, what the leverage is. 23 I'm concerned that so many 24 municipalities and other large 25 institutional investors that may not have 328 1 Q & A - Session 2 2 your sophistication have gone into these 3 contracts. 4 5 6 I'm concerned that the embedded risks in the leverage aren't fully understood. MR. BUFFETT: I'm sure you're right. 7 You had Orange County, you had Jefferson 8 County in Alabama. 9 if you go back a ways, when Bankers Trust But more importantly, 10 was selling them to P&G, I mean, can you 11 imagine bamboozling the CFO of P&G? 12 it -- when you get these exploding type 13 contracts where, if you hit a given 14 threshold, everything gets multiplied by 15 ten, or -- I don't even know, you know, 16 why the world they are needed. 17 contracts are out there, and I think many 18 times, the people that are buying them 19 don't know what they are doing. 20 COMMISSIONER BORN: So But those There's been 21 enormous growth in this market. The Bank 22 for International Settlement said that 23 globally, the market amounted to more than 24 $614 trillion at the end of last year. 25 There's enormous innovation that's been 329 1 Q & A - Session 2 2 going on, financial innovation. 3 enormous complexity in these contracts. 4 understand that they are very useful for 5 hedging purposes, and I think that's a 6 perfectly legitimate purpose. 7 need some speculators in order to allow 8 hedgers to effectively enter into 9 positions. 10 There's I think you I'm concerned about the enormous 11 growth of purely speculative transactions 12 in the market. 13 view is as to the economic benefit to our 14 society from that speculation. 15 I And I wonder what your MR. BUFFETT: I wrote a letter in 16 1982 to Congressman Dingell, giving my 17 views when they were introducing the S&P 18 index future. 19 legitimate uses for it in hedging out the 20 long positions and so on, but I said, 21 overwhelmingly, it's going to be become a 22 gambling vehicle. 23 between speculative and gambling. 24 Gambling involves, in my view, the creation 25 of a risk where no risk need be created. And I said there are And I would distinguish 330 1 2 Q & A - Session 2 Now, obviously, you plant a crop in 3 the spring and you're going to harvest it 4 in the fall, you're speculating on what 5 prices are going to be in the fall for 6 your corn or oats or whatever that it way 7 be, and you may lay that off on some other 8 speculator. 9 system has to take. 10 11 But that's a risk that that You can't grow it in one day. But when you start wagering on -- 12 well, on stock index futures, I think that 13 gambling instincts are very strong in 14 humans. 15 miles to a bunch of sand originally, you 16 know, and they built a whole city on it, 17 and they would travel on planes and go to 18 all kinds of things to do mathematically 19 unintelligent activity. 20 I mean people went a thousand So it exists. States prey on it with 21 their lotteries. And these contracts are 22 made to order for it, because you can do 23 it on a big scale, and you could do it, 24 and it's very easy to do and you don't 25 have to get on a plane, you don't have to 331 1 2 3 4 5 Q & A - Session 2 break a sweat, and -COMMISSIONER BORN: You don't have to put down any money. MR. BUFFETT: Yes. And the more 6 complex, generally speaking, the more 7 profit there's going to be for the 8 derivatives dealer. 9 a given. You can take that as 10 When I was at Salomon, originally you 11 talked about interest rate futures, fixed 12 to floating or foreign exchange. 13 they became known as plain vanilla 14 contracts because there wasn't any money 15 in them. 16 invented more exotic instruments and 17 that's where the money was. 18 It got competed a way. COMMISSIONER BORN: And then So they Well, I would ask 19 is that the 1982 letter by Mr. Buffett to 20 John Dingell be placed in the record. 21 last question -- 22 CHAIRMAN ANGELIDES: One We have it. 23 It's typed on a Smith-Corona typewriter, 24 apparently. 25 COMMISSIONER BORN: It's a carbon 332 1 Q & A - Session 2 2 copy. Mr. Buffett, in your view, is the 3 derivatives market still a time bomb 4 ticking away? 5 MR. BUFFETT: I would say so. 6 COMMISSIONER BORN: 7 VICE-CHAIRMAN THOMAS: Thank you. Mr. Chairman, 8 will you yield Commissioner Holtz-Eakin 9 one minute? 10 COMMISSIONER HOLTZ-EAKIN: 11 Mr. Buffett, I really appreciated that 12 testimony because what you said about the 13 derivatives and your response to them was, 14 you needed to manage your balance sheet, 15 in which case you just got rid of balance 16 sheets exposed to that. 17 unusual statement in the context of these 18 hearings. 19 again, that whether it be a Citigroup or a 20 Fannie Mae, that, you know, they didn't 21 manage their balance sheet. 22 overwhelmed by something so large that it 23 could not have been imagined, and had 24 everybody simply managed the risks on their balance sheets 25 appropriately, something that large could And that's an We've heard again and again and They just got 333 1 2 3 Q & A - Session 2 not have emerged. And so it is important to come back 4 to that and I think it's important in 5 light of this hearing because, at the 6 heart of the question that faces us today, 7 is the question of what was the management 8 of the balance sheet of these rating 9 agencies? Was the asset being managed, 10 their reputations, and if so, was due 11 diligence done in pricing the most 12 valuable risks, risks that are correlated 13 with the most important thing going on in 14 the economy, or was effort devoted 15 elsewhere to the ability to manage volume 16 and take advantage of pricing power? 17 Which asset management strategy was in 18 place? Thank you. 19 CHAIRMAN ANGELIDES: 20 VICE-CHAIRMAN THOMAS: Go ahead -Mr. Chairman, 21 I would yield Commissioner Wallison the 22 remainder of the time until the 2 o'clock 23 end of this portion -- 24 25 CHAIRMAN ANGELIDES: It's 2 o'clock, but why don't we just say a couple of 334 1 2 3 4 5 6 7 8 9 Q & A - Session 2 minutes, then. VICE-CHAIRMAN THOMAS: I kind of like the more dramatic way I said it. CHAIRMAN ANGELIDES: Or a minute, which is an empty offer since it's 2:01. COMMISSIONER WALLISON: Stop fighting guys, let me ask my question. One of the issues that is central to 10 this hearing today it seems to me is 11 whether the problems at Moody's, and I 12 think you'd all agree there were some 13 problems at Moody's, are systemic in the 14 sense that they extend across the board 15 throughout Moody's, or are simply unique 16 to the housing mortgage area. 17 And one of the ways we can address 18 that is by looking at how successful 19 Moody's, or unsuccessful Moody's has been 20 in rating non-housing asset-backed 21 securities. 22 So Mr. McDaniel, what I would like 23 you to do is to assemble as much 24 information as you can on the other kinds 25 of non-housing asset-backed securities 335 1 Q & A - Session 2 2 that Moody's has rated, and give us a 3 sense of the number of downgrades or even 4 upgrades that occur from time to time in 5 those securitizations. 6 compare the way Moody's operates as a 7 general rule, against what happened in the 8 very unusual housing area which, as you've 9 pointed out, has shocked everyone, 10 That way, we can including the estimable Mr. Buffett. 11 So what I think we want to do is see 12 that data and if you if you'd furnish it 13 to us, get it together and furnish it to 14 us, even without a question from us, that 15 would be very helpful. 16 17 MR. McDANIEL: Be happy to do so, sir. 18 COMMISSIONER WALLISON: 19 CHAIRMAN ANGELIDES: Thank you. Last comment as 20 we wrap up here. As I've read the 21 materials provided by the staff, read 22 innumerable interviews, other background 23 materials, I'm struck with the fact that, 24 with respect to the credit rating 25 agencies' practices and models, seems to 336 1 Q & A - Session 2 2 me that the question isn't so much why did 3 this system fail, but why has it lasted so 4 long. 5 And in that vein, I just want to ask 6 you today what risks do you see from the 7 current credit rating models? 8 way you said there were risks for 9 derivatives, do you see extant risks, In the same 10 current risks from the model essentially 11 being unchanged from where it was when the 12 mistakes, the disaster, however you 13 characterize it, happened? 14 MR. BUFFETT: Well, the huge 15 question, if you were running a rating 16 agency now, if I were running a rating 17 agency -- 18 19 20 CHAIRMAN ANGELIDES: Or if you owned 13 percent in stock-MR. BUFFETT: -- how would I rate 21 states and major municipalities? I mean, 22 if the federal government will step in to 23 help them, they are AAA. 24 government won't step in to help them, who 25 knows what they are? If the Federal I mean, if you're 337 1 Q & A - Session 2 2 looking now at something where you could 3 look back later on and say, "These ratings 4 were crazy," that would be the area. 5 Because it's bimodal. 6 basically -- I don't know how I would rate 7 those myself now. 8 because it's a bet on how the federal 9 government will act over time. 10 I mean, I mean, in other words, CHAIRMAN ANGELIDES: But the real 11 question -- well, but also, in that vein, 12 have you looked at whether the resources, 13 the discipline, the capacity is there 14 internally at Moody's? 15 MR. BUFFETT: I don't think -- I 16 don't think Moody's or Standard & Poor’s or 17 I can come up with anything terribly 18 insightful about the question of state and 19 municipal finance five or ten years from 20 now, except for the fact that there will 21 be a terrible problem and the question become what the federal 22 23 government -CHAIRMAN ANGELIDES: But does the 24 model, irrespective of the particular 25 imminent risk, is the model one that still 26 presents risk, given what you've heard and 338 1 2 3 4 5 Q & A - Session 2 learned today in looking at Moody's? MR. BUFFETT: I think-- you're talking about model-CHAIRMAN ANGELIDES: Talking about 6 the model, issuer pays, all the associated 7 issues we've raised with respect to the 8 Moody's business model. 9 MR. BUFFETT: I think there's utility 10 to the rating agencies. 11 less utility to somebody like me, who's in 12 the business of trying to evaluate credits 13 day by day and been doing it a lot of 14 years. 15 model. 16 I think there's But I think there's utility to the VICE-CHAIRMAN THOMAS: Mr. Chairman, 17 we might as well end on a high note. If 18 we're really looking at the states and 19 municipalities and the comfort that we 20 would get from the federal government 21 proposing to intervene, which then makes 22 the states and the municipalities AAA, 23 there are a lot of folk out there 24 wondering who watches over the watcher in 25 terms of how the federal government is 339 1 2 3 Q & A - Session 2 able to do that. Of course, we know they can print 4 their own money and do a few other things, 5 but they have been doing that for some 6 time now, and there is some concern about 7 that as well. 8 what we talked about in the beginning, 9 behavior should have consequences. I do like to go back to That 10 should apply to people, institutions and 11 governments. 12 13 14 CHAIRMAN ANGELIDES: Thank you very much, witnesses. We are going to take a break, 15 members, until 2:30 and we will reconvene 16 in this room. 17 thank you, Mr. McDaniel. 18 19 20 21 22 23 24 25 Thank you, Mr. Buffett, (Luncheon recess: 2:05 p.m.) 340 1 2 A F T E R N O O N S E S S I O N 3 (2:48 p.m.) 4 CHAIRMAN ANGELIDES: The financial 5 crisis inquiry about will come back to 6 order for our third and final session on 7 the credibility of credit ratings, the 8 investment decisions made based on those 9 ratings and the financial crisis. In this 10 last session, we will have with us, 11 Mr. Mark Froeba and Mr. Richard Michalek, 12 correct? 13 afternoon and to whom we will then direct 14 questions. 15 Who will be testifying this So, gentlemen, thank you very much 16 for being here. 17 submitted written testimony and would like 18 to ask you to give us verbal testimony of 19 no more than five minutes to lead off this 20 panel, and Mr. Froeba, we'll start with 21 you. 22 23 24 25 We know you have now Oh, yes, I forgot, thank you. I just got reminded. My 56-year old brain. Will you please stand and raise right hands so I 341 1 2 Proceedings can swear you in. 3 4 5 6 7 M A R K F R O E B A , R I C H A R D M I C H A L E K, Having been duly sworn, testified as follows: CHAIRMAN ANGELIDES: Good, thank you 8 very much. So the other thing I want for 9 do before we start here, as our agenda 10 reflected, Mr. Brian Clarkson, the former 11 president and COO of Moody's, was to 12 testify here today. 13 believe, his written testimony. And I -- 14 but he is unable to be with us. For the 15 record, I'm going to read a statement from 16 Christina Clarkson, whom I have been given 17 to understand is Mr. Clarkson's spouse, 18 and here's the statement for the record 19 that I've been asked to read: He did submit, I 20 "Brian was rushed to the emergency 21 room at Beth Israel Hospital late last 22 night suffering from acute pain in his 23 side. 24 and will undergo surgery later today. 25 Brian has appreciated the opportunity to He's been admitted to the hospital 342 1 Proceedings 2 participate fully with the FCIC. 3 submitted his testimony to the Commission 4 and had every intention to participate 5 but regrets that he is unable to attend 6 today's hearing." 7 He So I wanted to indicate that for the 8 record. We do have written testimony from 9 Mr. Clarkson. We also interviewed 10 Mr. Clarkson, and we will be presenting 11 written interrogatories to Mr. Clarkson 12 also. 13 14 15 With that, Mr. Froeba -Mr. Vice-Chair, do you have a comment? VICE-CHAIRMAN THOMAS: No, I just 16 said we're putting him on the 15-day 17 disabled list. 18 bring him back. 19 That means that we can CHAIRMAN ANGELIDES: All right, 20 terrific. 21 would begin your testimony. 22 With that, Mr. Froeba, if you MR. FROEBA: Sure. Rick and I have 23 talked about this before. I think my 24 statement is going to be a bit longer than 25 five minutes, which may not be 343 1 Opening - Froeba 2 appropriate. 3 would be willing to yield, and with your 4 consent, yield some of his time to me. 5 6 7 8 9 But if necessary, maybe he CHAIRMAN ANGELIDES: How long do you think your statement will take? MR. FROEBA: I regrettably have not actually tried it out but hopefullyit will be finished in about seven minutes. But if 10 not, I can bring it to a close whenever 11 you want me to. 12 VICE-CHAIRMAN THOMAS: Mr. Chairman, 13 I move that we adopt the quality rule 14 rather than the quantity rule. 15 depending on how good it is. 16 MR. FROEBA: Okay. So I'll try to make 17 it entertaining. 18 already read it, and can tell me what you 19 think. 20 Perhaps some of you have Anyway, my name is Mark Froeba. I'm 21 a lawyer. 22 York City, I am a 1990 graduate of the 23 Harvard Law School cum laude. 24 left Skadden, Arps in New York to join the 25 derivatives group at Moody's. 26 I live and work here in New In 1997, I I left Moody's in 2007 as a Senior 344 1 Opening - Froeba 2 Vice-President. 3 leader of the CLO team, co-chair of most 4 CLO rating committees and jointly 5 responsible for evaluating all new CLO 6 rating guidelines. 7 At that time, I was team I am happy to say that the majority 8 of CLOs have exhibited a high level of 9 stability throughout this crisis. Today, 10 I'm currently engaged with PF2 Securities 11 Evaluations, a New York-based firm which 12 consults on CDO securities. 13 You've asked me to answer several 14 questions about Moody's and its role in 15 the current financial crisis. 16 to these questions falls into three parts: 17 My answer First, I will describe in general the 18 cultural revolution that Moody's senior 19 management imposed at Moody's and some 20 compelling evidence of its impact; 21 Second, I will describe the 22 techniques Moody's senior management used 23 to implement this revolution, and why they 24 were successful; 25 And finally, if I have time, and I 345 1 Opening - Froeba 2 don't think I will, I will describe a 3 particularly egregious example of how the 4 revolution corrupted the process of rating 5 analysis. 6 CHAIRMAN ANGELIDES: 7 one of our first questions. 8 9 We can make that VICE-CHAIRMAN THOMAS: one first. 10 MR. FROEBA: Okay. Well, I'll get to 11 it. 12 give you a summary of it. 13 returning to the -- 14 Yes, make that Maybe we'll get to it. VICE-CHAIRMAN THOMAS: I'll at least Anyway, In all 15 seriousness, let me say, don't worry about 16 that one. 17 and you can do it on my time. 18 19 20 That will be my first question MR. FROEBA: Thank you. The cultural revolution at Moody's: The story of Moody's role in the 21 financial crisis begins sometime in the 22 year 2000, the year that Dun & Bradstreet 23 Corporation and Moody's Corporation became 24 separate, independent publicly-traded 25 companies; and I might add that Moody's 346 1 Opening - Froeba 2 senior managers were first able to begin 3 receiving compensation in the form of 4 stock options and other interests directly 5 in Moody's Corporation. 6 Before then, Moody's had an extremely 7 conservative analytical culture. Moody's 8 analysts were proud to work for what they 9 believed was by far the best of the rating 10 agencies. 11 any new product that was unusual or 12 complex, the Moody's rating was the one to 13 get; and that without it, it would be 14 difficult or even impossible to market 15 the new product. 16 of that time had the stature and maybe 17 even the power to stop something like the 18 subprime bubble, had it arisen then. 19 Everyone understood that for In short, the Moody's Unfortunately, by the time the bubble 20 arrived, Moody's had deliberately 21 abandoned its stature, surrendered its 22 power and given up its analytical 23 distinctiveness. 24 25 How did it happen? Under the guise of making Moody's more business-friendly, for example, 347 1 Opening - Froeba 2 making sure that analysts would return 3 telephone calls, Moody's senior managers 4 set in motion a radical change in Moody's 5 analytical culture that not only changed 6 the rating process but also profoundly 7 affected Moody's ratings. 8 9 When I joined Moody's in late 1997 an analyst's worst fear was that we would 10 contribute to the assignment of a rating 11 that was wrong. 12 analyst's worst fear was that he would do 13 something, or she, that would allow him or 14 her to be singled out for jeopardizing 15 Moody's market share. 16 When I left Moody's, an The best example of this was 17 described in a Wall Street Journal article 18 about Moody's managing director, Brian 19 Clarkson, published in April of 2008. 20 that article reports, Brian Clarkson 21 quadrupled Moody's market share in the 22 residential mortgage securities group by 23 simply firing or transferring nearly all 24 the analysts in the group and replacing 25 them with analysts willing to apply a new As 348 1 Opening - Froeba 2 rating methodology. 3 about this new approach to the bottom line 4 at Moody's in The Wall Street Journal 5 article, there was never an explicit 6 directive to subordinate rating quality to 7 market share; there was, rather, a 8 palpable erosion of institutional support 9 for any rating analysis that threatened 10 11 As I am quoted saying market share. My mom asked me once what did that 12 actually mean. 13 now I'll explain to you what it means. 14 Moody's senior managers never set out to 15 make sure that Moody's rating answers were 16 always wrong. 17 a new culture that would not tolerate for 18 long any answer that hurt Moody's bottom 19 line. 20 definition, the wrong answer, whatever its 21 analytical merit. 22 It was a little dense, but Instead, they put in place Such an answer became, almost by However, arriving at an accurate 23 answer was never objectionable, so long as 24 that answer did not threaten market share 25 and revenue. For this reason, there are 349 1 Opening - Froeba 2 some structured finance securities where 3 Moody's ratings continue to be accurate 4 and of high quality. This is not evidence 5 of rating integrity. It is simply 6 evidence that for these types of 7 securities, Moody's was not exposed to 8 rating competition. 9 In my opinion, wherever Moody's 10 encountered material market share 11 pressure, rating competition, we can 12 expect to see that its ratings become 13 indistinguishable from the ratings of its 14 competitors. 15 Is there evidence that this is what 16 really happened? I do not expect that you 17 will find e-mails, minutes of meetings or 18 memoranda setting forth the plan to change 19 Moody's culture. 20 evidence is the most obvious. 21 Moody's market share and revenue over time 22 for any particular structured finance 23 security, and compare it to the timing of 24 material changes in Moody's rating 25 methodology for that security. However, the best Simply plot You should 350 1 Opening - Froeba 2 find that Moody's consistently responded 3 to the onset of market share and revenue 4 pressures by initiating material 5 methodological changes. 6 There is also evidence of this from 7 Moody's own internal business 8 effectiveness survey, a periodic survey 9 that allowed Moody's employees to 10 criticize superiors anonymously. The BES 11 results were apparently so disturbing in 12 one survey that Brian Clarkson himself 13 visited various structured finance group 14 meetings, including a meeting of my group 15 at Moody's, to report that junior analysts 16 had complained in the BES that accurate 17 rating analysis was more and more being 18 subordinated to considerations of market 19 share and revenue in the rating process, 20 and two, to reassure everyone that this 21 was not at all the case. 22 Of course, at this meeting, Brian 23 seemed merely to pay lip service to a 24 principle that his other words and actions 25 contradicted. He did not describe any 351 1 Opening - Froeba 2 effort by Moody's to uncover the cause of 3 these complaints; moreover, he did not 4 describe anything Moody's had done to 5 eliminate those causes. 6 the effect of reinforcing the very view 7 that he was supposed to be there to 8 correct. 9 really were much more important than Together this had That market share considerations 10 getting the answer right. 11 neither he nor anyone in Moody's 12 management did anything to unwind the many 13 changes that provoked these BES survey 14 results. 15 And in the end, What were the changes, what were the 16 techniques they used to accomplish the 17 culture change? 18 19 20 21 22 There were two ways -- CHAIRMAN ANGELIDES: Just to do a little check here, how far along are you? THE WITNESS: I would same I'm about halfway. CHAIRMAN ANGELIDES: I'm going to ask 23 you to see if you can wrap up in the next 24 minute or two, all right? 25 MR. FROEBA: All right. 352 1 Opening - Froeba 2 CHAIRMAN ANGELIDES: 3 MR. FROEBA: 4 5 Okay. Two minutes. Well, Rick was going to cede me a couple minutes-CHAIRMAN ANGELIDES: Do me a favor, 6 just, I agree, just two minutes, hit the 7 high points, and then we can go to 8 questions. 9 MR. FROEBA: There were ways that 10 Moody's senior management imposed a new 11 culture on Moody's analysts. 12 used intimidation to create a docile 13 population of analysts afraid to upset 14 investment bankers, and ready to cooperate 15 to the maximum extent possible. 16 First, they Second, they emboldened investment 17 bankers, gave them confidence that they 18 could stand up to Moody's analysts and 19 gave them reason to believe that Moody's 20 management would, where necessary, support 21 the bankers against its own analysts. 22 And I will now skip over most of my 23 discussion of the ways in which Brian used 24 threats of employment termination to 25 intimidate analysts. But before I leave 353 1 Opening - Froeba 2 that topic of termination, I want to make 3 a point that, as a tool to implement the 4 culture change at Moody's, it is important 5 to point out that Brian was not a rogue 6 manager running amok. 7 While Moody's board and president 8 were deceived about his conduct, they 9 recognized in Brian the character of 10 someone who could do uncomfortable things 11 with ease and they exploited his character 12 to advance their agenda. 13 ones who put Brian in charge of the RMBS 14 group, and we can be quite confident he 15 was not put there to improve morale. 16 is why it is important not to think about 17 Brian separately from the people who were 18 using him to implement the culture change 19 at Moody's; first, John Rutherford, Jr., 20 and then Ray McDaniel. They were the This 21 One collateral consequence of the 22 cultural change was an inevitable and 23 sometimes deliberate change in the quality 24 of managers and analysts at Moody's, at 25 least in the structured finance area. At 354 1 Opening - Froeba 2 a rating agency, independence of mind 3 among managers and analysts is a very 4 valuable thing if you are looking for the 5 right answer, and a very inconvenient 6 thing if you are looking for an answer to 7 enhance revenue and profit. 8 For this reason, strong academic 9 credentials and the independence of mind 10 that comes with them came to be valued 11 less in promotion decisions than they had 12 once been. 13 derivatives group on the quantitative side 14 had very distinguished academic 15 credentials. 16 economics from Stanford; other another a 17 Ph.D. in mathematics from MIT, a third a 18 Ph.D. in statistics from Wharton; one 19 other did not have a Ph.D., but had both 20 an MBA and an M.S. in statistics. 21 At first, all the MDs in the One a had a Ph.D. in Later MDs did not have such 22 distinguished credentials. For example, 23 into the midst of all these academic 24 credentials, Brian promoted a new MD, Yuri 25 Yoshizawa, who had not earned any graduate 355 1 Opening - Froeba 2 degree at all. 3 credential is an undergraduate degree with 4 a major emphasis in international 5 relations. 6 Her only academic Of course, Yuri is a capable person 7 with undeniable skills. Nevertheless, the 8 marked contrast between her academic 9 qualifications and those of her 10 predecessors and colleagues at least 11 invites the inference that her selection 12 was intended to keep the scope of her 13 analytic work directed within new and more 14 limited boundaries. 15 16 17 CHAIRMAN ANGELIDES: If you would please wrap it up. MR. FROEBA: Yes. It cannot be the 18 case with such a limited academic 19 background that Yuri was expected to 20 interact as an equal with bankers who 21 themselves had much stronger and more 22 relevant backgrounds. 23 And then Moody's, without completing 24 that thought, and -- I'll just say in 25 summary, Moody's also in addition to 356 1 Opening - Michalek 2 intimidating analysts, went through a 3 whole series of steps that encouraged 4 bankers against the analysts. 5 6 7 8 9 10 And that will the conclusion of my testimony. CHAIRMAN ANGELIDES: And we can get to your comments and questions. Mr. Michalek? MR. MICHALEK: Mr. Chairman -- 11 Mr. Vice Chairman, fellow commissioners. 12 My name is Richard Michalek, and I want to 13 thank you and your staff for inviting me 14 to participate in today's hearings. 15 I'm a former employee of Moody's. I 16 joined the structured derivatives products 17 group at Moody's in June of 1999. 18 position was eliminated in December of 19 2007. 20 title of Vice-President, Senior Credit 21 Officer. 22 included performing legal analyses on the 23 structure and documentation of complex 24 structured finance transactions in order 25 to assign a rating to that transaction, My At the end of my tenure, I held the My general responsibilities 357 1 Opening - Michalek 2 and to assist in the development and 3 refining of rating practices, policies and 4 methodologies used by the group. 5 My regular responsibilities included 6 participating in rating committees within 7 the group and, on request, for other 8 groups; consulting on legal matters for 9 other groups in New York, London and the 10 Asian offices of Moody's when requested, 11 and speaking at industry conferences on a 12 wide variety of legal and structural 13 issues. 14 I also prepared and published the CDO 15 group's quarterly and annual review and 16 survey of activity, and I assisted with 17 the legal portion of semiannual training 18 sessions for all new hires in the 19 structured finance department. 20 During my last year at Moody's, my 21 primary responsibilities were split 22 between serving as a senior legal analyst 23 on a team responsible for developing, 24 refining and implementing the methodology 25 for assigning ratings to highly complex 358 1 Opening - Michalek 2 credit derivative product companies, and 3 being a project leader responsible for 4 developing a methodology for rating 5 collateral managers. 6 My testimony today is based on, and 7 primarily limited to, my experience 8 working in the CDO group at Moody's. 9 while I had the opportunity to interact And 10 with several other groups, I do not 11 profess any particular expertise or 12 advanced knowledge of the methodologies or 13 practices employed in those groups. 14 My testimony today is also not being 15 delivered with the intention to defame 16 Moody's or bring harm to any individual or 17 stand in judgment of individual behavior. 18 On the contrary, as I hope my oral remarks 19 and written statement will illustrate, I 20 believe that imperfections, flaws and 21 failures observed in the credit crating 22 products for structured derivative 23 products are neither surprising nor 24 unexpected in light of framework of 25 incentives presented to the competent and 359 1 Opening - Michalek 2 otherwise rational people comprising the 3 credit rating agencies. 4 In theory, credit rating agencies 5 serve the important function of providing 6 buyers and sellers of credit, that is, 7 investors in and issuers of a promise to 8 pay, with an independent measure of the 9 risk presented. Ideally, these agents are 10 independent. And because of repeat 11 experience and rationalization of cost, 12 they should be able to provide this 13 measure of risk at a lower cost than would 14 otherwise be faced if the buyers or 15 sellers produced the analysis themselves. 16 My experience as an analyst, however, 17 in the derivatives group and as a legal 18 resource in the derivatives group for 19 other groups at Moody's, provides what I 20 hope would be a useful perspective with 21 respect to a couple of questions 22 Commissioners may have asked or have already 23 asked. 24 A few questions keep coming up. 25 how independent are these agencies, Just 360 1 Opening - Michalek 2 particularly within an issuer-pays 3 framework, and what consequences the 4 rating agencies suffer under the current 5 or any proposed framework, when these 6 measures of risk either fail to perform as 7 reasonably expected, or which can be shown 8 to have lacked the level of care 9 commensurate with the risk of harm that 10 may foreseeably befall the user who relies 11 on such measures. 12 As for that first question, in my 13 view, the independence in culture of the 14 derivatives group changed dramatically 15 during my tenure. 16 decline to rate or just say no to proposed 17 transactions steadily diminished. 18 unwillingness to say no grew in parallel 19 with the company's share price and the 20 proportion of total firm revenues 21 represented by structured finance 22 transactions. 23 The willingness to That In my opinion, the apparent loss of 24 bargaining power by the rating agencies in 25 general and the group in particular was 361 1 Opening - Michalek 2 coincident with the steady drive towards 3 commoditization of the instruments we were 4 rating. 5 sensitive to the increasing complexity of 6 the products we were being asked to rate. 7 That drive was not sufficiently As our customers, principally, the 8 investment banks, produced more and more 9 product for yield-hungry investors, and as 10 the quality distinction between the 11 different rating agencies lost some of its 12 importance, the threat of losing business 13 to a competitor, even if not realized, 14 absolutely tilted the balance away from an 15 independent arbiter of risk towards a 16 captive facilitator of risk transfer. 17 The second question, in essence, what 18 should result if a rating agency gets it 19 wrong, is in my view asking a question of 20 more fundamental questions. 21 bear the risk of getting it wrong, 22 particularly when it's within reach to 23 either not get it wrong or choose not to 24 rate. 25 the rating agency's products, should all Who should If we accept that the ratings are 362 1 Opening - Michalek 2 the ratings issued by a rating agency he 3 entitled to the same defenses for product 4 liability? 5 I'm of the opinion that much more 6 could have and should have been done to 7 improve processes and procedures, but I'm 8 not so naive as to fail to appreciate that 9 this the competitive environment of hyper 10 growth, where the message from management 11 was not, "Just say no," but instead, "Must 12 say yes." 13 be spent on remedial corrections. 14 Installing improvements were left for the 15 "some day" pile. Any available resource had to 16 I'm in the camp that believes to a 17 significant degree that ratings provide an 18 important public good. 19 that some ratings, in light of the public 20 good they provide, deserve some measure of 21 protection from liability and 22 opportunistic claims of negligence. 23 I also believe However, to the extent that agencies 24 are to remain wholly private entities, 25 understandably concerned with market share 363 1 Opening - Michalek 2 and net profits, a distinction based on 3 the extent of the public good might be 4 made. 5 be raised as to the extent of the public 6 benefit from rating one or more of the 7 highly complex or novel instruments, the 8 liability for getting it wrong might be 9 more fairly assigned to the private 10 Where some question can reasonably parties involved. 11 I'm confident that if questions of 12 negligence were not as easily dismissed by 13 the protestations of free speech and 14 opinion, at least for that subset of 15 ratings on approximate with the benefit of 16 the rating falls primarily to the private 17 parties involved, the agencies would 18 redirect some of their extraordinary 19 profit margins into resources, research, 20 and would once again have an incentive to 21 just say no. 22 23 24 25 I stand ready to answer any questions you may have. Thank you. CHAIRMAN ANGELIDES: much, gentlemen. Thank you very I'm going to start with 364 1 Q & A - Session 3 2 a few questions, go to the other members, 3 and then we'll probably return to ask some 4 more at the tail end of this. 5 I think I actually want to start with 6 you, Mr. Froeba, and not to ask you to 7 complete the balance of your statement, 8 but to talk in substance about a couple of 9 things to which you alluded. 10 One is, you talked about charting 11 model changes over time. 12 elaborate specifically on that, you know, 13 and I'd like to you address very specific 14 instances of how models changed over time 15 to the detriment of the ratings quality. 16 MR. FROEBA: Sure. I want you to A rating agency's 17 primarily intellectual property is its 18 rating methodology for a particular type 19 of asset. 20 to junior people and they apply it on a 21 case-by-case basis and the rating 22 committee endorses that application. 23 That methodology is then taught But the key feature of what the 24 rating agency does is, a key tool it uses, 25 is its methodology for assigning rating to 365 1 2 3 Q & A - Session 3 a particular product. I'm simply, in my comments here, 4 saying that in order to verify what I'm 5 saying, that you would need to -- if you 6 plotted Moody's market share for any 7 particular type of structured finance 8 credit, and on the same chart, put Moody's 9 timing of major methodological changes, I 10 think you'll find a correspondence between 11 changes in methodology and market share 12 pressure. 13 trying to make. 14 So that was the point I was CHAIRMAN ANGELIDES: But what I'd 15 like to have you elaborate on, what kinds 16 of changes in methodology did you see? 17 Specific examples of the kind of changes 18 in methodology. 19 MR. FROEBA: In the CLO area where I 20 was primarily involved, we had almost no 21 major methodological changes, and we had 22 almost no rating competition. 23 areas where there was more pressure, for 24 example, in RMBS, there were major 25 methodological changes about the time that In other 366 1 Q & A - Session 3 2 the whole team was fired, and their market 3 share grew substantially. 4 Another area -- 5 CHAIRMAN ANGELIDES: 6 7 The team being fired in the early 2000s? MR. FROEBA: Yes. It wasn't just 8 that they fired the team, it was that they 9 also changed their methodology. 10 11 example is in the area of the CDOs of ABS. CHAIRMAN ANGELIDES: 12 for a minute. 13 change the methodology? 14 15 16 17 Another But stop there In which ways did they MR. FROEBA: I'm not an expert in the RMBS methodology. CHAIRMAN ANGELIDES: Well, you've been told that they changed it? 18 MR. FROEBA: Yes. 19 CHAIRMAN ANGELIDES: 20 MR. FROEBA: By? It was understood at 21 Moody's that the reason Moody's fired all 22 those people, including Mark Adelson, who 23 was the head of the group, was that the 24 market share was 14 or 15 percent, and 25 that his view of the asset was so 367 1 Q & A - Session 3 2 conservative that it was causing Moody's 3 to not be able to rate the bulk of the 4 deals that were out there. 5 In fact, to my recollection, people 6 described Mark Adelson's departure as 7 being associated primarily with the fact 8 that he allowed the market share to drop 9 to 14 or 15 percent and that he wasn't 10 11 willing to update his view. When you say, "update his view," what 12 do we mean? Change the methodology. 13 Improve it. To make it more -- to keep 14 Moody's in a position to acquire more 15 business. 16 17 18 CHAIRMAN ANGELIDES: All right, keep going. MR. FROEBA: And then my example at 19 the end of my prepared testimony is 20 another case where, under some market 21 share pressure, in anticipation of more 22 market share pressure, there was a 23 methodological change that restored market 24 share. 25 those are just examples that happened to So those are some examples. I -- 368 1 Q & A - Session 3 2 cross my path in my area, which was CLOs, 3 and was not even related to these other 4 areas, loosely related. 5 So I think what you'll find, if 6 you -- if you were to take all the major 7 structured finance asset classes, find the 8 ones where there was significant market 9 share pressure and check the timing of 10 major methodological changes, I think 11 you'd see some correlation between changes 12 in methodology and market share pressure. 13 That's the point I'm making. 14 evidence of the culture change. 15 longer possible to tolerate methodologies 16 which produce zero revenue, or -- not 17 zero, but which result in Moody's having 18 to say no to a transaction. 19 CHAIRMAN ANGELIDES: That becomes It's no All right. Talk 20 very briefly about Yuri Yoshizawa, very 21 quickly. 22 please, and don't hold the lack of a 23 graduate degree against her, because the 24 chair does not hold one. 25 record. You didn't finish that thought, Just for the 369 1 2 Q & A - Session 3 MR. FROEBA: I don't. I don't. I 3 use that as an example, not because she 4 lacks a graduate degree, but to point out 5 that her peers at the time had them, and 6 that she was put in a position where she 7 needed to interact with others on a 8 quantitative level who would be those 9 people -- 10 11 12 CHAIRMAN ANGELIDES: So it's the quantitative skill sets that were lacking? MR. FROEBA: I'm not even commenting 13 that I think she was lacking them. 14 simply saying, if you were looking at her 15 on paper, versus the people who were her 16 predecessors and colleagues, and versus 17 the people whom she would be dealing with. 18 CHAIRMAN ANGELIDES: 19 bright, talented -- 20 MR. FROEBA: 21 22 23 24 25 I'm She was very That's possible. That's possible. CHAIRMAN ANGELIDES: Talk specifically about the threats -MR. FROEBA: Even most very bright people are not going to be able to handle, 370 1 Q & A - Session 3 2 you know, quantitative discussions with 3 Ph.D.s in statistics and math, if -- based 4 on an undergraduate major in math. 5 would be -- that's my point. 6 wrong. 7 CHAIRMAN ANGELIDES: 8 MR. FROEBA: 9 10 That Maybe I'm Okay. Maybe it doesn't depend on -- she want to Stanford, so -CHAIRMAN ANGELIDES: I don't think 11 that matters, and I think it goes to 12 intrinsic capacity of a management leader. 13 Let me ask you this question -- 14 MR. FROEBA: You wanted me to follow 15 up on Yuri, was that -- 16 CHAIRMAN ANGELIDES: 17 18 19 20 I think you made your point -MR. FROEBA: Oh, there was one other, yeah. CHAIRMAN ANGELIDES: Go ahead. Was 21 there another point you wanted to make 22 very quickly? 23 MR. FROEBA: In my prepared testimony 24 I talked about the case where I happened 25 to be aware of an incident in which she 371 1 Q & A - Session 3 2 retaliated against an analyst by removing 3 them form a deal, even though she 4 testified recently that she remembered no 5 such case. 6 7 8 9 10 CHAIRMAN ANGELIDES: Is this the Steve Lucci, is that it, Liucci, or not? MR. FROEBA: No, he was not involved in that case. CHAIRMAN ANGELIDES: So why don't you 11 tell, I understand that she -- correct, 12 Ms. Yoshizawa -- 13 MR. FROEBA: Yes. 14 CHAIRMAN ANGELIDES: -- yes, that she 15 testified before the Senate subcommittee 16 that she never removed someone from a 17 transaction except for scheduling 18 purposes. 19 MR. FROEBA: Or, she also later on 20 went on to say that if she thought they 21 were being abused by bankers she would 22 remove them, too. 23 24 25 CHAIRMAN ANGELIDES: So do you want to give us a specific instance? MR. FROEBA: Yes, and I'm not 372 1 Q & A - Session 3 2 necessarily going to name the names of the 3 people involved, although I could do so. 4 5 CHAIRMAN ANGELIDES: the record. 6 MR. FROEBA: 7 CHAIRMAN ANGELIDES: 8 9 You should, for But not perhaps here. Well, there's only one place to do it. MR. FROEBA: Anyway, the person -- 10 maybe you don't want me to go into the 11 story if I don't name the names. 12 13 14 CHAIRMAN ANGELIDES: Well, just do it quickly. MR. FROEBA: There was a transaction 15 in which a banker complained vociferously 16 about an analyst who was relatively new, 17 and Yuri took her off the deal and 18 replaced her, and ultimately the person 19 who was replaced was fired; and the 20 analyst who was the replacement analyst, 21 both the one who left and the one who 22 stayed to work on the transaction, told me 23 about the story, and in that -- in that 24 story, it was clear that, from the 25 testimony to me, of the second analyst, 373 1 Q & A - Session 3 2 replacement analyst, that the work the 3 first analyst had done was good work, and 4 that it had not been defective. 5 6 CHAIRMAN ANGELIDES: MR. FROEBA: 8 CHAIRMAN ANGELIDES: 10 Had it been objected to by a banker? 7 9 So -- Yes. I'm going to ask you to provide the information to our staff. 11 MR. FROEBA: I will. 12 CHAIRMAN ANGELIDES: But given that 13 there was what personnel action, I'm not 14 going to press you right now for specific 15 names. 16 17 18 19 20 MR. FROEBA: That's why I didn't quantity to put in the name. CHAIRMAN ANGELIDES: Yes, Mr. Michalek? MR. MICHALEK: Mr. Chairman, you had 21 asked about specific instances where the 22 methodology was affected by potential 23 pressure for market share. 24 we can sort of focus is where there was 25 the development of new methodologies. One place that In 374 1 Q & A - Session 3 2 the area that I worked in, the credit 3 derivatives products companies, 4 which Dr. Witt referred to as structured 5 finance operating companies, because that 6 was their nomenclature when they were 7 still at that level of development, was 8 one area where the methodology was under 9 significant pressure because our 10 competitor rating agencies, Standard & 11 Poor’s, was developing a methodology that 12 was significantly less onerous from a 13 capital perspective. 14 Credit derivative product companies, 15 and I wouldn't try to describe in detail 16 what they were doing, were effectively 17 completing with the monoline insurers. 18 they were providing insurance to issuers 19 of AAA-rated obligations, because the 20 monolines, based solely on their balance 21 sheet, are offering this guarantee of the 22 performance of that AAA-rated entity and 23 if you'd -- as we've subsequently seen, 24 the risk that these monolines were exposed 25 to was enormous, and there wasn't actually So 375 1 Q & A - Session 3 2 a strong quantitative methodology for 3 determining whether or not that exposure 4 was adequately capitalized at the 5 monolines. 6 So the idea came forth to develop a 7 quantitative way of approaching the 8 sufficiency of a AAA, which created some 9 problems internally at Moody's because 10 effectively, we were now competing with 11 ourselves, because the monoline insurers 12 were getting their AAAs only after years 13 of demonstrated ability to perform; and 14 these new credit derivative product 15 companies and structured finance operating 16 companies were effectively coming and 17 saying, "We'll put up the right amount of 18 capital and we'll show you that it's the 19 right amount of capital, but we want a AAA 20 rating today, with no prior experience." 21 Well, clearly, that was a high risk 22 situation. You had to identify with 23 certainty that you can issue a AAA rating 24 based on largely a quantitative modeling 25 of what was actually being presented. 376 1 Q & A - Session 3 2 And so the development of that 3 methodology really was quite on point, 4 that we did have to delay and delay our 5 release of the methodology and we were, in 6 several cases, told that we had to go back 7 to drawing board because our competitor 8 rating agency was requiring a lower level 9 of capital and therefore, people were not 10 going to choose us as the rater but would 11 use our competitor. 12 CHAIRMAN ANGELIDES: And the final 13 outcome was the adoption of a methodology 14 that has since met the lower bar? 15 MR. MICHALEK: Well, it was a 16 compromise situation and I do think that 17 we had a couple of potential clients who 18 said, "I'm sorry, it's simply too onerous 19 so we're not going to use you." 20 did -- an extreme amount of pressure was 21 actually imposed on us to come to a rating 22 in a time that several people who were at 23 the rating committee were suggesting was 24 on too accelerated a basis and that we 25 still needed to do further work. But we 377 1 2 Q & A - Session 3 CHAIRMAN ANGELIDES: But was there 3 explicit pressure or was it methodological 4 discourse? 5 told, "Look, we can't have a standard 6 that's so much different than Standard & 7 Poor's," or was it "We think there are 8 flaws in the Standard & Poor's" -- I'm 9 just trying to get the dialogue. In other words, were folks 10 MR. MICHALEK: 11 combination of those. 12 It would have been a CHAIRMAN ANGELIDES: So there was 13 explicit elements of "We've got to be in 14 the marketplace with a product that's 15 close," and then obviously people think 16 about still trying to do that in a way 17 that we can -- 18 MR. MICHALEK: Correct. Things would 19 always be delivered that way and I think 20 that's the right way to -- 21 CHAIRMAN ANGELIDES: 22 constant tension? 23 MR. MICHALEK: 24 25 Was there a During the development of this methodology, it was significant. CHAIRMAN ANGELIDES: Okay. And what 378 1 2 3 Q & A - Session 3 time frame was this? MR. MICHALEK: 2005. If you look at 4 the development of the methodology, I 5 think there's a piece that Moody's 6 published and it's written by Dr. Radanti 7 Tzani. 8 took a long time in development, and 9 certain compromises had to be made in She's the author, and that piece 10 order to even come to the market with that 11 published methodology. 12 CHAIRMAN ANGELIDES: Along those 13 lines, was there a general understanding 14 in these, that the -- you know, that those 15 who give out the easier grades get the 16 biggest number of students? 17 MR. MICHALEK: Yes. It was a 18 constant case of balancing. We were 19 trying to maintain our competitiveness. 20 Obviously, we weren't going to get paid, 21 we weren't going to be able to give an 22 opinion if we weren't on the deal. 23 the same time, there was a concern, 24 particularly in this situation, that the 25 risk was enormous. Because we were But at 379 1 Q & A - Session 3 2 talking about a book of business that 3 would start at five hundred million 4 dollars, where they were needing to raise 5 capital of that amount because of the 6 exposure that they were going to 7 immediately be writing. 8 So they needed to raise initially, 9 the thought was, perhaps you would need as 10 much as five hundred million dollars 11 worth of capital to start rating and then 12 you'd have to build a book of business 13 that over time would ramp to ten or 15 or 14 $20 billion, and that leverage was 15 expected to continue to increase and it 16 would only be over time where they reduced 17 the amount of capital. 18 But that was significantly more than 19 our competitor rating agency was actually 20 expecting in order to issue that AAA 21 rating. 22 CHAIRMAN ANGELIDES: All right. I'm 23 going to hold -- I will ask one question, 24 if you can do it very quickly. 25 mentioned specific threats against You 380 1 Q & A - Session 3 2 employees if they didn't, what, rate 3 deals? 4 MR. FROEBA: Well, I think I left out 5 some discussion of ways in which Brian 6 threatened to fire people. 7 part of his approach -- 8 CHAIRMAN ANGELIDES: 9 10 That was a key It's explicit threats? MR. FROEBA: Are you saying, "I'm 11 going to fire you unless you rate this 12 transaction?" 13 it was -- it was, he would repeatedly tell 14 you -- he would remind you repeatedly that 15 you were vulnerable to being fired, with 16 the example, for example, of all the, the 17 22 people from the -- you probably haven't 18 heard this. 19 No, no. It was sort of -- Brian was famous for his joke within 20 Moody's that his only regret in firing 22 21 people from the RMBS group was that one of 22 them got a job before he could fire him. 23 And he repeated that joke regularly. 24 the point was to remind you that you were 25 vulnerable to being fired. And 381 1 2 Q & A - Session 3 There was a point which Rick has 3 actually talked about -- Mr. Michalek has 4 talked about a meeting that many of us who 5 were lawyers in the derivatives group had 6 with him, and that meeting was really 7 designed to remind us that we, too, were 8 vulnerable to being fired when he took 9 over the group. And I could elaborate on 10 that, but you wanted a short answer, so 11 that's my answer. 12 CHAIRMAN ANGELIDES: Okay. I think 13 that's it for me at this moment, and I'm 14 going to go on now to the Vice-Chairman. 15 VICE-CHAIRMAN THOMAS: Thank you, 16 Mr. Chairman. 17 now, unfortunately, not because of you 18 folk, but because of someone at a higher 19 management level, resembles more the first 20 panel that we had than we had anticipated. 21 This panel, in its makeup Notwithstanding the bona fides in 22 your testimony, Mr. Froeba, I do want to 23 ask those that I had talked to earlier, 24 Mr. Chairman -- this is highly unusual, 25 but I noticed off to my left, the 382 1 Q & A - Session 3 2 audience's right, Dr. Witt is still here. 3 And Dr. Kolchinsky is still here. 4 were the ten years that you were at 5 Moody's? 6 MR. FROEBA: 7 VICE-CHAIRMAN THOMAS: What '97 to 2007. '97-'07. That 8 coincides. You just nod your head, 9 because we're not going to put it on the 10 record, but I'll signify the direction of 11 the head movement, you were there at the 12 same time? 13 A VOICE: Yes, sir, I began in -- 14 VICE-CHAIRMAN THOMAS: You don't have 15 to talk. 16 those gentlemen nodded their heads. 17 Just nod your head. MR. FROEBA: Both of I can confirm on the 18 record, they were both there 19 contemporaneous with me in the same group. 20 VICE-CHAIRMAN THOMAS: I appreciate 21 your telling me that, but I asked them. 22 Okay? 23 Would you say that the testimony was 24 substantially accurate based upon your 25 experiences? Okay. You heard the testimony. Nod your head yes or no. 383 1 Q & A - Session 3 2 You have to say something, go ahead. 3 DR. WITT: I have to say yes or no. 4 I substantially, I wouldn't agree with he 5 every nuance, but I know exactly what Rick 6 is talking about, and there were 7 differences of opinion -- 8 VICE-CHAIRMAN THOMAS: 9 referring to. Rick I'm not Right now I'm referring to 10 Mark's testimony. 11 DR. WITT: About individuals. And about Brian applying 12 pressure to people, saying that they might 13 be fired? 14 VICE-CHAIRMAN THOMAS: This isn't 15 going to work. 16 have done it. 17 more like Judge Judy than most of the 18 testimony that we've had. 19 That's why I shouldn't This sounded a whole lot You were there for ten years. This 20 reduction in quality, this shift in 21 management toward getting the bucks 22 instead of getting it right, occurred 23 roughly when along that timeline? 24 25 MR. FROEBA: I think it was a progressive development over time. I got 384 1 Q & A - Session 3 2 there in '97. 3 probably accelerated. 4 acute beginning with the time when Brian 5 took over the group, which was, I think, 6 the derivatives group in 2002. 7 8 9 10 So the change in culture It was particularly VICE-CHAIRMAN THOMAS: And it accelerated from there? MR. FROEBA: Yes. VICE-CHAIRMAN THOMAS: So you were 11 there roughly five years, and then you 12 were there five years after it? 13 MR. FROEBA: 14 VICE-CHAIRMAN THOMAS: 15 stay that long? 16 MR. FROEBA: Correct. So why did you I'm not sure I 17 understand your question. 18 feel like I should leave because it was a 19 culture that was disturbing? 20 21 22 VICE-CHAIRMAN THOMAS: a good question. MR. FROEBA: You mean did I That would be So I'll say, sure. Okay. It wasn't 23 disturbing within my particular sphere. 24 Like I told you, the CLO area was one 25 where there was very little market share 385 1 Q & A - Session 3 2 pressure. 3 of market share pressure, I would have 4 been expose to the same difficult choices 5 that other people at Moody's were faced 6 with. 7 I think, had there been a lot VICE-CHAIRMAN THOMAS: But in your 8 testimony -- unfortunately, you weren't 9 able to deliver it orally -- you talk 10 about it in especially egregious case 11 which was a CLO. 12 MR. FROEBA: 13 VICE-CHAIRMAN THOMAS: 14 15 Correct. Was that one of the reasons you decided to leave? MR. FROEBA: Well, no, I was -- my 16 departure was not my own decision. 17 Moody's downsized me along with Rick at 18 the same time, Rick Michalek. 19 December of 2007. 20 It was The CLO issue that I describe in my 21 testimony is relevant to Moody's Europe. 22 And it is an independent office, and the 23 rating methodology that they applied, 24 though, very similar to the one in New 25 York, is its own. And the change I 386 1 Q & A - Session 3 2 described happened there. 3 VICE-CHAIRMAN THOMAS: 4 that. 5 Do you generally agree with this 6 characterization -- and you know, I'm 7 sorry that Mr. Clarkson has a kidney 8 stone -- 9 10 11 12 13 14 15 16 17 18 19 20 I read it. I understand Back to my nodders. COMMISSIONER GEORGIOU: Mr. Chairman, why don't we -CHAIRMAN ANGELIDES: I think it may be better to bring the witnesses back up. VICE-CHAIRMAN THOMAS: Do you mind, because we -CHAIRMAN ANGELIDES: Come back up. We even have name plates for you. VICE-CHAIRMAN THOMAS: Dig up the old name plates. CHAIRMAN ANGELIDES: Yes, let's do that. 21 MR. KOLCHINSKY: Our same seats. 22 (Dr. Witt and Mr. Kolchinsky are 23 seated at the witness table.) 24 VICE-CHAIRMAN THOMAS: 25 And the primary reason I'm doing this, Mr. Froeba, 387 1 Q & A - Session 3 2 so you appreciate it, we never had this 3 much direct accusatory, if you will, 4 testimony on the shift -- 5 CHAIRMAN ANGELIDES: Actually, before 6 we do this, I'd like to remind both of you 7 that you were sworn in earlier, and that, 8 would you please acknowledge, Dr. Witt, 9 you're still under oath? 10 DR. WITT: 11 MR. KOLCHINSKY: 12 13 I'm still under oath. I'm still under oath. CHAIRMAN ANGELIDES: Thank you, 14 Mr. Kolchinsky. 15 proceed with our orderly hearing. 16 Thank you. VICE-CHAIRMAN THOMAS: We may now I kind of 17 liked the head nodding. 18 relatively strong and definitive 19 statements that it was not driven by 20 money, your statement's probably more 21 extreme in providing specific examples 22 than the first panel, although there were 23 clear innuendoes and hints of that 24 direction. 25 Because of the So given the fact that yours are so 388 1 Q & A - Session 3 2 much bolder and direct, I really kind of 3 wanted to visit the first panel to help us 4 get a comfort level that, had you been on 5 the first panel, they would have agreed 6 with the statements you're making. 7 Mr. Michalek, your statement is 8 similar in terms of the extreme focus on 9 the money drive changing the culture at 10 Moody's to get it right more so than the 11 cost factor at Moody's. 12 So let me just say, do you generally 13 agree with the emphasis, not necessarily 14 every jot and tettle of the personal 15 stories? 16 MR. KOLCHINSKY: Well, I do agree. 17 And in my written and oral testimony, it 18 was the same thing. 19 share drove the methodologies down, and it 20 created the free fall -- 21 I think the market VICE-CHAIRMAN THOMAS: But you've got 22 to admit -- you're both attorneys. 23 really was a lot more graphic than you 24 were. 25 MR. KOLCHINSKY: He I'm -- you know, I 389 1 2 Q & A - Session 3 generally try -- 3 VICE-CHAIRMAN THOMAS: 4 MR. KOLCHINSKY: 5 6 7 8 9 style. It's okay. We have a different It's a different style. VICE-CHAIRMAN THOMAS: right off. I noticed that Dr. Witt? DR. WITT: You know, I would -- Mark's characterization would be a bit, 10 you know, was definitely more forceful 11 than mine. 12 points, but you know, and some of them, I 13 just don't know about. 14 anything about this CLO issue with Europe. 15 I mean, I heard a little bit about it. 16 wasn't my area. 17 Yes, I agree with some of his I don't know It But you know, I agree with a lot of 18 what he says, but definitely not 19 everything. 20 going to say it independently of him, it 21 would sound a lot less -- I'm not so sure 22 about it, you know, it's like -- it's not 23 that I'm saying I disagree with him, it's 24 just that I -- maybe he saw things I 25 didn't see. And I think his -- if I was 390 1 2 Q & A - Session 3 VICE-CHAIRMAN THOMAS: Well, my 3 concern is, the heart of his testimony 4 is -- what I consider to be the heart of 5 his testimony, in terms of a 6 cause-and-effect relationship between 7 those who had more alphabet letters behind 8 their names versus those who didn't, with 9 a clear implication that the analytical 10 mind, verified by the number of diplomas 11 on the wall, was being replaced by people 12 who were more, if you want to use a tough 13 term, shmoozy or understanding of the 14 bottom line and how you get there, versus 15 diplomas on the wall. 16 Her resume would not start off with 17 her law degree or the level at which she 18 performed in her law class. 19 DR. WITT: 20 VICE-CHAIRMAN THOMAS: 21 22 She was not a lawyer. I understand that. DR. WITT: Okay. I mean, Yuri, I 23 mean, she was a very capable person in a 24 lot of ways. 25 good administrator -- I mean, she was an extremely 391 1 Q & A - Session 3 2 VICE-CHAIRMAN THOMAS: 3 direct the question then. 4 capable person in many ways. 5 function was rating. 6 high at rating? 7 8 9 10 11 DR. WITT: at rating. Okay. Let me She was a very Your primary Would you rate her She had other talents. I wouldn't rate her high I would not. VICE-CHAIRMAN THOMAS: You would rate her high at shmoozing -DR. WITT: No, administration. 12 Managing a lot of people, remembering a 13 lot of stuff and training junior staff, 14 working well with the people above her. 15 16 VICE-CHAIRMAN THOMAS: That's a real talent. 17 DR. WITT: It is. 18 VICE-CHAIRMAN THOMAS: You can't 19 necessarily get a degree to get that kind 20 of talent -- 21 DR. WITT: No, I agree. I didn't 22 say -- when she and I were promoted 23 exactly the same time to managing 24 director, and they -- I think they 25 expanded the number of managing directors 392 1 Q & A - Session 3 2 at that time, and I didn't think that her 3 promotion was unwarranted. 4 obviously, Mark did. 5 thought she had a lot of talent. 6 thought that she and I were good 7 complements, to be honest. 8 different, but... 9 10 11 You know, I didn't. VICE-CHAIRMAN THOMAS: I mean, I I We were very Mr. Chairman, I'll reserve my time as well. CHAIRMAN ANGELIDES: I'd like to ask, 12 since you're all four back up here, each 13 of you very quickly, so we have four 14 individuals here in a firm with thousands 15 of employees. 16 In the structured products arena in 17 which all of you are operated, how 18 pervasive was the feeling or the belief 19 that market share was the driving force 20 and that you better pay attention to it? 21 How pervasive, do you hold a minority 22 view? 23 MR. KOLCHINSKY: I would say, 24 obviously, I can't speak for everyone; but 25 for people I know, people who have been 393 1 Q & A - Session 3 2 there more than a year, so more veterans, 3 I think I would venture close to a hundred 4 percent. 5 that market share drives the train at that 6 point. I think the people understood So... 7 CHAIRMAN ANGELIDES: 8 MR. FROEBA: 9 I completely agree. That's why I recommended that you look at 10 the DES survey results. 11 show a lot. 12 Mr. Froeba? MR. MICHALEK: I think that will I thought that it grew 13 over time. 14 hundred percent the point, but initially 15 it wasn't. 16 Towards the end it was a DR. WITT: I thought at the time I 17 was there, and this is the CDO group, U.S. 18 CDO group, it was pretty pervasive, that 19 thinking. 20 analysts, that's what they assumed. 21 definitely felt pressure for market share, 22 you know. 23 my mind, the question was, you know, was 24 it too far? 25 once I became -- I say this in my written You know, I think most I But as in my opening remarks, Did it go -- I thought -- 394 1 Q & A - Session 3 2 testimony. 3 thought about getting the deals right. 4 You know, I thought about ratings 5 integrity. 6 else. 7 When I was an analyst, I just I didn't think about anything Once I had, like, a budget to meet, I 8 had salaries to pay, I started thinking 9 bigger picture. I started realizing, yes, 10 we do have shareholders and, yes, they 11 deserved to make some money. 12 get the ratings right first, that's the 13 most important thing; but you do have to 14 think about market share. 15 do the other side of it. 16 did question in my mind, are we going too 17 far here. 18 CHAIRMAN ANGELIDES: We need to So I began to But I definitely A norm of 19 mission creep, or perhaps someone would 20 say mission sprint, a big shift over the 21 last seven years? 22 the nodding your heads, yes. 23 2000 on? You're all All right, let's move on. 24 Mr. Vice-Chairman, you want to move on to 25 other members? 395 1 2 3 4 Q & A - Session 3 VICE-CHAIRMAN THOMAS: Just one follow-up question. Mr. Witt, based upon your 5 transformation from doing the job to 6 overseeing those to a certain extent who 7 did the job in the CDOs area, was the 2005 8 assumptions for CDOs that we talked about, 9 where did that occur in your shift from 10 getting the rating right to looking at 11 market share? 12 continuum between those points and your 13 decision in '05? 14 DR. WITT: Can you place that on a The new methodology that 15 we introduced in 2005? Okay. We -- the 16 methodology that we introduced in 2005 was 17 in June 2005, in a paper that was, like 18 there was a committee of people. 19 decided to use the normal copy law. 20 was by far the most popular method on Wall 21 Street for rating CDOs and -- 22 VICE-CHAIRMAN THOMAS: It was It Hundred 23 percent ratings, 90 percent ratings, ten 24 percent market share? 25 DR. WITT: Fifty-fifty? We had a committee. We 396 1 Q & A - Session 3 2 did -- there was a data analysis that was 3 done and presented to us. 4 discussions. 5 center around market share at all. 6 7 8 9 There was The discussions did not VICE-CHAIRMAN THOMAS: Was it part of the discussion? DR. WITT: I don't -- I don't remember anybody bringing it up 10 explicitly, although I'm sure it was on 11 everyone's minds. 12 13 14 VICE-CHAIRMAN THOMAS: Okay. Thank you, Mr. Chairman. CHAIRMAN ANGELIDES: I am actually 15 going to make one comment before we go to 16 Senator Graham. 17 testimony -- excuse me -- page 11, you do 18 refer to Ms. Yoshizawa's testimony under 19 oath at the Senate Permanent Subcommittee 20 on Investigations, correct? On page 12 of your 21 MR. FROEBA: Correct. 22 CHAIRMAN ANGELIDES: And then what 23 you're saying is, in your view, which is 24 under oath, in your view that was not 25 truthful, correct? 397 1 2 Q & A - Session 3 MR. FROEBA: Well, she said she 3 couldn't remember, so I can't have an 4 opinion about whether she remembered. 5 I would -- 6 7 8 9 10 11 CHAIRMAN ANGELIDES: All right. But You said -- okay, I'm going to -MR. FROEBA: It was doubtful to me that you would not be able to remember a case where you fired someone. CHAIRMAN ANGELIDES: I'm going to ask 12 our staff to follow up with both you, with 13 the analyst involved and with Ms. 14 Yoshizawa because, you have not made the 15 allegation of perjury, but you noted that 16 a statement was made and you remember a 17 case that was contrary to those facts. 18 MR. FROEBA: Correct. 19 CHAIRMAN ANGELIDES: So this is a 20 various matter. Our staff will follow up, 21 with you, Ms. Yoshizawa, and the analyst 22 who has been identified. All right. 23 Let's move on now to Senator Graham. 24 COMMISSIONER GRAHAM: 25 Mr. Chairman. Thank you, Thank you, for those of who 398 1 Q & A - Session 3 2 you have testified the first time, and 3 those who are testifying the second time, 4 there's no additional compensation for 5 returning. 6 It seems here that we almost have a 7 he-said/she-said, because I asked the 8 specific question of Mr. McDaniel, was 9 there a relationship between quality of 10 product and aspiration for market share, 11 and he said no. 12 was such a relationship. 13 And you're saying there Is that correct? What would be, if we were to ask 14 Moody's to provide us with data that might 15 be able to answer the question of who was 16 correct in this assessment of the 17 situation, what data do you think would be 18 most determinative in whether there was a 19 relationship between market share and 20 product quality? 21 MR. FROEBA: Well, I think the nice 22 thing about what I was proposing in my 23 testimony is that you don't have to 24 believe me. 25 try to look at the history of major I'm suggesting that you can 399 1 Q & A - Session 3 2 methodological changes and see if they 3 correspond to market share pressure and if 4 you see that as a consistent pattern, it confirms 5 what I'm alleging. 6 we expected. 7 It was certainly what Now, I was in the CLO area and we 8 didn't have much, you know, we didn't have 9 much rating competition in our area. And 10 yet I happened to see a couple of 11 incidents where there was this pressure, 12 one of which I described in my testimony. 13 COMMISSIONER GRAHAM: Is there any 14 other piece of evidence that would be 15 relevant to establishing this 16 relationship? 17 MR. FROEBA: The problem was, you 18 weren't going to find people coming to 19 meetings and saying, "Let's change this so 20 we get more market share." 21 say, and perhaps this is innocuous, "Our 22 competitors can get to this answer, are we 23 right that we can't?" 24 begin an inquiry which could lead to a 25 methodological change. They would And that would That could be 400 1 2 3 Q & A - Session 3 innocent. It could be not innocent. MR. MICHALEK: What sort of evidence 4 might be in the concept of grandfathering? 5 And I think we need to make a distinction 6 between market share, where we're trying 7 to increase our market share, versus not 8 lose a transaction. 9 sides of the same coin, but that is much They are actually two 10 more easily identifiable, whereby the 11 imposition of a particular policy or 12 revised policy, if a banker were to 13 threaten that, you know, "If you're going 14 to hold us to that standard, we're not 15 going to use you," then there would be 16 this internal discussion as to, "Well, can 17 we grandfather them into the prior 18 existing methodology at least for this 19 deal." 20 And in that way, you could sort of 21 see that there was this constant pressure 22 to find a way to rate the transaction, 23 notwithstanding that it might be in 24 conflict with what our current or, as hard 25 as it is to be "current" with your 401 1 Q & A - Session 3 2 methodology, since it's a constantly 3 changing process, it's one way to 4 demonstrate that there was a response to 5 the pressure our clients, the investment 6 bank, to maintain a preexisting 7 methodology as opposed to imposing a new 8 methodology which would cause us to, in 9 the aggregate, lose market share. 10 COMMISSIONER GRAHAM: Although there 11 was one case in the staff review where an 12 announcement had been made that there was 13 going to be a change in methodology 90 14 days into the future, and that 15 announcement seemed to have sparked an 16 increase in applications for ratings, I 17 assume for fear that the new standards 18 were going to be more difficult than the 19 current standards. 20 So that would seem to argue that it's 21 not necessarily the case that all changes 22 were watering-down changes. 23 MR. MICHALEK: That's correct. And 24 that's the concept of grandfathering. 25 effectively, when there's a more And 402 1 Q & A - Session 3 2 restrictive methodology that was coming 3 through, you would get a request to be 4 grandfathered into the old methodology, 5 with good reason. 6 long time to get a transaction up and 7 running and you can't arbitrarily say, you 8 know, "January 1st of next year, we're 9 going to impose this new methodology." 10 Potentially, it takes a If we have the information today, 11 based on the argument that we've heard 12 that, you know, based on all of our 13 information today, we think the ratings 14 were right assigned today, well, if we 15 already have that methodology in our heads 16 that it needs to be changed, you still 17 have to make the judgment as to when 18 we're going to roll that methodology out. 19 Some deals are going to be halfway 20 ramped up, ready to go; and if you 21 suddenly say, "I'm sorry, we're using a 22 new methodology starting now, the net deal 23 might be blown up and that's going to 24 cost everybody a lot of money, so some 25 judgment had to be made. 403 1 2 Q & A - Session 3 COMMISSIONER GRAHAM: Staying with 3 that, changes, Mr. McDaniel, when asked 4 about some of the data that was coming 5 from the economic unit of Moody's, 6 particularly in October of 2006, you 7 stated that that economic analysis was 8 incorporated into the ratings methodology. 9 Was it your experience that, as units 10 such as the economics came forward with 11 data relative to declining house prices, 12 increasing defaults, et cetera, that that 13 led to a change in methodology, assumedly 14 one that would have taken those factors 15 into account and been more stringent? 16 Mr. Witt, you talked a lot about research 17 in your first round of testimony. 18 DR. WITT: 19 COMMISSIONER GRAHAM: 20 21 A lot about what? Research. The need for more independent research. DR. WITT: One of the things I was 22 thinking about when I said that was, I 23 listened to Paul McCauley, I think his 24 name is, from PIMCO when he was on the 25 shadow banking thing and I talked about 404 1 Q & A - Session 3 2 how PIMCO sent out people to cities all 3 across the country to talk to, like, real 4 estate brokers and homeowners -- 5 VICE-CHAIRMAN THOMAS: 6 DR. WITT: Shoe leather. Yes, shoe leather, and how 7 it just, I couldn't imagine that happening 8 in Moody's RMBS group because they just 9 didn't have time to do that. They were 10 really always short of staff and running 11 so fast that, if you had an independent 12 research group, maybe they would have 13 thought of things like that, as well as 14 doing, you know, surveys or sampling of 15 data files and things like that. 16 But in CDOs, you know, because we 17 were a derivative group and our ratings 18 were derived from other groups, there 19 wasn't as much response of looking to, 20 say, like economists and things like that. 21 So methodology -- the one big methodology 22 change that occurred on my watch, the one 23 I was talking about, the normal Copula for 24 ABS CDOs in my perspective, that was 25 driven not by lowering market share, but 405 1 Q & A - Session 3 2 it was driven by the fact that the types 3 of transactions that we were doing were 4 different. 5 We were doing deals that were mostly 6 residential that were highly correlated 7 and we needed a model that reflected that. 8 Our old model assumed that assets were not 9 correlated and we needed a model that 10 11 assumed the assets were correlated. But I wasn't, you know, that wasn't 12 something that comes from economists. 13 was driven by the market, those types of 14 deals we received. 15 COMMISSIONER GRAHAM: It If I have time, 16 I'd like to come back to pick up on that 17 issue before we finish. 18 couple of other questions. 19 Let me ask a As these changes were being made in 20 the last five plus or minus years, was 21 there any reporting to either investors or 22 regulatory agencies that methodologies and 23 personnel were being altered? 24 DR. WITT: Not that I know of. 25 MR. MICHALEK: I'm sorry, I might be 406 1 Q & A - Session 3 2 misunderstanding the question but it was a 3 part of our regular process to be telling 4 the market how our methodology was 5 evolving. Is that responsive? 6 COMMISSIONER GRAHAM: 7 DR. WITT: 8 9 Yes. I thought you said regulators. COMMISSIONER GRAHAM: When I say 10 regulators I mean like the SEC or bank 11 regulators, who have an interest in this 12 because they are -- they passed directives 13 requiring various entities to utilize 14 ratings services for a variety of 15 important economic purposes. 16 are modifying the way in which you are 17 doing yours business, I would think that 18 those agencies would be interested in 19 knowing that to ask the question, is it -- 20 does it continue to be appropriate for us 21 to be mandating the use of these ratings 22 services. 23 DR. WITT: So if you Well, like Rick said, our 24 methodologies in CDO group were 25 transparent. We posted them on the 407 1 Q & A - Session 3 2 website. 3 We tried to publicize them as much as we 4 could but we didn't reach out specifically 5 to any regulatory authority that I know of 6 with methodology changes. 7 We'd have investor conferences. COMMISSIONER GRAHAM: Let's now go to 8 the CDO question, because I don't think we 9 adequately have covered that, thus far. 10 It just, to me as a layperson, it 11 seems counterintuitive that you can take 12 stacks of mortgages which in their initial 13 review were considered to be marginal in 14 their value and, therefore, they got a 15 relatively mediocre rating, and then strip 16 those out of those securities and pile 17 them up on top of each other and suddenly 18 convert mediocre into 80 percent being 19 AAA. 20 21 22 What is the theory that underlies that ability to engage in alchemy? DR. WITT: Your staff told me that 23 that question would probably come up, and 24 it's actually -- and I've heard the 25 question before, you might not be that 408 1 Q & A - Session 3 2 surprised. 3 I tried to explain that. 4 It's in my written testimony. But it, you know, obviously, we use 5 mathematical models. 6 consists of a set of assumptions, some 7 mathematics then is used to draw 8 conclusions. 9 A mathematical model So when people ask me that kind of 10 question, some people are interested in 11 the assumptions and what they were and why 12 they were wrong and so people actually 13 want to understand the mathematics. 14 COMMISSIONER GRAHAM: I mean, if my, 15 to use an analogy, if you had a hundred 16 homes that were all rated, not financially 17 vulnerable but climactically vulnerable 18 because they are, for instance, right on a 19 coast that is subjected to periodic 20 hurricanes, and as a Floridian, I know 21 something about that, and you have those 22 hundred houses, all of which have been 23 rated vulnerable for a credible reason, 24 now, you take the hundred houses and 25 aggregate them together, and all of a 409 1 Q & A - Session 3 2 sudden, they haven't moved, but suddenly 3 they are less vulnerable. 4 That's, I don't understand how, by 5 aggregation, you eliminate the factor that 6 made them mediocre in their rating in the 7 first place. 8 9 DR. WITT: That's a good example, because it's an example of the one 10 extreme. 11 methodology that we used originally and 12 the one that they continued to use for 13 CLOs I think throughout Mark's career, is 14 called the binomial expansion technique, 15 which is based on the binomial 16 distribution. 17 of taking a whole lot of assets and 18 representing them as a smaller number of 19 assets. 20 And the method, the simple So it's based on the idea The most extreme case of that would 21 be, you've got a hundred, you know, let's 22 just say mortgages, and you want to 23 represent, you're going to represent them 24 as only one mortgage because you think 25 that they are all going to behave the same 410 1 Q & A - Session 3 2 way. 3 percent chance they will default, but when 4 they do it's because there's going to be a 5 hurricane and they are all going to get 6 wiped. 7 they are all paid off, five percent of the 8 time, they all default. 9 extreme case. 10 You think there's maybe a five So either 95 percent of the time, That is the The only way that you get to issuing 11 80 percent AAA against the example that 12 your staff mentioned was if assets were 13 BBB. 14 BBB assets, and you were going to issue 80 15 percent AAA against it, so obviously, 16 that's the senior 80 percent piece. 17 only way that could work, a BBB asset has 18 a default probability of about five 19 percent. 20 So if you started with say a hundred The So if you think about it in terms of 21 a binomial distribution, and if you'll 22 allow me, I actually worked up the numbers 23 for a 70 percent case, that was the 24 number, the case they actually mentioned 25 to me. But -- so for the case of a 70 411 1 Q & A - Session 3 2 percent AAA instead of 80 percent, 3 starting with BBB assets, if you reduced 4 it to ten, so if you said, instead of 5 saying they are all in Florida, let's say 6 we had a hundred mortgages but they are 7 not all in Florida, ten of them are in 8 Florida, and ten are in New York and ten 9 are in California and ten are in 10 Washington, you might think, "Well, we can 11 represent this as ten blocks of ten 12 mortgages and each block of ten is, you 13 know, highly correlated with itself, but 14 the blocks are from very different places 15 and they are not going to default at the 16 same time." 17 If you assume those blocks are 18 independent and you got ten, so instead of 19 having -- you actually have a hundred 20 homes, but you're going to represent it as 21 ten independent blocks of -- 22 however big these are -- ten times that size. 23 Then, if each one of them was a BBB, 24 you had a five percent default 25 probability, obviously the expected 412 1 Q & A - Session 3 2 default probability for the whole 3 portfolio is still five percent. 4 average, you expect like, you know, a half 5 of one of those blocks to default, because 6 that's what you were assuming from the 7 start. 8 got from, you know, the RMBS group, which 9 we're relying on. 10 On That was the BBB rating that we But the extra secret sauce that our 11 group puts in is this diversity score, 12 which is essentially a correlation, which 13 is the decision to reduce it from a 14 hundred down to ten. 15 ten, whether there's a five percent 16 default probability, if there are ten 17 independent assets, then at 70 percent 18 subordination, it would be AA 2. 19 about one out of nine hundred chance. 20 what that means is that there's a one out 21 of nine hundred chance that more than 22 three of those blocks are going to 23 default. 24 25 If you go down to It's And So that the average is that a half a block would default. 413 1 2 Q & A - Session 3 COMMISSIONER GRAHAM: Let me ask -- 3 my time is up. 4 concluding question, all right? 5 theory, let's say, of the CDOs that were 6 issued by Moody's in the '06, '07, '08 7 time period, what percentage of them had 8 greater defaults than the theory that 9 you've just stated would have 10 contemplated? 11 DR. WITT: Let me ask -- this is my With that You know, of course, 12 again, I left the group in '05. 13 huge number. 14 ABS -- for mezzanine ABS CDOs, for AAA 15 mezzanine ABS CDOs, that was the case that 16 was the worst, and I'm sure it's what, 90 17 percent or something? 18 I don't know. COMMISSIONER GRAHAM: It's a It's for Is it was 90 19 percent instead of something in the ten 20 percent area. 21 found to be at fault that resulted in such 22 a dramatic different outcome? 23 DR. WITT: Which assumptions were most You have to say it was 24 both. It was both the default probability 25 was wrong, and the correlation was wrong 414 1 Q & A - Session 3 2 or the diversity score. 3 the way I think of it. 4 I mean, that's You could -- you could just say "Oh, 5 it was the RMBS group, they screwed up, we 6 got it right, they messed up." 7 have that interpretation. 8 some logical coherence to it. 9 think that's valid. 10 11 You could It would have But I don't I think we both messed up. COMMISSIONER GRAHAM: I'm system 12 sticking with my hundred houses on the 13 ocean. 14 They are all going to go under. MR. KOLCHINSKY: I think, I was in 15 charge of the CDOs at the time and it was 16 primarily driven by the underlying RMBS 17 ratings. 18 the expected loss in those deals was 19 approximately one percent on the BBBs. 20 turned out to be a hundred percent, so off 21 by a factor of a hundred. 22 In our deals, we assumed that It But at the same time, the correlation 23 assumptions that, diversity, using your 24 analogy, we assumed that the houses 25 weren't just all on the coast in Florida. 415 1 Q & A - Session 3 2 They have some in had Colorado, some in 3 Idaho. 4 side of 1 -- A1A. 5 came and flooded it all out. 6 Turned out they were on either And so the hurricane CHAIRMAN ANGELIDES: But the 7 original, just to pick up, the original 8 sin was the assumption you'd have the one 9 percent expected loss in a mezzanine 10 tranche of what ended up being a very 11 risky, well a pool of very risky loans that 12 had been made, predicated essentially not 13 on ability to pay but on continuing house 14 price acceleration. 15 MR. KOLCHINSKY: Yes, in general, but 16 also the CDO structures that also became 17 the sole buyers of those tranches, and, 18 because there's no real money buyers as 19 well. 20 So our CDOs made it possible for 21 those deals to get done, and because we're 22 using these actuarial assumptions. 23 were the vacuum cleaner that sucked those 24 deals in and made those transactions 25 possible. So we So yes, those ratings were 416 1 Q & A - Session 3 2 wrong. 3 either believed that those ratings were 4 wrong, or they were not getting paid for 5 that risk, so they went away. 6 CDOs basically took up all that slack that 7 was, that the real money investors took 8 out. 9 I think most people in the market So it was a combination. And these The 10 underlying ratings were wrong but our 11 assumptions on diversity score were also 12 wrong, and made -- created the possibility 13 of those deals being economically 14 feasible. 15 money, if they had to find investors, 16 those deals just wouldn't get done. 17 economics wouldn't work. 18 Because if they had to pay more COMMISSIONER GEORGIOU: 19 can I follow up on that? 20 is -- 21 CHAIRMAN ANGELIDES: Mr. Chairman, 'Cause this Well, 22 actually -- yes, you can. 23 to Mr. Wallison but if it's just -- 24 25 The COMMISSIONER GEORGIOU: I'd like to go Well it's just the one question, you can do it on my 417 1 2 3 Q & A - Session 3 time. You know, Commissioner Graham and I 4 had been talking about this quite a lot. 5 Isn't the problem that -- first of all, to 6 characterize this BBB tranche as mezzanine 7 seems to me to be an overstatement as well 8 in the RMBS world because it's the 9 lowest-rated tranche short of equity. 10 So to call it mezzanine, I mean, it's 11 kind of low, it seems to me, rather than 12 mezzanine. 13 in the normal financing world, mezzanine 14 is sort of the debt just under senior 15 debt, which is kind of nice. 16 mezzanine tranche is like the ninth 17 tranche out of ten, the tenth being 18 equity. 19 misnomer, number one. Mezzanine, I have this sense, But So to call it mezzanine is a 20 Number two is that its defies common 21 sense not to assume that these tranches, 22 which only required a modest decline in 23 home prices across the board, to render 24 worthless, which is actually what 25 happened. When you take all these BBB 418 1 Q & A - Session 3 2 tranches, a hundred BBB tranches from a 3 hundred different RMBSs and put them into 4 a CDO, for those of us who actually 5 operate in the normal world, as opposed to 6 in world that Moody's analytics was 7 operating in, you would think that there 8 might be some human common sense 9 intervention that might say, "Look, we've 10 had whatever, 90 percent price 11 appreciation," as the Chairman constantly 12 says, "In the last nine years, or seven 13 years. 14 you've got to do is correct by five or seven 15 percent in the house prices and then all 16 of these BBB tranches will become 17 worthless because they will -- they are 18 the lowest, the first impaired tranches 19 other than equity and all those RMBSs." 20 These things all might -- all So the fact that you assumed that 21 they didn't correlate seems to me to be an 22 elevation of theory over reality in the 23 analysis, in the analytical structure that 24 was applied. 25 And, you know, that's why we've been 419 1 Q & A - Session 3 2 harping on it, again, from a common sense 3 perspective. 4 mathematics to some extent. 5 major in college. 6 not infallible. 7 have to apply some judgment to the 8 process. 9 DR. WITT: I mean, I understand I was a math I'm just saying that's You have to apply -- you Please, I -- these are 10 like really simplistic models. 11 why I keep going back to, you know, we 12 needed independent research. 13 aware, these were very simplistic models. 14 I wanted very much to -- we talked 15 about -- I was trying to get into that I 16 wanted to do a look-through analysis, one 17 of the -- maybe Senator Graham -- someone was asking me about 18 This is I was very doing a look-through analysis. 19 I really wanted that when I was an 20 MD. I went up to Boston, negotiated with 21 this firm Intex to buy some software. 22 They charged us a rapacious $350,000 a 23 year. 24 help, I got the money approved by senior 25 management and the deal fell down on a I actually, with Nicolas Weill's 420 1 Q & A - Session 3 2 non-compete clause because Moody's wanted 3 to develop its own software. 4 know, we never did, at least while I was 5 there. 6 But you But, you know, I wanted to go 7 further. Exactly the kind of thing you 8 talked about. 9 of a decline in house prices was going to I wanted to know how much 10 cause, you know, like a default in these 11 AAA ABS CDOs that I was rating, but I had 12 no -- no way to do that. 13 trying to get deals out the door. 14 thought up in my spare time a methodology 15 that I thought was superior to normal 16 copula that we ended up not using in the 17 way into I had anticipated. 18 was very, very simplistic. 19 I was, you know, I But even that What we needed was more fulsome 20 models that took into account, you know, 21 like not the whole economy, but that 22 linked house price sensitivity to the 23 ratings on the -- on the CDOs, which we 24 did not have. 25 were going to have that when you were But there was no way we 421 1 Q & A - Session 3 2 trying to do research with analysts who 3 were, in their spare time, were just 4 rating deals all the time, and then they 5 had to, monitor deals, and then you had 6 to do research in your spare time. 7 just wasn't going to happen. 8 9 COMMISSIONER GEORGIOU: the question, doesn't it? It But that begs I mean, it 10 still doesn't answer -- I understand. 11 time -- I intervened in this middle of it 12 but I wanted to follow the point through 13 because it makes sense to complete it. 14 VICE-CHAIRMAN THOMAS: My One quick 15 comment, then to Peter. 16 like they wanted you to frame houses but 17 they wouldn't give you a hammer. 18 was about getting it right, that's a kind 19 of tool that would be essential to help 20 you getting it right. 21 DR. WITT: 22 VICE-CHAIRMAN THOMAS: 23 24 25 I sounds to me If it You know, I agree -That's kind of an indictment, isn't it? DR. WITT: Like I say, it wasn't that we were trying to get it wrong -- it 422 1 Q & A - Session 3 2 wasn't that I thought what we were doing 3 was wrong, it's just that I was so sure 4 that we were not using enough resources to 5 make sure that we were getting it right, 6 and that was at a time when, you know, the 7 profit margin for our group must have been 8 like 80 percent or something. 9 VICE-CHAIRMAN THOMAS: 10 11 Yes, so it was small "i" integrity, not capital "I." CHAIRMAN ANGELIDES: Let's go to 12 Mr. Wallison, but I must ask you, were you 13 the witness interviewed who said your 14 superior questioned why you were doing so 15 much research, to quit reading reports, 16 was that you? 17 MR. KOLCHINSKY: 18 CHAIRMAN ANGELIDES: 19 20 That was me. Thank you. All right, Mr. Kolchinsky, sorry. Alright, Mr. Wallison. COMMISSIONER WALLISON: Thank you, 21 thank you. This morning, I think it was 22 this morning, maybe it was this afternoon, 23 we talked about whether the problems at 24 Moody's were systemic, or pervasive, if 25 you will, or limited, or rather might be 423 1 Q & A - Session 3 2 an artifact of simply the confusion about 3 maybe correlations in the housing and 4 mortgage area. 5 were here, but I asked Mr. McDaniel to 6 provide us with information about all of 7 the asset-backed deals, that -- the 8 different kinds of asset-backed deals that 9 Moody's was rating so that we could And I asked, maybe you 10 compare what was happening in those deals 11 with what happened in the housing area. 12 Because if it was all the same, there 13 were lots of write-downs and downgrades 14 going on in all the those other deals, we 15 would really have a sense, then, that it 16 was a systemic problem. 17 not the case, then we might be looking 18 simply at something that occurred because 19 of the peculiarities of the housing 20 business and the fact that very few people 21 were able to predict the huge fall in 22 housing prices. 23 And if that was So I'm going to ask all of you, we 24 have four of you here, what do you think 25 Mr. McDaniel's submission to us will show? 424 1 2 Q & A - Session 3 Mr. Kolchinsky? 3 MR. KOLCHINSKY: It probably shows 4 that it was limited, but I can suggest a 5 few categories to the staff which they 6 should look into. 7 securities, which was Trump CDOs. 8 one is CBOs, the first time go-around; 9 market value CDOs, mobile home One, I credit to PF2 Another 10 securitizations. 11 one on the top -- those are all -- and 12 CMBS hasn't gone full cycle, but it will, 13 so those are categories I suggest look into-- 14 15 16 Let's see, I had another COMMISSIONER WALLISON: all. We asked for So -MR. KOLCHINSKY: Those are the 17 categories I would look into. 18 homes are real-estate-related, but they're 19 more -- they're not really real estate -- 20 21 22 COMMISSIONER WALLISON: Mobile They're credit cards -MR. KOLCHINSKY: Credit cards are 23 basically backed by the government, so 24 they couldn't get that one wrong. 25 auto companies have now been The 425 1 2 3 4 5 Q & A - Session 3 effectively -COMMISSIONER WALLISON: Backed by the Government? MR. KOLCHINSKY: Because they are 6 backed by the banks which are too big to 7 fail and the banks can support the credit 8 card programs, so effectively they have 9 taken steps in the past couple of years to 10 support their conduits by issuing class D 11 tranches and recapitalize them. 12 essentially, because the credit card 13 program is backed by a bank which is too 14 big to fail, usually, they have done well. 15 You're essentially, in my mind, very -- 16 COMMISSIONER WALLISON: So This is -- I 17 don't want to use up all my time on this, 18 but of course the banks were also issuing 19 mortgage-backed securities. 20 MR. KOLCHINSKY: 21 COMMISSIONER WALLISON: 22 23 Yes, yes. And those did fail. MR. KOLCHINSKY: But in this case, 24 the credit card conduits are an intrinsic 25 part of a bank's business operating model 426 1 2 3 Q & A - Session 3 because that's how they finance -COMMISSIONER WALLISON: Okay, we'll get to see 4 an awful lot of those. 5 your prediction, and will it show that 6 there are as many downgrades as in the -- 7 MR. KOLCHINSKY: Now, what's There are some 8 product, as I mentioned, that will show, 9 probably not as bad as in the mortgage 10 area but pretty bad. 11 COMMISSIONER WALLISON: 12 MR. FROEBA: 13 14 Mr. Froeba? I don't really have much to add to what Eric said. COMMISSIONER WALLISON: Well, your 15 prediction is that there will be areas 16 that we will look at that will show as 17 many downgrades as in the mortgage area, 18 I'd just like you to -- 19 MR. FROEBA: Yes. 20 COMMISSIONER WALLISON: 21 MR. FROEBA: 22 MR. MICHALEK: -- say that. Some. I would suggest that 23 they just decompose the transition studies 24 into in individual asset classes, you'll 25 get the information you're looking for. 427 1 Q & A - Session 3 2 They give you a general transition study for all 3 the AAAs rated by Moody's. 4 population. 5 different assets that are being rated. 6 you say, "Please give me a decomposed 7 analysis so that I can see asset by asset 8 what those transition studies are," then 9 you can see whether -- 10 11 It includes a lot of COMMISSIONER WALLISON: MR. MICHALEK: 13 COMMISSIONER WALLISON: 15 If That's what we will try to do. 12 14 It's a large Exactly. And what is your prediction? MR. MICHALEK: My prediction is that 16 there will be, amongst the assets that 17 Eric mentioned, I'd also mention SIBs, 18 these CPDOs to the extent that they are 19 actually going to acknowledge those. 20 what was the double -- double aircraft 21 leasing, what is -- EETCs. 22 COMMISSIONER WALLISON: 23 24 25 Okay. And And Mr. Witt? DR. WITT: As Mark said before about CLOs, you know, CLOs have done very well. 428 1 Q & A - Session 3 2 That would be a counterexample, and I 3 think there will be some other consumer 4 finance asset classes that have done okay. 5 But manufactured housing was the one that 6 always stuck in my mind that we -- because 7 that one, the problems were in like 2003, 8 and it was like a warning light that we 9 just didn't pay attention to. 10 COMMISSIONER WALLISON: The CLO area 11 is something I do want to cover because I 12 gather that there was no, or little 13 competition in that area. 14 Why is that? 15 MR. FROEBA: That's an interesting 16 question. 17 drove competition, I think, in the RMBS 18 area. 19 why Moody's market share at one point 20 dropped so precipitously in RMBS 21 securities. 22 Moody's brought by Fitch. 23 Fitch is the rating agency that And they were one of the reasons It was competition against In the corporate area, remember that 24 a CLO is backed by corporate loans. There 25 was no real competition from Fitch. And 429 1 Q & A - Session 3 2 that meant that for every transaction 3 which needed two ratings, there were two 4 rating agencies available to rate them. 5 The underlying credits were not being 6 rated by Fitch so the managers weren't 7 really interested in getting a rating from 8 Fitch on the CLO because the underlying 9 credits weren't rated by Fitch. 10 11 That's why there was very little competition. COMMISSIONER WALLISON: Okay. 12 Mr. Michalek? 13 issue of competition as being very 14 important in how opinions are given 15 under -- under the pressure of 16 competition. 17 experience that I have had with auditors 18 and law firms, which also give opinions 19 under very similar kinds of circumstances. 20 And I'm not asking you to talk about them 21 at all. 22 The -- you point to this And I keep thinking back to But I am wondering how Moody's or 23 rating agencies in general are different 24 and why you believed that, or believe that 25 their opinions are so heavily affected by 430 1 Q & A - Session 3 2 competition, or do you believe it's all 3 the same and the auditors are also 4 succumbing to competitive pressures? 5 MR. MICHALEK: Well, I do think that 6 both the auditors and the law firms are 7 subject to an enormous amount of 8 competitive pressures, particularly during 9 this ramp-up period when things were 10 getting extremely busy, the response, 11 as -- I worked at a law firm prior to 12 coming to Moody's -- the response was to 13 offer capped transaction costs. 14 effectively, they are under the same 15 pressures to try to get the work done and 16 the deal signed off without ruining their 17 own profit margin. So 18 So that was also generating, in the 19 way that the law firms would often deal 20 with it was, to generate a standard 21 template opinion that would then be, you 22 know, affected on the margins but the 23 opinion committee would work very hard to 24 make sure that they weren't introducing 25 any risk to the partners for having issued 431 1 Q & A - Session 3 2 an opinion that would ultimately generate 3 liability for the firm. 4 But the additional work that they had 5 to do in order to do the work necessary to 6 get these complex transactions rated, 7 proved to be yet another source of 8 pressure that came back to the rating 9 agencies, because they were directly in 10 communication with our clients, the 11 investment banks. 12 And so to the extent that we, as 13 analysts, were working on a transaction 14 and saying we need more time, or, you 15 know, there's issues with this 16 documentation, their lawyers, the 17 investment bank's lawyer would then report 18 back to their client and say, "The analyst 19 at Moody's is causing us to have to run 20 our bill up and we're going to have to ask 21 for an exception from our cap." 22 So they were responding to the 23 pressure by either pushing back on us and 24 putting more pressure on the rating 25 agencies, or putting pressure on the 432 1 2 3 Q & A - Session 3 clients who put pressure on us. COMMISSIONER WALLISON: I understand 4 that. I was actually asking a slightly 5 different question. 6 judgment about why law firms and 7 accounting firms, outside the issue of 8 ratings, outside the offering of 9 structured financings of various kinds, I was asking for your 10 which are subject to the same kind of 11 competitive pressures that you were 12 referring to, why we don't see the same 13 degree of elimination of standards or 14 reduction in standards or weakening of 15 standards as we have seen at Moody's. 16 MR. MICHALEK: It's an interesting 17 question. I do think that there is a 18 segregation of the service providers, at 19 least by the clients. 20 I won't try to name them, top-tier law 21 firm and then, to the extent that your 22 budget doesn't provide, then there's the 23 second-tier law firm and the third-tier 24 law firm. 25 and their own business model as to where they You can go to a -- And it's up to the law firms 433 1 Q & A - Session 3 2 want to compete. 3 establish the quality that they are 4 delivering and the prices that they are 5 setting according to where they think they 6 are going to be most effective at 7 competing. 8 9 And so they will COMMISSIONER WALLISON: But they have, they are always under the same 10 pressure, and that is, "If we don't give 11 this opinion, this client is going to go 12 to another law firm and get that opinion 13 from another law firm," and it doesn't 14 have anything to do with the tier of the 15 law firm or the level of the law firm. 16 MR. MICHALEK: Well I think there is, 17 in terms of the marketing of the security 18 that they were hired to provide the 19 opinion for. 20 I'll just use, I don't know, Sullivan & 21 Cromwell is a very well known firm, if you 22 say, "I'm going to go to Dewey Cheatem & 23 Howe down the street and get an opinion 24 from them,” that's going to come directly 25 to the bottom line of the issuer because If you're going to go, and 434 1 Q & A - Session 3 2 people might notice that. So there is 3 this competition that says they do have 4 the right, because of the brand that they 5 have established, to actually stay at a 6 higher level of quality -- 7 COMMISSIONER WALLISON: But there are 8 many, many law firms that are at the same 9 level with Sullivan & Cromwell. There are 10 probably twenty just within Manhattan. 11 And so Sullivan & Cromwell has to worry in 12 each case, if they don't give an opinion, 13 that someone else will. 14 that, if that someone else does give that 15 opinion, that someone else may become the 16 general counsel for all of these matters. And not only 17 MR. MICHALEK: Fair enough. 18 COMMISSIONER WALLISON: So is there, 19 is there -- why is, and I want to just 20 repeat the question, why are things 21 different at Moody's when it is competing 22 with S&P? 23 standards, rather than a law firm or an 24 accounting firm doing the same thing? 25 Why did it sacrifice its MR. MICHALEK: I think that, and I'd 435 1 Q & A - Session 3 2 be interested to hear my other colleagues 3 opinion, I think it does relate to the fact 4 that this was a very narrow asset class 5 where the expertise, at least in the 6 rating of these assets, was already 7 captured by the two most highly 8 intellectually capitalized agencies. 9 Standard & Poor's and Moody's just 10 had more resources and a longer experience 11 from developing these products, and so we 12 were competing strongly with each other, 13 but the competition we felt from another 14 entrant was not as high. 15 COMMISSIONER WALLISON: How much time— 16 DR. WITT: Can I-- 17 CHAIRMAN ANGELIDES: 18 19 20 21 You have another two minutes, 45 seconds. COMMISSIONER WALLISON: Was it you, Mr. Witt? DR. WITT: You know, I think I'm sort 22 of beginning to disagree. We're starting 23 to say Moody's standards deteriorated, 24 Moody's standards deteriorated. 25 like in ABS CDOs, we made one change in 26 methodology. 27 methodology for highly concentrated RMBS I know, The impact of that change in Q & 436 1 A - Session 3 2 deals, you know, mezzanine RMBS deals, 3 that's just the name the market gives to 4 it, I don't think that that methodology 5 had much impact, and I actually think it 6 probably strengthened our ratings slightly 7 for those types of deals, and those were 8 the deals that had by far the worst 9 performance. 10 So I don't think our standards for 11 ABS CDOs really declined in the way I 12 would think of it. 13 collateral that just completely 14 disintegrated below us and we didn't 15 react and we should have. 16 have taken a little more, you know, we had 17 to be looking for a problem. 18 weren't looking. 19 It's the underlying COMMISSIONER WALLISON: But it would And we Do I 20 understand that you just said that the 21 change, the one change that occurred in 22 your area, which I think was in 2005, when 23 the correlation was changed -- 24 DR. WITT: Yes. 25 COMMISSIONER WALLISON: -- was not 437 1 Q & A - Session 3 2 induced by a competitive issue or an 3 effort to capture more market share? 4 5 6 DR. WITT: I do not believe that it was. COMMISSIONER WALLISON: And so you 7 disagree, then, with Mr. Froeba about 8 that. 9 DR. WITT: Well, I don't know that he 10 actually said that that particular change 11 was -- 12 COMMISSIONER WALLISON: His point as 13 I understand it was that we could easily 14 see the effect of competition by looking 15 at changes in the standards. 16 MR. FROEBA: 17 DR. WITT: That's correct. But he also, he said 18 specifically, though, I think, that you 19 could look at the -- you could say there 20 was a decline in market share. 21 there's a change in methodology. 22 is a case where, you know, that's true. 23 There was a decline in market share, and 24 there was a change in methodology. 25 Then And this However, that, based on what I know, 438 1 2 3 4 5 6 7 Q & A - Session 3 there was not a cause and effect. COMMISSIONER WALLISON: That's the point. VICE-CHAIRMAN THOMAS: That's what I was talking about. DR. WITT: The cause and effect was, 8 the market changed, they were doing 9 RMBS-focused deals. There had been 10 multi-sector deals before. 11 dealings had lots of different types of 12 collateral. 13 independence wasn't right, but it wasn't 14 so as far wrong. 15 RMBS-focused deals, then the model just 16 didn't work at all. 17 The ABS A model that assumed Once they became all I needed a new model. I advocated for a, you know, a 18 correlation-focused model. The normal 19 copula wasn't my first choice, but it was 20 better that what we had. 21 to that particular category were not 22 great, so I don't think it was a 23 deterioration of standards, but it was a 24 deterioration of collateral with a failure 25 to react. But the changes But there is in my testimony, 439 1 Q & A - Session 3 2 my written testimony, I do talk about what 3 was going on with respect to market share 4 in that particular category. 5 don't have time to discuss that now. 6 COMMISSIONER WALLISON: I probably No, but 7 that's the answer I think we were looking 8 for. 9 MR. FROEBA: 10 11 May I follow up on that? CHIARMAN ANGELIDES: Very quickly then I want to Mr. Georgiou. Very -- Do you have a one minute addition? 12 MR. FROEBA: Moody's used the diversity score as a tool 13 for analyzing correlation in early CDOs of 14 ABS. 15 source of intense complaint by managers 16 because -- CLO managers, managers of those 17 transactions, because they felt, and they 18 blamed Moody's for the fact that they were 19 investing in securities other than RMBS 20 securities. 21 pressure that Moody's experienced predates 22 somewhat the change Gary is talking about. 23 But there was a response to pressure from 24 managers and from other constituents. 25 And it was a thing that became a So the real market share COMMISSIONER WALLISON: My whole 26 point was simply, you said we could learn 27 by looking at the changes in methodology Q 440 1 & A - Session 3 2 to show the effect of the competition. 3 And here’s a case, where there was a change in 4 methodology, it doesn't appear as though 5 it was induced by competition so it would 6 be very hard for us to make any decisions 7 based on the kinds of things you were 8 suggesting we should try. 9 MR. FROEBA: The main change happened 10 before that change, that's correct. It 11 was one in which Moody's adapted its 12 methodology to make it possible to have a 13 hundred percent RMBS in one CDO of ABS. 14 COMMISSIONER WALLISON: 15 UNIDENTIFIED SPEAKER: Where was Standard & Poor's relative 16 17 Thank you. to that though? MR. MICHALEK: Their methodology had 18 changed and our change was in some sense a 19 reaction to the fact that they had already 20 changed. 21 22 23 CHAIRMAN ANGELIDES: Mr. Georgiou, on your remaining time? COMMISSIONER GEORGIOU: Thanks. 24 Thank you gentlemen. I guess I need to 25 ask this question even though there are 441 1 Q & A - Session 3 2 quite a number of other trained lawyers on 3 this panel. 4 ask it. 5 But I'm the one who's got to Do you think that the fact that you 6 were insulated from liability, both 7 statutorily and ostensibly, 8 constitutionally, had any impact on the 9 methodology that you pursued and the 10 11 failure to comport it to reality? MR. FROEBA: You know, at one time, I 12 was going to jump in, in response to the 13 question that was being asked of Rick, and 14 say the difference between Moody's and an 15 accounting firm or a law firm is that at 16 least there is some theoretical risk that 17 the accounting firm and the law firm might be 18 found liable. 19 Andersen. 20 Take the case of Arthur Nothing could be better for Moody's 21 then that some other rating agency were to 22 be found liable in a lawsuit and to 23 collapse. 24 future lawsuits would create a discipline 25 in the analytical process that I think Why? Because the fear of 442 1 Q & A - Session 3 2 would add a tremendous amount of 3 integrity. 4 the best way to solve the current problem 5 with rating agencies. 6 That is my own opinion about Their lack of vulnerability is a 7 serious problem. And another serious 8 problem relate to it is the fact that they 9 pay no price for degrading their 10 reputation. 11 that, you know, no matter how bad the 12 reputation got, their business would grow. 13 What do you think is going to happen now 14 after this crisis if they pay no price? 15 That's a question that the people on this 16 commission should ask because all of your 17 children and family members are facing, 18 you know, a world economy that's 19 vulnerable to that reality. 20 They learned after Enron, COMMISSIONER GEORGIOU: Right. And I 21 take it that, well, let me hear from the 22 rest of you with regard to this legal 23 liability issue, if you have anything else 24 to add. 25 MR. KOLCHINSKY: I think in general, 443 1 Q & A - Session 3 2 legal liability was almost -- discussions 3 of legal liability, almost nonexistent. 4 That was part of the problem. 5 didn't think. 6 thoughts in thinking about, we were just 7 offering an opinion and that was it, the 8 bottom line. 9 People That never entered people's I actually want to also add to the 10 other question about the lawyers and 11 accountants, lawyers and accountants have 12 standards. 13 cases, accountants have GAAP. 14 again to Arthur Andersen, if Arthur 15 Andersen, after Enron, said, "You 16 know what? 17 was our methodology. 18 to walk away." 19 Lawyers have to follow court Imagine -- Yeah, we did this, but that Sorry, we're going And that's the difference. What you heard today was Ray McDaniel saying, 20 "That's our methodology. Sorry." There's 21 no standards to judge rating agencies. 22 Each one of them has its own methodology. 23 That's the problem I think we'd all -- but 24 once you have the standards, then you can 25 apply legal liability by saying, "You 444 1 2 3 Q & A - Session 3 failed, that is fraud," and that's it. COMMISSIONER GEORGIOU: Mr. Michalek, you’re a lawyer as 4 well, are you not? 5 MR. MICHALEK: I am, and I agree, I think 6 liability would be a necessary deterrent 7 to lack of attention to common issues of 8 negligence that occurred regularly. 9 10 11 COMMISSIONER GEORGIOU: Mr. Witt? Dr. Witt? DR. WITT: I'm the only non-lawyer 12 here and I don't think the courts are the 13 best way to address this. 14 because the issue is whether or not you 15 got the ratings right, not, you know, how 16 did you go about getting them or did you, 17 you know, fill out all the right forms or 18 something. 19 COMMISSIONER GEORGIOU: I would, All true. 20 All true, but they tend to have a salutary cautionary 21 impact. 22 crude methods of enforcing these kinds of 23 standards, but the fear of having to go 24 there often motivates behavior in a 25 positive way. 26 DR. WITT: 27 I mean, courts are extremely Well, you know, the Financial Stability Act does give the SEC 445 1 Q & A - Session 3 2 the power to levy fines, and I thought 3 that a better way to go is to have the SEC 4 basically have a menu of fines that are 5 issued when you get the ratings wrong in a 6 major way. 7 you misrated, you pay a big fine; and you 8 know when, you're rating it, that's what 9 you're going to have to pay if you 10 misrate. 11 sense. 12 Proportional to how many bonds I think to me, that makes more COMMISSIONER GEORGIOU: You think the 13 analysts who did it ought to have to pay 14 part of the fine, too, or do you think 15 just the company ought to pay the fine? 16 MR. FROEBA: Certainly make for a 17 more disciplined process if the analysts 18 had to pay. 19 DR. WITT: If the analyst had to pay, 20 you may not have any analysts at rating 21 agencies. 22 COMMISSIONER GEORGIOU: I'm sorry, 23 Commissioner Wallison, go ahead and take 24 some of my time there. 25 COMMISSIONER WALLISON: The bosses 446 1 2 Q & A - Session 3 are very jealous of this, so -- 3 CHAIRMAN ANGELIDES: Right. Well, 4 actually, I'm going to suggest you look 5 this way. 6 Mr. Wallison. 7 Yes, I recognize you, Go ahead. COMMISSIONER WALLISON: I just had 8 this one point to make about standards. 9 And it is true that there are, it's easier 10 to identify the standards for lawyers and 11 for accountants. 12 lawsuit about an opinion has to do with 13 whether you applied whatever standards 14 there were negligently. 15 negligent, even if you came to the wrong 16 answer in a legal opinion, as long as you 17 were not negligent in coming to an answer 18 that turned out, because of future events, 19 to be wrong, you were not liable. 20 However, the issue in a MR. KOLCHINSKY: If you were That is correct. 21 But in this case, you don't even have 22 standards to judge by. 23 negligent if there's no standards to judge 24 by. 25 your own determinant. You can't be found It's your own standards, and you're And that's the 447 1 Q & A - Session 3 2 problem. 3 standards to be able to have normal legal 4 procedures. 5 any standards and legal liability, the 6 flip side of it, you're going to have a 7 lot of false negatives and people just 8 suing because they bought at the wrong 9 time. 10 11 That is a problem. And you need Otherwise, if you don't have So you need standards and you need legal liability. COMMISSIONER GEORGIOU: Okay, let me 12 finish back up here. 13 earlier today, which showed that, 14 notwithstanding a number of cautionary 15 warnings, either from Mark Zandi, and other 16 downgrades that occurred along the way. 17 Each time there was a downgrade, there 18 appeared to be a spike up in the MBS 19 ratings, the number of MBS rated and the 20 number of CDOs rated. 21 We had this chart I wonder if the two panelists who 22 weren't here this morning, I think I asked 23 you that this morning, did I not, as to 24 the other two of you? 25 of you could tell me why it is that you Maybe the other two 448 1 Q & A - Session 3 2 think -- obviously, we understand that 3 it's easy for you to rely upon the general 4 perception that housing prices weren't 5 going to decline thirty percent or more in 6 certain marketplaces to justify your 7 initial ratings. 8 9 However, why is it that, once we knew that the -- you were downgrading certain 10 RMBS and CDOs, and that the market was 11 declining, that there was still an attempt 12 to utilize the same methodology to rate 13 additional product coming in the door? 14 And, you know, I likened during the 15 prior panel here, it looked like you folks 16 were trying to mop up the last bit of 17 gravy before they took the plates away. 18 That really, was this just a market share 19 deal, try to get all these deals done 20 before they were gone? 21 MR. MICHALEK: Mr. Michalek? I was responsible for 22 doing the activity reviews, quarterly 23 activity reviews. 24 there was a flush of activity in late 2006 25 and started through the first part of the And I did notice that 449 1 Q & A - Session 3 2 first quarter of 2007, even though we had, 3 at that point, already published 4 significant research that suggested that 5 those downgrades were potentially outliers 6 relative to previous history. 7 The simple explanation for this is, is 8 that our customers, the investment banks, 9 were clearing their warehouses. And it 10 was a case of, with respect to why didn't 11 we stop and change our methodology, there 12 is a very conservative culture at Moody's, 13 at least while I was there, that suggested 14 that the only thing worse than quickly 15 getting a new methodology in place is 16 quickly getting the wrong new methodology 17 in place and having to unwind that and to 18 fail to consider the unintended 19 consequences. 20 So there was a lot of research as to 21 what are we going to be doing if it turns 22 out that this really is an outlier. 23 was, in fact, during the year-end review 24 for 2006, I was pointing this out in a 25 draft of one of the annual reviews and I There 450 1 Q & A - Session 3 2 was surprised by the reaction that was 3 coming from the people from RMBS saying, 4 "You don't want to mention that this is a 5 big outlier because we're still analyzing 6 this data and we can't say as yet as to 7 whether or not this is a front-loading of 8 a normal amount or a tolerable amount of 9 defaults that we're going to experience 10 11 over this cohort's life" -COMMISSIONER GEORGIOU: But couldn't 12 you tell this these were downside risks, 13 not upside risks? 14 the direction of this data ought to have 15 led you to be more skeptical, and the mere 16 fact that the investment banks wanted to 17 clear out their warehouses doesn't mean 18 you have to pick up a broom and help them 19 sweep them out the door -- 20 MR. MICHALEK: Couldn't you see that You're asking me to 21 wear two different hats. As an analyst, 22 of course you're right. 23 signs. 24 about it. 25 somebody's going to make the forceful These are warning We should be saying something From a business perspective, 451 1 Q & A - Session 3 2 argument that it could be that these are 3 just front-loaded defaults and this isn't 4 going to be any worse than '92. 5 that's the case, we have the opportunity 6 right now to do a lot of business. 7 COMMISSIONER GEORGIOU: And if Right. Nine 8 basis points on a lot of billion dollar 9 deals, that's almost a million bucks every 10 11 deal. MR. MICHALEK: And there's no 12 question, if we step away, those are going 13 to be rated by somebody else. 14 15 16 COMMISSIONER GEORGIOU: Mr. Kolchinsky was trying to answer as well. MR. KOLCHINSKY: One thing, you know, 17 I -- once they did make a decision to 18 downgrade in '07, in September, and I 19 found out about it and actually tried to 20 stop the factory, a manager, 21 Ms. Yoshizawa, did not want to do that. 22 And I actually spoke to Dr. Witt. 23 didn't know what to do. 24 we go to somebody more senior-- and we did a notching procedure. 25 But that's -- it was almost, as I said, I He suggested that 452 1 Q & A - Session 3 2 the last couple of bits of paper. 3 that's one of the reasons, that is the 4 reason, I believe, I was then asked to 5 leave the rating agency in October of that 6 year. 7 MR. MICHALEK: And There's one final 8 point that I think Mr. Buffett actually 9 made. He was taking advantage and 10 exploiting the possibility that they 11 weren't rated correctly. 12 heard from the Moody's representatives 13 effectively that their concern was, you 14 know, downgrades are bad news, and that 15 you don't want to prematurely downgrade; 16 and I think that it could be seen, because 17 of the multiple downgrades that took 18 place, that that first downgrade was 19 probably not going to be far enough. 20 We've already So one impetus to structuring of more 21 issuance at that particular time is, "Hey, 22 we just got a whole bunch of things that 23 have been downgraded three notches, but 24 I've just done my independent analysis, 25 and I think it should have been six 453 1 Q & A - Session 3 2 notches. 3 door." 4 Let's get this stuff out the COMMISSIONER GEORGIOU: Okay. But 5 you're still rating them AAA. But the 6 problem is that you didn't rate them down 7 at all, you rated them AAA. 8 those that you rated after you started 9 discovering downgrading the other ones, And even 10 you rated AAA and then they had to be 11 downgraded again. I mean -- 12 VICE-CHAIRMAN THOMAS: 13 CHAIRMAN ANGELIDES: Grandfathered. Quickly, I want 14 to move on, we need to keep our schedule 15 here -- my privilege as Chairman. 16 MR. FROEBA: A million dollars is 17 really not that much revenue in the end. 18 It was business relationships and 19 preserving them that was key, to answer 20 your question. 21 22 23 COMMISSIONER GEORGIOU: Well, but that's just one CDO, the million dollars. MR. FROEBA: I know, but they might 24 have a hundred million of business in the 25 coming year. 454 1 Q & A - Session 3 2 COMMISSIONER GEORGIOU: 3 MR. FROEBA: 4 5 6 7 8 9 Of course. That's why they did those one million dollar deals. CHAIRMAN ANGELIDES: Thank you. Let's move on, now, to Mr. Thompson. COMMISSIONER THOMPSON: Thank you, Mr. Chairman. So you had the opportunity to hear 10 your CEO or former CEO speak of what was 11 the most important metric or outcome, 12 which in his mind was rating quality. 13 How do you respond to that, do you 14 believe that's the tone he set at the top 15 or not? 16 I'll start with you, Mr. -- MR. KOLCHINSKY: No, I do not. I don't 17 think he was against ratings quality, but 18 certainly it was not something that I 19 was -- there was a culture there, the old 20 culture, but no, I don't believe that that 21 was the tone set at the top. 22 COMMISSIONER THOMPSON: So would you 23 call him something other than truthful in 24 that representation? 25 MR. KOLCHINSKY: I can't judge that. 455 1 Q & A - Session 3 2 Maybe that's what he felt, but what came 3 down to us people working in the trenches 4 was -- 5 COMMISSIONER THOMPSON: So the tone 6 you heard was something other than 7 ratings. 8 MR. KOLCHINSKY: 9 MR. FROEBA: Yes. I agree. I don’t think-- I would have a 10 hard time identifying any particular means 11 by which they communicated their -- that 12 that was the value. 13 recall any. 14 15 16 I mean, I don't COMMISSIONER THOMPSON: Mr. Michalek? I got it right, by the way. MR. MICHALEK: I'm a lawyer, so I'm 17 trained to hold two opposing thoughts in 18 my mind at the same time. 19 COMMISSIONER THOMPSON: Well, just 20 give me one and I'll come back to the 21 other one later. 22 MR. MICHALEK: I think he does 23 believe that he was telling people that 24 ratings quality was the most important 25 thing. I think that there were reports 456 1 Q & A - Session 3 2 internally that he was already receiving 3 suggesting that he was getting information 4 that people were concerned about the 5 quality of the ratings. 6 DR. WITT: I put this in my written 7 testimony, but there has been other 8 testimony and other investigations saying 9 the same thing. In November or October of 10 2007, we had a global MD meeting. 11 pretty sure Eric was there. 12 is after the massive downgrades have 13 already occurred. 14 I'm Where -- this And the CEO and CFO led off with the 15 exact same tone that they always did, 16 which was to focus on our profit margin 17 relative to Standard & Poor's, and they 18 were talking about, "Oh, it's one percent 19 lower than Standard & Poor's, we've got to 20 work on this." 21 We'd already had these massive 22 downgrades. Morale was really shot. And 23 somebody, one of the MDs in the corporate 24 side raised their hand and said, "You 25 know," this was after about thirty 457 1 Q & A - Session 3 2 minutes, and said, "What are you doing to 3 restore Moody's reputation?" 4 sudden, there was this big scramble among 5 management, like, they didn't expect the 6 question. 7 smoking gun in terms of, after that, I 8 didn't give Ray the benefit of the doubt 9 anymore. 10 And all of a And to me, that was like, the COMMISSIONER THOMPSON: So there was 11 an entity within Moody's that had 12 responsibility for credit policy. 13 you were building models and anticipating 14 how they would be applied, what 15 interactions did you have with the credit 16 policy organization? 17 end of the table. 18 DR. WITT: So as I'll start on this Well, the incident that 19 Eric was just explaining, he was concerned 20 about -- this is in September '07, he's 21 worried about an imminent downgrade of 22 RMBS, and the fact that he believes that 23 they are going to continue to rate ABS 24 CDOs in spite of the fact that they know 25 there’s going to be this big downgrade. 458 1 2 Q & A - Session 3 So I got in touch with the head of 3 credit policy, Andy Kimball, and let him 4 know about this, and he decisively 5 intervened. 6 methodology was changed. 7 main interaction with them prior to -- 8 9 And the next day, the That was my COMMISSIONER THOMPSON: So it did function as a check and balance but you 10 had to go and overtly bring it to the 11 table. 12 13 14 DR. WITT: Yeah, and that was when Andy was the head of it. MR. KOLCHINSKY: That was true 15 because of Mr. Kimball’s, as the head of 16 credit policy. 17 think head of international. 18 point -- prior to that, I do not recall 19 having any contact with credit policy 20 whatsoever. 21 methodology internally. 22 communicated it to others, but that was 23 due to Mr. Kimball's sort of forceful 24 nature and he got that done. 25 Prior to that, he was, I At that I think we made our May have COMMISSIONER THOMPSON: So much has 459 1 Q & A - Session 3 2 already been said about the lack of 3 resources or, in many instances, the lack 4 of talent that you had to do the job as 5 the bubble was building. 6 Would that also be true for the 7 credit policy organization as its internal 8 watchdog? 9 MR. KOLCHINSKY: Like I said, I think 10 prior to Mr. Kimball signing onto 11 credit policy, I don't believe we had an 12 effective -- there was a nominal credit 13 policy function. 14 any effective -- I never dealt with them. 15 There was never any back-and-forth. 16 didn't know what they did. 17 I don't believe it had I Today, as part of my, the complaint, 18 I was suspended for last year, that there 19 is a nominal credit policy function. 20 are better, but in most respects and 21 purposes, they are outvoted and outgunned, 22 if you will, by the lines of business. 23 24 25 They So it's sort of -- I forget the term. They are not effective still. COMMISSIONER THOMPSON: Mr. Michalek, 460 1 2 3 Q & A - Session 3 do you have a point of view? MR. MICHALEK: I didn't interact with 4 credit policy. I interacted with 5 structured credit committee, which was 6 responsible for harmonizing the overall 7 rating methodologies across different 8 groups in different regions, so I can't 9 speak directly to credit policy. 10 COMMISSIONER THOMPSON: 11 MR. FROEBA: Mr. Froeba? We had very little, if 12 any, interaction with credit policy. 13 would say none. 14 COMMISSIONER THOMPSON: I So you were 15 allowed to do whatever you wanted to do 16 with no oversight as long as it meant 17 market share? 18 MR. FROEBA: Yes. And as I said, I 19 was in an area where this was no market 20 share pressure, so we were actually able 21 to be very conservative. 22 until my departure, I -- as Gary mentioned 23 earlier, people were proud of the work 24 that they did. 25 that I did. And right up I was proud of the work I worked hard on those deals, 461 1 Q & A - Session 3 2 and I think they will stand up, not that 3 they're -- am I the CDO saint? 4 group had been exposed to significant 5 market share pressure, I would have 6 probably been as -- 7 COMMISSIONER THOMPSON: 8 MR. FROEBA: 9 COMMISSIONER THOMPSON: 10 DR. WITT: No. If my Vulnerable. Exactly. Dr. Witt? To be fair to credit 11 policy, there were procedures about new 12 methodologies. 13 methodology piece, you had to get 14 sign-offs. 15 I suspect that you had to get a sign-off 16 from credit policy. 17 If you published a rating I don't remember for sure, but COMMISSIONER THOMPSON: So they were 18 involved in the development process of the 19 models? 20 21 22 DR. WITT: Well, yeah, they were involved. COMMISSIONER THOMPSON: 23 reluctance there. 24 DR. WITT: 25 I sense a Well, they were not heavily involved at the time that I was an 462 1 Q & A - Session 3 2 MD, but I think there was this, that 3 involvement to that extent that they 4 did -- they had a veto in theory, if they 5 wanted to use it. 6 7 8 9 10 COMMISSIONER THOMPSON: I yield the balance of my time, Mr. Chairman. CHAIRMAN ANGELIDES: Thank you. Mr. Holtz-Eakin. COMMISSIONER HOLTZ-EAKIN: Thank you, 11 Mr. Chairman, thank you gentlemen, for a 12 depressing afternoon of testimony. 13 Let me just try to clarify a couple 14 of things. 15 how all this all went down. 16 all, just, I guess, for all of you, did 17 Dun & Bradstreet not care about making 18 money? 19 I'm trying to sort out about MR. FROEBA: So first of No, I think they did. 20 The theory, and probably one of the 21 reasons why Warren Buffett invested, is 22 because the idea is that a conglomerate is 23 not a sufficiently pure play for the 24 marketplace to be able to value the 25 company. So if you split them up, and 463 1 Q & A - Session 3 2 that's exactly what happened, you split 3 them up and, voila, there was lot of value 4 that the market wasn't acknowledging 5 before. 6 I'm sure Dun & Bradstreet didn't want 7 to get rid of Moody's. 8 to by its shareholders who found the 9 combined entity unsatisfying as a 10 11 It was compelled performer. COMMISSIONER HOLTZ-EAKIN: And so 12 your testimony in particular is about the 13 evolution of a model that would be more 14 profitable at the expense of the quality 15 of the ratings. 16 MR. FROEBA: 17 COMMISSIONER HOLTZ-EAKIN: Yes. So one of 18 the things that you pointed us to is ways 19 to understand this better, the changes in 20 methods that are used to come to ratings, 21 and, but we've been told pretty clearly 22 that ratings are more than models. 23 guess I'd like to hear what the 24 non-quantitative folks on one of these 25 ratings committees brought to the table, So I 464 1 Q & A - Session 3 2 what information did they introduce, and 3 how were they affected by this evolution 4 of culture. 5 Mr. Witt. 6 DR. WITT: Why don't I start with you, Well, the people who were 7 saying that very strongly, I think it was 8 Jay Siegel especially, that ratings are 9 not just models, he was in the RMBS group. 10 And ratings were not just models in CDOs 11 either. 12 in part because we could be, because we 13 had the ratings as input, so you knew what 14 the ratings were. 15 of a, just almost like a mathematical 16 function. 17 But the CDO was more model-based So you could have more But we also had a very strong culture 18 of, you know, we had legal analysts on 19 every deal, which they did not have, 20 because the documentation was so much more 21 complex. 22 So I thought of it as, the legal 23 analysts were helping to make sure that 24 the document conformed with what the model 25 said. And that was definitely a 465 1 2 3 4 5 Q & A - Session 3 non-trivial task. COMMISSIONER HOLTZ-EAKIN: Mr. Michalek? MR. MICHALEK: I think the 6 non-quantitative role of the rating 7 analyst which fell to the lawyers, 8 largely, was as Gary describes, a task of 9 confirming that the documentation was 10 faithful to what the quantitative analyst 11 was modeling. 12 for legal risks, whether or not there was 13 an isolation of assets, all of the usual, 14 very standard and very overpaid legal work 15 that was being done by the law firms. And then, we were looking 16 And we were also looking for some, 17 potentially, non-easily quantifiable risks 18 that could come from, for example, the 19 valuation of the collateral managers. 20 would go, for each transaction, if there 21 was a collateral manager that we had not 22 recently visited, and that original -- it 23 evolved to where, if we hadn't seen them 24 within the past year, we needed to go see 25 if collateral manager. We So we would make a 466 1 Q & A - Session 3 2 trip to the collateral manager and 3 evaluate, do some due diligence on their 4 processes, and report in the committee as 5 to what our opinion of the collateral 6 manager was, and were they capable of 7 doing the work that was going to be 8 involved in this particular transaction. 9 That was one of the places where 10 there was a greater opportunity to say no 11 and in fact, I don't think that 12 opportunity was exploited. 13 COMMISSIONER HOLTZ-EAKIN: I actually 14 want to pursue that. 15 if I’m wrong, please correct the record, who 16 said, it became pretty clear that you had 17 some of these ratings wrong because the 18 market wouldn't take them. 19 underlying RMBSs that you referred to, the 20 market wasn't going to buy them, it was 21 clear that the RMBS guys had these things 22 rated wrong, but you took their ratings 23 anyway, put them into the CDOs and moved 24 these. 25 MR. KOLCHINSKY: It think it was you, So the That was me. 467 1 Q & A - Session 3 2 3 COMMISSIONER HOLTZ-EAKIN: Do not answer, sir. 4 So that strikes me as information 5 that is very important to bring into the 6 ratings process but indeed was not. 7 not? 8 9 MR. KOLCHINSKY: Why It was very hard for us to determine where -- it became clear 10 later in the process that a lot of this 11 product was being sold into sort of 12 captured and captive vehicles, even 13 warehouses. 14 that day one. 15 But it's very hard to tell As I said before, we were not told 16 where this was being sold. 17 evidence we had to gather sort of piece by 18 piece. 19 they placed these bonds. 20 So it's Bankers would not tell us where So because -- and if you actually look at 21 the spreads on this product, they all kept 22 coming down, because in the beginning, 23 they really needed to have real investors. 24 But by the end, the spread was driven, as 25 somebody put it, actuarially, by the -- by 468 1 Q & A - Session 3 2 the model, the CDO model. So they 3 actually kept coming down as more 4 investors left, when you'd expect the 5 opposite. 6 investors left, you would -- spreads go 7 up. You would expect that if 8 But because you had a loss of real 9 investors, and a gain of more, sort of 10 statistical investors, if you will, the 11 spreads were coming -- so it was very 12 tough to tell until very late in the 13 process, and a lot of the things that I've 14 mentioned now are things that I've put 15 together since the crisis through the work 16 of commissions like this and other 17 committees. 18 wasn't out there, it wasn't available to 19 us to see where the demand was coming 20 from. 21 So the information just COMMISSIONER HOLTZ-EAKIN: So if no 22 one hears from the RMBS group, but it does 23 seem pretty clear, especially with 24 hindsight, that they got the expected loss 25 wrong, and that means they got the 469 1 Q & A - Session 3 2 expected returns way too high, which means 3 they totally missed the risk, because 4 that's the only way you get that kind of 5 return, which may explain why it was a bad 6 idea to lower all the sensitivity to housing prices. 7 they at least were working off data and 8 cash flows. 9 So my question for the folks doing 10 the CDOs and the diversity scores is, how 11 was that done in the absence of actual 12 data on actual performance, only using the 13 now-faulty ratings you had from the RMBS 14 folks? 15 DR. WITT: Well, we had two 16 methodologies in my career. 17 was actually, it's, they thought it up 18 just before I got there, but I do explain 19 it in my testimony. It was called the 20 multi-sector paper. It was written by Jerry Gluck-- 21 22 23 The first one COMMISSTIONER HOLTZ-EAKIN: -- correlated. DR. WITT: Well, it's this reduction 24 in diversity score, and the diversity 25 score is -- it is calculated by a some -- But 470 1 Q & A - Session 3 2 correlation assumptions to calculate a 3 diversity score. 4 diversity score, you use this binomial 5 framework that assumes independent assets. 6 Those correlations if you read the paper, 7 it's very clear, and Jerry use to say 8 this, Jerry Gluck who wrote the paper, 9 when people say, "Where did you get them," Once you have the 10 he'd say, "We just made them up," you 11 know, because they didn't have any data. 12 And they say that. 13 They went to the analysts in those 14 groups, and say, "How correlated do you 15 think these things are?" 16 1999. 17 have a model that had correlation built 18 into it, we also had more data by that 19 time, so there was a data analysis. 20 So this was in By '05, when we felt we needed to It was primarily, the useful data 21 on correlations was from rating 22 transitions. 23 actual defaults, but, you know, they did 24 look at rating transitions to see how 25 correlated they were. There was not enough data on And we used that as 471 1 Q & A - Session 3 2 the basis, but in a very, very general 3 sense, for the correlation matrix we came 4 up with. 5 COMMISSIONER HOLTZ-EAKIN: So this is 6 the point I want to try to understand in 7 the way the culture worked mechanically. 8 Ongoing surveillance clearly is very 9 important, because transitions in rating 10 would be important information for initial 11 rating of these securities. 12 heard that some would be grandfathered, 13 and thus, the ongoing surveillance would 14 have to take place using a standard method, 15 which is not the current one. 16 But I've also I've also heard that ongoing 17 surveillance was not well tied in, 18 especially with the RMBS. 19 the previous panel. That was from 20 Would each of you tell me, in your 21 line of business, the degree to which your 22 ratings were informed by information 23 coming out of the surveillance process and 24 the way in which you communicated with 25 them, and whether the process took 472 1 Q & A - Session 3 2 advantage of the ability to be better or 3 simply discarded the information that was 4 learned. 5 Mr. Kolchinsky? MR. KOLCHINSKY: I think in our 6 group, in the beginning, when I joined, 7 there was no separate surveillance group, 8 so analysts had to surveil their own 9 deals. 10 In that case, we had pretty good 11 feedback. 12 on, and we had some developments that we 13 saw from the fallout in what I've called 14 the stage 1, which was the CBO class bond 15 obligations, as well as the first 16 re-securitization, multi-sector deals that 17 we put into new methodologies. 18 Obviously, you see what's going But further on, we used actually the 19 same methodology for, generally, for 20 surveillance and rating. 21 have as good a feedback because we didn't 22 see what the folks on the surveillance 23 side were doing. 24 RMBS where they used two different 25 methodologies completely. So we did not But it wasn't like on 473 1 2 Q & A - Session 3 COMMISSIONER HOLTZ-EAKIN: I see. My 3 time is short, so if there's anything 4 anyone wants to add; otherwise, thank you. 5 6 7 8 9 10 11 CHAIRMAN ANGELIDES: Need any more time? COMMISSIONER HOLTZ-EAKIN: Only as necessary to complete. CHAIRMAN ANGELIDES: minutes. A couple of Anything? If not we’ll take away-- MR. MICHALEK: The only question, I 12 just wanted to revisit the idea of what 13 non-quantitative elements went into the 14 rating, and that was the assessment of the 15 quality of the collateral manager. 16 a case where we would have had more of an 17 opportunity to say, "You know, this 18 particular collateral manager isn't really 19 up to speed or is somehow not what we 20 would prefer." 21 implemented as to how much we were going 22 to effectively charge the deal for a lack 23 of quality for that particular collateral 24 manager. 25 That was It was discussed but never That, again, was a very, very strong 474 1 Q & A - Session 3 2 issue, if you want to call it that, that 3 impacted relationships with the investment 4 bankers. 5 particular investment banker that we were 6 going to charge half a notch of rating to 7 this particular collateral manager just 8 because this was his first deal, or just 9 because it's really three guys and a You couldn't tell this 10 Bloomberg, which was what we would 11 characterize the upstart collateral 12 manager who was not particularly prepared. 13 So that was an opportunity where we 14 would bring information to the ratings 15 process and then whether or not it was 16 going to be acted on was a function of 17 business considerations. 18 19 20 COMMISSIONER HOLTZ-EAKIN: Thank you, gentlemen. CHAIRMAN ANGELIDES: Let me, just before we go to 21 Ms. Born, let me wrap up some of what 22 Mr. Holtz-Eakin talked about, because one 23 of the things that struck me, as I've 24 looked at all the materials over the last 25 month or so, is the extent to which this 26 really was a blend between the 475 1 Q & A - Session 3 2 quantitative with whatever deficiencies, 3 and I say that not to say necessarily 4 sloppy work, but a lack of, perhaps, 5 knowledge of what was going on, an 6 evolving knowledge of what's going on, and 7 obviously, judgment. 8 9 I mentioned this morning that I saw a whole beam on the qualitative side. Not 10 having, you know, that kind of knowledge 11 on the ground, you want to look through -- 12 and I mean, I would make an observation -- 13 not only look through, but look all the 14 way down to the ground. 15 would you characterize, two things, how would you 16 But in total, how characterize in total the ratings 17 process if you were to -- and let me add 18 one other thing: 19 I also understood that models were 20 run, they'd be looked at qualitatively, 21 and you'd make adjustments. 22 Mr. Stein said that, you know, for 23 example, in the RMBS world, they might 24 take the worst loss and then multiply it. 25 So you'd run the model, people would look 26 at it and essentially feed back Today, 476 1 Q & A - Session 3 2 information to have the model come out 3 where people thought it ought to be. 4 How much would you say in large order 5 of this process was qualitative, 6 quantitative? 7 and here's the second part of this, which 8 is, if you look at kind of what Moody's 9 puts on the website, you would come away Because I think the understanding, 10 believing it's quantitative mostly; is 11 that a fair statement? 12 A VOICE: Sure. 13 CHAIRMAN ANGELIDES: So I think the 14 representation was quantitative. 15 was folks making their best judgment, 16 working with models that were only as good 17 as they were? 18 How much What's the blend? MR. KOLCHINSKY: I think I would 19 separate it in two: things that were already 20 established, non new things were 21 almost all qualitative, just run them 22 through the model. 23 CHAIRMAN ANGELIDES: Where there was 24 high confidence levels about the quality 25 of the data? 477 1 2 Q & A - Session 3 MR. KOLCHINSKY: No, it was because 3 you were held to that standard by the 4 bankers. 5 better follow that. This is your methodology. 6 CHAIRMAN ANGELIDES: 7 MR. KOLCHINSKY: 8 9 10 11 You By the bankers? By the bankers. Where there's qualitative -CHAIRMAN ANGELIDES: Well, give me an example of that, and then I -MR. KOLCHINSKY: They would, for 12 example, as we said, our methodology was 13 open book. 14 models, run themselves, and they would 15 say, this is -- 16 They could download the CHAIRMAN ANGELIDES: Oh, the bankers 17 saying -- bankers saying, "This is what 18 you represent, I want it. 19 shelf, this is" -- okay. 20 MR. KOLCHINSKY: It's on the For example, the 21 simple synthetic model was a CLO model. 22 You could download it, anybody can for 23 free, put the portfolio in, here's it is, 24 the banker says, "I want this." 25 you're kind of limited to what you could And 478 1 Q & A - Session 3 2 say because here's your model and there it 3 is out there, and where you could have 4 more qualitative is in what I call the 5 Delta. 6 So this has changed from this model. 7 And it's a question of -- what stopped is 8 that you had less time to look at these 9 changes, the Deltas, "Is the model no 10 longer appropriate for this type of 11 portfolio." 12 you had less time to analyze it and you 13 had less time to say what the effective 14 change ought to be, is it five percent, is 15 it fifty percent? 16 17 You had less time to do that, CHAIRMAN ANGELIDES: So that part was qualitative. 18 MR. KOLCHINSKY: That's qualitative. 19 CHAIRMAN ANGELIDES: But to the 20 extent that bankers insisted on using a 21 certain factor, I would assume they 22 weren't insisting you use those things 23 they thought were overly stringent. 24 MR. KOLCHINSKY: Of course not. 25 CHAIRMAN ANGELIDES: Okay, just 479 1 2 3 Q & A - Session 3 checking. All right. MR. FROEBA: Quickly, reactions? I would say it's mostly 4 model but unless you made sure that your 5 documents reflected the model, your 6 analysis could be completely wrong. 7 the non-model part was very important. 8 just was not, it was not driving the 9 ratings. 10 11 So It You couldn't look at the document and determine something was AAA. MR. MICHALEK: The willingness of the 12 bankers to use and adhere to standard 13 documentation would determine how 14 important the non-quantitative element of 15 the transaction was. 16 swap document was going to have huge 17 sections that would come in to a lot of 18 play, definitions of the defaults and the 19 credit events would be manipulated and 20 otherwise massaged because that's where 21 all the vig was for the bankers who were 22 structuring this transaction. 23 Even if the standard So to the extent that you're 24 considering that for be non-quantitative, 25 that was, it was a hundred percent of my 480 1 2 3 Q & A - Session 3 job. DR. WITT: Well, I'll give an example 4 that Rick and I worked on that was, again, 5 it was in my written testimony, something 6 that you guys have talked about in a 7 previous panel, was about the liquidity 8 puts that were used to issue CP out of 9 CDOs. We worked on the early transactions 10 and those, the way those agreements were 11 crafted into the documentation in the 12 early Citibank deals were just 13 horrendously complicated. 14 And if I hadn’t had Rick there with me, 15 you know, there's no way -- they would 16 have been able to -- I thought that their 17 agenda was to try to put contingencies 18 into those liquidity puts so that, if 19 investors didn't buy the CP, they would 20 have some out where they would not have to 21 buy it themselves and then investors 22 would, you know, be holding CP that became 23 you know, thirty years long and could well 24 be money market funds, and I was extremely 25 afraid of that. 481 1 Q & A - Session 3 2 And, you know, it was only because 3 Rick was so dogged and skilled at looking 4 for documentation, it was just a big 5 spaghetti bowl of back-and-forth between 6 the prospectus and all these ISDAs and 7 stuff. 8 very qualitative, but it had quantitative 9 aspects. 10 So that was an example of these CHAIRMAN ANGELIDES: And ISDA, for 11 folks, the International Swap Dealers 12 Association, or I guess they will call 13 themselves something else today, but, 14 correct? 15 DR. WITT: Right. 16 CHAIRMAN ANGELIDES: All right. So, 17 okay, very interesting observation and in 18 many respects to the extent that products 19 were customized, particularly complex, and 20 amplified the non-quantitative. 21 22 DR. WITT: new type of product. 23 24 25 Especially when it was a CHAIRMAN ANGELIDES: you. All right, thank Ms. Born? COMMISSIONER BORN: Well, just 482 1 Q & A - Session 3 2 continuing on with that, I want to go back 3 to the synthetic CDOs is that I was 4 talking with Mr. Kolchinsky about earlier 5 today. 6 You were saying how you saw a number 7 of CDOs come along during 2007 that had a 8 synthetic aspect to them; that is, they 9 had credit default swaps in the asset pool 10 to some extent, rather than pure RMBS; 11 isn't that right? 12 MR. KOLCHINSKY: That is correct. I 13 don't have the exact data, but I would 14 venture that, by '07, nearly all CDOs had 15 some exposure to synthetics, either in the 16 RMBS or the CDO buckets for the high grade 17 deals. 18 COMMISSIONER BORN: And we were 19 talking about a number of issues that 20 these new, more complex instruments had 21 that you were concerned about. 22 listed a number of them. 23 wanted to ask you a little bit more about 24 that. 25 You've And I just One is, you know, when you had a 483 1 Q & A - Session 3 2 credit default swap on a residential 3 mortgage-backed security, rather than the 4 residential mortgage-backed security 5 itself in the pool, how did you rate, or 6 what rating would you assume for the CDS? 7 Would you go to the underlying of the CDS, 8 that is, to the underlying residential 9 mortgage-backed security? 10 MR. KOLCHINSKY: That is correct. 11 Most of the CDS that were done on RMBS 12 were of the pay-as-you-go variety, which 13 meant theoretically, they sought to mimic 14 the payments on the actual RMBS. 15 was some mismatch, but we did not penalize 16 them for it. 17 There The great problem with those were the 18 secondary risks that came along, which 19 were primarily the funding risks, because 20 now you had cash on hand which wasn't 21 invested in the RMBS. 22 invested in something else. 23 bankers wanted to take that money and 24 increase their returns by investing it in 25 other risky assets, and those risky assets It had to be And the 484 1 Q & A - Session 3 2 added risk to the CDO. 3 COMMISSIONER BORN: So that's where 4 the questions about collateral and other 5 issues -- 6 MR. KOLCHINSKY: Yes. 7 COMMISSIONER BORN: I wonder whether 8 or not it was really accurate to look at 9 the rating for the underlying RMBS when 10 there were all these additional issues 11 posed by the fact of the credit default 12 swap. 13 away from the mortgage-backed security 14 itself. 15 I mean, this was clearly a big step MR. KOLCHINSKY: I think we tried to 16 ring-fence those other risks. Some of 17 them didn't turn out so well, and I think 18 some of the lawyers -- I'm not a 19 practicing lawyer, as I like to emphasize, 20 but these practicing lawyers will tell you 21 about the bankruptcy of Lehman and what 22 this did to some of the protections that 23 were in CDOs. 24 it better than I. 25 turned out to be poor in some of these They can probably speak to So the ring-fencing 485 1 Q & A - Session 3 2 issues. 3 not just, in some cases, the CDOs were 4 funded by the CDOs themselves in the case 5 of one underwriter. 6 circular structures that created a mess 7 for the banks themselves. 8 9 But yes, those turned out to be So it created these So yes, on a macro basis, the use of credit defaults also created many other 10 problems within the financial system, not 11 as much probably for the CDO itself except 12 for this Lehman Brothers bankruptcy. 13 COMMISSIONER BORN: Holding that for 14 a minute, I'd like to ask you about 15 default correlation issues raised by the 16 facts that these CDOs were coming along 17 with credit defaults swaps in them, and I 18 think you were saying in your testimony 19 that you would see, in a series of CDOs 20 coming in, that there could be in each of 21 them, CDSs on the same underlying that you 22 saw in the last CDO. 23 MR. KOLCHINSKY: Yes. In an 24 all-cash-product world, your -- the 25 probability of one bond appearing in two 486 1 Q & A - Session 3 2 pools was limited by some economics, so 3 there's maybe a total of ten million of 4 that entire tranche, and that was split 5 among ten investors, and that's it. 6 That's the entirety of that element in the 7 entire world. 8 9 With synthetics, you can take that tranche and you can replicate it 10 infinitely. 11 ABX where, I believe, again, this is with 12 hindsight, what we saw with a lot of hedge 13 funds who wanted to short the ABX and the 14 bankers didn't want to take just that 15 side. 16 CDOs, which meant that there were a lot of 17 CDOs with very similar portfolios. 18 didn't know about that at the time but 19 sort of with twenty-twenty hindsight you 20 could see that. 21 It was especially true of the So they off-loaded that risk into We And we had a -- what we were 22 concerned about with the ABX was that it 23 was becoming, starting to become very 24 widely used. 25 discount, which cash did not. It had somewhat of a dollar So that 487 1 Q & A - Session 3 2 would make it, increase the arbitrage, 3 which means increase the probability of it 4 occurring in multiple deals. 5 replicate it infinitely. 6 limitation on it, no natural limitation on 7 it. 8 correlation, a hundred percent 9 correlation, effectively. 10 11 And you can There's no So that would increase the COMMISSIONER BORN: Exactly, because it's the very same asset. 12 MR. KOLCHINSKY: Yes. 13 COMMISSIONER BORN: Did you indicate 14 in your testimony that there was a paper 15 that was prepared on this issue -- 16 MR. KOLCHINSKY: 17 COMMISSIONER BORN: 18 19 20 Yes. -- in October of '06? MR. KOLCHINSKY: Yes, we had a paper ready to go, the author was an analyst, 21 Sushnita Nagarajan -- I’ll give you the spelling later. 22 of the things 23 it says, we want to limit the exposure of 24 the ABX in any deal to a de minimis 25 amount, and I think my manager thought 26 that was not appropriate, given -- and she But one 488 1 Q & A - Session 3 2 asked not to publish the paper, so we 3 never did. 4 5 COMMISSIONER BORN: Because of the potential loss of business? 6 MR. KOLCHINSKY: Yes. That's what I 7 believe, I don't know but that -- I 8 believe that was due to potential loss of 9 business. 10 11 CHAIRMAN ANGELIDES: paper, do we know? 12 13 Do we have that MR. KOLCHINSKY: I have a draft of that paper, and, yes. 14 CHAIRMAN ANGELIDES: Can you provide 15 it? 16 us -- we request that document. 17 We can also request it, if you give MR. KOLCHINSKY: Yes, I believe you 18 already actually have it. 19 the specific e-mail that it contained. 20 COMMISSIONER BORN: I will identify Let me ask 21 Mr. Michalek about the reference to the 22 Lehman Brothers bankruptcy and the issues 23 posed there. 24 25 MR. MICHALEK: I don't want to expand and state something incorrectly because I 489 1 Q & A - Session 3 2 know it's obviously going to turn on the 3 facts of the individual case. 4 general, the point is this, that there 5 were assumptions being made when we were 6 rating synthetic CDOs, that depended 7 largely on the documentation, is the 8 documentation and the other standard form 9 documentation, particularly with respect But in 10 to collateral and rights to collateral in 11 the event of a bankruptcy. 12 in which the obligors or the creditors 13 would be paid out given the contractual 14 obligations represented by the standard 15 documentation. 16 And the order The Lehman bankruptcy case has shown 17 that in fact, some of the assumptions were 18 incorrect, and that the structural 19 subordination that has been discharged, I 20 think, was one consequence which was 21 contrary to the assumptions that we were 22 using when we were rating these 23 transactions. 24 25 COMMISSIONER BORN: We may ask some follow-up written questions to you and 490 1 Q & A - Session 3 2 also to Mr. Kolchinsky about the synthetic 3 CDO issues. 4 Let me just ask, some of these CDOs 5 were I think called something like 6 actively managed assets. 7 actually have the pool of assets at the 8 time you were rating them, or they could 9 change as time went on. 10 So you didn't Also, with some of the CDOs, they 11 were actually -- had as the underlying 12 assets mezzanine tranches of other CDOs; 13 that is, they were CDO squared or CDO 14 trebled. 15 How did you handle valuing the 16 underlying in those cases? 17 those pose some monumental issues? 18 MR. KOLCHINSKY: And didn't I'll take the second 19 question first. In fact, we probably, if 20 you would extend back, we had CDO to the 21 infinite power because each CDO had a CDO 22 bucket, had to be passed on and on and on. 23 We handled each one as a separate bond, 24 and this goes on to what Dr. Witt was 25 saying. We didn't have the computing 491 1 Q & A - Session 3 2 power to look through. 3 didn't, but that's something that you 4 would want because that increased the 5 correlation. 6 Most people There were CDO squareds. We looked 7 at them on an individual level. 8 problem with them, again, from a 9 structural macro perspective is that they 10 started as ways for bankers to get rid of 11 the mezzanine tranches that nobody would 12 buy. 13 didn't have a buyer for these deals 14 because it was uneconomic. 15 didn't think it was going to blow up, but 16 it wasn't economic, that changed the 17 economics for the deals. 18 thing that made ABSs possible was this 19 takeout through other CDO. Could you 20 repeat the first question? I'm sorry. 21 COMMISSIONER BORN: And that was the problem. The If you Maybe they So the only The first one was 22 about the actively-managed assets where 23 maybe the assets weren't there to analyze 24 at the time you were rating them, or maybe 25 they -- if they were, they could change at 492 1 2 3 Q & A - Session 3 any time? I know you said you relied on the 4 parameters outlined in the documentation 5 for what the assets manager was supposed 6 to purchase. 7 MR. KOLCHINSKY: That is correct. I 8 think most of the trading was actually in 9 the CLOs, but all CDOs were structured, 10 almost all CDOs, cash CDOs were structured 11 as actively managed in the sense we rated 12 them to minimum average parameters. 13 I think on a practical basis, there 14 was not as much trading in ABS CDOs as 15 there were in CLOs, and these folks can 16 talk about that. 17 the ability to reinvest proceeds or sell 18 and buy assets. But all the managers had 19 So we had to rate them to minimum 20 covenant parameters in the documents. 21 the problem is, they were averages that -- 22 in twenty-twenty hindsight, the problems, 23 we rated them averages and we didn't 24 anticipate the risk layering, if you will. 25 COMMISSIONER BORN: And And just one last 493 1 Q & A - Session 3 2 issue. 3 infinite degree, didn't those raise some 4 real risk parameters for these instruments 5 as well? 6 In these CDOs to the -- to the MR. KOLCHINSKY: They did. We 7 didn't -- because we didn't know where 8 they sold them into, I think if we did 9 know, we could track a hundred percent 10 went into this in CDOs. 11 other side of it and only because we rated 12 to parameters only when they went into 13 effect, it was hard for us to 14 reconstruct that at the time. 15 think, yes, I mean, I think if that was 16 raised, that should have raised some 17 bells. 18 We only had the But I I'm not sure it would have, given the 19 market share focus, but that certainly 20 should have raised some alarms saying, 21 "Gee, a hundred percent of this deal is 22 going into another deal; aren't there any 23 real investors?" 24 time finding that. 25 Yes. COMMISSIONER BORN: But we had a hard Thank you. 494 1 2 3 4 Q & A - Session 3 CHAIRMAN ANGELIDES: Ms. Murren? The cleanup. COMMISSIONER MURREN: Thank you. 5 Thank you all for spending so much time 6 with us today. 7 Appreciate it. One of the things we're hoping to 8 achieve with looking at case studies is to 9 be able to determine if there are 10 similarities or differences in industry 11 practices across the various participants. 12 And so I was wondering if you could each 13 comment on similarities or differences 14 that you see between Moody's, S&P and 15 Fitch in terms of the culture, the 16 methodology and also to the extent that 17 they did or didn't get the ratings right. 18 Mr. Kolchinsky? 19 MR. KOLCHINSKY: I think the 20 interesting part is, the methodologies are 21 very different. 22 loss, S&P and Fitch rate to probability of 23 default. 24 we all came up with the same standards. 25 Moody's rates to expect a Very different concepts, and yet The analyses that each firm uses are 495 1 Q & A - Session 3 2 also extremely different. 3 of the day, due to the market share 4 mechanism, the ratings came out exactly 5 the same. 6 Yet, at the end I would want to say about the 7 culture, I think one of the reasons, it's 8 my personal view, you're seeing a lot more 9 Moody's people out here is that we had, 10 the old culture was a bit idealistic. 11 lot of us liked that academic culture. 12 And I think a lot of us have been -- 13 again, this is a point of pride at having 14 worked at the old Moody's, and the Moody's 15 I still love, is that there was a great 16 culture then which I think a lot of us 17 have been disappointed, and I think that's 18 one of the reasons you're seeing a lot of 19 folks from Moody's here in front of you, 20 because we do remember how it used to be, 21 and liked it. 22 never worked at S&P or Fitch but I think 23 that's one aspect of Moody's culture. 24 25 MR. FROEBA: A So I think that's -- I I said earlier, in response to a question, that I was 496 1 Q & A - Session 3 2 somewhat befuddled by the example of the 3 methodological change that Gary developed, 4 the application of the correlated binomial 5 to CDOs in connection with my assertion 6 that if you tracked market share. 7 I thought about it, I realized it really 8 isn't a problem to what I'm asserting 9 because what I'm asserting is that But as 10 material changes, changes which affect the 11 rating, that those corresponded to market 12 share pressure. 13 And I think if we quiz Gary, I 14 hope -- and I don't know the answer to 15 this question, which is a bad sign in a 16 lawyer, never ask a question you don't 17 know the answer to, I think Gary will 18 assert or confirm that there was very 19 little material substantive difference 20 between the two methodologies, that the 21 correlated binomial as applied to CDOs did 22 not really materially change the ratings. 23 That's I think an important point. 24 25 The point is, therefore, it was fine at Moody's to change methodology if it had 497 1 Q & A - Session 3 2 no impact on the ratings, and therefore, 3 revenue and market share. 4 change it, whatever. 5 ahead. 6 Fine, you could Go ahead. Right If you change methodology, however, 7 and it was going to cut your market share 8 in half, that was going to have a big 9 impact. And it wasn't going to happen. 10 So I think if you look at what happened at 11 Moody's, the changes, the material changes 12 in methodology, the changes that led to a 13 different rating occurring, only happened 14 when there was market share pressure and 15 the result was always that the ratings 16 were more competitive with our 17 competitors' ratings. 18 Now, why that whole preface? Because 19 I think what was happening with the other 20 rating agencies is that they were doing 21 the same thing. 22 Moody's, they were watching, S&P was 23 watching Fitch and Moody's, Moody's was 24 watching Fitch and S&P, and Fitch was 25 watching Moody's and S&P. They were watching 498 1 2 Q & A - Session 3 COMMISSIONER MURREN: Were you aware 3 of any instances where the analysts wanted 4 to change the methodology but essentially, 5 that was suppressed? 6 MR. FROEBA: It's important to 7 remember when you think about the process 8 that an individual analyst had almost no 9 capacity to change a methodology. 10 11 At the margins, they could make small changes. As I said, I think somewhat earlier, 12 the agency's intellectual property is the 13 methodology and that's really controlled 14 by a small select group, with a much less 15 formal process, and it's usually very 16 senior people. 17 so in response to your question, normally, 18 an individual analyst couldn't make a 19 material change to methodology. 20 have had to have been something that was 21 driven by people much more senior than an 22 ordinary analyst. An individual analyst -- 23 COMMISSIONER MURREN: 24 MR. MICHALEK: 25 It would Thanks. Two comments. I had an opportunity to testify in front of the 499 1 Q & A - Session 3 2 Permanent Subcommittee of Investigations 3 for the Senate Governmental Affairs 4 Committee. 5 would suggest is an even worse culture at 6 S&P, in terms of their frustration in 7 trying to affect meaningful changes to the 8 methodology that was being employed. 9 And I was struck by what I So in that sense, I think that we 10 probably did have -- and I'm only 11 speculating because I can't compare, I 12 wasn't at S&P -- we did have a stronger, 13 deeper intellectual culture in place, at 14 least prior, so that it was slower to 15 erode potentially than what I saw from the 16 exhibits and the testimony that was given 17 regarding S&P's culture, if you will. 18 Regarding changed methodologies that 19 were suppressed, I can think of one 20 example in the market value CDOs where a 21 quantitative, esteemed colleague of ours 22 was suggesting that there needed to be a 23 revision to the market value methodology, 24 and his efforts were discouraged. 25 Further, that he had provided, the same 500 1 Q & A - Session 3 2 Individual, had provided some critical 3 analysis to the SIV methodology that was 4 being employed, and was "convinced," and I 5 use that in air quotes, that potentially 6 the benefit from installing his more 7 conservative perspective would not 8 outweigh the potential loss that would 9 come from the market share that would 10 11 occur. And what he was effectively doing, 12 and I can only summarize because I can't 13 speak at his level of quantitative skill, 14 was increasing the likelihood of a 15 depression-level scenario in terms of 16 defaults and risks. 17 Had they done that, it would have 18 effectively made SIVs, or at least this 19 sector of SIVs that were under 20 examination, not possible to be rated. 21 22 COMMISSIONER MURREN: may want to follow up on that. 23 MR. MICHALEK: 24 CHAIRMAN ANGELIDES: 25 I'm guessing we you said? Happy to cooperate. Can you say what 501 1 Q & A - Session 3 2 DR. WITT: The name of that analyst 3 was Cesar Crousillat, and the reason that 4 I asked was that Cesar, along with Mark 5 and Rick, were -- their positions were 6 terminated in the fall of 2007. 7 you've heard their testimony. 8 really smart guys, and Moody's needed 9 their services, and I always thought it I mean, These were 10 was the personnel decisions that made me 11 the most uncomfortable, especially at this 12 time, in terms of what was management's 13 real purpose. 14 person that they took out of the rating 15 agency at the point in time was Eric. 16 And of course the other They removed him to a software 17 company. So I mean, these were, like the 18 most independent minded, you know, people 19 they had, and some of the best people they 20 had. 21 As far as the -- 22 CHAIRMAN ANGELIDES: Before you 23 proceed, I just want to say that if you 24 would please give Crousillat's 25 information, do you know -- certainly, 502 1 Q & A - Session 3 2 would you please give it to our staff so 3 we can follow up on this. 4 VICE-CHAIRMAN THOMAS: 5 6 At least the spelling. DR. WITT: As the other rating 7 agencies, this is kind of ancient history, 8 so I'm not sure it's relevant, but I 9 worked at Prudential Securities before I 10 came to Moody's. And it was an investment 11 bank, and, you know, I was working on 12 structuring CDOs, so I had to, I dealt 13 with S&P and Fitch from that side. 14 was -- I didn't want to stay in investment 15 banking, and I met Jerry Gluck and I got 16 to know a few of the analysts at Moody's 17 and I was just very impressed with the 18 culture at that time. And I This was in 2000. 19 And I concur with Rick's opinion 20 that, you know, it was just much more of 21 a, you know, a bunch of smart people 22 getting together and saying, "How can we 23 do this right," kind of culture at 24 Moody's, which was one of the reasons why 25 I wanted to join. 503 1 2 Q & A - Session 3 COMMISSIONER MURREN: 3 I still have more time? 4 CHAIRMAN ANGELIDES: 5 COMMISSIONER MURREN: Thank you. Do Yes. Question for 6 all of you: In your experiences at 7 Moody's, were you ever aware of an 8 instance where the issuer or the 9 investment bank gave information to you as 10 the rating agency that was either 11 incorrect, poorly represented, or 12 incomplete? 13 MR. FROEBA: Well, I just generally 14 assume that investment bankers were lying 15 to me whenever it was, you know, if there 16 was any -- anything at issue. 17 was a useful thing to do. 18 checked. 19 And that I always I never relied. They would do things like do creative 20 black-lining so this thing they didn't want 21 you to catch wouldn't show up in the 22 black-line. 23 scrupulous if you wanted to avoid -- and 24 it was a very contentious relationship 25 often that arose between Moody's and the You had to be very 504 1 Q & A - Session 3 2 banks. 3 when things were hidden, concealed, 4 misrepresented. 5 I didn't experience that. 6 So yes, there were often times Fraud, I don't think so. MR. KOLCHINSKY: In some cases, where 7 we rated deals using the CDO ROM model, 8 and it was a static pool, so we actually 9 rated to the pool. We've gotten, and I 10 don't think it's fraud just because I 11 don't know what, I think it was mostly 12 copying, pasting by the analysts, but we 13 got back a CRO form that we looked at 14 that -- there were certain columns that we 15 had to fill out, and unless the text was 16 exactly the same, compared text to text, 17 so the text strings were -- weren't 18 exactly the same, they were treated 19 differently. 20 And different bonds, the same exact 21 bonds that should have had identical text, 22 they were not, I think that's mostly 23 copying, pasting, but that just -- maybe 24 in some cases, there's no way for us to 25 know, but something you had to check. 505 1 2 Q & A - Session 3 MR. MICHALEK: There was an example, 3 from -- I can't remember the exact year, 4 2003? 5 Suisse. 6 been alluded to here is, I would mention a 7 cleaning out of the warehouse. 8 effectively, you do deal one, and you 9 can't sell the equity or you can't sell Structuring bank I think was Credit One of the processes that has That 10 junior-most piece, so they take it out onto 11 their balance sheet. 12 from CDO 1 would end up being an asset for 13 CDO 2. And then that bond 14 So they've got a period of -- they 15 are extended a line of credit by their 16 credit committee as to how much of this 17 they can have, but it's important that 18 they keep rolling this stuff off of their 19 balance sheet, getting it into the 20 subsequent CDOs. 21 restrictions are just inviolable with 22 respect to the Moody's methodology, you 23 can't have more than X percent that were 24 not rated by Moody's because of the 25 problems, et cetera, et cetera. However, there's some 506 1 Q & A - Session 3 2 Well, there was a case where, here 3 was a structure that had gotten assembled, 4 that had some non-qualifying assets that 5 we only learned about at the very end, and 6 in fact, it was after the deal had 7 originally been rated, and we were coming 8 to a closing, we ended up having to, “what 9 are we going to do about this?” And we're 10 going to have to withdraw the rating and 11 make an announcement that says this 12 was incorrectly rated, and it was a huge 13 embarrassment. 14 So the banker at the time suggested, 15 "Well, I think I have a solution. 16 buy back all of those bonds so that your 17 rating will not have been at issue." 18 was agreed that we would do that provided 19 that none of these bonds ended up in any 20 CDO that Moody's subsequently rated. 21 We'll It And about three months later, low and 22 behold, there's that bond sitting there 23 and it was like, "Oh, that was just an 24 accident, we'll buy that one back out of 25 this one as well." 507 1 2 Q & A - Session 3 So that sort of, you know, can I say 3 that this was fraud? 4 it was shark dealing? 5 No. Can I say that Daily. COMMISSIONER MURREN: Daily. Any investment 6 banks stands out as making the most 7 innocent mistakes repeatedly? 8 VICE-CHAIRMAN THOMAS: 9 10 Nicely phrased. MR. MICHALEK: Banks don't make 11 mistakes. 12 could probably find some particularly 13 aggressive bankers, their names are well 14 known, and those bankers have moved from 15 bank to bank, and perhaps in your 16 research, I'm sure these names have 17 already come up. 18 The people make mistakes. You Obviously Lehman Brothers, there were 19 individuals at Lehman Brothers who were 20 extremely aggressive and it was difficult 21 to actually say no, and they were very 22 aggressive about pushing back. 23 don't want to accuse anybody of fraud 24 without having all of the details and 25 facts in front of me. Again, I 508 1 Q & A - Session 3 2 COMMISSIONER MURREN: 3 CHAIRMAN ANGELIDES: Thank you. All right. 4 Thank you very much, gentlemen, for being 5 with us here today. 6 yous -- go ahead, are Vice-Chairman. 7 I'll wrap up. 8 A couple -- few thank VICE-CHAIRMAN THOMAS: No, I just 9 wanted to thank you and I hope our two new 10 witnesses didn't mind the expansion to the 11 two earlier ones 'cause frankly, about 12 three-quarters of the way through this, 13 you kept trying to explain Moody's culture 14 to us. 15 faculty lounge that I'm very comfortable 16 in, and I appreciate the testimony and I 17 think you were an extremely valuable asset 18 for this hearing and I want to thank you. 19 And it felt a whole lot like a CHAIRMAN ANGELIDES: Well, thank you. 20 I'd like to thank our witnesses who were 21 with us today, I'd like to thank, again, 22 President Kerrey and staff of The New 23 School, you've been wonderful hosts. 24 I just want to thank you for going out of 25 your way to accommodate us, to make us And 509 1 Q & A - Session 3 2 feel at home and set us up on the road, a 3 very difficult undertaking. 4 terrific job. You did a 5 And I particularly want to just thank 6 all my colleagues for the countless hours 7 they are putting into this important task 8 for the country and just the preparation 9 and the hard work and the good questions. 10 Frankly, it's an honor to serve on this 11 Commission. 12 And finally to the staff who have put 13 in countless hours and now will get a 14 three-hour break before we go on to the 15 next mission. 16 17 18 19 20 21 22 23 24 25 (Continued on following page.) 510 1 2 Q & A - Session 3 Thank you all very much. 3 Commissioners, we've been asked by 4 Gretchen if we could all convene in the 5 holding room together briefly. 6 some materials and instructions for us on 7 the next part of our field trip. 8 you all very much. 9 She has Thank Oh, excuse me, there are some 10 materials in the corner. Staff reports, a 11 wonderful chart that the staff prepared in 12 multicolor, with many dimensions on CDOs 13 and CDO squareds, and those are all also 14 on our website. Thank you all very much. 15 This meeting is adjourned. 16 (Time noted: 17 18 19 20 21 22 23 24 25 26 5:24 p.m.)
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