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THE ROLE OF CREDIT RATING AGENCIES
IN THE STRUCTURED FINANCE MARKET

HEARING
BEFORE THE

SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES
OF THE

COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION

SEPTEMBER 27, 2007

Printed for the use of the Committee on Financial Services

Serial No. 110–62

(
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WASHINGTON

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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
´
NYDIA M. VELAZQUEZ, New York
MELVIN L. WATT, North Carolina
GARY L. ACKERMAN, New York
JULIA CARSON, Indiana
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
´
RUBEN HINOJOSA, Texas
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin,
LINCOLN DAVIS, Tennessee
ALBIO SIRES, New Jersey
PAUL W. HODES, New Hampshire
KEITH ELLISON, Minnesota
RON KLEIN, Florida
TIM MAHONEY, Florida
CHARLES A. WILSON, Ohio
ED PERLMUTTER, Colorado
CHRISTOPHER S. MURPHY, Connecticut
JOE DONNELLY, Indiana
ROBERT WEXLER, Florida
JIM MARSHALL, Georgia
DAN BOREN, Oklahoma

SPENCER BACHUS, Alabama
RICHARD H. BAKER, Louisiana
DEBORAH PRYCE, Ohio
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
PAUL E. GILLMOR, Ohio
STEVEN C. LATOURETTE, Ohio
DONALD A. MANZULLO, Illinois
WALTER B. JONES, JR., North Carolina
JUDY BIGGERT, Illinois
CHRISTOPHER SHAYS, Connecticut
GARY G. MILLER, California
SHELLEY MOORE CAPITO, West Virginia
TOM FEENEY, Florida
JEB HENSARLING, Texas
SCOTT GARRETT, New Jersey
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
STEVAN PEARCE, New Mexico
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia
GEOFF DAVIS, Kentucky
PATRICK T. MCHENRY, North Carolina
JOHN CAMPBELL, California
ADAM PUTNAM, Florida
MICHELE BACHMANN, Minnesota
PETER J. ROSKAM, Illinois
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel

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SUBCOMMITTEE

CAPITAL MARKETS, INSURANCE,
ENTERPRISES

ON

AND

GOVERNMENT SPONSORED

PAUL E. KANJORSKI, Pennsylvania, Chairman
GARY L. ACKERMAN, New York
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
´
RUBEN HINOJOSA, Texas
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
´
NYDIA M. VELAZQUEZ, New York
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin,
LINCOLN DAVIS, Tennessee
ALBIO SIRES, New Jersey
PAUL W. HODES, New Hampshire
RON KLEIN, Florida
TIM MAHONEY, Florida
ED PERLMUTTER, Colorado
CHRISTOPHER S. MURPHY, Connecticut
JOE DONNELLY, Indiana
ROBERT WEXLER, Florida
JIM MARSHALL, Georgia
DAN BOREN, Oklahoma

DEBORAH PRYCE, Ohio
RICK RENZI, Arizona
RICHARD H. BAKER, Louisiana
CHRISTOPHER SHAYS, Connecticut
PAUL E. GILLMOR, Ohio
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
FRANK D. LUCAS, Oklahoma
DONALD A. MANZULLO, Illinois
EDWARD R. ROYCE, California
SHELLEY MOORE CAPITO, West Virginia
ADAM PUTNAM, Florida
J. GRESHAM BARRETT, South Carolina
BLACKBURN, MARSHA, Tennessee
GINNY BROWN-WAITE, Florida
TOM FEENEY, Florida
SCOTT GARRETT, New Jersey
JIM GERLACH, Pennsylvania
JEB HENSARLING, Texas
GEOFF DAVIS, Kentucky
JOHN CAMPBELL, California
MICHELE BACHMANN, Minnesota
PETER J. ROSKAM, Illinois
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan

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CONTENTS
Page

Hearing held on:
September 27, 2007 ..........................................................................................
Appendix:
September 27, 2007 ..........................................................................................

1
53

WITNESSES
THURSDAY, SEPTEMBER 27, 2007
Adelson, Mark H., Adelson & Jacob Consulting, LLC ..........................................
Bass, J. Kyle, Managing Partner, Hayman Capital Partners, L.P. .....................
Kanef, Michael B., Group Managing Director, Asset Finance Group, Moody’s
Investors Service ..................................................................................................
Mason, Dr. Joseph R., LeBow College of Business, Drexel University ...............
Mathis, H. Sean, Miller Mathis & Co., LLC .........................................................
Tillman, Vickie A., Executive Vice President, Standard & Poor’s .......................

12
11
14
17
7
15

APPENDIX
Prepared statements:
Kanjorski, Hon. Paul E. ...................................................................................
Adelson, Mark H. ..............................................................................................
Bass, J. Kyle .....................................................................................................
Kanef, Michael B. .............................................................................................
Mason, Dr. Joseph R. .......................................................................................
Mathis, H. Sean ................................................................................................
Tillman, Vickie A. .............................................................................................

54
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69
78
112
132
147

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THE ROLE OF CREDIT RATING AGENCIES
IN THE STRUCTURED FINANCE MARKET
Thursday, September 27, 2007

U.S. HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The subcommittee met, pursuant to notice, at 2:07 p.m., in room
2128, Rayburn House Office Building, Hon. Paul E. Kanjorski
[chairman of the subcommittee] presiding.
Present: Representatives Kanjorski, Ackerman, Sherman, Baca,
Lynch, Marshall; Pryce, Castle, and Manzullo.
Chairman KANJORSKI. The subcommittee will come to order. This
hearing of the Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises will take up the question of
oversight of the mortgage credit market by the reporting agencies.
First, I will give my opening statement, and then we will go down
the line to all Members who wish to make an opening statement.
We meet this afternoon to examine a complex but familiar
issue—the performance and oversight of credit rating agencies. Today’s hearing also furthers our investigations into the recent credit
crunch that occurred in our capital markets and focuses on the role
of credit rating agencies in engineering and grading structured finance products.
A strong, robust, free market for trading debt securities relies on
the independent assessments of financial strength provided by
credit raters, entities like Moody’s, Fitch, and Standard & Poor’s.
When a company or a debt instrument blows up in our capital market, critics will often raise concerns about the failures of rating
agencies to warn investors, as was the case after WorldCom’s bankruptcy, Enron’s insolvency, New York City’s debt crisis, Washington Public Power Supply System’s default, and Orange County’s
collapse. In recent weeks, many marketplace observers have again
criticized the accuracy of credit rating agencies in anticipating
problems with debt instruments like mortgage-backed securities
and collateralized debt obligations, or CDOs.
As part of the Sarbanes-Oxley Act, Congress required the Securities and Exchange Commission to study the performance of rating
agencies. Congress then used this report to inform its debates
about how best to register and oversee the work of nationally recognized statistical rating organizations. Ultimately we approved
the final version of the Credit Rating Agency Reform Act on the
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2
House Floor exactly 1 year ago today, and it became law a short
while later.
Throughout these debates, my fellow House Democrats and I insisted that the new legislation contain quality controls, which the
final version did. The new law, therefore, permits the Commission
to hold the rating agencies accountable for producing credible and
reliable ratings and following their internal policies. It also allows
the Commission to prohibit or mitigate conflicts of interest. It further provides the Commission with the power to examine the financial wherewithal and management structures of approved credit
raters.
Additionally, we have seen tremendous growth in our structured
finance markets in recent years. For example, the global sale of
CDOs tripled between 2004 and 2006 to stand at $503 billion.
These CDOs, a financial instrument first engineered by Drexel
Burnham Lambert, have also grown increasingly complex. Because
history has a way of repeating itself, I am not surprised that the
ghosts created by Drexel are with us today.
To help investors cut through the complexity of CDOs, the major
rating agencies have expanded their services to evaluate these
products in terms of their likelihood for defaults. Their investmentgrade stamp of approval helped to provide credibility for the CDOs
that had the toxic waste of liars’ loans and problematic subprime
products buried deep within the deal. In return, the rating agencies
also made great sums of money from issuers.
To me, it appears that none of the parties that put together or
purchased these faulty home loans, packaged them into mortgagebacked securities, and then divided these securities into tranches
and repackaged them into CDOs, CDOs squared, and CDOs cubed,
had any skin in the game. In the end it was a final investor left
with this hot potato of prime debt and significant losses. In my
view the rating agencies helped to create this Lake Woebegone-like
environment in which all of the ratings were strong, the junk
bonds good-looking, and the subprime mortgages above average. In
reality, however, we now know that they were not.
That said, the conundrum facing the rating agencies is much like
the conundrum facing Fannie Mae and Freddie Mac. Even though
the securities issued by the two government-sponsored enterprises
explicitly indicate that they are not backed by the full faith and
credit of the United States, many investors believe otherwise. Similarly, even though rating agencies only calculate the likelihood of
default, many investors believe that these grades measure the financial strength of the underlying instrument.
Past cases of criticism about the failure of the rating agencies to
detect faults generally focused on a single issuance or issuer. In
this most recent case, however, these financial failures seem to
have been much more pervasive; they occurred across a class of financial product. As a result, I am very concerned about systemic
failures within the rating agencies themselves and the potential for
a systemic failure within our global capital markets. I hope to explore these issues today.
As we proceed on these matters, I also want to assure everyone
that I have not yet reached any conclusions. That said, we may ultimately decide that we need to revisit last year’s law and improve

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upon the quality controls adopted within it. Some of the policy options that we could consider include requiring more disclosure for
rating agencies like those required of auditors, instituting rotations
in raters like auditors, altering the methods by which raters receive compensation, mandating simultaneous disclosure of nonpublic information to all Commission-registered raters, improving
the transparency of underlying debt products, and forcing a delay
in allowing complex products like CDOs to come to market so as
to allow a deal to season in its performance.
In closing, I look forward to a lively debate today. We have an
excellent panel of witnesses with experience in credit ratings, valuation, hedge funds and the securitization process. They also have
a variety of views, and we will likely learn much from them.
Ms. Pryce.
Ms. PRYCE. Thank you, Mr. Chairman. Thank you for holding
this hearing today. This is another important piece in a series of
hearings to help us better understand the mortgage crisis our country is facing.
The shockwaves have been felt everywhere across the country
and throughout the world, but no State has been as impacted as
my own home State of Ohio. Ohio’s foreclosure rates have increased
138 percent since August of 2006, and the number of foreclosure
filings has nearly quadrupled since 1995. There seems to be no end
to this crisis. An estimated $14 billion in adjustable-rate mortgages
are expected to reset in Ohio over the next 5 years, putting more
homeowners at risk of foreclosure.
Last week we looked at ways to help homeowners facing the
prospect of foreclosures. Today we are here looking at one of the
primary actors within the structured finance market. Rating agencies and their credit risk assessments have become a cornerstone
of our housing market, in particular as the amount of subprime
mortgages in the market shot up from $35 billion in 1994 to $625
billion in 2005. Mortgages sold into the secondary market are combined, carved up, evaluated by the rating firms, and resold to Wall
Street as asset-backed securities. This process has provided much
liquidity into the housing market and helped drive the housing
boom and the growth of the subprime market.
As we look at all aspects of this crisis, we should be asking tough
questions about the rating agencies’ role. They are uniquely positioned as monitors of the risk associated with different mortgage
products. Their insight into how these risks have changed and how
methodologies and ratings have changed to meet them will be invaluable to us; their open questions about the timing of lowering
rating scores, whether original ratings appropriately reflected the
credit risks presented by residential mortgage-backed securities,
and whether the rating agencies adequately monitor previously
issued ratings for structured finance products.
Since June, 2,400 tranches of RMBS have been downgraded. This
does not fit the model of recent history. Until 2006, upgrades outnumbered downgrades, but we have seen a quick turnaround of
this pattern. There is no doubt that the subprime mortgage boom
of 2004, 2005, and even early 2006 was unlike anything we have
ever seen before. We can learn much from rating agencies’ successes and failures engaging that risk.

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I want to thank our witnesses for testifying today and I look forward to your testimony. Thank you.
Chairman KANJORSKI. Mr. Ackerman.
Mr. ACKERMAN. Thank you, Mr. Chairman.
Much of the blame for the current economic mess can sure be
placed on the shoulders of the subprime mortgage business. Too
many brokers sold these complex and inherently risky financial
products to people who had no business being approved for a blackand-white TV loan, let alone a six-figure mortgage. A handful of
these institutions even went so far as to offer mortgages with
promises of, ‘‘no background checks,’’ and ‘‘no income verification,’’
and advertised in low-income areas saying that no one could be
turned down for a loan.
In my view, such business practices, very clearly designed to bait
the hook with the American dream to entrap economically strapped
and often less financially savvy customers into mortgages that they
could not afford were not just irresponsible, but they were reprehensible, if not criminal.
But there is more blame to be apportioned. Loan originators took
these junk mortgages, packaged them into securitizations, and then
marketed the collateralized debt obligations, or CDOs, on the secondary mortgage market after absent transparency. We now know
that credit rating agencies by their own admission assigned overly
favorable ratings to many of these products. The why of it is very
simple. Some of these firms were double-dipping. First they profited by helping the originators put these shady securities together,
and then they collected fees for deliberately misrating these risky
products at a higher value than they were worth. This is what the
Arthur Andersens of the world did for the Enrons and the
WorldComs. The credit raters helped put the Spam in the can,
made it sizzle, and then they sold it as steak. As I noted at a hearing earlier this month, that is not the free market at work; that
is fraud. And fraud is a crime, not a correction.
Now, nobody here today will argue that the ratings assigned by
Moody’s or S&P’s are the sole factors that investors used when deciding whether or not to purchase a securitization. In fact, many
sophisticated investors voiced their concerns about CDOs products
when the subprime lending spree hit its peak about 2 years ago.
But nobody can deny that credit ratings played a major role in
many investors’ decisions, and my concern here is not that Wall
Street players lost money because good-faith credit ratings turned
out to be bad estimates of risk; the outrage here is that the credit
rating agencies colluded with loan originators and then consciously
assigned overly favorable ratings and deliberately manipulated the
market for their own greedy profit.
Collusion and misrepresentation are not elements of a genuinely
free market. It is the job of the Federal Government to protect the
integrity of our markets. And as I said earlier this month, the committee, this committee, and this Congress, will not be passive speculators as banks, nonbank banks, and credit rating agencies use
their control of information to fool investors into believing that a
pig is a cow and a rotten egg is a roasted chicken.
I am pleased that we have some witnesses from the credit rating
agencies with us this afternoon, and I am hoping that their testi-

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mony will merit a Triple A rating. In light of the industry’s recent
performance, something closer to a C, might be more likely expected. I would caution them that their forthrightness today about
where their industry went wrong and what steps they are taking
to ensure that unduly favorable ratings are not given to shaky financial products in the future may determine their future earnings
or losses.
Thank you, Mr. Chairman.
Chairman KANJORSKI. Thank you, Mr. Ackerman.
The gentleman from Delaware, Mr. Castle.
Mr. CASTLE. Mr. Chairman, I have no opening statement, but I
congratulate you and the committee on a good list of witnesses and
I look forward to the testimony.
I yield back.
Chairman KANJORSKI. Thank you, Mr. Castle.
Mr. Sherman.
Mr. SHERMAN. Thank you, Mr. Chairman. You are to be commended for your Lake Woebegone reference, a reference to an idyllic Minnesota town where the women are strong, the men are goodlooking, all the children are above average, and all the mortgage
pools are investment grade.
When we look at this crisis, we should expect borrowers to borrow. Many are optimistic about what will happen to real estate
prices in their area, and they are optimistic as Americans are and
should be about their own job prospects. Some were sold bad products or misled. But even with perfect information, borrowers are
going to buy homes that they only have an 80 percent chance of
really being able to afford. And, in fact, when we look at today’s
subprime loans, even under bad conditions roughly 85 percent of
the homebuyers are going to be able to keep their homes, and most
of them couldn’t have bought those homes without some sort of a
subprime loan. So we can’t blame borrowers for wanting an extra
bedroom or wanting to be homeowners instead of renters, especially
at a time when they saw all of these real estate values going up
and all their friends becoming considerably more wealthy as a result of real estate value increases.
We shouldn’t be surprised that intermediaries want to intermediate. After all, they package the loans and sell them without
recourse. And as long as they don’t get stuck with inventory on the
shelf, they do quite well under any market circumstances. So we
shouldn’t be surprised that investors will invest. After all, they are
buying in a debt, basically a debt instrument. They are getting 100,
150 basis points above the same rate that is available for equivalent terms of government paper, and the rating agencies are saying, ‘‘Hey, it is an A instrument.’’
So we have to look at the rating agencies and see why they
missed. Borrowers were going to borrow, investors were going to invest, but the rating agencies don’t have to give a high rate to every
pool of mortgage debt. And I am told that rating agencies tended
to look at the performance of prior pools. Well, a rising tide lifts
all boats, so all boats must be aircraft or at least levitating hovercraft if the tide is rising.
It is pretty difficult, or often you don’t default on a loan in a rising real estate market even if you lose your job, because all of a

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sudden, if you have lived there for a few years, you have a lot of
equity, and somebody will buy the house from you before you lose
it in foreclosure. Heck, there are 17 mortgage brokers ready to loan
you more because you have so much equity in spite of the fact that
you lost your home.
So you have to look not at—I mean, the first question is why so
much rating was done looking at the past, looking at prior performance; and then, in particular, why you folks allowed and gave high
grades to such low underwriting standards. Because it is only the
underwriting standards that can protect investors if there is a decline in nationwide employment, which, thank God, there really
hasn’t been to a large degree, or a decline in real estate values.
We don’t need rating agencies to tell us what to do in great
times. We need rating agencies to tell us what instruments are investment grade if real estate values level off or even decline. What
we have seen is you have given, or some of you have given, high
ratings to stated income loans even when your own people called
them ‘‘liars’ loans.’’ And you have given high ratings to pools that
include what I call—I don’t know if a term has emerged in this
area—teaser rate qualification. You go to the borrower and you
say, hey, your interest rate is only 4 percent for the first 3 years,
and then you go to the investors and say, that is a qualified borrower because for the first 3 years, they can afford to make the
payments.
We need better—whether that requires a restructuring of the industry, or whether that just requires a change in your behavior, I
don’t know, but I hate to think that teaser rate qualification and
liars’ loans are going to find their way into pools that you folks give
investment-grade ratings to, and I look forward to hearing—I am
going to have to leave for part of this testimony, but I look forward
to hearing much of what you have to say.
Chairman KANJORSKI. The gentleman from Illinois, Mr. Manzullo.
Mr. MANZULLO. I am looking forward to the testimony.
Chairman KANJORSKI. Okay. The gentleman from Georgia, Mr.
Marshall.
Mr. MARSHALL. Thank you, Mr. Chairman. I would like to associate myself with your opening statement; I found myself in complete agreement.
I am open-minded on this subject, though quite concerned. It is
pretty obvious if you look at the system, the only two real weak
points are the initial transaction that created the debt—and we
may need a much more robust Truth in Lending Act if nothing
else—and then the rating agencies. Those are the two really weak
points.
The rating agencies have failed us many times in the past. It
seems to me that this committee must have looked at this problem
before today many times. And you mention that legislation was
passed last year designed to deal with it.
I hope I don’t have to feel like I should have associated myself
with Mr. Ackerman’s very entertaining opening statement, because
where the substance is concerned, it is pretty damning. And if he
is correct, some people need to go to jail.

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Chairman KANJORSKI. Without objection, all Members’ opening
statements will be made a part of the record.
And without objection, the statements of the witnesses will be
made part of the record, and will be recognized, after I introduce
them, for 5-minute summaries of their testimony.
The panel will consist of: Mr. H. Sean Mathis, Miller Mathis &
Co., LLC; Mr. J. Kyle Bass, managing partner, Hayman Capital
Partners, L.P.; Mr. Mark H. Adelson, Adelson & Jacob Consulting,
LLC; Mr. Michael B. Kanef, group managing director, Asset Finance Group, Moody’s Investors Service; Ms. Vickie A. Tillman, executive vice president, Standard & Poor’s; and Dr. Joseph R.
Mason, LeBow College of Business, Drexel University.
First, we will hear from Mr. Mathis.
Mr. ACKERMAN. Mr. Chairman, I would just like to exert the prerogative of a homeboy here. We are fortunate to have among our
expert witnesses today a gentleman with over 25 years of advisory
and principal-side investing experience. Sean Mathis is the senior
managing partner at Miller Mathis, an independent investment
bank headquartered in my City of New York. He holds an MBA
from the Wharton Graduate School of Business, has previously
served as the president or chairman of any number of companies
within the financial services industry, and has a proven track
record of success within the financial markets.
I had the opportunity to meet with Mr. Mathis a month or so ago
regarding the role of credit rating agencies in the subprime crisis,
and I was very impressed with his insight. I am sure that the
members of our subcommittee will be equally impressed listening
to his testimony along with the others.
Thank you, Mr. Chairman.
STATEMENT OF H. SEAN MATHIS, MILLER MATHIS & CO., LLC

Mr. MATHIS. Mr. Chairman and members of the subcommittee,
good afternoon. I would like to thank you for inviting me to testify
here today in the matter of the role of credit rating industries in
the structured finance market. I do so with regard to my experience and that of my colleague Julia Whitehead in connection with
many companies and public entities we have worked with over the
years whose pension arms have an intense interest in the topic before the subcommittee.
In the wake of the subprime meltdown, we are facing perhaps
the most serious crisis of confidence in our domestic and international financial market since the Great Depression. I submit,
however, that the fallout would have never assumed these proportions if it were not for the extension of ratings issued by our nationally recognized statistical rating organizations to structured finance securities.
In some ways it is easy to blame the rating agencies whose willingness to attach investment-grade labels to untested, unproven,
and, in many cases, deeply flawed structures allowed the incidence
of these instruments to grow to enormous proportions, infiltrating
the portfolios of even the most risk-averse investors. I believe, however, that the true culprit of the system that allowed NRSRO ratings to become critical and an embedded part of the protections
built into our capital markets, financial institutions, and pension

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funds without sufficient or appropriate thought given to accompanying supervision or accountability. In an age of financial engineering where complex, opaque, and off-exchange products have
outpaced the ability of regulators to understand or control them, it
is the failure to properly supervise the rating agencies that has
brought the financial markets to their knees.
For Congress, to focus on finding a villain is only part of the effort. If there is a legal or inappropriate behavior, these people can
be dealt with in the legal process. In part, I really believe Congress’
focus should be on fixing the regulatory structure whose malfunction impeded the ability of our markets to function.
In that vein I draw your attention to the following four points.
First of all, there is nothing small or self-limiting about the current
situation. Subprime is not the source of all evil, it is merely the
first eruption of a disease which has been growing in structured finance for some time. Make no mistake, the pain that will be suffered from collapses across the financial structured finance landscape will not merely be borne by well-heeled hedge fund managers
or greedy, intemperate citizens looking to make a fast trade in a
frothy housing market. The pain will be felt by regular people
whose pension funds have been impaired by investments in goldplated, highly rated securities whose performance will turn out to
be far worse than the promise implied by these ratings.
Second, the significant flaws in the NRSRO rating system which
precipitated this crisis are less ones of conception than they are of
execution. In fact, the motive for the creation of NRSROs to give
regulators charged with ensuring the capital adequacy of financial
institutions a way to piggyback on the rating agency’s designation
of highly liquid and stable securities was never made explicit in the
rating agency regulatory construct. As a consequence, moves by
rating agencies to extend investment-grade ratings to securities
that are liquid and unpredictable is significantly at odds with the
original intent, and it was only a question of when, not if, they
would migrate to these securities. Moreover, the lack of accountability placed on rating agencies freed them from the normal
checks on behavior and judgment that such accountability tends to
confer.
Third, as a result of the damage done via the rating system, it
is critical that Congress view the reestablishment of the NRSRO
system as its most important objective. As the legislative arm of
our government, Congress must use its power to repair the body
of law that has brought us to this point.
Fourth, to fix the inadequacies of the current NRSRO system,
Congress must address its two most fundamental problems. First,
it must seek to draw a line between securities eligible for NRSRO
investment-grade designation and those that are still too new and
complex to be modeled appropriately. The line will not be a perfect
one, but it must be drawn in a way not to hamper innovation,
while preventing the application of investment-grade labels on securities whose structures and assets are too unseasoned or volatile
to be reasonably evaluated.
Second, it must imbue the system with accountability. The functioning of a free market relies on individuals and corporate entities

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being responsible for what they do. Congress must see to it that
this principle is built into the rating system.
Let me expand. Imprudently granted ratings have been a key
contributor to the excesses in the extension of credit not just in
housing, but also, as we are finding, in commercial real estate; corporate loans; and complicated, sometime near fantastical synthetic
bets on credit. The unwinding of all these will cause significant
trauma in many sectors.
Additionally, since our system of ensuring the capital adequacy
of our financial institutions is heavily ratings-driven, flaws in the
award of ratings impact the very bedrock of our financial markets.
Those flaws, however, do not invalidate the purpose for which the
rating system was initially intended to serve.
When the SEC created the rating agency regime in 1975, it
sought to use the rating agency metrics to categorize the relative
risk of broker-dealer securities for the purpose of ensuring capital
adequacy. The NRSRO designation was certainly not intended to
convey any power to the agencies. It was merely the result of the
SEC’s recognition ‘‘that securities that were rated investment-grade
by credit rating agencies of national repute typically were more liquid and less volatile in price than securities that were not so highly
rated.’’ While the SEC clearly equated the term ‘‘investment-grade’’
with liquidity, that fact was never memorialized in legislation,
process, or definition.
Notwithstanding that lack of provision, regulators all over the
world jumped on the SEC bandwagon by referencing NRSRO ratings in a multitude of capital requirements and investment mandates at every level of the domestic and international economy.
Regardless of the SEC intent or lack thereof, the NRSRO designation gave a few fortunate rating agencies enormous authority,
establishing them as the de facto gatekeepers of the investmentgrade universe. Moreover, without any sort of regulatory or legal
definition of investment-grade, the rating agencies were free to
apply that grade at will. Since, for reasons that may have seemed
important at the time, the SEC enacted various provisions which
protected the rating agencies from securities liability, and since the
rating agencies themselves successfully appropriated the freedom
of speech shield for their ratings, they confidently extended their
ratings umbrella in a remarkably unfettered fashion. And with
enormous compensation they received from issuers, the rating
agencies were handsomely rewarded for these ratings.
The ultimate result is what we see today, that the investmentgrade ratings framework has been stretched beyond its initial conception to cover uses in instruments which were exactly the opposite of what was intended, causing it to backfire on the capital
structures and investors it was designed to protect. There have
been warnings before this, previous blowups, most notably Enron
and WorldCom.
These fixes, however, remained elusive. The generously named
Credit Rating Agency Reform Act of 2006, if anything, institutionalizes much of the current rating agency activity, leaving those
firms generally free to do what they are paid to do, issue ratings.
This time the blow-up is not confined to one company or security,
but an entire asset class of structured finance. What we first saw

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in subprime issuances, dubious assets, faulty structures are now
appearing in other vehicles whose rapid-fire issuance depended on
a successful Triple A rating of a large part of their capital structure
including SIBs and other asset-backed commercial paper vehicles,
CDOs, CLOs, and many structures which are not based on money
assets, but are based mainly on synthetic bets.
The damage from the collapse of these hastily conceived instruments will take years to play out. In recognition of the wreckage
wrought by not acting sooner, Congress must act to repair this
framework. There is no question that modifications of the current
rating structure must be thoroughly and carefully evaluated with
appropriate input from vested and unvested interests to avoid unintended consequences. But if the desire is to restore functions to
our markets and credibilities to our institutions, Congress must address the following:
Regulatory oversight and supervision of the rating agencies must
be had. Despite the fact that rating agencies are broadly and deeply felt throughout our economy, supervisory authority, which is
largely vested in the SEC, remains de minimis.
Applicability of NRSRO ratings. The accelerant fuel fueling the
growth of this generation of subprime and subprime-linked securities was the willingness of the rating agencies to stamp them investment-grade so they could be injected into the portfolio of yield
star fiduciaries. Congress should review the use of NRSRO ratings
for securities or structures which lack liquidity, transparency, and
seasoning, as well as the process and authority under which new
asset classes are brought into the investment-grade world.
Compensation-driven conflicts of interest. The rating agencies
have been paid enormous sums of money by their structured finance clients, which has caused outsiders to question the impartiality and objectivity of the ratings.
Accountability. Unlike other professionals—accountants, lawyers
and the like—rating agencies have heretofore escaped any liability
when their ratings opinions proved wrong. Requiring the rating
agencies to bear responsibility for their ratings and performance,
perhaps in the manner of other professionals who function as experts, must be examined.
Finally, if Congress wishes to remedy these defects that contributed to the near meltdown of our financial markets, it must comprehend just how deeply NRSRO influence is entrenched in measures intended to protect capital and financial institutions and fiduciaries, both domestic and internationally, including Basel II,
whose provisions to regulate international bank capital adequacy
are being implemented as we speak. We believe past failures to recognize the pervasiveness of NRSRO activity contributed to a reduced search sense of urgency on Congress’ part. Now is the time
for Congress to take a more deliberate stand. We urge Congress to
act.
[The prepared statement of Mr. Mathis can be found on page 132
of the appendix.]
Chairman KANJORSKI. Mr. Bass.

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STATEMENT OF J. KYLE BASS, MANAGING PARTNER, HAYMAN
CAPITAL PARTNERS, L.P.

Mr. BASS. Thank you. Chairman Kanjorski and Ranking Member
Pryce, this is an incredibly complex issue that is very difficult to
distill into a 5-minute remark, so I will refer you to my written testimony for a more detailed explanation of my position.
I am here today as an investor and participant in the residential
mortgage-backed securities market, the RMBS market. In total I
manage or advise over $4 billion of investments in the RMBS marketplace. I am here today because I am worried about the recent
behavior of the ratings agencies and their work that has been irresponsible and flawed.
The two things I would like to talk about are: one, the instrument that should never have been invented, the Mezzanine CDO;
and two, the operating duplicity of the ratings agencies.
Mezzanine CDOs are arcane structured finance products that
were designed specifically to make dangerous, lowly rated tranches
of subprime debt deceptively attractive to investors. This was
achieved through some alchemy and some negligence in adapting
unrealistic correlation assumptions on behalf of the ratings agencies. They convinced investors that 80 percent of a collection of
toxic subprime tranches were the ratings equivalent of U.S. Government bonds. This entire process completely ignored the fact that
these assets had a near perfect correlation of homogenous collateral
as home prices declined nationwide.
Within this new vehicle the tranches were rebundled, marked up,
and upwardly rerated. Now, in Mezzanine CDOs, anything less
than Triple A is likely to be completely wiped out, and the Triple
As will be severely impaired on average. This structure has made
a mockery of the Triple A ratings, which contributed to the loss of
faith in the ratings agencies that has frozen financial markets
worldwide.
There is a gross inconsistency of modeling assumptions, and it
still exists today. While the provisioning of Triple A ratings to Mezzanine tranches of subprime debt is the most egregious example of
the flaws in the current ratings process, the clearest and easiest
error to correct is the ratings agencies’ refusal to acknowledge historical mistakes in the application of model assumptions.
In 2007, the ratings agencies changed many of their inputs into
their structured securities ratings for mortgage-backed securities.
Those changes were sweeping changes in many of the model inputs
of their black box. And while they made those changes prospectively and tried to solve the problem going forward, where they
stand today and where their duplicity lies is those model assumptions that changed in 2007 have not been input into their models
for 2006, and 2005, and 2004. And they haven’t put those assumptions in and subsequently rerated those prior transactions. They
take the stance of the prior transaction and say, well, we will wait
and see how they perform, and we will downgrade them as they
happen. Well, until the ratings agencies plug their model assumptions in from 2007 to the prior ratings, no one will have faith in
the ratings agencies.
With great power comes great responsibility. All participants in
the fixed-income market recognize the enormous power the ratings

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agencies wield over pricing with their ability to bestow universally
recognized ratings. This power has turned the ratings agencies into
de facto for-profit regulatory bodies. This role is both explicit in the
reliance on the benchmark of what constitutes investment-grade
debt and implicit in the power to dictate the life or death of a
monoline financial guarantor with a simple ratings action.
I will tell you why and how regulators completely missed the epic
size and depth of this problem in the credit markets today. An important concept to appreciate is that each securitization is essentially an off-balance-sheet bank. Like a regular bank, there is a
sliver of equity and 10 to 20 times leverage in a securitization or
CDO, and 20 to 40 times leverage in the CDO Squared and Bespoke instruments. The booming securitization market has in reality been an extraordinary growth of off-balance-sheet banks.
However, the securitization market has no Federal and State banking regulators to monitor its behavior. The only bodies that provide
oversight or implicit regulation are the ratings agencies, the bodies
that are inherently biased towards their paymasters, the
securitization firms. Without sufficient oversight, this highly
levered, unregulated off-balance-sheet securitization market and its
problems will continue to have severe ramifications on global financial markets.
My belief is that the following two policy principles are an important step in addressing the issues I have raised above. First, we
need additional disclosure by the ratings agencies to their regulator, the SEC, to ensure the consistency of economic assumptions
for models across all securitizations and vintages, as well as a requirement to rerate securities based on any new model assumptions.
Second, I think we should sponsor and facilitate the creation of
a buy-side credit rating consortium funded by a limited fee on each
fixed-income transaction in the fixed-income market, similar to an
SEC fee on equities transactions. Ultimately something must be
done to resolve the problem of a market that is forced to rely upon
the ratings agencies that are only paid to rate securities, and they
are not paid to downgrade them.
Thank you.
[The prepared statement of Mr. Bass can be found on page 69 of
the appendix.]
Chairman KANJORSKI. Mr. Adelson.
STATEMENT OF MARK H. ADELSON, ADELSON & JACOB
CONSULTING, LLC

Mr. ADELSON. Thank you Mr. Chairman.
Mr. Chairman, I have been in the structured finance business for
my whole career, 22 years, first as a lawyer on mortgage-backed securities, and then I worked at Moody’s for almost 10 years. For the
last 6 years, I was at Nomura Securities, heading up structured finance securitization research. And now I have a little consulting
company with my ex-boss, my partner, and we consult on
securitization and real estate.
Thank you for inviting me here to give some testimony. Obviously, I can’t cover everything that I addressed in my written testi-

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mony in 5 minutes, and so I recommend that you take a look at
my written statement.
There are two points I want to particularly emphasize, though,
and a couple of little things that have come up from your remarks
and the remarks of the witnesses who already spoke. The first is
the transparency of the ratings, of the rating methodologies. In my
view, it is entirely clear that the rating methodologies are fully
transparent. The evidence of the transparency of rating methodologies is in the voluminous reports that come from the agencies; the
fact that they make the actual quantitative models available; the
fact that analysts, hundreds of analysts, leave the rating agencies
each year to take jobs with issuers, underwriters, etc.; and most
important of all, the spirited debate about the pros and cons, the
strengths and weaknesses of the methodologies that takes place in
the open from individuals like me writing research reports. I have
cited many of those reports in my written testimony, as you will
see.
So they are not black boxes, but they are also not totally simple.
They are actually quite technical, and you have to have the right
kind of technical background to grasp it. I mean, if my watch was
broken, I couldn’t fix it to save my life. But if I went to watch repair school, eventually I would learn how to fix a self-winding mechanical watch, and then I could do it. So it is a technical area. It
is not going to be graspable by everyone. But to folks in the business, it is perfectly graspable.
The second thing that I want to emphasize is the issue of conflicts of interest. One kind of conflict of interest that gets talked
about with respect to rating agencies is the exact same kind that
any publishing company, a regular old magazine, would have.
Motor Trend takes advertising money from car manufacturers and
then writes about those cars. Does that mean that all the reviews
in Motor Trend are worthless or tainted? Of course not. They do—
like publishers have done since the beginning, they have a reasonable separation to preserve editorial independence. Rating agencies
also do that.
Another aspect of conflict of interest, though, that is a little different is that rating agencies—or different for the rating agencies—
is that the rating agencies can come under pressure to loosen their
standards for a whole sector. And this can happen from a behavior
by the issuers called rating shopping, where the issuers, an issuer
let us say, shows a deal to multiple rating agencies and then picks
one or two that have the easiest standards to rate the deal. Then
the other rating agencies that had tougher standards become invisible, and, once more, they don’t make any money, because the way
you make money rating a deal is you rate the deal and charge the
issuer. So it puts pressure on the rating agencies to loosen their
standards, and we call this competitive laxity.
Years ago the way rating agencies combated the pressure of competitive laxity—I want to emphasize, there is no conclusive evidence that the competitive laxity was actually practiced by the
major rating agencies. It is a potential, it is clearly a potential.
Rating shopping is undisputable; it happens, and it has been happening for more than 15 years. But the way the rating agencies
used to combat it was by doing unsolicited ratings. They would call

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each other out. If one put a triple-A on a security that another
thought should be single-A, they published a report that said, we
think that is a single-A security, and then the market would see
it and deal with it.
In the 1990’s, that practice was abandoned because it was bad
relations with issuers. One of two rating agencies said they
wouldn’t do it, and then the others had to stop.
I would say if you want to really address that issue and clean
it up, you want to encourage or require unsolicited ratings even
though that is something that you have viewed as a bad thing before.
I see I am out of time, so I will stop there, but if you ask me
questions, I will have something to say about some of your remarks
and the remarks of the other witnesses.
Thank you.
Chairman KANJORSKI. Thank you, Mr. Adelson.
[The prepared statement of Mr. Adelson can be found on page 56
of the appendix.]
Chairman KANJORSKI. Mr. Kanef.
STATEMENT OF MICHAEL B. KANEF, GROUP MANAGING DIRECTOR, ASSET FINANCE GROUP, MOODY’S INVESTORS
SERVICE

Mr. KANEF. Thank you. Good afternoon, Chairman Kanjorski,
Ranking Member Pryce, and members of the subcommittee. I am
pleased to be here on behalf of my colleagues at Moody’s Investors
Service to speak about the role rating agencies play in the financial
markets and to discuss some of the steps that we believe rating
agencies and other market participants can take to enhance the effectiveness and usefulness of credit ratings.
Moody’s plays an important but narrow role in the investment
information industry. We offer reasoned, independent, forwardlooking opinions about relative credit risk. Our ratings don’t address market price or many of the other factors beyond credit risk
that are part of the investment decision-making process, and they
are not recommendations to buy or sell securities.
Let me briefly address the subprime mortgage market, which has
been part of the broader residential mortgage market for many
years. While subprime mortgages originated between 2002 and
2005 have generally continued to perform at or above expectations,
the performance of mortgages originated in 2006 has been influenced by what we believe are an unprecedented confluence of three
factors: First, increasingly aggressive mortgage underwriting
standards in 2006. Numerous resources also indicate that there
have been instances of misrepresentation made by mortgage brokers, appraisers, and others; second, the weakest home price environment on a national level since 1969; and third, a rapid reversal
in mortgage lending standards which first accommodated and then
quickly stranded overstretched borrowers needing to refinance.
Moody’s response to these increased risks can be categorized into
three broad sets of action. First, beginning in 2003, Moody’s began
warning the market about the risk from deterioration in origination standards and inflated housing prices, and we published frequently and pointedly on these issues from 2003 onward.

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Second, we tightened our ratings criteria, steadily increasing our
loss expectations for subprime loans and the credit protection we
look for in bonds they backed by about 30 percent between 2003
and 2006. While Moody’s anticipated the trend of weakening conditions in the subprime market, neither we nor most other market
participants anticipated the magnitude and speed of the deterioration in mortgage quality by certain originators or the rapid transition to restrictive lending.
Third, we took prompt and deliberative action on specific securities as soon as the data warranted it. We undertook the first rating
actions in November 2006 and took further actions in December
2006 and April and July 2007, and will continue to take action as
appropriate. In addition, we are undertaking substantial initiatives
to further enhance the quality of our analysis and the credibility
of our ratings. These include enhancing our analytical methodologies, continuing to invest in our analytical capabilities, supporting
market education about what ratings actually measure in order to
discourage improper reliance upon them, and developing new tools
to measure potential volatility in securities prices, which could relieve stress on the existing rating system by potentially curtailing
the misuse of credit ratings for other purposes. We also continue
to maintain strong policies and procedures to manage any potential
conflicts of interest in our business.
Among other safeguards, at Moody’s, ratings are determined by
committees not individual analysts. Analyst compensation is related to analyst and overall company performance and is not tied
to fees from the issuers and analyst rates. Our methodologies as
well as our performance data are publicly available on our Web
site, and a separate surveillance team reviews the performance of
each mortgage-backed transaction that we rate.
Finally, beyond the internal measures we undertake at Moody’s,
we also believe that there are reforms involving the broader market that would enhance the subprime lending and securitization
process. These include licensing of mortgage brokers, tightening
due diligence standards to make sure all loans comply with law,
and strengthening and enforcing representations and warranties.
We are eager to work with Congress and other market participants on these and other measures that could further bolster the
quality and usefulness of our ratings and enhance the transparency
and effectiveness of the global credit markets. Thank you. I will be
happy to answer any questions you have.
Chairman KANJORSKI. Thank you very much, Mr. Kanef.
[The prepared statement of Mr. Kanef can be found on page 78
of the appendix.]
Chairman KANJORSKI. Ms. Tillman.
STATEMENT OF VICKIE A. TILLMAN, EXECUTIVE VICE
PRESIDENT, STANDARD & POOR’S

Ms. TILLMAN. Mr. Chairman and members of the subcommittee,
good afternoon. I appreciate this opportunity to address S&P’s role
in the financial markets, to discuss our record of offering opinions
about creditworthiness, and to assure you of our ongoing efforts to
improve.

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Before I do so, however, I would like to offer a brief comment on
the testimony of SEC Chairman Cox at yesterday’s hearing before
the Senate Banking Committee. The Chairman testified that pursuant to recently adopted regulations under the 2006 Rating Agency Act, the SEC is examining various allegations that have been
leveled at the rating agencies. Chairman Cox further shared his
view that the 2006 act struck a sound balance between regulatory
oversight and analytical independence. S&P agrees with the Chairman and will continue to work with the SEC on the examinations.
Let me turn to S&P’s excellent record of evaluating the credit
quality of RMBS transactions. As a chart on page 6 of my prepared
testimony demonstrates, we have been rating RMBS transactions
for 30 years, and over that period of time, the percentage of defaults of transactions rated by us as Triple A is 4/100ths of 1 percent. Even our lowest investment-grade rating, Triple B, has a historical default rate of only slightly over 1 percent.
That said, we at S&P have learned some hard lessons from the
recent difficulties in the subprime mortgage area. More than ever
we recognize it is up to us to take steps so that our ratings are not
only analytically sound, but that the market and the public fully
understand what credit ratings are and what they are not. Our
reputation is our business, and when it comes into question, we listen, we learn, and we improve.
Credit ratings speak to one topic and only one topic: the likelihood that rated securities will default. When we rate securities, we
are not saying that they are guaranteed to repay, but, in fact, the
opposite; that some of them will likely default. Recognizing what
a rating constitutes is critical given that the recent market turmoil
has not been the result of widespread defaults on rated securities,
but rather the tightening of liquidity and a significant fall in market prices. These are issues our ratings are not meant to and do
not address.
Ratings do change, in our view, if a transaction can and doesn’t
evolve as facts develop often in ways that are difficult to foresee.
This has been the case with a number of the recent RMBS transactions involving subprime. In these transactions a number of the
behavioral patterns emerging are unprecedented and directly at
odds with historical data.
At S&P we have been expressing in publications our growing
concerns about the performance of these loans and the potential
impact on rated securities for over the last 2 years. We have also
taken action, including downgrading RMBS transactions more
quickly than ever before. Moreover, we continue to work to enhance
our analytics and processes by tightening our criteria, increasing
the frequencies of our surveillance and modifying our analytical
models.
We take affirmative steps to guard against conflicts of interest
that may rise out of the fact that we, like most every other major
rating agency, use an issuer pay model. This issue was thoroughly
debated in Congress during the consideration of the 2006 act. Independent commentators, including the head of the SEC’s Division of
Market Reg, agreed that the potential conflicts of interest can be
managed. At S&P analysts are neither compensated based on the
number of deals they rate, nor are they involved in negotiating

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fees. These controls and others are set forth in our code of conduct.
Every employee receives training in this code and must attest to
its compliance.
Equally important, Standard & Poor’s has not and will not issue
higher ratings so as to garner more business. From 1994 through
2006, upgrades of U.S. RMBS ratings outpaced downgrades by approximately seven to one. This pattern surely would not exist if
S&P issued inflated ratings to please issuers.
Mr. Chairman, the issuer pays models help bring greater transparency to the market as it allows all investors to have realtime
access to our ratings. Unlike under a subscription model, the issuer
pay model allows for broad market scrutiny of our ratings every
day.
Others have questioned how pools of subprime loans can support
investment-grade securities. The reason is the presence of credit
enhancement, such as excess collateral in these transactions. We
do not simply take a pool of subprime loans and rate the issued securities Triple A. Instead, drawing on our expertise and experience,
we carefully analyze the appropriate amount of credit enhancement
or cushion needed to support a particular rating. Without this
cushion of additional collateral protection, we simply could not and
would not issue what some consider high ratings on securities
backed by a pool of subprime loans.
Let me end by reiterating our commitment to do all that we can
to make our analytics the best in the world. Let me also assure you
again of our desire to continue to work with the subcommittee as
it explores developments affecting the subprime market.
Thank you, and I would be more than happy to answer any questions that you may have.
Chairman KANJORSKI. Thank you, Ms. Tillman.
[The prepared statement of Ms. Tillman can be found on page
147 of the appendix.]
Chairman KANJORSKI. Dr. Mason.
STATEMENT OF DR. JOSEPH R. MASON, LeBOW COLLEGE OF
BUSINESS, DREXEL UNIVERSITY

Mr. MASON. Mr. Chairman, Ranking Member Pryce, and members of the committee, thank you for the opportunity to be here
today.
By way of introduction, I am an associate professor of finance at
Drexel University. I am a senior fellow at the Wharton School. Before joining Drexel University, I worked at the Office of the Comptroller of the Currency, studying structured finance. Since I moved
to academics, I have advised bank and securities market regulators, as well as many industry groups and the press, on recent
difficulties with structured finance. And I am also an expert in the
economic dynamics of financial panics and crises of which the most
recent market difficulties are a shining example.
My own academic research has shown that the leading contributor to financial crises historically, this one included, is information transparency. Market participants recently discovered that
they do not know all that they thought they did. Investors are,
therefore, rationally applying discounts to all banks and investment funds indiscriminately until they find out who is holding the

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risk. Hence, investors need more information about the value and
the holdings of structured products.
Note that funds rate cuts, increased agency mortgage limits,
FHA programs or even, as in the U.K., blanket deposit insurance
coverage will solve that information problem. The solution lies in
changes to the manner in which information about structured finance investments is gathered and disseminated. Today’s hearing
on the role of NRSROs is, therefore, a good start in gathering information that can be used to make meaningful changes that will reduce information problems.
NRSROs like to say that investors are free to avoid their products if ratings are not useful. Not so. Issuers must have ratings
even if investors do not find them very accurate. When the government stipulates that BBB or better-rated instruments are acceptable for public pension fund investments, the government confers
on NRSROs the unique power to act as regulators, not mere opinion providers. Thus, the NRSROs are the gatekeepers to the majority of the investment world.
The problem is that a letter rating can mask an extremely wide
range of risk. For instance, a Moody’s Baa rating can indicate a 5year, 24 percent default rate for CDOs or a 0.097 percent default
rate for municipal bonds, a 250-times magnitude of economic difference. Hence, the BB rating cutoff for ERISA eligibility is no
longer meaningful. Using ratings for the Basel II framework of
banking supervision will only worsen the problem.
While the general statistical methods for NRSRO ratings criteria
are disclosed, the NRSRO ratings criteria are not disclosed to a
level of replicability. The reason is that the NRSROs do not release
the economic assumptions they include in the models. When pressured, the NRSROs have divulged assumptions that differ significantly from reasonable forecasts issued by the NRSRO’s own economic research affiliates. NRSROs have not strived to keep their
models up to date, refusing to incorporate data on subprime mortgage products into their models until recently, while at the same
time warning investors about the risks since 2003 and selling those
investors tools to evaluate the difference.
Even when models are improved, NRSROs apply changes only
prospectively, not retrospectively to the deals that they have admittedly misrated. Furthermore, while NRSRO ratings criteria are
somewhat transparent, the NRSROs do not issue criteria for rerating securities and do not have systematic methods for doing so,
presumably because they are not paid to do so. Rerating, however,
is crucial in structured finance.
In their reluctance to adequately monitor structured finance, the
NRSROs have also been complicit in allowing servicers to use aggressive modification and reaging practices to manipulate
cashflows on behalf of structured finance noteholders. Since roughly half of modifications result in consumer redefaults, it appears
that many loan modifications may be for the sole purpose of extracting money from consumers who still cannot afford even lower
loan payments.
While the NRSROs do not play a formal role in the development
of new products in structured finance, the integrity of the financial
engineering plays a crucial role in establishing the credit risk of

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the investment securities. In structured finance, therefore, ratings
serve as a seal of approval issued after NRSROs inspect the safety
and soundness of the financial engineering. In that financial engineering, collateral types that are very heterogeneous and/or do not
have a long history of demonstrated performance cannot be expected to allow as fine a slicing and dicing of risk as collateral
types that are very homogenous and have a long history in credit
markets. The NRSROs, however, overlooked the crucial and wellknown characteristics of collateral risk and heterogeneity and supported the rapidly growing sector by rating complex and lucrative
security structures for subprime mortgages as if the collateral were
typical prime conforming mortgages.
Going forward, enforcement of SEC Regulation AB and FAS140
will alleviate significant problems in structured finance, but the
NRSROs themselves need to be monitored if they are to continue
to fulfill a regulatory role for pension funds and see that expanded
to banks under Basel II. But how? The solution is fairly simple.
Basel II already proposes that bank regulators monitor bank internal credit models, but it allows banks that do not build their
own models to use NRSRO ratings. I merely propose that if
NRSRO models are to be used in the same manner as bank internal models they be subjected to the same supervision. The
NRSRO’s regulatory responsibility, however, cannot be maintained,
much less expanded, without accountability.
[The prepared statement of Dr. Mason can be found on page 112
of the appendix.]
Chairman KANJORSKI. Thank you very much, Doctor.
Way back in the early dealings with the computer rates, I remember people arguing that anything could be done with computers, and then some very smart person came up and made the
simple statement, ‘‘Garbage in, Garbage out.’’ It seems to me you
put a finger on why we have jurisdiction in this matter.
You know, as far as I am concerned, I am not worried about
wealthy people losing money. They know what they are doing. That
is their game. As a matter of fact, I will be happy to go to the casino with them. My problem is that we are dealing here with pension funds and other important funds, which you have just indicated in some instance because of these rating circumstances the
risk of these CDOs are 250 times worse than other rated bonds or
securities, so that they miss the mark on what the rating is supposed to do in the protection of these various areas of money. Is
that correct?
Mr. MASON. I would say that they purposefully miss the mark in
order to satisfy the investment manager and, in some cases, those
who were looking for the fat yields that come from structured products.
Chairman KANJORSKI. All right. So, I guess I am trying to get
to the measuring of where do we have jurisdiction. What jurisdiction should we utilize and for what purposes? We are not the cure
of the world, and we are not to guarantee people profits or even
that they do not get taken. I mean Nigeria is running a very strong
economy and is getting people to send money to protect their rights
and checks.

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Mr. Adelson, I am not going to attack you, but I notice you are
an attorney by profession.
Mr. ADELSON. I am still admitted to the bar, but I have not practiced law—
Chairman KANJORSKI. But you have never heard of that pleasurable thing about what sirens do to lawyers?
Mr. ADELSON. No.
Chairman KANJORSKI. Well, you have heard of the concept of
‘‘ambulance chasers.’’
Mr. ADELSON. Yes. Oh, sirens. Yes.
Chairman KANJORSKI. Sirens. What causes ambulance chasing?
It is profit motive, isn’t it?
Mr. ADELSON. Sure.
Chairman KANJORSKI. So that would indicate that even people of
supposedly a higher ethical calling respond to that ugly thing
called ‘‘profit’’ and sometimes abuse their ethical standards in order
to obtain a profit. Wouldn’t that be a logical conclusion from that
humorous statement about ambulance chasers?
Mr. ADELSON. I think the reason that we would say is that, you
know, ambulance chasing is improper conduct and that it violates
a lawyer’s code of ethics to engage in it. It is not the right thing
to do. I mean—
Chairman KANJORSKI. It is not the right thing to do because the
object is money as opposed to performing your professional activity.
Let me give you another example. Have you ever heard about
orthopaedic surgery in hospitals? In September and February, the
operation rate gets to be the highest, and there are correlation
studies—I think Drexel did one of them—of when tuitions of
orthopaedic specialists are due. Now, I am not saying all
orthopaedic surgeons are driven by money, but there is an unusually high surgery performance at the particular times when monies
are necessary for tuition. There could be other causes, I grant you.
Mr. ADELSON. But you are not saying that you would expect either lawyers or orthopaedic surgeons or anybody else to be working
for free, right?
Chairman KANJORSKI. No, they should not be working for free,
but you used an example of Motor Trend Magazine. Honestly,
would you buy an automobile from Consumer Reports if you knew
that General Motors was paying them millions of dollars to write
the recommendation?
Mr. ADELSON. Well, actually, I like to read both Consumer Reports and Motor Trend Magazine because I value getting different
points of view.
Chairman KANJORSKI. Are you familiar with the publications
across America of the 100 Best Lawyers? They show you pictures
of them, and they give you writeups of them. Whenever I am, you
know, in a waiting room and waiting for something, these are interesting things for me to read because I know a lot of these people, and I have come to the conclusion that there is a tremendous
correlation between how great these 100 lawyers in each of the
States are and how much they pay for ads in the book that publishes the 100 Best Lawyers. It is just an unusual correlation. The
best lawyers seem to be the best advertisers. I am not certain why
or what the exact relationship is, but what I am getting to is how

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can we miss profit motive here as a problem? I am beginning to
believe we have to take profit out of some of these areas.
It is not unusual that Moody’s and Standard & Poor’s showed almost 50 percent of their revenues coming out of this rating area,
and if we had just been—if somebody had been perceptive enough
to watch how their profits were growing in that area, they probably
could have detected a little earlier that the ratings may not be reflecting the true picture.
Ms. TILLMAN. Mr. Chairman, could I make a comment?
Chairman KANJORSKI. Sure, Ms. Tillman.
Ms. TILLMAN. Two comments—one in terms of Dr. Mason’s statistics. I cannot speak to where he came up with his statistics, but
if you take the same statistics on an investment grade CDO—
okay?—at a Bbb level over a 5-year period, the average default rate
is somewhere around 21⁄2 percent. If you look at a corporate bond—
okay?—rated by Standard & Poor’s in the same time period rated
Bbb, then you have approximately 21⁄2 to 3 percent of a probability
of default.
So I think we have to be very careful in terms of using statistics
and understand really, you know, the other element that I think
that the act was getting at is to have diverse opinions, and because
Moody’s or Fitch or someone else may have a different methodology
than Standard & Poor’s, I would assume that is part of the competitive environment that we are looking for.
Chairman KANJORSKI. Ms. Tillman, what I am getting at is
maybe we have to do several things, and of those several things,
probably information and transparency are the most important. I
am absolutely convinced that in this computer age we could have
a system in which these structured financial deals, by the push of
a button, could give you the reflection of performance to the moment. That would allow people who are advisers, people who are
buyers in the field, and individual investors to find out what the
relative position of their security is at any given moment. I think
that is very important. The fact that somebody gets away without
that, they are really selling a pig in a poke.
Ms. TILLMAN. I agree wholeheartedly with you, Mr. Chairman.
Chairman KANJORSKI. I think, from a prior discussion, I cannot
understand why the rating agency has not come forward and recommended to the Congress or to the SEC that we do something
about that. We cannot wait until the horse has escaped from the
barn all the time and then come up here and try to do remedial
legislation. Some of these things are anticipatory, and I think this
is very clearly anticipatory.
I wanted to make one other comment—and I know I am a little
over my time.
I had a great conversation with the CEO of one of the major accounting firms in the United States that no longer exists, and that
is as far as I am going to go to disclose who it was, and I remember
sitting on the edge of my chair, asking, ‘‘How could this happen?’’
Now I am going to tell you why.
I am a lawyer by profession, and I know a lot of the bad eggs
in the legal profession, and I know some of the bad eggs in the
medical profession, but I always had this incredibly high respect
for the accounting profession. Why? Because I did not understand

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their field too well, and I knew that all of us relied on them to be
absolutely correct if we wanted to know what was happening in a
business. Finally, in weakness, when we were talking about
WorldCom, he looked at me and he said, ‘‘Congressman, you have
to understand, I have an organization throughout the world that I
need $12.5 billion a year in revenue to operate.’’ That was the justification of why this special allotment of making accounting principles warp, to allow WorldCom to do this, and that was it.
That is scary to me. It is scary to me that the rating agencies
are all profit-driven from the companies that own them, up to the
holding company, all the way down. I am sure you can say there
is separation, and maybe I am getting gun shy, but even the New
York Times? Now in years past, we used to have a great deal of
respect for the standards and ethics of the New York Times. Didn’t
they run an ad for $65,000 when it should have been billed at
$170,000, and it was attacking personalities that were against
their stated position in advertising? It is amazing how, if it is their
political conviction or for profit or for whatever reason, that corporations, companies, and other entities in America today, mostly
profit-driven, are starting to make significant changes and are lessening their standards.
If the rating agencies are the only thing between absolute fraud,
do we have to make them nonprofit and take the profit motive out
of it? I do not know, but we certainly have to have disclosure. I
agree with Dr. Mason on that. That is easy to do, and I expect the
agencies to come to the Congress with recommendations of how it
can be done. We could very quickly put that in place, or get the
regulators to put it into place, but we have to do something about
this.
You know, I want to close and let my good friends get their time
in, but to those of you whom I have talked personally about, I have
constantly mentioned what really scares me about our whole economic system today—over the last decade or two, the very sophisticated people in the field of finance have learned how to take their
skin out of the game, and they have no risk. They only have the
upside. They make a profit if they sell a mortgage. They do not lose
anything if the mortgage fails. They make a profit if they sell the
securitization. They do not lose any money if the securitization
fails. All of the people who sell the securitization rates, they all
make profits. They risk nothing if it fails. We have to find a way
of putting skin back in the game, and if we do not, all we are doing
is creating a market out there that pretty soon people just will not
believe in.
Now, I had a discussion with a European Parliament member
yesterday, and he was telling me about the run on the bank in
England and how the Bank of England stepped up with total insurance, which is an interesting concept since I think I just read—or
did I hear it in your testimony, Dr. Mason?—that 10 percent of the
banks of America’s securities involve these types of securities that
are in their vaults. That could be very serious if they collapsed.
That would take down the entire banking system in the United
States, as I understand it. They do not have the equity to withstand a 10 percent total failure, do they?

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Mr. MASON. No. Neither does the FDIC have the funds to cover
the outlays.
Chairman KANJORSKI. So the last thing. For the last several
weeks, I have had a terrible feeling that we are in a serious condition in this country. Is there anybody at the witness table who
thinks this is not a serious problem, and it will pass? Or do you
agree—you do not think it is a serious problem, Mr. Adelson?
Mr. ADELSON. No, Mr. Chairman. With respect to the securities
on the subprime side, the amount of securities are very small by
dollars. One of the other members referred to the number of bonds.
The dollar amount of the affected securities from subprime deals
is actually very modest in relation to the total amount.
Chairman KANJORSKI. You do not see cross-pollenization or pollution occurring?
Mr. ADELSON. You are talking about where the problem is now.
You can have a problem, which we have not gotten into at all,
about the derivatives guys and the CDO sector’s using derivatives
to create $130 billion of exposure when there was only $40 billion
of actual triple-B paper created in the subprime area that has been
put under pressure. Even CDOs, themselves, are just not that big
a piece of the pie.
I think you do have a problem. I will agree with you that you
have a problem in how lenders made subprime loans, but you guys
make the laws. You have computers, too. You see the little dancing
robot telling people they can get a loan for no money down. It is
not like anyone at this table was seeing anything that you were
not, okay? If you want banks to have skin in the game when they
make loans—right?—and if you want to temper or to restrain the
ongoing
process
or
evolutionary
trend
of
financial
disintermediation, you are the guys to stop it. You just make a law
that says whenever you make a loan, you must retain 10 percent
of it forever.
Chairman KANJORSKI. Let me say this to you. I am one Member
here. I have preached a little, but that does not exonerate me from
responsibility.
The Congress of the United States adopted a policy of maximum
homeownership even when we knew financial literacy was lacking,
and capacity performance was lacking, and managerial capacity
was lacking. It made us all feel so good to say everybody has a perfect cure if they own a home. I think this may be the beginning
of understanding that is not true. I hope it is. We are responsible
for that.
Yes.
Mr. MATHIS. Mr. Chairman, could I respond to this not being a
big issue?
Chairman KANJORSKI. Yes?
Mr. MATHIS. The main issue—and you brought up North Rock.
North Rock was an institution that by most measures was not in
financial trouble. This is an issue of trust.
Chairman KANJORSKI. Right.
Mr. MATHIS. These securities have been issued, not only CDOs
and mortgage-backs but also CLOs that number in the trillions.
They are across the marketplace. When the marketplace loses the
trust in the rating system that it had come to trust and it believes

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that ratings do not mean anything, you are going to have essentially the run on the bank that you had in the U.K., and that is
why this is a significant problem. There is a contagion that comes
from a lack of faith in what is in a security and what it means.
This is the thing that I say—this is one of the bigger crises to face
the financial markets since the Depression because there were not
tangibles. These were intangibles. People just lost their trust in
those securities, and if it happens on a larger scale, God forbid.
Chairman KANJORSKI. I agree with you, and I will get back to
you.
Ms. Pryce, you have all the time in the world.
Ms. PRYCE. Thank you, Mr. Chairman. I will not take too much
time.
Mr. Chairman, you talked about skin in the game. I think some
of the skin that the rating agencies have is their reputation. I
mean your reputation is what the trust of the world markets has
relied on. I think that you have lost some skin in this game, and
I might be wrong, but let me ask a question.
Mr. Bass and Dr. Mason both brought up the point that the 2007
home prices assumptions have been changed prospectively but not
retrospectively for products needing rerating, and that goes to the
chairman’s point, that is because you are not being paid to rerate,
but your reputation is at stake.
Is there a reason you do not rerate? Don’t you want to regain
some of these layers of skin that you have lost? So why are they
not being rerated? Will you address that in some depth?
Mr. KANEF. Congresswoman, could I answer that question,
please?
Ms. PRYCE. Sure.
Mr. KANEF. The one thing I would like to say—and I would like
to, actually, try to correct the record here—is that, contrary to
some of the statements that have been made at Moody’s—and I can
only speak for Moody’s—when we have gone through on the review
of this subprime RMBS transactions that we have rated, the assumptions that have been used for ongoing transactions, transactions on a going-forward basis, are the assumptions that are used
by our monitoring team to monitor the existing and the outstanding subprime RMBS transactions.
We held a teleconference in July when we had downgraded a
substantial number of subprime RMBS transactions, a small percent of the total outstanding but a substantial number of transactions. During that teleconference, we did explain the methodology that we were using for the surveillance and for the rating
downgrades of those transactions, and that process involved an application of the forward-looking assumptions to the existing transactions.
Ms. TILLMAN. May I respond, as well?
Ms. PRYCE. Yes. Then we will go back to Mr. Bass.
Ms. TILLMAN. I wanted to sort of reiterate what Mr. Kanef has
said. We have both a new issue group and a surveillance group
that seem to have gotten lost in some of the criticism here at the
table. What our surveillance group does, which is totally separate
from the new issue deal, is we get information in on a monthly
basis from servicers, and we review the performance of how these

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deals are operating because on a primary deal the new deal, you
are really rating against what your expectations are. On the surveillance side, you are reviewing what is actually happening and
what the behavior is of those loans in their portfolio.
In addition, we change our models that we utilize both internally
as well. That is totally accessible to anyone in the marketplace, and
it has been for quite a period of time. We have changed the model
multiple times as we have changed our assumptions.
Ms. PRYCE. Well, would either one of you say that you are doing
this retroactively or just prospectively?
Mr. KANEF. Well, I think, again, there is a separate monitoring
team, and the monitoring team needs to look at two aspects of the
previously rated transactions. I mean they do that monthly. Data
usually comes in on these transactions once a month, and so every
month every transaction is reviewed by the separate monitoring
team that we have.
Ms. PRYCE. It is reviewed. Is it rerated?
Mr. KANEF. When I say ‘‘reviewed,’’ what I mean is the performance of the loans underlying the securitization is reviewed, and it
is compared to our original expectations and to the enhancement
levels that are in place to protect the bonds, and to the extent that
the analyst reviewing the transaction believes that the performance or the enhancement levels have changed in a material way,
there is a committee, and each and every deal that requires it is
rerated. Yes.
Ms. PRYCE. Okay. Mr. Bass and Mr. Adelson and Mr. Mason,
then, if you want to jump in.
Mr. BASS. Let us be clear here.
I have met with your—specifically yours, Mr. Kanef—surveillance team numerous times. Your surveillance team drives in the
rear view mirror. They look at the performance; they look for
outliers, and they downgrade the outliers after the performance.
My comments as to your operating duplicity are specifically aimed
at your global assumptions on the front end of rating those
securitizations. When those global assumptions change—let us say
the two most important assumptions for this asset class, I would
say, are home price appreciation assumptions and loss severity assumptions. When you change those assumptions from an up 6 to
8 home price for the next 3 years—flat to down—and you slightly
raise your loss severity assumptions for 2007 deals, all of a sudden,
the OC that you are requiring in these transactions balloons and
makes them much less profitable, but more importantly, if you
were to take those assumptions and drop them in your 2006 models, you would have to rerate the entire securitization that day.
You guys are not rating them using your modeling expectations,
you know, retrospectively. You are driving with the rear view mirror retrospectively.
Ms. PRYCE. Mr. Adelson.
Mr. ADELSON. I think there is a little bit of confusion. Maybe it
is the terminology here.
When the rating agencies are called on to rate a new deal, it usually involves brand new mortgage loans that have no performance
history on them. So the analysis goes, in very large measure, off
of the measurable characteristics of the loans—the loan-to-value

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ratio, the borrowers’ FICO scores, the kind of loan product it is. On
a deal that has been rated and has been closed and has been in
the market for a while, that stuff becomes a lot less important.
What is really important is seeing how those loans are doing
month after month, right? It is much less meaningful, if you have
a pool of loans that are a year old, to take your new rating model—
let us say you have upgraded it and changed it somehow—and put
the pool of loans through it as if it had no history at all, because
in fact you can do a lot better by looking at the actual performance
of these loans, this honest to God pool right in front of you.
I think that is what the witnesses from the rating agencies are
saying, that when you have a deal that is out there for a while you
are doing it differently because you have more information.
Ms. PRYCE. Mr. Mason, do you want to have the last word on
this? My time has expired.
Mr. MASON. I have trouble with ‘‘rerating’’ being entirely in the
rear view mirror. If ‘‘rating’’ is prospective and ‘‘rerating’’ is in the
rear view mirror, let us call it something else. ‘‘Review’’ is not the
same function. The important thing to remember is in the context
of structured finance, and partially relating to the chairman’s previous question, this is a structured finance problem, not a subprime
problem; the structures have fallen apart. Whether it is subprime,
leverage buyouts, or other new collateral types, the structures are
falling apart because the structures have been stressed too much,
like a bridge that was underengineered.
There are certain cumulative dynamics to these pools. These are
pools of mortgages. You take 5,000 mortgages and put them in a
pool. Now, the pool will demonstrate some dynamics as it goes, but
if a loan defaults and a loan goes into foreclosure and the property
is sold and we book a 40-cents-on-the-dollar loss from that one,
that money is not going to be recovered from somewhere. So we
book a certain percentage loss in the pool, and that rises, certainly,
early in the deal because we are not sure of what loans are going
to do. They generally default in the first couple of years of life, and
that is the way things go, and then they start tailing off and they
start leveling out. The issue is where that tail-off and that levelingout goes, but the point is the cumulative loss never goes down.
Those cumulative dynamics do not come back. It is not like a corporate bond on—I do not know—some company, because I do not
want to name a company inappropriately—but a corporate bond on
some company that has an ongoing operation. Maybe they are getting some losses—okay?—and those losses are tailing up, but then
they rejigger their investment program, go into a new product area,
start some new plants, raise some capital, and they earn some
money that can offset those earnings, and the curve can go back
down. This does not happen in structured finance. This is the pool.
That is all there is. It is static, done. So to look in the rear view
mirror in that environment is really misleading because in the context of these mortgage-backed securities today and these other
structured investments it is not going to get any better. We have
what we have.
Secondly, I think that part of the incentive conflict that has to
do with this industry is that structured finance brought to the industry a great number of repeated transactions, and one of the first

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things you learn in grad school in economics and in micro-game
theory is that repeated games have very different outcomes than
single, individual games. So, if one of the ratings agencies is thinking about downgrading an issuer’s deals, that has dramatic implications for that issuer going forward and also as to what choice of
ratings agency that issuer uses going forward in their new deals
next month and next quarter and ongoing.
I had a very interesting discussion with a researcher at one of
the ratings agencies. I have always been interested because these
loans are supposed to be truly, indeed, sold under FAS140 (which
I will not go into, but FAS140 has not been enforced and has been
overlooked for years, but they are supposed to be sold); they are
supposed to be separate from the bank that originated a loan. So
what happens to the bank or to the originator when the deals are
downgraded? I had been interested in researching the stock price
effect on the financials, and the researcher laughed and said, ‘‘They
die. They are done. It is the end of the road.’’
So is it surprising to see that the downgrades that we saw last
summer were of New Century, American Home—the other originators had already died—that there was no reputational hit, that
there was no problem with new business coming up the pipe because there was no new business from those originators?
Ms. PRYCE. Well, it is all very fascinating, and I think we really
have not even touched on how to change if we need to, and it may
be the subject for a whole new hearing or for a whole new discussion group.
So thank you all. It certainly is not less than complicated, so I
appreciate.
Thank you, Mr. Chairman.
Chairman KANJORSKI. Mr. Ackerman.
Mr. ACKERMAN. I had a car once. It said on the rear view mirror
that ‘‘Objects you see in the rear view mirror may be a lot closer
than they look.’’ A couple of observations.
Fascinatingly, I have not heard anybody uttering the words ‘‘the
market can correct itself’’—it is just an observation—because the
debate that we have is whether or not we should be trying to fix
the market or whether we should keep our hands off the market
because the market is going to take care of this situation. Nobody
came charging up here saying that. Interesting.
Somebody mentioned the word ‘‘faith.’’ It is very, very interesting
how much trust we place in the hands of others upon whom we
rely. Cookies. These are Girl Scout cookies as it turns out. There
are people who are, as a principle of their faith, orthodox Jews,
who have to keep laws that are the kosher laws, the Kosheret laws.
They have to know that the foods they eat are kosher by the law
that they have to adhere to. That means they have to know, as the
consumer of edible products, how the process was done, what went
into the process and that each of the ingredients meets the specifications according to the standard, the ‘‘standard.’’ Girl Scout cookies meet that standard. The average person not familiar with
Kosheret laws does not know to look for a little thing somewhere
in the small print. Within a little, tiny circle, there is a ‘‘u.’’ That
is the clue that the people who manufacture it choose to put on to
signal to those people who are interested in doing their due dili-

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gence that this meets the standard that they have to by law uphold, and they put a lot of faith into that. One of the reasons is
they cannot see into this. It is not a black box, because nothing is
a black box in any of the markets. They are fancy boxes with beautiful pictures, and they are gussied up to make them appealing.
This is not even translucent, let alone transparent, and the only
thing that a person has to rely on, who needs to keep the law, is
someone else’s word.
I think—and you can comment on it—that faith that we have
had in the markets, because we have been relying on the rating
agencies to keep the deals kosher, is a faith that has been, in this
case, misplaced. If I wanted to take these cookies apart and eat
them one by one, I would know they are all still kosher. If somebody repackaged this package by taking 50 percent of this package
and combining it with 20 percent of another package—the ingredients of which might all be listed—and then down the road someone
else repackaged that repackage and that kept going on, there
would be no way for anybody to certify the processes by which the
ingredients were assembled and whether or not the package that
they were buying met the standards that they were required to
keep. That is why you cannot rerate, because even you in a fourth
generation of a package of securitized mortgages could not tell me
what was in it. You could not even tell me, of the subprime people’s
mortgages that were in it, how many of them might have lost their
jobs, how many of them were mortgaged together with their husbands as co-borrowers and the breadwinner died without insurance. There is no way of knowing the viability of that package.
Maybe I am missing something.
How does a prudent consumer know?
Ms. TILLMAN. Can I make a comment, sir?
Mr. ACKERMAN. Please.
Ms. TILLMAN. When we look at a mortgage-backed security, on
average, there are about, probably, around 3,000 loans in each of
the pooled packages. We evaluate over 70 characteristics of each of
those loans, including—
Mr. ACKERMAN. Each of the 3,000?
Ms. TILLMAN. Each of the 3,000.
There are 70 characteristics that range from what kind of loans
they are, the FICO score of the borrower, the employment, and so
forth and so forth. We run those.
Mr. ACKERMAN. When you review the employment for 3,000 people in the package—
Ms. TILLMAN. Well—
Mr. ACKERMAN. —how many people have lost their jobs? Do you
reinvestigate that?
Ms. TILLMAN. No, we do not reinvestigate it.
Mr. ACKERMAN. It was not investigated to begin with, so how do
you know that—
Ms. TILLMAN. Well, can I finish, sir?
Mr. ACKERMAN. Please.
Ms. TILLMAN. Basically, it is the originators. It is their responsibility, obviously, in terms of not only making the loans but in ensuring that they meet the underwriting standards there. There is
due diligence. There is a responsibility of both the underwriters

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and of the investment bankers in terms of reviewing them, and
they have to—
Mr. ACKERMAN. And you—
Ms. TILLMAN. Let me finish.
Mr. ACKERMAN. I just want to understand what you just said.
Please, do finish.
You are relying on the original underwriter?
Ms. TILLMAN. No. What I said is that what we look for is—it is
the originators. It is the originators of the loans’ responsibility to
ensure that the loans that are being lent to the borrower are meeting their underwriting standards, at which point in time the investment banker, if they are working with an investment banker—
Mr. ACKERMAN. Some of those are the underwriters who helped
participate in the ‘‘no background check’’ thing?
Ms. TILLMAN. Yes, they are the originators of the loan.
Mr. ACKERMAN. And that is what you are relying on?
Ms. TILLMAN. It primarily the non—
Mr. ACKERMAN. It is a pretty high standard to rely on somebody
else’s ‘‘no please lie to me’’ standard.
Ms. TILLMAN. Well, I am just telling you—
Mr. ACKERMAN. If somebody says to me ‘‘no background check,’’
man, you know, I am Rockefeller.
Ms. TILLMAN. Well, to that point, sir, actually the Mortgage
Bankers’ Association commissioned a study, and it did find out, in
fact, sir, that, especially in the 2006 loan originations, there were
substantially higher misrepresentations and fraudulent information in those sets of loans, where you had a FICO score for an individual borrower in the 2006 that acted more like an individual borrower of a much lower FICO score in previous times.
So I totally agree with you relative to the transparency, in terms
of the types of loans that we are seeing, the enforcement of underwriting standards, and due diligence, but, sir, we get this information. We state very clearly that it is this information that we look
at, and then we run it loan by loan through our models, again
which are totally available to the public and to the investment
banker’s rep, and warrant to the accuracy of that information. You
know, we are not accountants. We depend on the accuracy of what
is given to us. Our job is to really look at the probability of default,
and we do a very extensive review of all of those loans.
In essence, to your point about the kosher box and the ‘‘u,’’ our
criteria and the models that we put out are so transparent that
just about everybody in the marketplace knows exactly what it is
that our models are saying and the types of things that we are
looking for, and so it is not a great mystery to the marketplace how
Standard & Poor’s views particular kinds of residential mortgagebacked securities.
Mr. ACKERMAN. Thank you.
If I put different cookies in this box, the three chief rabbis in Jerusalem could not tell me they were still kosher.
Ms. TILLMAN. I agree, but that is why we have a surveillance
group that surveils those deals that have been rated so that we can
look at the performance of the deals after the fact, not only at the
time of the sale.
Mr. ACKERMAN. Mr. Mathis.

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Mr. MATHIS. One of the things, I believe, that one of the people
from a rating agency said is that, when they looked to rerate, they
did not look at those original FICOs because they did not mean as
much anymore, and as to the whole process you have to ask yourself—and I believe the chairman sort of alluded to that with the
metaphor of the ambulance. Here you have investment bankers
who are—you know, these are private offerings; these are not public offerings, and they are warranting to them that these loans are
going away; they are going to make a big fee in selling them; the
originators they are talking about are never going to hold these
loans; they are going away; they are never going to see them again.
The only person who is going to see them again or who will be with
them are the pension funds, and what they depended on was that
mark that you were talking about, which in this case happens to
be a AAA.
I mean one of our suggestions is that maybe one of the ways to
deal with this—and this was alluded to by the people from the rating agencies, that you do not know for a couple of years. Well,
maybe one of the ways is that everybody who makes these loans
has to live with them for 3 years, that you cannot issue some structured finance along these lines until they are seasoned for about
3 years. So that means that everybody who made these loans, including the originators and the investment bankers and all of that,
would have to live with them for 3 years. Just think about common
sense. Do you think you would have a different world if they had
to live with these for 3 years? I think you would. I think it would
be a different world.
Chairman KANJORSKI. Thank you.
Mr. Sherman is going to jump off this platform.
Mr. SHERMAN. Thank you.
I would point out that the little ‘‘u’’ issued by the rabbi who is
paid—compensated—by the people who put the cookies in the box
could claim a conflict of interest, but the rabbi has to answer to a
higher power. Then again, so do you. In addition to Wall Street,
you have to answer to the tort system, and while some have argued
that God is dead, the rock is only in jail.
So let us say: You guys get paid—what?—about one or two basis
points? On average, what is the fee that you charge for rating
them? How many basis points?
Mr. MATHIS. I would like them to answer, but it is a little higher
than—
Mr. SHERMAN. Okay. How many basis points? Can you give me
an answer quickly on average?
Mr. KANEF. I can give you a rough dollar. Very, very roughly for
all of RMBS—so it would include prime and subprime both—it is,
roughly, $130,000 per rating, sir.
Mr. SHERMAN. Per rating. You are rating how large a pool?
Mr. KANEF. That would be for a pool of anywhere from several
hundred million to several billion dollars. That would be the total
fee for all of the bonds issued relating to that pool.
Mr. SHERMAN. Okay. So, of the folks who are from rating agencies, raise your hand if you are not currently getting sued as a result of what has happened with these mortgage pools over the last
2 months.

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For the record, no hands are going up.
So we do have what economists call the ‘‘moral hazard.’’ That is
you are subject to lawsuits by the investors who have lost money,
and that is the best argument for our not changing the system in
that there is a way to hold you folks accountable.
I would like to focus—I believe Ms. Tillman was talking about
how you have transparent standards. When you rate a pool of
mortgages and over 5 percent of them are stated income mortgages,
what does that do to the rating?
Ms. TILLMAN. Well, basically, as we look at each characteristic—
and as stated incomes, we understand that those are more risky,
and so, as to each of the pools, if they have a certain number of
stated income, they would basically have to have more credit protection built in that deal than if you did not have it, so we go
through each one of these 70 different characteristics and estimate
not only the probability of default because of those characteristics
but the estimated loss.
Mr. SHERMAN. Now, your modeling, was that based on stable real
estate prices or declining real estate prices?
Ms. TILLMAN. Actually, declining real estate prices.
Mr. SHERMAN. Declining real estate prices.
So you did your model for the market that we face today. So why
are investors losing money?
Ms. TILLMAN. What I said was is we based it on declining prices,
but what I will tell you is there has been an unprecedented housing decline since the late 1960’s, and we have already published—
Mr. SHERMAN. Unprecedented in housing declines?
Ms. TILLMAN. In prices.
Mr. SHERMAN. Prices. A price decline.
Ms. TILLMAN. Price declines, and we publicly stated that—
Mr. SHERMAN. Well, since you faced an absolutely unprecedented, in-over-a-century increase, didn’t you model for the possibility that you would have an unprecedented decrease? That which
goes up, up, up real high goes down real, real low?
Ms. TILLMAN. Well, sir, we used both external and internal economic data that we have received like everybody else receives
about the housing market, and if the housing market were going
to be, you know, growing, whether it was going to be declining 8
percent or 5 percent, we would stress it even more than that, so
we were extremely conservative, but obviously the declines happened a lot faster. In fact, in 2006—and we are talking about the
2006 loans—we started downgrading these loans only 6 months
after these loans were originated. I mean that is an unprecedented
quickness in downgrade.
Mr. SHERMAN. You would think that you would have been—Mr.
Mathis, I see you have something to say.
Mr. MATHIS. Well, I think that is remarkable. Did things change
so much in that 6 months? We have housing prices now that have
been more under pressure in the more recent period, but until the
end of 2006, housing prices were going up; they just started to
move down. Unfortunately, I think the right word is they just
started to go down.
Ms. TILLMAN. Yes, but that is not the only thing we look at. We
look at 69 other things, sir.

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Mr. MATHIS. Well—but you were saying it was unprecedented.
You were saying it was unprecedented.
Ms. TILLMAN. Well, it was.
Mr. MATHIS. The ‘‘unprecedented’’ only just started when you
were doing those ratings, and what was going on is you were putting into your models, in your original models 6 months before,
that housing prices would go up at the same rate they have been
going.
Ms. TILLMAN. No, sir. I said that they were going down.
Mr. SHERMAN. If I can reclaim my time—and I know you folks
could have the hearing without us up here. As a matter of fact, we
are about to vote. You folks are welcome, with the chairman’s permission, to continue without us.
I am just flabbergasted that you folks would allow any stated income or teaser rate loans at all into something that you would rate
as investment grade, and I know you have models, but those models have failed.
Secondly, if you look at the value of houses as a percent of GDP
and inflation adjusted for the last 100 years, etc., every single
chart shows unprecedented increases over the last 5 years. I would
like to see models. I do not know if Mr. Marshall has—I want to
be quiet just in case you have something—
Chairman KANJORSKI. Well, we will break now, Mr. Sherman.
This is a great panel. Myself, I would just suggest that we come
back. We have about a 40-minute vote on the Floor.
Would that terribly inconvenience the panel if we kept you waiting for 40 minutes before we get back or would you like to conclude
it now? Mr. Marshall has not had a chance, and he has been a soldier here all day, waiting.
Mr. MARSHALL. Mr. Chairman.
Chairman KANJORSKI. Yes.
Mr. MARSHALL. It is me.
Chairman KANJORSKI. Yes.
Mr. MARSHALL. I have spent a lot of time preparing for this. The
written testimony is something I have not had an opportunity to
read. It is very thorough. It seems to me that we ought to ask them
to stay.
Chairman KANJORSKI. All right.
Mr. MARSHALL. If there are not too many people here, let us go
ahead and have more of a conversation amongst you so that we can
better understand. If I had all of the knowledge that each of you
has, I would be better able to question each one of you about your
positions, and given a little bit of time here, I suspect that we can
clear up, maybe, this dispute between Mr. Bass, Dr. Mason, and
the two representatives of the industry. I think that is a pretty important dispute.
Chairman KANJORSKI. Is there any objection to staying on and
taking a break now? We will be back. We will even try and get you
coffee if you would like. You all go and have a drink.
With that in mind, we have about 2 minutes to get to the vote.
The subcommittee will stand in recess until we reassemble after
the last vote on the Floor in approximately 30 to 40 minutes.
[Recess]
Chairman KANJORSKI. The committee will come to order.

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I will now hear from Mr. Marshall from Georgia.
Mr. MARSHALL. Thank you, Mr. Chairman. Since it is just you
and me, I would invite you to chime in, as you have questions to
follow up on.
I am hoping that I can get a little bit more conversation among
the panelists. And if it winds up being feisty, that is fine with me.
Mr. Bass, I think you started it off with your suggestion concerning rerating and said something to the effect that the industry
was not going to regain its credibility until it does that. And while
you were saying that, Mr. Kanef sort of stood up, turned around
and talked to somebody behind him.
And as I understand it now, your contention, Mr. Kanef, I guess
the industry’s contention, is that there is rerating. But then Mr.
Bass would say that is only with regard to those issues that they
actually check that have previously been rated, and that there is
not a wholesale going back and rerating when the industry is
aware of the fact that some of the fundamental assumptions that
it made were either wrong at the time or are no longer valid.
And I assume you are referring to, not the list of 70, the ones
that would be particular to that particular issue, but, of those 70,
the ones that are global and apply to all of these investments. And
so, could you just go ahead, quickly tell us what are the global
ones, assumptions concerning market conditions?
Mr. BASS. Sure. My contention is when you look at the 70 inputs,
in my opinion, it boils down to two. And we are just going to talk
on a larger scale here. The home price appreciation assumption
built into their models is the single most important input in the
model, in my personal opinion.
Mr. MARSHALL. Now, could I ask you this: In your view, that
home price appreciation assumption is not one that varies from
issue to issue or rating, group.
Mr. BASS. Right. At any one point in time, whatever their opinion of home prices is. In 2005—
Mr. MARSHALL. You apply it across everything that they are rating.
Mr. BASS. In 2006, let’s say it was significantly positive, meaning
they set it for the rest of 2006, 2007, 2008, and 2009. They model
in assumptions as to how much home prices will be going up. And
then they factor that into their model to figure out how the models
should be rated, how every class of security should be rated.
Mr. MARSHALL. And what weight would you assume they put on
that?
Mr. BASS. In 2006, I think it was around 6 percent.
Mr. MARSHALL. Six percent.
Mr. BASS. They won’t tell you exactly—
Mr. MARSHALL. No, no. I asked weight. Of all the factors they are
taking into account, what weight would you say that—
Mr. BASS. I would say it is more than half.
Mr. MARSHALL. More than half of the weight in making the evaluation.
Mr. BASS. And it is more complicated than that, because the way
they get there is—and I will let them speak—
Mr. MARSHALL. I just want to make sure that everybody understands what you are saying they should be doing.

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Mr. BASS. The point I am trying to make is whenever they rate
a securitization, they have an HPA, home price appreciation assumption, built in.
On October 4, 2006, Moody’s chief economist, or Moody’s economy.com’s chief economist, Mark Zandi, did a detailed report on
every metropolitan statistical area in the country on what he
thought home prices were going to do, and it differed markedly
from their expectations they were building into their models from
securitization. It was significantly lower, and their models were
saying significantly higher. They started implementing his recommendations on where he thought home prices were going some
time in mid-2007, and, you know, they can speak to exactly when
they implemented that.
My point being that if your home price assumption goes from up6 to down-2, there is an exponential change that happens in the
securitization. It is not a linear change. It is massively sensitive to
that assumption.
So, in 2007, when they started putting negative home price assumptions into their models, they didn’t put the negative assumption in the 2006 models and see where those securities should be
rerated. What they are doing in 2006 is they have surveillance
teams and their surveillance teams look for outliers on how bad
things are performing.
And, you know, Mr. Kanef and I talked afterwards; they did up
some of the loss assumptions in the pool—
Mr. MARSHALL. Could I ask—let me interrupt here. I think I get
your point. I think everybody does at this point.
It is just an observation that if one person in Moody’s, somebody
who is probably pretty sharp, no doubt about it, thinks that things
are going south doesn’t necessarily mean that the entire team does.
It might take the team some time to get there. So that might defend the fact that they didn’t simply adopt in October of last year
that the—
Mr. BASS. Yes.
Mr. MARSHALL. Are there people out there who are hedging, who
are going short, on the assumption that, if there is a rerating that
is across the market, they are going to make a fortune? If you are
successful in persuading Moody’s to do what you would like, is a
whole bunch of money going to change hands, the derivatives that
people are betting?
Mr. BASS. We are in the marketplace. We own securities and we
bet against securities. We do both in the mortgage marketplace.
Mr. MARSHALL. Right.
Mr. BASS. We were very lucky to have identified this problem in
the beginning of 2006. We didn’t believe their ratings, and we met
with them—
Mr. MARSHALL. Let me ask you, if they rerated as you request,
what happens to your portfolio?
Mr. BASS. Well, clearly—
Mr. MARSHALL. You would make a bunch of money?
Mr. BASS. Absolutely.
Mr. MARSHALL. Okay. Now, back to Moody’s. Why shouldn’t you
do what they are requesting? I mean, if, in fact, you have in the
rating, whatever you call it, a model that you use, factors such as

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price appreciation assumptions that apply across the board, and
you just uniformly do them, why not just, as soon as you come up
with a change, why not go ahead and plug that into your rating
for all these different things? If you have a computer, it is all set
up; it can’t be that much work to do. And then you quickly notify
those who are holding those instruments that they have been
rerated, that they are not—you know, from AAA they have gone to
whatever they have gone to. I guess that is bad news for the people
who are caught holding them. It at least warns those investors that
they might get passed to that, in fact, these are no longer a AAA.
In other words, you are doing a great service for the industry, in
a sense, by rating these things as rapidly as possible, either going
up, going down. And if you have the ability to do it across the
board, just do it across the board.
Mr. KANEF. Congressman, there are really two components to the
surveillance process for an existing transaction.
One process is looking at the performance of the pool to date.
And the performance of the individual loans within the pool over
a period of time, the seasoning of those loans, can be a very important factor and a predictive factor of the performance of the pool
as a whole.
Then there is also the fact that you need to think about the
change in the environment and how that might have changed your
original assumptions.
At Moody’s, we have done both things. And so we have, in fact,
changed our original assumptions to reflect the fact that the deals
we are rating on a going-forward basis are looking at new assumptions. So we have, in fact, looked back and changed our expectations based upon the new assumptions. But we also have considered the performance of the pool to date and the seasoning and predictability of that information in the ratings.
Mr. MARSHALL. Mr. Bass?
Mr. BASS. Yes?
Mr. MARSHALL. Can you come back to that?
Mr. BASS. The point I am trying to make is, when you change
an assumption as important as any assumption that you apply on
your deals going forward, it just makes sense to me and it makes
sense to the rest of the marketplace to restore credibility in the ratings. If you plug in the new assumptions into your 2006 models,
the deals would look completely different than you originally rated
them. We have had exponential changes in these numbers.
Mr. MARSHALL. Well, back to Mr. Kanef, you are not interested
in doing what he is suggesting because?
Mr. KANEF. Sir, we have made significant rating changes.
Mr. MARSHALL. But he is suggesting a much broader—I think I
understand, though I am not that familiar with your industry, but
he is suggesting that a much broader brush be used here. I mean,
as you get this information, you hit the computer button that says
‘‘all.’’
Mr. KANEF. That is correct, sir. And there are many people who
place bets both positive and negative on the way in which these securities move. It is our job to provide our best possible forwardlooking opinion as to the credit strength of each and every security

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that we rate, by not only applying the past information we have,
but also the updated information. And that includes—
Mr. MARSHALL. I am sorry. If you are answering my question, I
can’t really follow the answer. I think the question was, why don’t
you do as he suggests? What is the objection to doing this?
Mr. KANEF. The performance of the pool itself of each of the
loans—so if a pool was originated in January of 2006, for example,
the performance of that pool over the past 18, 20 months of time
is an extremely important predictor of how that pool will continue
to perform on a going-forward basis.
Mr. MARSHALL. So you are saying that if you simply applied—
price appreciation assumptions have changed, and so consequently
we are going to go back to the model that we used in January of
2006 with regard to that particular pool, plug in the new price appreciation assumption, see what the rating would be, and then notify everybody that the new rating is B instead of AAA, that would
not be the right thing to do, you say, because the 18 months of history is a better predictor of the likely future performance? And, in
fact, it would be misleading not to take into account that 18
months of history and various other things, is that what you are
saying?
Mr. KANEF. That is correct, sir. It is also an important predictor.
Mr. MARSHALL. Mr. Bass?
Mr. BASS. You can go back and look at how the securitization has
performed to date. On the 25th day of every month, you see exactly
what is happening in the securitization. You see what the cumulative loss and delinquency numbers are.
And all I am saying is we have had an exponential change in
home price assumptions. And the ratings agency have a business
disincentive to cut ratings.
Mr. MARSHALL. What is the business disincentive to cut ratings
now?
Mr. BASS. It will upset the entire—
Mr. MARSHALL. I mean, initially I could see that there would be
a business disincentive to give bad ratings, because then that
would dampen the entire sector and there wouldn’t be as many
issuances and consequently not as many future ratings.
And they say, and I accept them at face value, that is not what
drives them. But then others would say that is kind of odd if that
is not a significant factor in your decisionmaking.
Mr. BASS. Right. When you look at what they have cut to date
in just the RMBS marketplace, in general—and, again, you have to
make general comments here, because every deal is a little bit different—but the deals that they have cut to date have been mostly
below the investment grade line. They have cut the BB’s to B’s.
The all-important investment grade line, when you start cutting
the BBB- and BBB bonds—and this gets into what I said in my
oral remarks to lead off today.
I keep getting back to this mezzanine CDO. And I know I am digressing from your question, but I think this is a really important
point that I am not sure everybody understands what is going on
here. A mezzanine CDO, when you have a securitization, you have
a traditional securitization that we have been discussing all of
today that has AAA all the way down to collateralization. The in-

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vestment grade piece just above the investment grade line is considered mezzanine. That is about 4 percent of the capital structure
of these deals.
These mezzanine CDOs collected all of those mezzanine
tranches—so the riskiest tranches of subprime debt—they took all
of those tranches, packaged them up, levered it 20 times, and 80
percent of that structure is AAA. They can’t defend themselves that
that was a great structure. That structure, in itself, is flawed, regardless of your opinion of HBA.
Chairman KANJORSKI. These buyers are pretty sophisticated, are
they not?
Mr. BASS. The buyers of those assets—the reason the mezzanine
CDO business came about—and I have met with the heads of
structured products marketing of some of the biggest securities
firms in the world, so this comes from them. The reason that those
mez CDOs ever came about was that no one in the United States,
from 2003 on, the real money buyers in the United States wouldn’t
buy those bonds. They were too risky for them. So Wall Street had
to figure out a way to package up the risk opaquely. With the aid
of the ratings agencies, were able to magically rerate 80 percent of
those bonds AAA, and then they sold them to Asia and Central Europe.
Chairman KANJORSKI. Okay. So we peddled that product to Asia
and Central Europe.
Mr. BASS. It was a way to get all the risk off the book.
Chairman KANJORSKI. Even when they perfumed it, it did not
sell.
Mr. BASS. Correct.
Mr. MARSHALL. How are they making money right now by not
dropping the ratings?
Mr. BASS. And this goes to—
Mr. MARSHALL. It seems to me they are probably not doing a lot
of ratings of these things because these things don’t sell right now.
There is a future market for them—
Mr. BASS. Now, all of a sudden, people realize what is in there.
But to Mr. Mathis’s point earlier—and when you ask about the
size of the problem, it is not the dollars that we are talking about
here; it is the loss of faith in the ratings agencies, because AAA is
not AAA anymore. They bestowed 80 percent of that particular
securitizations ratings AAA. AAA, I mean, that implies it is a U.S.
Government bond. Right? AAA is the lowest—
Chairman KANJORSKI. Did they lose faith in the United States,
or did they lose faith in the ratings agencies, the Asian and European buyers?
Mr. BASS. Basically, what you are seeing with the ABCP markets
freezing, the commercial paper markets, to Mr. Mathis’s point, the
reason they are failing is, all of a sudden, people aren’t buying AAA
because it is AAA anymore; they realize that it is not what it was
cracked up to be.
Mr. MARSHALL. It might not be.
Mr. BASS. Right. So that is the crisis that the United States and
the world is facing today. And the reason that is—it is not just because of subprime. Subprime was the spark that set it off.

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Mr. MARSHALL. Do you suppose that the rating agencies here
going back and rerating, in a sense, with the new assumptions, all
of the issues that have been made so far, would enhance our credibility? Wouldn’t it just be more extremely bad news? If you are
worried about somehow globally sending bad news, wouldn’t we, in
fact, be sending really bad news if they did that?
Mr. BASS. Would we rather sit here and let the opacity continue
and take the pain over time, or would you rather take the pain all
at once and try to restore credibility? I will ask you the question.
How would you handle it?
Mr. MARSHALL. I get to ask the questions, by the way. That is
the way it works.
Mr. BASS. I’m sorry about that.
Mr. MARSHALL. I have nowhere near your expertise. Part of me
asking questions is to try to get some information here. You don’t
need information from me. I am not going to tell you anything you
don’t know.
So it seems to me, though, that your central argument is that
somehow we would restore credibility by doing this. And now what
you are saying is that, well, you can either dribble out the loss of
credibility or you can have it all right now, but it is going to be
a loss of credibility either way.
Mr. BASS. Correct.
Chairman KANJORSKI. Well, has anybody estimated faced this
issue right square? Has anybody figured out what the actual loss
is out there? Is there some way you can total up what that loss
would be?
I get all these weird figures. And generally they are in the range
of $150 billion to $200 billion.
Mr. BASS. I think that loss figure is directly related to just
subprime cumulative losses. When you get into the structured finance markets, the synthetic markets for CDOs, I haven’t found
anyone to give me a hard number, but I will tell you—
Mr. MARSHALL. Dr. Mason is going to offer some. That is what
academics do. They sort of think about things like this.
Mr. MASON. I just want to—I am going to be straight. I can’t give
a dead-on number, but I can give some perspective on these situations that we have faced, before because this is nothing new.
We started the thrift crisis with about $10 billion of losses that
the FSLIC could have absorbed.
Chairman KANJORSKI. $10 billion to $15 billion.
Mr. MASON. And we ran that up to about $100 billion.
Chairman KANJORSKI. $150 billion.
Mr. MASON. By allowing the losses to dribble out, as it were, is
to forebear on the closures.
Chairman KANJORSKI. Now, all we did was we contaminated
good organizations with bad assets. And ultimately those assets
failed and dragged down the good organizations, so that we had to
have a bail-out. We call that supervisory goodwill or something.
Mr. MASON. Which the lawsuits are still going on.
Chairman KANJORSKI. See, our big problem, Doctor, is that there
are only three or four of us left up here who remember that crisis.
So we like to relive history so these youngsters down here can—

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Mr. MARSHALL. I wish I was as young as he is; all of us were
studying exactly this problem back then.
Chairman KANJORSKI. Here is what I am worried about. I am
going to jump in, and you jump into this thing, too.
I am not one of these people who are saying we ought to uncap
the ceiling for Fannie Mae and Freddie Mac so they can go in and
buy these things up and do a quasi-rescue, like in 1989 in the S&L
crisis, because that is really what it would be. And we would be
taking two fairly decent organizations and encouraging them to
create much greater equity risk out there that does not cover these
bad obligations they would be buying in. And then the temptation
politically is to do it, because if you can make 3 years and we do
not have a recession or if the real estate bubble is not as bad as
it could be, we will make it out, and nobody will know the difference. And we will have just made a tremendous recovery, and
everybody will say how brilliant the Administration and the Congress was, and particularly the regulators.
On the other hand, if we get into a 20 or 30 percent depreciation
in real estate in the hot markets of California, Florida, Texas, Virginia—which, to my way of thinking, it looks to me like it may be
moving in that direction—and you tap on a recession over the next
year to 18 months, then all hell is going to break loose, and we are
going to go into a meltdown. But in order to fix that, it would seem
to me, using the mathematics of the S&L, would cost several trillion dollars, which we do not have. And I don’t know anybody in
Asia who is going to dig in their pockets and give it to us. So currency, as weak as it is today, will look terribly strong when everybody bails out of American currency. And, literally, we could collapse the whole world system.
I do not particularly like that scenario or that risk factor. And
I think it is sufficiently high enough that we have to protect the
Fannie Maes and Freddie Macs and others that would come to
their rescue from themselves and from the politicians, which is
probably the most important thing. And then, we just have to find
another vehicle to address this issue and try and straighten it out
without constructing an RTC, which would come later on if that is
the only thing left as a last resort. But there are other things here.
I mean, we can make a couple more tranches, can’t we?
Mr. MASON. Oddly enough, that is something that was done in
the U.K. recently.
Chairman KANJORSKI. No, I think if we get some tranches that
are paying 35 or 40 percent, like credit card interest, we will find
somebody in the world who will buy them.
Mr. SHERMAN. Mr. Chairman, if I can interject on your idea, I
don’t think we should let Fannie and Freddie take unwarranted
risks. I hope we can rely on OFHEO to make sure that doesn’t happen.
Chairman KANJORSKI. No, they are on their way there now. The
recommendations are to lift the portfolio restrictions.
Mr. SHERMAN. I could think that portfolio restrictions could be
lifted—I may differ a bit from you—if they are not overpaying or
taking excessive risks. I think we originally set those portfolio limits in part because other competitors in the market didn’t want to
face too much competition.

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If it is just banks screaming that they don’t like the competition,
or the securities industry screaming they don’t want the competition, that is one thing. If, on the other hand, you are right and
what Fannie and Freddie have planned is a risk to the solvency of
those institutions—
Chairman KANJORSKI. Well, unless they are going to do some
new offerings for equity, it seems to me if they go into the marketplace to get more capital to buy these securities they are thinning
out their equity support system.
Mr. SHERMAN. If they sell more stock, then they will have more
equity to—
Chairman KANJORSKI. I do not hear that is their intention; now,
of course, I am not sitting on their board.
But I look at what everybody is talking about in town, and I do
not want to attribute this to Fannie and Freddie. I think they are
standing there saying, ‘‘Can we be helpful, and what can we do?’’
I think many of us in government, whether it is in the Congress
or the Administration, do not want to face a bad situation now, and
would rather cover it up.
A government-sponsored enterprise is going to try and appeal to
take care of us. They are a dangerous instrumentality, from that
standpoint. There is a very close relationship between the government, so we force them to live with us, in a way. They know that;
they are very conscious of it. So they are going to try and create
an S&L bail-out of some sort of the first order that we had, and
I think it is going to be very dangerous. Now, I do not want to suggest that is going to happen. I am just trying to send a message,
‘‘Do not even think about it happening.’’
But along that line, I would like to get to some—Deborah Pryce
mentioned it before she left. You know, we really should talk
about—obviously, we have here a wealth of intelligence, of thought
process. And I may have given the impression earlier on that I was
going to use some old tacks and crosses on the rating agencies. I
do not want to impart that to you. I will fight to my damnedest
to hope we can get you all back to resuscitation so that you are believed. I would have a hard time believing—I mean, maybe I am
harsh that way. Fool me once, shame on you. Fool me twice, boy,
I am never coming to your house to eat again. It is just not worth
taking the chance.
And I think that is where the rating agencies, for whatever reason that you did not go back, whatever reason that you say you
wrote all these learned articles that nobody read, or all the whistles that you blew that nobody listened to, now it is absolutely incumbent upon the rating agencies to be part of the recommenders
of what we do.
And my recommendation, if nothing else, is that you should live
up here and camp out with us and get the best academics in the
world to help us out of this maze and to get it done and get it done
quickly. Because I think, we are not going to know about the real
estate for another 18 months or so.
That is a question I wanted to ask you, on the real estate question. When you do these 70 questions to set up these pools, one of
the significant questions would be where this mortgage is issued,
what state, what county?

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Ms. TILLMAN. Absolutely, yes.
Chairman KANJORSKI. So how do you take into consideration, for
instance, the California principle that you just hand your keys in
and that forgives the mortgage obligation, as opposed to Pennsylvania, that we not only have a mortgage on the property, we have
a judgment note on all your assets? You know, a Pennsylvania
mortgage is a lot more secure than a California mortgage. So how
do you rate that?
Mr. SHERMAN. Mr. Chairman, I resemble that remark.
Ms. TILLMAN. Well, we certainly look for geographic dispersion,
because, obviously, if a pool is concentrated into one specific area,
it is probably going to be more risky. Because if something happens, obviously, in the California market, it is going to impact everything exponentially across the board. And we do take into consideration the different loan characteristics and what the underwriting practices and practices are in each of the States.
But you still are getting a pool, and they are generally dispersed,
and, again, dispersing the risk. And we look at them and then assign an appropriate probability of default to each of the characteristics and the expected loss on each of those. And when we look at
it, depending on what kind of tranche it is, there is certain
overcollateralization—
Chairman KANJORSKI. I am going to stop you right there. I want
you to give me your honest answer, not as an employee of Standard
& Poor’s. I am not suggesting it was not an honest answer you
were giving, but your gut answer. If you had an opportunity to do
something different than you did, would you? And what would that
be?
Ms. TILLMAN. Well, I think that we would look for more quality
information than potentially that we are getting right now. Because it has just proven not necessarily to be as reliable as it has
in the past. And just really push for—
Chairman KANJORSKI. Why would you suggest—when I take the
string of 8 or 12 people who are involved in this transaction, even
down to the last guy recommending to the pension fund that they
buy this particular security, they are all making money on the deal
and they have no skin in the game and they are out of the deal
in a moment. Why wouldn’t you question the motives and the activities and the judgments of every person in that line, and how
could you do that?
Ms. TILLMAN. Well, one of the things that we are doing, and it
probably didn’t get out here, is that we do look at the originators
and the servicers in the mortgage market. And what we have started to do is really look very heavily on what fraud protection-types
of policies that these originators have in place. Because I think I
said earlier the—
Chairman KANJORSKI. Okay. Let us stop right there. I have been
involved in this subprime problem for about 5 or 6 years now. It
is a big, big huge problem. You practically never find a fraud situation unless you find a fraudulent appraiser. You have to have a bad
appraiser to go along with the deal. Didn’t you all know that?
Ms. TILLMAN. Well, we do take into consideration—we work into
every deal that we do on RMBS a certain amount of fraud, because
it is known in the mortgage field that it takes place.

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Chairman KANJORSKI. Well, but I do not mean prosecutable
fraud or prosecuted fraud.
Ms. TILLMAN. Fraud in the sense that the information that we
are getting may not be the type of information or characteristics
that you would assume. And that is what I said. Like the FICO
scores that we looked at, the high FICO scores in 2006 are actually
behaving like very low FICO scores in 2004 and 2005.
Chairman KANJORSKI. Yes, because they have been restructured
and fixed.
Ms. TILLMAN. Well, exactly.
Chairman KANJORSKI. But you all watch television, you see who
you can call to fix your FICO score. I mean, that does not take a
penetrating mind, does it?
Ms. TILLMAN. Well, it is one of the things we are currently really
looking into now. But that occurrence just didn’t happen in the
past.
Mr. MASON. Mr. Chairman?
Chairman KANJORSKI. Let us get Dr. Mason in there.
Mr. MASON. I just want to say that I am sympathetic to what the
ratings agencies’ representatives are saying at this point. That, at
a certain point, yes, there are things that can be fixed in the ratings end of the industry. But the problems that we face today had
fraudulent borrowers, in some cases, fraudulent brokers, fraudulent appraisers, fraudulent underwriters, all the way up through
the chain.
And from my days with the bank supervisors, if somebody is
going to commit fraud, they are going to try to cover it up as much
as possible. And, yes, it will eventually spill out, and it is really
going to mess up your model if you have a statistical model that
you are running. And that is part of what we have seen.
For these data feeds that the agencies rely upon for the review
in the monthly performance, those are coming from servicers. And
the servicers are sometimes related to the same firm that originated the loan, sometimes not. They are a whole other source of
the problem here. One of the incentives they often hold is a residual, a bottom first loss stake in the securitized pool. They want to
maximize the value of that residual.
And one way of doing that is keeping as many of the borrowers
paying as possible. Because, in fact, if the borrowers don’t pay, the
servicer has to act as if they are paying and pass the money on to
the note holder. So there are dire implications for the servicer in
the amount of default and every reason to try to keep loans out of
default by hook or by crook.
And one of the key elements that needs to be looked at here is
the process of modification and what is called re-aging, the process
by which you determine that a loan, after it has been defaulted for
a while, is good again. Some servicing firms are very aggressive at
re-aging. They will even lower your payment to get you to make
one on-time payment so that we can call you good again and we
can take you out of the default category and call you a good, ontime loan. But the loan is not going to stay there; it is going to redefault. But the servicer reports back to the ratings agency that
this loan is good, this is performing, we received the payments on

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time, everybody is happy. And then you see the deal go along beautifully for a while and then drop off a cliff.
And we have seen a lot of—
Mr. MARSHALL. Mr. Chairman?
Mr. MASON. —inappropriate behavior in the industry.
Mr. MARSHALL. Mr. Chairman, may I?
Chairman KANJORSKI. Yes.
Mr. MARSHALL. Mr. Kanef—and I kind of did this to you, and I
almost feel badly about it. Okay, so your reason for not going back
and rerating in light of this new information is that it would be
misleading, potentially, because of the fact that there has been a
history, an 18-month history, a 2-year history, something like that,
depending upon the issue obviously, and that is probably better
evidence of what the lack of future performance is going to be than
going back and trying to refigure out what we should have said
back in 2006.
And so, I guess that prompts a question. Do you randomly
check—you know, you do do some revisiting of the expected performance, with regard to certain issues. You sort of track them,
and that is that rear-view mirror stuff that Mr. Bass was talking
about, correct?
Mr. KANEF. Yes. If—
Mr. MARSHALL. Is that done randomly?
Mr. KANEF. If I could be clear—because this is something that
I perhaps didn’t answer as clearly as I should have—what we really have between Mr. Bass and myself is a difference of opinion of
the way in which the ratings should be surveilled or reviewed.
We review every single rating that we have on an RMBS transaction every month. So every single transaction, the past performance of that transaction is reviewed every month. And, in addition,
we do also consider the changes that have been made to deals that
need to be rated on a going-forward.
But we don’t rely 100 percent on the new information, because
the performance information of the pool is also an important component of the way in which we continue to rate the outstanding
transactions.
Mr. MARSHALL. So you are saying you are looking at, you are
thinking about the necessity to rerate across your entire portfolio
every month?
Mr. KANEF. On a monthly basis, when we get the new data on
the performance of that transaction. We receive data once a month
on each transaction. And, again, we do review it, each transaction,
in our rating universe once a month when that data comes in.
Mr. MARSHALL. It seems to me that for these mez deals that
were batched, they are the ones, just offhand, just mathematically,
they are the ones that are disasters as soon as the entire industry
moves, because they, by definition, are that portion of the industry.
Have you gone back and looked at all of them? Have you rerated
all of them?
Mr. KANEF. Yes. And we, in fact, have moved, changed the ratings, the initial ratings, on a number of BAA tranches issued out
of the subprime RMBS sector in 2006. And, in fact, on the CDO
side is the mez CDOs that Mr. Bass has referred to. Those are also
rerated on a monthly basis.

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Mr. MARSHALL. Thank you.
Mr. SHERMAN. Mr. Chairman?
Chairman KANJORSKI. Yes?
Mr. SHERMAN. I would like to get back to the issue of what the
economic incentives are for those in the rating industry.
I am an old CPA auditor, and we used to say we were the only
umpires that were paid by one of the teams. Now I realize we
weren’t alone; you folks are also paid umpires, paid by one of the
teams.
One thing that is obvious is, if you are in a league in which the
pitchers pay the umpires, you don’t want to get a reputation as the
guy with the narrowest strike zone. The economic incentive with
regard to this deal is to make sure you have a good reputation as
a pitcher’s umpire in order to get the next assignment. And so, you
are in a situation where you need some reputation with investors.
And, obviously, this recent problem has not helped any of your
agencies with that.
But up until the last few months, what you needed was at least
an investment grade image with investors. And then with the
issuers, if you were thought to be slightly more liberal but still
credible with investors, you got the assignment.
What do we need to do, or should we do anything, to change the
economic incentives in the rating business? Should we require rotation? Should we have the SEC do the assigning, so that the pitchers don’t get to pick the umpire? Or is the present system, combined with the reputational risk that you have experienced and the
lawsuits risk that you have experienced, sufficient enough to make
sure that the strike zone doesn’t get too wide?
Mr. Mathis?
Mr. MATHIS. On the issue of the strike zone and whatever, accountability comes into that play. If you are doing something and
you have to pay—you mentioned earlier, Congressman, that they
could be sued. Well, this is America and anybody can be sued. The
question is, can you win a judgment? And, as you know, the 1975
Act basically exempted all of the NSROs.
Mr. SHERMAN. ‘‘NSRO’’ standing for?
Mr. MATHIS. I am sorry, NRSROs—exempted all of them basically from any underwriters liability.
In addition, the agencies have been able to win decisions in court
saying that their opinions are free speech, and therefore they are
not liable for any of their opinions if they are, in fact, wrong. And
then—
Mr. SHERMAN. Wait a minute. I used to be a lawyer too. If I told
the guy that the will was valid and it turns out, from his heirs’
standpoint, that it wasn’t, I could say it was free speech. I mean,
isn’t there malpractice liability?
Mr. MATHIS. For the most part, the courts have held that the actions of the rating agencies are free speech and that, if they are
later proved to be wrong, they don’t have the same kind of liability
that you do as a lawyer, as a professional.
Mr. SHERMAN. Why does the First Amendment apply to the
speech of rating agencies but not the speech of lawyers and doctors
or accountants, for that matter, who, by the way, do the exact same

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thing? They rate the financial statements instead of rating the securities.
Mr. MATHIS. Well, here you have a basically government-sponsored program, through legislation, where the people have been essentially exempted from accountability on a legal basis. And in addition—
Chairman KANJORSKI. I was going to suggest to you, we have
Dan’s father in the audience. Maybe we can get an expert opinion
here. I could not resist saying that.
Mr. MATHIS. Can I just say one more thing? Recently, one of the
rating agencies, in a lawsuit, cited the 2006 Act as something that
really exempted them from liability along these lines.
Mr. SHERMAN. So their argument is somehow they are in a different position than the accountants? Although the accountants
issue an opinion, an opinion on financial statements, the rating
agencies issue an opinion on the creditworthiness of the security.
What legal doctrine—and, boy, you guys have some great lawyers.
Mr. Kanef?
Mr. KANEF. If I could just state that there is one significant difference between the opinion that is provided by a rating—well,
there may be many, but one that I would like to point out is the
difference between the opinion of a rating agency and the opinion
of an accountant or perhaps a lawyer. And that is the opinion provided by a rating agency is a subject of forward-looking opinion
about the likelihood that a default will or will not occur at some
point in the future. An accountant is reviewing a set of financial
statements that are factually present and that reflect a situation
that has already occurred.
And so, one of the large differences is simply the fact that—
Mr. SHERMAN. I would say, if you know more about accounting,
you realize that you have to, for example, write off an asset that
won’t be valuable in the future. When a company buys research results, you have to determine, are they going to be valuable in the
future? And so, it is odd to say that accountants, in determining
whether the financial statement is accurate now, don’t have to
have a crystal ball about the future.
I realize that accountants like to give the impression that they
are in a science and not an art, but anybody who looks at the individual decisions realizes the opposite. Likewise, lawyers give opinions all the time; I used to write tax opinions, saying, if you get
challenged by the IRS, you are going to win this thing and get your
tax deductions. Thank God the statute of limitations has expired
on those.
I mean, it is hard for me to say that everyone else—medicine,
law, accounting—is a science to which we can hold the practitioners accountable to a standard of due care, but that rating agencies are an art which is only in the eye of the beholder.
Let me hear from the doctor.
Mr. MASON. I just want to point out that I think Congress has
acted on this part. And I am in line with the views espoused by
the IMF in the recent Global Financial Stability Report, that we
have a lot of regulations that have not been enforced by the SEC,
by bank regulators, by accountants sometimes. One of them is the
2006 Act, which, as I understand it, tried to bring the industry into

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adherence with—and this is from my written testimony—the International Organization of Securities Commissions, or IOSCO, code
of conduct, which reads that, ‘‘The credit rating agency should
adopt, implement and enforce written procedures to ensure that
the opinions it disseminates are based on a thorough analysis of all
information known to the CRA that is relevant to its analysis, according to the credit rating agency’s published rating methodology.’’
And yet, we still have—and this is from—now, I will admit, my
particular quote here predates—
Mr. SHERMAN. Doctor, if I can interrupt you with perhaps a more
narrowly drafted question. Is it your understanding that, even if a
plaintiff could show negligence or even gross negligence, they might
be unable to recover from a rating agency?
Mr. MASON. Well, let me read the disclaimer that Moody’s uses,
that Moody’s has no obligation to perform—it does not perform due
diligence with respect to the accuracy of information it receives or
obtains—
Mr. SHERMAN. Well, Doctor, if I can interrupt you. We only hold
a professional responsible for doing their own job well. If the X-ray
is bad and the radiologist reads it correctly, you can’t sue him for
malpractice.
Mr. MASON. Right. But—
Mr. SHERMAN. The question is not whether Moody’s is responsible for the quality of work done by others. The question is, if they
themselves perform their role in a negligent manner, are they subject to liability?
Mr. MASON. But Moody’s does not undertake to determine that
any information that they use is complete.
Mr. SHERMAN. What was that again?
Mr. MASON. They don’t even try to see if the information is complete. They just—
Mr. MARSHALL. Will the gentleman yield?
Mr. SHERMAN. I yield to the gentleman.
Mr. MARSHALL. Let me, instead of stating it abstractly, bring it
back to what we are talking about here. And if this particular mezzanine tranche is the one that is the problem, I suppose the contention would be that the raters, in buying the pitch that this should
be listed—that any segment of this should be listed AAA, were
grossly negligent in not taking into account what would inevitably,
anybody looking at this would conclude inevitably, happen if the
economy turned south on housing, that this was what was going—
they were not AAA. Nobody in good faith could rate these things
AAA.
So, suppose that is the contention. Suppose reasonable people listened to it and conclude, ‘‘You are right; they were utterly incompetent in concluding that that 80 percent could be listed AAA. It
doesn’t meet any standard of expertise in the industry.’’ Let us assume that is the case. Are you saying that there is no recovery?
Mr. MASON. That appears to be the treatment from the courts,
that there is no recourse to the ratings agency.
Mr. MARSHALL. Do you agree—
Chairman KANJORSKI. Based on constitutional law, First Amendment rights, or based on some failure to put a regulation in effect

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or pass a statute? I mean, are they barred? Is there no way we can
make them responsible?
Mr. MASON. Now, I am an economist, not an attorney, but it is
my understanding that it is based upon First Amendment rights,
that this is merely an opinion.
But my assertion stands that when we begin to base ERISA or
pension fund legislation on a BBB cutoff, this is more than—
Mr. SHERMAN. If I can just interject. All accountants ever do is
express an opinion on financial statements. I am flabbergasted to
hear that medical opinions, legal opinions, and accounting opinions
are all subject to malpractice and rating agencies aren’t.
Mr. MARSHALL. I doubt this happened in this case. I mean, it is
entirely possible that they were pretty negligent in assessing this.
But let us take it one step further, and let us assume that there
was intentional fraud here. Let us assume, it is just hypothetical,
that the rating agency, tempted by fees that were going to be
earned as a result of being able to pass all these things, went
ahead and said, it is a lot of give and take, back and forth, ‘‘Okay,
we will rate this 80 percent of these things, we will rate them at
AAA; we will do what you want to do.’’ And some jury concludes
that that is just flat-out fraud. They knew at the time they were
doing it that these weren’t AAA, and they did it just to get some
money. Is there no recovery there?
Mr. MASON. I have seen—I think if you could find printed evidence that parties were colluding beyond tacit collusion, explicit
collusion—of course, again, I am not an attorney—but it appears
that there have been occasional cases where the First Amendment
protection has been breached. The one that I know of, in particular,
is where the agency was found to be actively guiding the structure
of the securitization, recommending that, in particular, 80 percent
be AAA and actually providing—
Mr. MARSHALL. Some of the ratings given earlier, the derivatives,
were just stunning, how bad they were.
Mr. MASON. Well, another point of regulatory bite here that I
think is very important to your original question about CDOs is
that CDOs are often built with contractual triggers that are only
enacted upon a ratings decision. So that if the ratings decisions on
what I would call the primary structured finance instruments, the
residential mortgage-backed securities are delayed, then the terms
in the CDOs that would be enacted by those downgrades don’t get
triggered, and we don’t get a revaluation of the CDO, nor do we
get even a clean-up or an investor recourse action so the investors
can get out of the non-performing CDO.
So, to me, this presents another regulatory responsibility of the
ratings agencies to act in a timely and complete manner and to
continue to rerate regularly and completely.
Now, I am going to say that, the way the industry is currently
built, they are not paid to do that. And I think that is a shortcoming of the way the industry developed.
Mr. MARSHALL. Before they get paid to do that, what does the
industry have to say in response to the doctor’s observation, Dr.
Mason’s observation about responsibility here, rerating responsibility? Ms. Tillman? Mr. Kanef?

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Mr. KANEF. I think, as a representative of Moody’s, I will tell you
that Moody’s believes it has a responsibility to review the data that
we receive every month. Calling it rerate or review is, I think, beside the point. What we do—and we have a separate team that is
made up of analysts and chaired by a chief credit officer, and that
team reviews the updated information we have that relates to each
of the outstanding securitizations that we rate each month. And it
is a responsibility that we take very seriously.
Mr. MARSHALL. Suppose you just decided to take Mr. Bass’s advice, and you got very aggressive, and then you are reviewing this
month, you had been thinking about it for a while, and you said,
‘‘Okay, we are going to rerate, I am going to rerate just about everything here, and I am going to drop it all.’’ What effects on
Moody’s—
Mr. KANEF. I think that we have a responsibility to, based upon
the approach that we are using, to make certain that we are providing our best possible opinion to the market. And I believe that
we take that responsibility seriously. If the approach that we use
in rating suggested that we needed to take significant additional
downgrades beyond the downgrades that we have already taken
during the past 18 months, we would do so.
Mr. MARSHALL. But you do that reluctantly.
Mr. KANEF. I would not do that reluctantly, sir. We would try to
make certain that we had our best possible opinion on the future.
Mr. MARSHALL. Okay, so I accept that is what drives you, for
purposes of this question. I accept that is what drives you. What
consequences?
Ms. TILLMAN. Our reputation and what you have all been talking
about here has been a big part of the consequence of what has been
going on here. I mean, our reputation is everything. The market
evaluates us every day.
And I think that one of the things we have to recognize here, and
you all have talked about it, you know, that somehow our reputation has been tarnished. And we have to be able to go out and explain what it is we do better to a broader audience to be involved
with other industry associations. Because the bottom line is a couple of things: We only are talking about probability of default. We
are not talking about whether this is a suitable investment. We are
talking about a highly sophisticated institutional investor—
Mr. MARSHALL. The problem with that observation is that, in
fact, the probability of default goes way up if, indeed, the entire industry can’t get any money. It is the nature of how all of this is
structured. So the suitability—
Ms. TILLMAN. But that is not around—
Mr. MARSHALL. Pardon me? The suitability of the investment is
directly related to the stability of the industry. You can’t separate
the two, in this instance.
Ms. TILLMAN. We are not setting market values or market prices.
The market does that. And there is a lot more that goes into—
Mr. MARSHALL. But when the market price goes way down on
these things, money drives up, refinancings don’t occur, defaults go
up. So there is a direct relationship between performance of the instrument that you are judging and the market, in this instance.
Am I mistaken about that?

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49
Ms. TILLMAN. Well, I think what has happened in the markets,
and I think one of the panel members said it, there is a fear factor
in the markets right now. And, certainly, a more open, transparent
marketplace is something that we absolutely agree with, because
the fear is that people don’t necessarily know what exactly it is
that they are holding.
And what we do is do our best to explain what is in the portfolios, what we are looking at. When circumstances change, we talk
to investors, we talk to issuers. We talk about ideas that we have
on an ongoing basis. We talk to the market. We have teleconferences. We go on and on and on about what our views are.
And we do change. Ratings aren’t static. It is supposed to be stable, but it can’t be static when you have changing circumstances
occurring, which is why you have a surveillance process. And as
you, in the surveillance process, see that behavior is changing, sir,
we change our models, we review everything that may be impacted
by that, and we go out and we do what we need to do.
And that is all I can say. I don’t know how to seriously explain
it any further than that.
Mr. MARSHALL. I got you. Right. So, as you are looking, as you
are reviewing, monthly, across the board, is there this feeling that,
to the extent that have you to rerate, somehow you lose a little bit
of credibility with regard to your original rating?
Ms. TILLMAN. Actually, since our responsibility is to speak to the
creditworthiness and probability of default, it absolutely is our responsibility that, if it is a weaker credit than we had first anticipated, that we will downgrade it. That is our responsibility.
Mr. MARSHALL. Mr. Bass?
Mr. BASS. I know I keep going back to this, but I think it is very
important. When they talk about their credibility and the probability of default, the probability of default of a mezzanine CDO
AAA piece is exponentially higher, you probably can’t even calculate how much higher it is, in this structure than it is in a corporate structure.
And they haven’t even told us yet that they have blown it. The
fact that they allowed that structure to be rated the way it was
rated, it doesn’t matter what their surveillance teams are doing.
The fact that they allowed a mezzanine CDO structure to be
launched is where they blew it, and they lost their credibility. Because those AAAs, some of them will be fully impaired, and anything below AAA will be wiped out. And that is the loss of credibility from the beginning, not as we rerate things. That is the
structural problem.
Mr. MARSHALL. Mr. Adelson?
Mr. ADELSON. Yes, I have to respond a second to what Mr. Bass
is saying.
You know, the issue of the mezzanine CDOs is a great illustration, and it is interesting that he is saying it now, you know, after
the fact. You know, there were researchers, a number of us, myself
included, but others in the research community, who basically took
that view a long, long time ago, right? So it is not a surprise.
But the rating agencies’ view—where I differ with Mr. Bass is
the rating agencies’ view was not unreasonable. We had a different
point of view. We differed from their point of view. Their point of

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50
view was not unreasonable. Ours was not unreasonable. It is a
complicated problem as to which reasonable people can differ in
making assumptions and in tackling the analysis.
Mr. MARSHALL. Mr. Adelson, I am getting the impression that no
reasonable person could conclude that these particular issues—
Mr. ADELSON. No.
Mr. MARSHALL. Let me finish—that these particular issues would
survive a substantial turndown in the housing market.
Mr. ADELSON. What they had was actually historical evidence—
Mr. MARSHALL. Well, that was—
Mr. ADELSON. —about the correlated performance of BBBs, okay?
Now, I would have said you look beyond the historical performance
and you place more emphasis on what might happen, what you
could imagine to happen—okay?—as opposed to relying more on
the actual data, what you had observed. And you did have data for
a pretty long time series about the performance of BBBs. The correlation factors that the rating agencies came up with, as much as
I disagreed with them—right?—were not coming out of thin air, all
right?
I have probably criticized the rating agency correlation—
Mr. MARSHALL. Mr. Adelson—
Mr. ADELSON. —more than anyone.
Mr. MARSHALL. Mr. Adelson, can you rate something or should
you rate something AAA if there is a 5 percent chance you will lose
the entire investment?
Mr. ADELSON. I think the question—
Mr. MARSHALL. Just answer that question. Can you answer that
question?
Mr. ADELSON. I don’t think I can. I think the best answer I could
give you would be it depends on what you mean with your ratings.
Mr. MARSHALL. Well, you were at Moody’s for a long time. You
said so yourself; you have given ratings before. So how would you
rate that? If you thought there was a 5 percent chance that the entire investment would be lost entirely, gone, and you say—
Mr. ADELSON. Well, I would give that a very low rating.
Mr. MARSHALL. Pardon me?
Mr. ADELSON. There is a 5 percent chance that you are going to
have a 100 percent loss, so a 5 percent expected loss is going to be
a low rating.
Mr. MARSHALL. It would not be investment grade?
Mr. ADELSON. That would be below investment grade on the
short-term horizon.
Chairman KANJORSKI. I am sorry. Thank you.
Mr. MARSHALL. You guys have been very patient—we appreciate
it—and very informative.
Chairman KANJORSKI. Panel, I want to thank you very much. I
wish we could stay here for another hour and ask you questions.
As a matter of fact, I hope that you will all be available if we want
to have a future hearing. I think it would be helpful for the whole
committee. And you can see how well-attended the committee hearing was today, so we know that so many people will miss you in
the future.
But because we have about 3 minutes to vote, and because you
have been so kind, we are going to wrap this up.

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51
The Chair notes that some members may have additional questions for this panel which they may wish to submit in writing.
Without objection, the hearing record will remain open for 30 days
for members to submit written questions to these witnesses and to
place their responses in the record.
And, with that, this hearing is adjourned. Thank you.
[Whereupon, at 5:55 p.m., the hearing was adjourned.]

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APPENDIX

September 27, 2007

(53)

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