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SEPTEMBER 26, 2007

Mr. Chairman, Members of the Committee, good morning. I am Vickie A. Tillman,
Executive Vice President of Standard & Poor’s (“S&P”) Credit Market Services, and head of
Ratings Services, our nationally recognized statistical rating organization (“NRSRO”). I
appreciate the opportunity to appear before you today. I especially appreciate your invitation
because I believe it is important to clarify the role of rating agencies such as S&P in the
financial markets, the rigor S&P applies in fulfilling that role, and our overall record of
delivering unbiased opinions on creditworthiness.

To that end, I also welcome the

opportunity to address some questions that have been raised about how we have served the
market in the midst of unprecedented conditions in the subprime mortgage market and the
credit crunch and pressure on the economy that have followed.
I want to assure you at the start of my testimony that we have learned hard lessons
from the recent difficulties in the subprime mortgage area.

While we fully agree with

Secretary Paulson’s observation last week that “the subprime mortgage market improved
access to credit and homeownership for millions of Americans,” it appears that abuses may
have occurred in the origination process. We support Congress’ efforts to investigate those
abuses and to prevent their recurrence. For our part, we are taking steps to ensure that our
ratings — and the assumptions that underlie them — are analytically sound in light of shifting
circumstances. As I am sure you know, and as my testimony will set forth in some detail,
S&P began downgrading some of its ratings in this area towards the end of last year and had
warned of deterioration in the subprime sector long before that. Nonetheless, we are fully
aware that, for all our reliance on our analysis of historically rooted data that sometimes went
as far back as the Great Depression, some of that data has proved no longer to be as useful or

reliable as it has historically been. Additionally, the collapse of the housing market itself has
been both more severe and more precipitous than we had anticipated. As I will describe in
more detail later, we have taken a number of steps in response to enhance our analytics and
process and continue to look for ways in which to do still more.
Our reputation and our track record are the core of our business, and when they come
into question, we listen and learn. We take our work seriously, very seriously, and at no time
in our history more than now, as I speak to you.
In my testimony I would like to address four broad topics:

First, the nature of S&P’s ratings and their role in the capital markets;


Second, S&P’s approach to rating residential mortgage-backed securities
(“RMBS”), including mortgage securities backed by subprime mortgage


Third, a number of the questions that have been raised in the press and
elsewhere related to ratings, including:

Questions as to whether payment of fees by issuers presents a
conflict of interest that could compromise analytical


Questions as to whether S&P is somehow involved in
“structuring” RMBS and other structured finance transactions;


Questions about the appropriateness of our ratings because
securities backed by subprime collateral sometimes receive
‘AAA’ ratings; and


Questions about whether S&P has acted too slowly in responding
to the deterioration of the subprime mortgage market.



Fourth, steps we have taken in light of the Credit Rating Agency Reform
Act passed by this body in 2006.

Ratings and Their Role In The Capital Markets
I would like to begin today by discussing the nature of our credit ratings, as it appears
from numerous press reports that this matter is sometimes misunderstood. At their core,
S&P’s credit ratings represent our opinion of the likelihood that a particular obligor or
financial obligation will timely repay owed principal and interest. Put another way, we assess
the likelihood, and in some situations the consequences, of default — nothing more or less.
When we issue a rating on a particular security we are expressing our view that the
security shares similar credit characteristics to those securities that have, in the past,
represented a particular range of credit risk. A bond that we rate as ‘BBB’ has received the
lowest of our so-called “investment grade” ratings; one rated ‘BB’ has received the highest
non-investment grade rating. “Investment grade” securities are those securities that certain
regulated investors may legally purchase. On S&P’s ratings scale, such securities are those
rated at the ‘BBB’ level or higher. Since we began rating RMBS in the late 1970’s, only
1.09% of those securities rated by us ‘BBB’ have ever defaulted. For ‘BBs’ this number is
2.11%. Thus, when we rate securities, we are not saying that they are “guaranteed” to repay
but the opposite: that some of them will likely default. Even our highest rating — ‘AAA’ —
is not a guarantee or promise of performance.
although rarely.


‘AAAs’ do default and have defaulted,

Another misconception about ratings relates to their purpose and use. Ratings speak
to one topic and one topic only — credit risk. As we have repeatedly made clear in public
statements, including statements to the SEC, testimony before Congress, and innumerable
press releases, ratings do not speak to the likely market performance of a security. Thus,
ratings clearly do not address:
o Whether investors should “buy”, “sell” or “hold” rated securities;
o Whether any particular rated securities are suitable investments for a
particular investor or group of investors;
o Whether the expected return of a particular investment is adequate
compensation for the risk;
o Whether a rated security is in line with the investor’s risk appetite;
o Whether the price of the security is appropriate or even commensurate with
its credit risk; or
o Whether factors other than credit risk should influence that market price,
and to what extent.
I want to be clear. Ratings matter; as the individual who oversees S&P’s ratings
business I would be the last person to suggest to you that they do not. But in the current
climate, it is especially important to bear in mind just what it is we do and that other
developments also affect market perceptions and behavior. The current credit crunch is very
real, but we certainly have not witnessed widespread defaults of mortgage-backed securities.
This dynamic and its relationship to the nature of ratings was recently recognized by one of
Europe’s top regulators, Mr. Eddy Wymeersch, Chairman of the Committee of European
Securities Regulators and also Chairman of Belgium’s Banking and Financial Commission.
According to Mr. Wymeersch:

“[t]he press and general opinion is saying it’s the fault of the credit rating agencies . . .
Sorry, the ratings are just about the probability of default. Nothing more. Now we
have a liquidity crisis and not a solvency crisis.”
Though they may move more slowly than market prices, ratings are not designed to be
static. Our view of an RMBS transaction evolves as facts and circumstances develop, often in
ways that are difficult to foresee. We issue ratings and, as new information becomes available
with the passage of time, we either affirm those ratings — i.e., leave them unchanged —
upgrade them, downgrade them, or put them on CreditWatch, which is a warning to the
market that the rating is subject to change after a pending review. To make such decisions,
we perform surveillance on our ratings. I will discuss our surveillance process in greater
detail a little later on, but the three important points here are:

That we have a team and process in place whose responsibility it is to monitor
developments and bring about ratings changes to reflect those developments as


Changes in RMBS ratings are not based on speculation or market sentiment; and


Such changes are often based upon events which were not predictable.

To cite only a few recent examples on this last point, the level of early payment
default trends in recent subprime loans is unprecedented; so is the fact that, while individuals
who purchased homes have generally paid their mortgages before paying off their credit
cards, that now appears no longer to be true to the extent it once was; so is the reality that,
while individuals who live in homes they purchase historically repay the mortgages on these
homes more regularly than those who live elsewhere, that long-standing pattern now appears
of questionable validity in a striking number of cases. These are ahistorical behavioral

modes, ones of particular import at a time of a substantial fall in real estate prices, and ones
that, together with other factors, required downgrading some RMBS ratings even though no
substantial amount of pool losses have occurred.
I said earlier that we have made repeated statements about the nature and role of
ratings. To the extent those efforts have failed to communicate sufficiently clearly about that
topic, we view this hearing, and this process overall, as an opportunity to begin to rectify that.
We recognize that we bear primary responsibility for getting the message out. We are
making, and will continue to make, every effort to do so.
S&P’s Rating of Securities Backed By Mortgage
Loans, Including Subprime Loans
Our ratings of residential mortgage-backed securities, particularly RMBS backed by
pools containing subprime mortgage assets, have recently received a significant amount of
attention. S&P has been rating RMBS for thirty years and has developed industry-leading
processes and models for evaluating the creditworthiness of these transactions. As a result,
S&P has an excellent track record of assessing RMBS credit quality. For example, S&P’s
cumulative U.S. RMBS default rate by original rating class (through September 15, 2007) is
as follows:
Initial Rating

% of Default




Default statistics are the critical measure of ratings analytics because, as I explained
earlier, at their core ratings speak to the likelihood of timely repayment, not other market
factors, such as supply and demand, that may go into the pricing of securities. Moreover,
these default numbers for our RMBS ratings are lower, in some cases materially lower, than
the long-term default rates for similar ratings issued on corporate bonds.
While evaluating the credit characteristics of the underlying mortgage pool is part of
our RMBS ratings process, S&P does not rate the underlying mortgage loans made to
homeowners or evaluate whether making those loans was a good idea in the first place.
Originators make loans and verify information provided by borrowers. They also appraise
homes and make underwriting decisions. In turn, issuers and arrangers of mortgage-backed
securities bundle those loans and perform due diligence. They similarly set transaction
structures, identify potential buyers for the securities, and underwrite those securities. For the
system to function properly, S&P relies, as it must, on these participants to fulfill their roles
and obligations to verify and validate information before they pass it on to others, including
S&P. Our role in the process is reaching an opinion as to how much cash we believe the
underlying loans are likely to generate towards paying off the securities eventually issued by
the pool. That is the relevant issue for assessing the creditworthiness of those securities.
As a practical matter, S&P’s analysis of an RMBS transaction breaks down into the
following categories:
The LEVELS® Model

The first step in our analysis is evaluating the overall

creditworthiness of a pool of mortgage loans by conducting loan level analysis using our Loan
Evaluation and Estimate of Loss System (LEVELS®) Model. This model is built on, and


reflects, our analytical assumptions and criteria. S&P’s criteria do not dictate the terms of the
mortgage loans; those terms are set by the originator in the underwriting process. S&P
collects up to seventy different types of inputs, including, but not limited to: the amount of
equity a borrower has in the home; the loan type; the extent of income verification; whether
the borrower occupies the home; and the purpose of the loan. This analysis allows us to
quantify multiple risk factors, or the layered risk, and allows us to assess the increased default
probability that is associated with each factor. Based on the individual loan characteristics,
the LEVELS® model calculates probabilities of default and loss realized upon default. The
assumptions and analysis embedded in the LEVELS® model are under regular review and are
updated as appropriate to reflect our current thinking about rating residential mortgages.
As part of our commitment to transparency, S&P makes its LEVELS® model available
to investors who wish to license it. The vast majority of those involved in issuing RMBS
have access to LEVELS® and use it regularly. We also publicly announce any changes to our
LEVELS® model in a timely manner. In other words, our basic criteria is out there every day,
subject to criticism and comment.
The SPIRE® Model Another important aspect of our rating process is assessing the
availability of cash flow, which comes from the monthly payments generated by the mortgage
loans, to timely pay principal and interest. To do this, we use our Standard & Poor’s Interest
Rate Evaluator (SPIRE®) Model.

The model uses the S&P mortgage default and loss

assumptions (generated by the LEVELS® model) as well as interest rate assumptions. Like
the LEVELS® model, our SPIRE® model reflects our analysis and assumptions and is
regularly reviewed and updated as warranted.


Also like our LEVELS® model, our SPIRE® model is publicly available, used
extensively by market participants, and subject to market comment and review every day.
Review of Originator and Servicer Operational Procedures

S&P also reviews

the practices, polices, and procedures of the originators and servicers primarily to gain
comfort with the ongoing orderly performance of the transaction. For an originator, the topics
we review include, but are not limited to: loan production practices; loan underwriting; and
quality control practices and findings. S&P may adjust its credit support calculation based on
the underwriting employed at origination.
Review of Legal Documents

S&P also reviews, with the assistance of internal

and external counsel, the legal documents of the securities to be issued, and, where
appropriate, opinions of third-party counsel that address transfer of the assets and insolvency
of the transferor, as well as security interest and other legal or structural issues. S&P reviews
the underlying documentation in order to understand the payment and servicing structure of
the transaction.
Credit Enhancement

Any description of our ratings of RMBS would be

incomplete without discussing the critical concept of credit enhancement.


enhancement is the protection (i.e., additional assets or funds) needed to cover losses in
deteriorating economic conditions, sometimes referred to as “stress”.

Sufficient credit

enhancement allows securities backed by a pool of subprime collateral to receive what might
otherwise be considered high ratings. One form of credit enhancement, although there are
several, would occur if the pool has more in collateral than it issues in securities, thereby
creating a cushion in the pool.

We refer to this form of credit enhancement as


“overcollaterization,” and it is a key component in our ratings analysis. It provides protection
against defaults in the underlying securities. That is, if the pool ends up experiencing losses,
it should still generate enough cash from which to pay the holders of the securities. I will
discuss credit enhancement in more detail later in my testimony.
The Rating Committee

After reviewing the relevant information about a

transaction, including information related to credit enhancement, the lead analyst then takes
the transaction to a rating committee. As with all S&P ratings, structured finance ratings are
assigned by committee. Committees are comprised of S&P personnel who bring to bear
particular credit experience and/or structured finance expertise relevant to the rating. The
qualitative judgments of committee members at all stages of the process are an integral part of
the rating process as they provide for consideration of asset and transaction specific factors, as
well as changes in the market and environment. Personnel responsible for fee negotiations
and other business-related activities are not permitted to vote in ratings committees and vice
Notification and Dissemination

Once a rating is determined by the rating

committee, S&P notifies the issuer and disseminates the rating to the public for free by,
among other ways, posting it on our Web site, Along with the
rating, we frequently publish a short narrative rationale authored by the lead analyst. The
purpose of this rationale is to inform the public of the basis for S&P’s analysis and enhance
transparency to the marketplace.
Surveillance After a rating has been issued, S&P monitors or “surveils” the rating to
review developments that could alter the original rating. The surveillance process seeks to


identify those issues that should be reviewed for either an upgrade or a downgrade because of
asset pool performance that may differ from original assumptions. The surveillance function
also monitors the credit quality of entities that may be supporting parties to the transaction,
such as liquidity providers. Analysts review performance data periodically during the course
of the transaction, and as appropriate present that analysis to a rating committee for review of
whether to take a rating action. The rating committee then decides whether the rating change
is warranted. For changes to public ratings, a press release is normally disseminated.
S&P’s Commitment to Constant Improvement
While our ratings process is the product of three decades of analytical experience and
excellence, we are always looking for ways to enhance that process and our analytics. This is
a hallmark S&P principle and is especially true when, as with recent subprime loans,
developments indicate that historically-rooted behavioral patterns that have served as solid
foundations for analysis may lack their prior value.
By now there is no doubt that subprime loans made from late 2005 through at least
early 2007 are behaving very differently from loans in prior periods, even when the loans
share the same basic credit characteristics. For example, for years a primary indicator of a
borrower’s credit has been so-called FICO credit scores. FICO scores are provided by
another independent market participant and are an industry standard. In recent loans, we are
seeing borrowers with high FICO scores behaving in a manner consistent with how materially
lower FICO borrowers have historically behaved. Similarly, as I observed earlier, there are a
number of other ahistorical anomalies that make more problematic applying a number of
historically-rooted assumptions about the behavior of borrowers. At the same time, these


behaviorial shifts appear not to be occurring in loans generated in 2004 and most of 2005,
which include many of the same type of subprime characteristics present in the more recent

We are still gathering data to analyze the causes for these inconsistent market

In response to these developments, and as part of our constant commitment to
enhancing our analytical processes, S&P has already initiated a number of steps:

We have significantly heightened the stress levels at which we rate and
surveil transactions to account for deteriorating performance as evidenced
by data we have received. We have also increased the frequency of our
review of rated transactions;


We are modifying (and will soon be releasing) our LEVELS® model to
incorporate these new stress levels and other changes recently made to our
ratings assumptions, as announced in our July 10, 2007 press release;


We recently acquired IMAKE consulting and ABSXchange.


services have long provided data, analytics and modeling software to the
structured finance community and we feel they will further enhance our indepth surveillance process;

We have also undertaken a survey of originators and their practices,
particularly with respect to issues of data integrity. We are in the process
of compiling the results of this survey and will publish those results when
finalized; and



We have hired a Chief Compliance Officer to augment our internal control

In addition to these steps, we continue to look at areas in which we can further
enhance our analysis and processes. Some of the areas include:

Our policies and procedures to protect against conflicts of interest;


The quantity and quality of data available to us; and


Modification of our analytics to reflect changing credit behaviors.

S&P’s Response To Various Questions
Some have raised questions about ratings and the ratings process in recent months in
light of the turmoil in the subprime mortgage market. As I have previously said, we are well
aware that certain historically-rooted assumptions we made in determining which RMBS
ratings to issue do not, in retrospect, appear to have remained as relevant as they previously
have been. Whether that is because of factors unique to the period immediately prior to and
after 2006 or whether we must change those assumptions on a long-term basis is a subject of
robust and continuing examination and re-examination at S&P.
At the same time, some of the questions recently put to S&P reflect a fundamental
misunderstanding of what ratings are or are based on inaccurate or, in some cases, incomplete
information. Let me now address those questions.
The “Issuer Pays” Model Does Not Compromise
the Independence and Objectivity of Our Ratings
A number of commentators have asked whether payment of fees by issuers and/or
their representatives presents a conflict of interest that compromises the independence and

objectivity of ratings. Skeptics question whether, in pursuit of fees, S&P and other major
rating agencies may give higher ratings than they otherwise would. Not only is this not true at
S&P, but this line of questioning ignores the significant benefits of the “issuer pays” model to
the market.
S&P currently makes all of its public ratings available to the market free of charge in
real time. When a rating is assigned or changed, the announcement is made on our Web sites
— and — and a press release is provided to news
outlets and other media. Today there are approximately 9 million current and historical
ratings available on RatingsDirect. In addition, as many as 1.3 million active ratings are
available for free on The benefits to the market are obvious: any and all
interested market participants can access the same information at the same time. It creates a
level playing field and a common basis for analyzing risk. It also leads to higher quality
ratings as our analysis is subject to market scrutiny and reaction every day from every corner
of the capital markets.
This type of free, public disclosure and transparency is only possible under the “issuer
pays” model.

Developing and maintaining models and hiring experienced and skilled

analytical talent is costly. Without payment by issuers, those costs would have to be covered
by subscription fees, an approach with several insurmountable problems. A subscription
model would severely limit the transparency and broad (and free) dissemination of ratings, as
access would necessarily be expensive and exclusive to subscribers. Not only would this
result in less, not more, information in the market, but it would also take away an important
check on ratings quality — the constant scrutiny of a broad market. Moreover, because


subscription fees would necessarily be significant (given the breadth of our ratings coverage
and the depth of our analysis), many investors, including the vast majority of individual
investors, simply would not be able to afford access to ratings information. The likely result
would be one of two equally harmful outcomes: either (i) these investors would have no
meaningful access to ratings information; or (ii) a ratings black market would develop in
which S&P’s intellectual property — its ratings analysis — would be misused or resold in a
manner all too consistent with the pervasive misuse of other intellectual property and with the
same destructive impact.
As noted, some have questioned whether the “issuer pays” model has led S&P and
others to issue higher, or less rigorously analyzed, ratings so as to garner more business. First
and foremost, there is no evidence — none at all — to support this contention with respect to
S&P. This is not surprising since it would be clearly against S&P’s self-interest as well as its
cornerstone principles.
Indeed, what evidence there is on the subject shows the opposite.

Consider, for instance, the performance of our RMBS ratings. As reflected in

the chart below, in every year from 1994 through 2006, upgrades of U.S. RMBS ratings
significantly outpaced downgrades by multiple factors — about 7:1 on average. The ratio was
even higher from 2001-2006. That is to say, after S&P initially provided its ratings in this
area, actual performance of the rated transactions led to upgrades far more often than
downgrades as time passed.


1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
% of Ratings






2.78 10.08 10.21

9.24 12.82 10.74



% of Ratings














If, as some claim, S&P deliberately issued high ratings to please those who paid for
them, one would expect that the initial (allegedly inflated) ratings would require downward
adjustment to reflect actual performance. Similarly, one would expect default rates on our
RMBS ratings to be higher — indeed, materially higher — than the statistics I cited earlier.
But, over the years, the opposite has emphatically been the case.

Similarly, if S&P put revenue ahead of analytical rigor, we would not refuse to

rate, as we have, transactions that do not meet our criteria. A recent highly publicized
example occurred in Canada where significant amounts of asset-backed commercial paper
became illiquid. The paper had not met S&P’s minimum criteria and so we did not rate it.
These are not the actions of an agency that would rate every deal that reaches our door.

The primacy of our reputation has been recognized by independent sources. A

report prepared by two Federal Reserve Board economists found “no evidence” that rating
agencies acted in the interest of issuers due to a conflict of interest. After detailed study, the
report concluded that “rating agencies appear to be relatively responsive to reputation
concerns and so protect the interests of investors.” See Daniel M. Covitz & Paul Harrison,
Testing Conflicts of Interest at Bond Ratings Agencies with Market Anticipation: Evidence
that Reputation Incentives Dominate (Dec. 2003) at

The real question is not whether there are potential conflicts of interest in the “issuer
pays” model, but whether they can be effectively managed by S&P and other credit rating
agencies. Mr. Erik Sirri, director of the SEC’s Division of Market Regulations, recently
testified at a congressional hearing that the conflicts raised by this long-standing business
model are indeed manageable. As Mr. Sirri testified:
“Typically, [rating agencies] are paid by the underwriter or the issuer. That
presents a conflict. But we believe that conflict is manageable. Credit rating
agencies should have polices and procedures in place, and they should adhere
to those policies and procedures when they evaluate deals.”
S&P maintains rigorous policies and procedures designed to ensure the integrity of our
analytical processes. For example, analysts are not compensated based upon the amount of
revenue they generate. Nor are analysts involved in negotiating fees. Similarly, individuals
responsible for our commercial relationships with issuers are not allowed to vote at rating
committees. These policies, and others, have helped ensure our long-standing track record of
excellence. As previously noted, our track record speaks for itself. Moreover, the Credit
Rating Agency Reform Act of 2006, and the SEC’s implementing regulations, give greater
assurance that those policies will be enforced.
S&P Does Not “Structure” Transactions
Similar misunderstandings have led some to question whether rating agencies
“structure” transactions, thereby threatening ratings independence.

These questions are

particularly troubling as they give false and negative impressions about a practice that benefits
the markets — the open dialogue between issuers and ratings agencies.


It is true that our analysts talk to issuers of RMBS transactions as part of the ratings
process, as they have traditionally had discussions with corporate issuers with respect to
rating their non-structured securities. This dialogue provides benefits to the marketplace.
Critical to our ability to rate transactions is a robust understanding of those transactions.
Reading documents and reviewing the results of modeling are important, of course, but so is
communication with the people responsible for the transaction itself. Through dialogue with
issuers and their representatives our analysts gain greater insight into transactions to be rated,
including any modifications to those transactions that may occur as the process goes forward.
This dialogue promotes transparency into our ratings process, a virtue we believe in, and one
that regulators have consistently espoused.
Nor does the dialogue amount to “structuring” by S&P, even in cases where the
discussion is about the effect different structures may have on ratings. S&P does not tell
issuers what they should or should not do. Our role is reactive. Using our models with set
publicly available criteria, issuers provide us with information and we respond with our
considered view of the ratings implications. In the process, and as part of our commitment to
transparency, we also may discuss the reasoning behind our analysis. Those who question
this practice ignore that the ratings process is not and should not be a guessing game. Without
informed discussion, issuers would be proposing structure upon structure until they stumbled
upon the structure that best matches with their goals. That certainly would not make the
markets more transparent and efficient.
Nor should anyone view as suspicious the fact that some issuers structure transactions
so as to achieve a specific rating result. Indeed, a variety of potential structures could merit a


particular result. Our role is to come to a view as to the structures presented, but not to
choose among them. Again, we do not compromise our criteria to meet a particular issuer’s
goals. As noted, we make criteria publicly available. If we were not applying our criteria to
particular transactions, it would be readily apparent to the market and would immediately
diminish the credibility — and thus the value — of our ratings business.
Credit Enhancement — How Securities Backed
By Subprime Mortgages Can Receive, and Merit,
Investment Grade Ratings
A potentially incomplete understanding of the ratings process has also led to questions
about how a pool of subprime mortgage loans can support securities with investment grade,
even ‘AAA’ ratings. The answer lies in the concept of credit enhancement.
As discussed earlier, credit enhancement — additional assets or funds — affords
protection against losses in deteriorating conditions. When an issuer comes to us with a pool
of subprime loans to be used as collateral for an RMBS transaction, S&P is well aware, of
course, that all of this collateral is not likely to perform from a default perspective like ‘AAA’
securities. Nonetheless, the pool of collateral loans will yield some amount of cash, even
under the most stressful of economic circumstances.
A key component of our analysis is looking at the pool of collateral to determine how
much credit enhancement — extra collateral, for example — would be needed to support a
particular rating on the securities to be backed by that collateral. To do this, we analyze the
expected performance of the collateral in stressful economic conditions. To determine the
amount of credit enhancement that could support an ‘AAA’ rating, we use our most stressful
economic scenario, including economic conditions from the Great Depression. The stress


scenarios are then adjusted for each rating category. Thus, if our analysis of a particular
collateral pool’s expected performance indicates that the pool would need 30% credit
enhancement to support an ‘AAA’ rating, the issuer would have to have 30% additional
collateral above and beyond the value of the securities issued in order for the securities issued
by the pool to have enough credit enhancement for an ‘AAA’ rating. To put it in more
concrete terms, if the pool was comprised of, for example, $1.3 million in collateral, it could
only issue $1 million in ‘AAA’ rated securities in this scenario. This way, if the collateral
performs poorly — and thirty percent in losses is very poor performance — there will still be
sufficient collateral to cover losses incurred upon loan defaults. This credit enhancement
figure would, of course, be lower for ratings other than ‘AAA’, as those ratings address the
likelihood of repayment in less stressful economic environments. For example, the issuer
might be able to issue $1.2 million in ‘BBB’ rated securities backed by the same collateral
pool. Thus, it is not the case that through securitization, poor credit assets magically become
solid investments. Rather, it is because, in our example, a pool has $1.3 million in collateral
to support $1 million in securities that it may receive an entirely appropriate ‘AAA’ rating on
those securities.
S&P Has Been Warning the Market, and Taking
Action, in Response to Deterioration in the
Subprime Market Since Early 2006
Others have questioned whether S&P has acted quickly enough in response to the
deteriorating subprime market. Again, we believe these questions result from an incomplete
understanding of the facts. S&P has spoken out — and taken action — early and often on
subprime issues.


For some time S&P has been through our publications repeatedly and consistently
informing the market of its concerns about the deteriorating credit quality of RMBS
transactions. For example:
• In a January 19, 2006 article entitled U.S. RMBS Market Still Robust, But Risks Are
Increasing And Growth Drivers Are Softening, we said: “Standard & Poor’s expects
that some of the factors that drove growth in 2005 will begin to soften in 2006 . . . .
Furthermore, Standard & Poor’s believes that there are increasing risks that may
contribute to deteriorating credit quality in U.S. RMBS transactions; it is probable that
these risks will be triggered in 2006.”

On May 15, 2006, in an article entitled A More Stressful Test Of A Housing Market
Decline On U.S. RMBS, we reported on the results of our follow-up analysis to our
September 2005 housing-bubble simulation. We stated: “[t]he earlier simulation had
concluded that most investment-grade RMBS would weather a housing downturn
without suffering a credit-rating downgrade, while speculative-grade RMBS might not
fare so well . . . . In the updated simulation . . . [S&P used] more stressful
macroeconomic assumptions [which] lead to some downgrades in lower-rated
investment-grade bonds.”


On July 10, 2006, in an article entitled Sector Report Card: The Heat Is On For
Subprime Mortgages, we noted that downgrades of subprime RMBS ratings were
outpacing upgrades due to “collateral and transaction performance.” The article also
identifies “mortgage delinquencies” as a “potential hot button,” and notes that such
delinquencies “may become a greater concern for lenders and servicers.”


On July 17, 2006, we noted a 38% increase in downgrades in U.S. RMBS, a
significant number of which came from the subprime market. Structured Finance
Global Ratings Roundup Quarterly: Second-Quarter 2006 Performance Trends.


On Oct. 16, 2006, in our Ratings Roundup: Third-Quarter 2006 Global Structured
Finance Performance Trends, we reported a 15% decline in upgrades for U.S. RMBS
while the number of downgrades more than tripled compared to the same period in
2005. We also noted that the quarter’s ratings actions among RMBS transactions had
set a record for the most performance-related downgrades.



Then on December 8, 2006, in an article entitled Credit Trends: 2007 Global Credit
Strategy: Asset Class Outlook, we informed the market of our view that “[c]redit
quality in the RMBS sub-prime market has been under scrutiny this year. Standard &
Poor’s RMBS surveillance group sees the environment ahead as portending greater
downgrade potential along with lower upgrade potential.” We also stated that “the
jump in third-quarter downgrade activity for the sub-prime market raises some risk
flags for this segment; with 87 third-quarter downgrades adding to the 46 downgrades
of the second quarter and 34 in the first.”


On January 16, 2007, in an article entitled Ratings Roundup: Fourth-Quarter 2006
Global Structured Finance Performance Trends, we stated: “Rating activity among
subprime transactions has started to shift to being predominantly negative from being
predominantly positive. . . . We expect this trend in subprime rating performance to
continue during 2007.”


Ten days later on January 26, 2007, in our Transition Study: U.S. RMBS Upgrades
Are Down And Downgrades Are Up In 2006, we reported that for 2006 “[d]owngrades
overwhelmed upgrades for subprime mortgage collateral” and that we expected
“losses and, therefore, negative rating actions to continue increasing during the next
few months relative to previous years.”


Our statements to the market continued throughout the first half of 2007. On March
22, 2007, in an article entitled A Comparison Of 2000 and 2006 Subprime RMBS
Vintages Sheds Light On Expected Performance, we stated: “[w]hile subprime
mortgages issued in 2000 have the distinction of being the worst-performing
residential loans in recent memory, a good deal of speculation in the marketplace
suggests that the 2006 vintage will soon take over this unenviable position.”


In an April 27, 2007 article entitled Special Report: Subprime Lending: Measuring
the Impact, we stated: “The consequences of the U.S. housing market’s excesses, a
topic of speculation for the past couple of years, finally have begun to surface. . . .
Recent-vintage loans continue to pay the price for loosened underwriting standards
and risk-layering in a declining home price appreciation market, as shown by early
payment defaults and rising delinquencies.”


Then on June 26, 2007, in an article entitled Performance of U.S. RMBS Alt-A Loans
Continues To Deteriorate, we reported: “The most disconcerting trend is how quickly
the performance of these delinquent borrowers has deteriorated. We continue to see
migration from 60-plus-day to 90-plus-day delinquencies within the 2006 vintage,
suggesting that homeowners who experience early delinquencies are finding it
increasingly difficult to refinance or work out problems, as opposed to being able to
‘cure’ falling behind on payments.”


None of these warnings were hidden by S&P and I will gladly provide the Committee
with these documents. In addition to these warnings, we also took action in response to
subprime deterioration. For example:

On June 1, 2006, almost sixteen months ago, we tightened our criteria through
changes in our LEVELS® model targeted to increase the credit enhancement
requirements for pools with subprime loans. In announcing these changes to the
market, we specifically identified subprime loans, such as “[l]oans with simultaneous
second liens (especially those with very low FICO scores)”, as loans “much more
likely to default than non-second-lien loans with similar FICO scores.”


Then in February 2007, we took the unprecedented step of placing on CreditWatch
negative (and ultimately downgrading) transactions that had closed as recently as
2006. As we informed the market in the accompanying release: “Many of the 2006
transactions may be showing weakness because of origination issues, such as
aggressive residential mortgage loan underwriting, first-time home-buyer programs,
piggyback second-lien mortgages, speculative borrowing for investor properties, and
the concentration of affordability loans.” In a February 16, 2007 Los Angeles Times
article, S&P’s announcement was described as “‘a watershed event’ because it means
S&P is now actively considering downgrading bonds within their first year.” See
S&P to Speed Mortgage Warnings, Los Angeles Times, Feb. 16, 2007.


We continued taking downward action through the Spring. In May we announced that
“Standard & Poor’s Ratings Services took 103 rating actions affecting 103 classes of
residential mortgage-backed securities (RMBS) transactions backed by subprime,
closed-end second-lien, and Alt-A loan collateral originated in 2005 and 2006; we
lowered 92 ratings . . . and placed 103 ratings on CreditWatch negative . . . . These
rating actions were due to collateral performance.” We also noted that “[m]ost of the
transactions affected by CreditWatch placements (and no downgrades) have not
experienced significant losses. The placement of our ratings on CreditWatch when a
transaction has not experienced significant losses represents a new methodology
derived from our normal surveillance practice.”


On June 22, 2007, we announced further ratings actions in an article entitled 133
Subordinate Second-Lien, Subprime Ratings From 2006, 2005-Vintage RMBS On
Watch Neg, Cut. We explained that “[t]he downgrades and CreditWatch placements
reflect early signs of poor performance of the collateral backing these transactions.”


Then in July of this year, we again took action in response to increasingly bad
performance data, including loss levels that continued to exceed historical precedents
and our initial expectations. Specifically:


We increased the severity of the surveillance assumptions we use to
evaluate the ongoing creditworthiness for RMBS transactions issued during
the fourth quarter of 2005 through the fourth quarter of 2006 and
downgraded those classes that did not pass our heightened stress test
scenario within given time frames.


In addition, we modified our approach for ratings on senior classes in
transactions in which subordinate classes have been downgraded.


We also announced that, with respect to transactions closing after July 10,
2007, we would implement changes that would result in greater levels of
credit protection for rated transactions and would increase our review of
lenders’ fraud-detection capabilities.

No one can see the future. The point of these articles and actions, however, is to
highlight our reaction to increasing subprime deterioration — looking, as we always do, to
historical or paradigm-shifting behaviors to help analyze long-term performance. Consistent
with our commitment to transparency we repeatedly informed the market of our view that the
credit quality of subprime loans was deteriorating and putting negative pressure on RMBS
backed by those loans. And, consistent with our commitment to analytical rigor, we revised
our models, took action when we believed action was appropriate, and continue to look for
ways to make our analytics as strong as they can be.
Impact of The Credit Rating Agency Reform Act
of 2006
Earlier this year, the Credit Rating Agency Reform Act of 2006 took effect. As a
result, over the past few months, S&P has been actively engaged in the process of
implementing the requirements of the Commission’s new Rules regulating NRSROs under
the Act.
On June 25, 2007 we filed our application to register as an NRSRO. The application
includes, among other things, our procedures and methodologies for determining ratings;

credit ratings performance measurement statistics; and information related to our ratings
analysts and the largest users of our credit ratings. In addition, the application includes a
description of our policies for preventing the misuse of material, non-public information and
addressing and managing potential conflicts of interest. We also hired a Chief Compliance
Officer who is responsible for administering and overseeing these policies and procedures and
ensuring compliance with applicable securities laws.
Additionally, S&P has continued its ongoing efforts to develop and streamline internal
record-keeping policies and procedures in order both to ensure the integrity of the ratings
process and to satisfy Commission requirements that records be available for inspection. We
recently received a notice of examination from the Commission seeking the production of a
substantial amount of documents that may relate to the issue of the potential conflict of
interest discussed above. We are in the process of complying with this notice.
S&P supported final passage of the Credit Rating Agency Reform Act and remains
committed to that Act’s stated goal of improving ratings quality for the protection of investors
and fostering oversight, transparency and competition in the credit rating industry. Given that
we are relatively early in the process of seeing this new law fully implemented, we would
respectfully urge you to allow the Commission to proceed with its task of enforcing the
provisions of the new law and the regulations so recently adopted before Congress proposes
any further actions.
I thank you for the opportunity to participate in this hearing. Over the past several
decades, S&P’s consistent approach has been to evolve our analytics, criteria, and review


processes when appropriate, and you can expect that same approach in light of new consumer
credit behaviors in all markets, including residential mortgages. Let me also assure you again
of our commitment to analytical excellence and our desire to continue to work with the
Committee as it explores developments effecting the subprime market. I would be happy to
answer any questions you may have.