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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

(

(II)

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. VELA ́ ZQUEZ, 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 

RUBE ́ N 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 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, AND GOVERNMENT SPONSORED

ENTERPRISES

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 

RUBE ́ N HINOJOSA, Texas 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, 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 

(V)

C O N T E N T S 

Page 

Hearing held on: 

September 27, 2007 .......................................................................................... 1

Appendix: 

September 27, 2007 .......................................................................................... 53

WITNESSES 

THURSDAY, SEPTEMBER 27, 2007

Adelson, Mark H., Adelson & Jacob Consulting, LLC .......................................... 12

Bass, J. Kyle, Managing Partner, Hayman Capital Partners, L.P. ..................... 11

Kanef, Michael B., Group Managing Director, Asset Finance Group, Moody’s 

Investors Service .................................................................................................. 14

Mason, Dr. Joseph R., LeBow College of Business, Drexel University ............... 17

Mathis, H. Sean, Miller Mathis & Co., LLC ......................................................... 7

Tillman, Vickie A., Executive Vice President, Standard & Poor’s ....................... 15

APPENDIX 

Prepared statements: 

Kanjorski, Hon. Paul E. ................................................................................... 54

Adelson, Mark H. .............................................................................................. 56

Bass, J. Kyle ..................................................................................................... 69

Kanef, Michael B. ............................................................................................. 78

Mason, Dr. Joseph R. ....................................................................................... 112

Mathis, H. Sean ................................................................................................ 132

Tillman, Vickie A. ............................................................................................. 147

(1)

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 

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 

3

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. 

4

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 testiVerDate 0ct 09 2002 16:44 Jan 08, 2008 Jkt 039541 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 K:\DOCS\39541.TXT HFIN PsN: TERRIE
5

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 

6

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. 

7

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 

8

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 

9

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 

10

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. 

11

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 

12

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 testiVerDate 0ct 09 2002 16:44 Jan 08, 2008 Jkt 039541 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 K:\DOCS\39541.TXT HFIN PsN: TERRIE
13

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 

14

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. 

15

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. 

16

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 

17

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 

18

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 5-

year, 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 

19

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. 

20

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 

21

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 

22

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? 

23

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 

24

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 

25

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 

26

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 

27

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 diliVerDate 0ct 09 2002 16:44 Jan 08, 2008 Jkt 039541 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 K:\DOCS\39541.TXT HFIN PsN: TERRIE
28

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 

29

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. 

30

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. 

31

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. 

32

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. 

33

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. 

34

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 

35

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 

36

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 inVerDate 0ct 09 2002 16:44 Jan 08, 2008 Jkt 039541 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 K:\DOCS\39541.TXT HFIN PsN: TERRIE
37

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. 

38

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— 

39

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. 

40

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? 

41

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. 

42

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 

43

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. 

44

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 

45

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 

46

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 

47

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? 

48

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? 

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 

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. 

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.] 

(53)

A P P E N D I X

September 27, 2007

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