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S. HRG. 110–913 

SUBPRIME MORTGAGE MARKET TURMOIL: 

EXAMINING THE ROLE OF SECURITIZATION 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES AND INSURANCE AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

FIRST SESSION 

ON HOW SUBPRIME MORTGAGES ARE SECURITIZED; THE EFFECT OF 

RECENT INCREASES IN DEFAULTS AND DELINQUENCIES ON THE 

SUBPRIME SECURITIZATION MARKET FOR BOTH BORROWERS AND INVESTORS; AND HOW CREDIT RISK FOR MORTGAGE-BACKED SECURITIES IS DETERMINED AND HOW THE ASSIGNED RATINGS ARE MONITORED 

TUESDAY, APRIL 17, 2007 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 


smartinez on DSKH9S0YB1PROD with HEARING
(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

GEORGE WHITTLE, Editor 

SECURITIES AND INSURANCE AND INVESTMENT

JACK REED, Rhode Island, Chairman 

WAYNE ALLARD, Colorado, Ranking Member 

ROBERT MENENDEZ, New Jersey 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT P. CASEY, Pennsylvania 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

MICHAEL B. ENZI, Wyoming 

JOHN E. SUNUNU, New Hampshire 

ROBERT F. BENNETT, Utah 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

DIDEM NISANCI, Staff Director 

TEWANA WILKERSON, Republican Staff Director 


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C O N T E N T S 

TUESDAY, APRIL 17, 2007 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Allard ................................................................................................... 2 

Senator Menendez ............................................................................................ 3 

Senator Crapo ................................................................................................... 4 

Senator Casey ................................................................................................... 5 

Senator Schumer .............................................................................................. 6 

WITNESSES 

Gyan Sinha, Senior Managing Director and Head of ABS and CDO Research, 

Bear Stearns & Company, Inc. ........................................................................... 9 

Prepared statement .......................................................................................... 42 

David Sherr, Managing Director and Global Head of Securitized Products, 

Lehman Brothers, Inc. ......................................................................................... 11 

Prepared statement .......................................................................................... 49 

Response to written questions of: 

Senator Reed .............................................................................................. 139 

Senator Schumer ....................................................................................... 141 

Susan Barnes, Managing Director, Standard & Poor’s Ratings Services ........... 14 

Prepared statement .......................................................................................... 55 

Warren Kornfeld, Managing Director, Residential Mortgage-Backed Securities 

Rating Group, Moody’s Investors Service .......................................................... 16 

Prepared statement .......................................................................................... 74 

Response to written questions of: 

Senator Reed .............................................................................................. 144 

Senator Schumer ....................................................................................... 148 

Kurt Eggert, Professor of Law, Chapman University School of Law .................. 17 

Prepared statement .......................................................................................... 90 

Christopher L. Peterson, Associate Professor of Law, University of Florida ...... 19 

Prepared statement .......................................................................................... 118 


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SUBPRIME MORTGAGE MARKET TURMOIL: 

EXAMINING THE ROLE OF SECURITIZATION 

TUESDAY, APRIL 17, 2007 

U.S. SENATE, SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The subcommittee met at 3 p.m., in room SD–538, Dirksen Senate Office Building, Senator Jack Reed (Chairman of the Subcommittee) presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. I call the hearing of the Subcommittee to order, 

and I want to thank Senator Allard, the Ranking Member, for joining me. I want to thank our witnesses for being here today. Senator Menendez has joined us, too. 

Our hearing this afternoon builds on the record begun last fall 

by Senators Allard and Bunning when the Subcommittee on Housing and Transportation and the Subcommittee on Economic Policy 

first began to look to these issues. 

In recent months, there has been a dramatic increase in home 

loan delinquencies and foreclosures, the closure or sale of over 40 

subprime lenders, and an increase in buybacks of delinquent loans. 

While the subprime market has experienced most of the turbulence, there are now signs of weakness in the Alt-A market. 

This is a complicated issue. Chairman Dodd and Senator Shelby 

have held a number of hearings where we have heard from brokers, originators, regulators, and borrowers regarding the causes 

and consequences of the current mortgage market turmoil. However, we are here today to look at the financial engine which helps 

drive this market: the securitization process. 

Clearly, there are many benefits from securitization. 

Securitization creates liquidity, enables lenders to originate a 

greater volume of loans by drawing on a wide source of available 

capital, spreads risk, and allows investors to select their risk level 

of pattern of returns. When securitization works well, it bridges the 

gap between borrowers and investors and makes homeownership 

more affordable. 

However, what happens when it does not work as well as it 

should? Does the complex structure of mortgage-backed securities 

and the servicer’s duty to act on behalf of different investors limit 

the servicer’s ability to provide loan workout options for the borrower? Also, is it possible that securitization can create perverse inVerDate Nov 24 2008 05:10 Dec 12, 2009 Jkt 050315 PO 00000 Frm 00005 Fmt 6633 Sfmt 6602 E:\HR\OC\A315.XXX A315

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centives, such as an erosion of underwriting standards or the development of exotic loan products that do more harm than good? 

Lewis Ranieri, the pioneer of mortgage-backed securities, recently stated that he believes standards are largely set by the risk 

appetites of thousands of hedge fund, pension fund, and other 

money managers around the world. Emboldened by good return on 

mortgage investments, they have encouraged lenders to experiment 

with a profusion of loans. As many credit-stressed borrowers still 

face resets on some of these experimental loan products, the Center 

for Responsible Lending has estimated that one in five subprime 

loans originated during the prior 2 years will end in foreclosure, 

costing homeowners $164 billion, mostly in lost equity. 

Last, there is some cause for concern on the investor front. 

Again, Lewis Ranieri stated last year, ‘‘When you start divorcing 

the creator of the risk from the ultimate holder of the risk, it becomes an issue of, Does the ultimate holder truly understand the 

nature of the risk that you have redistributed? By cutting it up in 

so many ways and complicating it by so many levels, do you still 

have clarity on the nature of the underlying risk? It is not clear 

that we have not gone in some ways too far, that we have not gone 

beyond the ability to have true transparency. That is a fair question that many of us in the business and people in the regulatory 

regime are wrestling with.’’ 

A related issue on this front is the steadily increased loss expectations for pools of subprime loans. According to a recent Moody’s 

report, loss expectations have risen by about 30 percent over the 

last 3 years. Loss expectations ranged from an average of 4 to 4.5 

percent in 2003 to an average of 5.5 to 6 percent today. 

I am also concerned about possible downgrades of these securities that could affect pension plans and other large institutional investors and whether there could be a systemic effect down the 

road. As such, the purpose of our hearing this afternoon is twofold: 

First, we want to examine how subprime mortgages are 

securitized, how credit risk for mortgage-backed securities is determined and monitored, and what effect the recent increase in defaults and foreclosures has had on the subprime securitization market. 

Second, we want to learn what role, if any, the securitization 

process has played in the current subprime market turmoil and 

what issues Wall Street and Congress should consider as we move 

forward. 

We will hear from one panel of witnesses, but before I introduce 

them, I want to recognize Senator Allard and other Members of the 

Committee who are with us today for their statements. Senator Allard. 

STATEMENT OF SENATOR WAYNE ALLARD 

Senator ALLARD. First, I would like to congratulate my friend 

from Rhode Island on his first hearing as Chairman of the Subcommittee on Securities, Insurance, and Investment. 

Over the years, I have had the privilege of working with Senator 

Reed in a number of different capacities, always valued our partnership and our ability to work together. We worked together on 

the Strategic Subcommittee on Armed Services at the time I was 


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Chairman, and then over here on Housing and Transportation we 

worked together, and now I have an opportunity to continue to 

work with him on Securities. And I am looking forward to continuing our working relationship. He has always had a thoughtful 

approach, and I have enjoyed working with him in that regard. 

Today we are here, well aware of the difficulties in the mortgage 

markets. The effects have been dramatic and widespread. Individual families, neighborhoods, and entire communities suffer when 

foreclosure rates rise. That is the unfortunate reality for far too 

many. 

Last year, Senator Reed and I had an opportunity to examine the 

matter from several different angles, including examining the role 

of nontraditional mortgage products. Under the leadership of Senator Dodd and Senator Shelby, the full Committee has also provided opportunities to delve into the mortgage markets. 

Lately, we have even seen the uncertainties in the mortgage 

markets spill over into the broader financial markets, and this is 

concerning and certainly worthy, I think, of careful review. Yet in 

taking account of the mortgage and financial markets, there is still 

one significant component that we have not yet examined, and that 

is the secondary market. 

As we transition from the Housing Subcommittee to the Securities Subcommittee, Chairman Reed has chosen an especially appropriate topic: the role of securitization in the subprime mortgage 

market. Today’s hearing will allow us to build on our previous 

record in a new area of jurisdiction. I will be interested in hearing 

about how securitization has expanded homeownership opportunities, but also the accompanying policy concerns. As noted by FDIC 

Chairman Sheila Blair, there is no doubt that securitization has 

had an impact on looser underwriting standards as we have seen 

by lenders. I will be interested in hearing about the other ways in 

which the dispersion of risk has affected the subprime mortgage 

markets. 

Once again I would like to thank Chairman Reed for convening 

this important hearing. We have an excellent line-up of witnesses, 

and I am confident that they will help us understand the role of 

securitization in the subprime mortgage markets, which will give 

us a much fuller and richer understanding of the markets. I look 

forward to your testimony. 

Chairman REED. Thank you very much, Senator Allard. 

Senator Menendez, do you have an opening remark? 

STATEMENT OF SENATOR ROBERT MENENDEZ 

Senator MENENDEZ. Thank you, Mr. Chairman. I, too, want to 

commend you on having this as your first hearing on an incredibly 

important issue, and also I appreciate Senator Allard and his work. 

As we proceed with the hearing, I think it is important to remember what this is ultimately all about, and that is, the American dream of owning a home. In the last full Banking Committee 

hearing, we heard from individuals who became victims to deceptive predatory lenders, and I told of a story, one of many in my own 

State in New Jersey, of a woman who could not make the payments on her home after the teaser rate expired, and she is still 

facing foreclosure action today. 


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It seems to me that in the face of the tsunami of foreclosures we 

are facing, we must not lose sight of our objective and work toward 

a solution that protects the homeowners. I do not think anyone can 

argue against the notion that we are in an increasing subprime crisis. Over 40 subprime lenders have halted operations or filed for 

bankruptcy. We now have the highest delinquency rate in 4 years. 

As many as one in five recent subprime mortgages will end in foreclosure, and 2.2 million subprime borrowers have had their homes 

foreclosed or are facing foreclosure. That to me is simply unacceptable. 

So as we move forward today on one of the different dimensions 

of this issue, Mr. Chairman, I hope we remember this is not just 

numbers. They are a single mother struggling to make ends meet, 

an elderly couple facing the depletion of their life savings, or a minority family crushed with the reality that they may lose their first 

home. It is a financial nightmare for families across America, and 

I fear it is only going to get worse. 

Last, I think it is time for all parties to take responsibility, to 

change behavior in order to prevent particularly in the context of 

predatory loans. In the Banking hearing last month, after some of 

my questions, regulators were forced to stand up and say that they 

did too little too late. And today I hope we will hear from those who 

are involved in the overall chain of this process to take some responsibility for their part in how we move forward and how we can 

improve the securitization process. As long as it appears that there 

is an overzealous secondary market for these loans, they will continue to flourish without checks and balances. And so we certainly 

want to see the secondary market continue to exist, but we also, 

I believe, need to make sure that there are some appropriate 

checks and balances at the end of the day in order to ensure that 

we do not have the animal instincts of the marketplace take over, 

as it seems to have today. 

So I look forward to the testimony and to working with you, Mr. 

Chairman. 

Chairman REED. Thank you, Senator Menendez. 

Senator Crapo, do you have a statement? 

OPENING STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Yes, just very briefly, Mr. Chairman. I also applaud you for holding this hearing. I think it incumbent on all of 

us to understand much better the role of securitization in the mortgage market, not just the subprime market. But as this moves forward, we are going to be facing the question of whether there 

should be a regulatory governmental response and, if so, whether 

that response should come from the agencies who now have authority, or whether it requires further legislative authorization in terms 

of statutory changes, or whether the market discipline that is already being seen is adequate. 

I agree with Senator Menendez. The ultimate question here is 

about protecting homeowners and making sure that that part of 

the American dream which is homeownership is something that we 

assure is available to the maximum number of people in America 

who want to have that part of their dream. There are two sides to 

that. 


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We are now seeing the very harmful side of the collapse or the 

crisis that we are seeing in the subprime market, and the stories 

that we are seeing about the impact that has on people. 

The other side of it is that there are lot of people who will not 

be able to get a home if there is not adequate credit available to 

them. And it is that balance that we have to strike. 

I am going to be very interested, as we go through this hearing 

and other hearings, to get answers to the basic question of what 

type of market discipline needs to be in place, what type is in 

place, what is happening today, why didn’t it happen in a better 

way, why did we face this crisis, what was not in place that should 

have been, and is that going to lead us to require more regulatory 

oversight or more statutory authorities for such oversight. 

I would note that if you look at the market itself right now and 

the adjustments that are occurring, we have noticed that stock 

prices of major subprime specialists have already plummeted. 

Firms which could not support their representations and warrants 

for loans that were sold into the secondary market when asked to 

buy back poorly unwritten loans are closing their doors as equity 

is exhausted. Credit spreads on lower-rated tranches of subprime 

securities have widened appreciably as investors already demand 

greater returns on these investments. Various segments of the 

subprime market have already raised credit standards on their 

own. Federal regulators in March have issued for comment a proposed statement on subprime mortgage lending. 

So things are happening in the market itself and among the regulators and here in Congress as we are evaluating in hearings such 

as this. 

But, again, Mr. Chairman, and to the witnesses and others, I 

really think our focus needs to be on finding that balance. You 

know, the proverbial pendulum needs to be adjusted, probably. The 

question is: Will we adjust it too far and stop people who should 

have some sort of credit from being able to get that credit and 

being able to get a hand on that rung and start down the process 

of homeownership? Or will we not move it far enough and leave 

people exposed to credit practices that will deny them that dream 

and cause them economic and financial hardship that will deprive 

them of the dream longer than it should have happened? 

So it is that balance that I hope that we are able to strike here 

as we proceed, Mr. Chairman. Thank you. 

Chairman REED. Thank you very much, Senator Crapo. 

Senator Casey, do you have opening remarks? 

OPENING STATEMENT OF SENATOR ROBERT P. CASEY 

Senator CASEY. Just very briefly. Thank you, Mr. Chairman, for 

calling this hearing and for the witnesses who will testify and everyone else who is here. I will, with your permission, submit a 

written statement for the record, but just by way of reiteration of 

what we have heard, this is a complex and technical area. But like 

a lot of things that happen in this town, it gets back to real people 

and real families and their lives. And one thing that we are going 

to be listening carefully to are the areas of testimony and the areas 

of questioning which involve incentives. What kinds of incentives 

do brokers have and firms have that create problems for real peoVerDate Nov 24 2008 05:10 Dec 12, 2009 Jkt 050315 PO 00000 Frm 00009 Fmt 6633 Sfmt 6602 E:\HR\OC\A315.XXX A315

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ple and real families who have real-live budgets? And sometimes 

they are left out in the cold on their own because of the way some 

of these deals go down. 

So I am going to be listening carefully to that, but I do want to 

commend the Chairman for calling this hearing, and we want to 

get to the statements. 

Thank you very much. 

Chairman REED. Thank you. 

Senator Schumer. 

STATEMENT OF SENATOR CHARLES E. SCHUMER 

Senator SCHUMER. Thank you, Mr. Chairman, and I appreciate 

the opportunity to be here. I have a whole bunch of questions, but 

I have to be gone by 4, so I do not think we will get up to them. 

So I want to maybe ask a few of them in my opening statement 

and ask the witnesses to submit them in writing eventually, if that 

is OK. 

But, first, let me just say I agree with my colleague from Idaho 

that we have to set a balance here, but I think we have to be cognizant of a few things as we do. 

First, an amazing statistic which has not gotten enough attention. You know, you read some of particularly the more conservative publications, and they say, well, listen, this is great because 

all this subprime lending is allowing people to buy homes for the 

first time. 

Well, that has some degree of truth, but only some. Eleven percent of the subprime mortgages issued were to first-time homebuyers. That is all—11 percent. The remainder were to two groups: 

one, people who had bought one home and were moving to another; 

but a large number are people refinancing. And at least in my experience—and this is mainly based on just people I have talked to 

in the field. There is no statistical basis that I have. A lot of the 

people who refinanced their homes were called up on the phone, 

they said, ‘‘Hey, do you want $50,000? I will do it for you.’’ And 

their home is refinanced. 

I bring up the case of a fellow I met from Ozone Park named 

Frank Ruggiero. He had a $350,000 mortgage. He has diabetes. He 

needed extra money. Some guy called him on the phone regularly 

and said, ‘‘I can get you $50,000, and the mortgage will be $1,500,’’ 

which Ruggiero knew he could pay. He lived in Ozone Park. Of the 

$50,000 increase in the mortgage, he got $5,700. The mortgage 

broker got about $20,000 because they liked the spread on the loan 

between his old loan and his new loan. And the others picked up 

the rest. Worse, his interest rate went from $1,500 to $3,800 in a 

short time, and he is about to lose his home, and he did not get 

the help he needed to pay for his diabetes condition. 

Well, something is wrong when that happens, and to just say, 

well, we are creating new markets for people, yes, we said that in 

the 1890’s and maybe the 1920’s, but not in the 21st century. So 

we have got to figure out what to do. 

Just a couple of other quick points. The market itself has pretty 

severe discipline. Any company that has gotten involved in buying 

a lot of these loans, they are paying a price now—lots of them. And 


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that discipline, sometimes even the pendulum swings a little too 

far. But that is how markets work. 

The people who are left holding the bag are the Mr. Ruggieros, 

and then people who initially sold them the mortgages are gone. 

You know, the guy who sold Frank Ruggiero his mortgage got 

$20,000, and he is off into the sunset, and there is virtually no regulation over people like that. And we ought to have it, and I intend 

to fight for it. That is very, very important, particularly if the mortgage broker did not come from a bank. That is not to condemn all 

mortgage brokers. Some do a very fine and necessary job in society. 

And the questions that I have relate to how we help the future 

Mr. Ruggieros. We all know in 2007, 2008, and maybe 2009, there 

are going to be more of these loans because the most extreme of 

the liar loans, of the ARMs that just jumped, were issued in 2005, 

2006. So the chickens will come home to roost a year, 2 years, 3 

years later, when the rate goes way up. 

What can we do to assist them? I have called for aiding some 

nonprofits, for the Federal Government to actually shell out some 

money to the nonprofits who help people refinance the loans. We 

have found that a foreclosure can on average cost stakeholders up 

to $80,000. Foreclosure prevention may only cost $3,300. 

And my questions are: If we give money to these nonprofits and 

others, they could be—but they are people whose job is to help the 

next Mr. Ruggiero refinance. My questions that I would ask the 

holders, particularly Mr. Sinha and Mr. Sherr, is: How much leverage do these nonprofits have in getting some of the existing stakeholders to get back in the game when it is in their interest to do 

so? What percentage of the securitized subprimes have clauses that 

prohibit or significantly limit loan modifications? I would ask the 

panel again, in writing, to discuss those. Is there anything the 

holder of the loan can do to ease the servicer’s ability to prevent 

foreclosures by modifying the loans? And since it would be in both 

the servicer’s and loan holder’s best economic interest to prevent 

foreclosure, shouldn’t loan servicers put a time-out on foreclosures 

until they can work out loan modifications consistent with what the 

loan holders need? 

So those are some of the questions that I would like to ask, practical questions. I would ask that you folks all submit something to 

the Committee in writing so we can take a look, but these are 

aimed at preventing large numbers of foreclosures. 

One final fact, Mr. Chairman. Sorry to go on a little bit here. 

This is not just going to affect the people who have the loans, the 

mortgagor side or mortgagee side, no matter how far up the chain. 

It is estimated that for every foreclosure within one-eighth of a 

mile of your home the property falls by 0.9 percent. That is an average, obviously. But in some neighborhoods, some communities, 

our Joint Economic Committee issued statistics that one out of 

every 21 homes in Detroit had foreclosure; one in 23 in Atlanta. It 

is going to hurt property values significantly. 

So having a diminution of future foreclosures, which will get 

worse if we do nothing, makes sense for everybody. And I would 

ask all of your help in figuring out how we do that. 

Thank you, Mr. Chairman. 


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Chairman REED. Thank you very much, Senator Schumer. And 

if your staff prepares those questions, we will forward them to the 

witnesses. 

Senator SCHUMER. Thank you. 

Chairman REED. Thank you very much. 

We are very fortunate to have a knowledgeable and very accomplished panel. Let me introduce them, and then I will recognize Mr. 

Sinha to make his presentation. 

We are joined by Gyan Sinha. He is the Senior Managing Director and Head of the Asset-Backed Research Group at Bear Stearns. 

He has been consistently one of the top-ranked analysts in Institutional Investors All-American Fixed Income Research Survey for 

his work in asset-backed securities, notably in prepayments, ARMs, 

and CDOs. Prior to joining Bear Stearns, he was a Vice President 

at CS First Boston in the mortgage research area, an assistant professor in the Faculty of Commerce at the University of British Columbia from 1991 to 1993. 

Next to Mr. Sinha is Mr. David Sherr. Mr. Sherr is currently 

serving as a Managing Director and Head of the Global 

Securitization Products business at Lehman Brothers. Mr. Sherr 

first joined Lehman Brothers in 1986 and has previously served as 

head of mortgage trading. Additionally, he is a member of the 

Fixed Income Division Operating Committee. 

Next to Mr. Sherr is Ms. Susan Barnes. Ms. Barnes is the Managing Director and Practice Leader of the U.S. Residential Mortgage Group, with responsibility for managing all Standard & Poor’s 

U.S. RMBS activities, products, and analysis. Previously, as the 

senior analytical manager of the Residential Mortgage Group, Ms. 

Barnes was responsible for the development and implementation of 

criteria for all residential mortgage products. Prior to joining 

Standard & Poor’s in 1993 from Citicorp Securities Markets, she 

worked with primary mortgage companies as well as secondary 

market participants. 

Next to Ms. Barnes is Mr. Warren Kornfeld. Mr. Kornfeld coheads Moody’s Residential Mortgage-Backed Securities Group, 

which is responsible for rating residential mortgage securitizations, 

including subprime, jumbo, Alt-A, HELOC, FHA, VA, and closed 

and seconds. In addition, Mr. Kornfeld is in charge of Moody’s 

RMBS and ABS Service Ratings Group. Mr. Kornfeld has more 

than 20 years of experience in the securitization market. Prior to 

joining Moody’s in 2001, Mr. Kornfeld headed up the Securitization 

Group at William Blair and Company. Before joining William Blair, 

Mr. Kornfeld was previously with the Industrial Bank of Japan, 

Bickford & Partners, Inc., and Trepp & Company. 

Next to Mr. Kornfeld is Mr. Kurt Eggert. Mr. Eggert is a professor of law and Director of Clinical Legal Education at Chapman 

University Law School. He has written extensively on 

securitization and predatory lending issues, and previously testified 

before Congress on predatory lending issues. Professor Eggert is a 

member of the Federal Reserve Board’s Consumer Advisory Council, where he chairs the Subcommittee on Consumer Credit. From 

1990 until 1999, he was a senior attorney at Bet Tzedek Legal 

Services in Los Angeles, where he specialized in complex litigation 

including consumer fraud and home equity fraud. 


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Finally, Mr. Chris Peterson is an assistant professor of law at 

the University of Florida, Levin College of Law, where he teaches 

commercial and consumer law courses. Professor Peterson served 

as the judicial clerk for the United States Court of Appeals for the 

Tenth Circuit. He has also served as a consumer attorney responsible for consumer finance issues on behalf of the United States 

Public Interest Research Group. His book on the economics, history, and law governing high-cost consumer debt received the 

American College of Consumer Financial Services Attorneys’ Outstanding Book of the Year prize for 2004. 

We look forward to all of your testimony, ladies and gentlemen. 

Let me just say that all your statements will be in the record. Try 

to hold to 5 minutes. You can assume everything that you have 

written will be read by all of us—at least by all the staff—and that 

we will eagerly await your improvised comments and your insights 

into this very difficult problem. I must commend my colleagues for 

very thoughtful opening statements. 

Mr. Sinha. 

STATEMENT OF GYAN SINHA, SENIOR MANAGING DIRECTOR 

AND HEAD OF ABS AND CDO RESEARCH, BEAR STEARNS & 

COMPANY, INC. 

Mr. SINHA. Good afternoon, Chairman Reed, Ranking Member 

Allard, and members of the Senate Subcommittee on Securities, Insurance, and Investment. My name is Gyan Sinha. I am a Senior 

Managing Director at Bear Stearns and head the division responsible for market research regarding asset-backed securities and 

collateralized debt obligations. In that capacity, I analyze mortgage 

loans and securities in the private-label market. The nonprime sector constitutes a portion of the private-label market. 

I have been invited today to present testimony regarding four 

matters related to the mortgage securitization process and recent 

developments in the marketplace. I will address each of these 

issues in turn, beginning with an overview of the mechanics of 

nonprime mortgage securitization. 

Nonprime borrowers maintain loans through mortgage brokers or 

retail lending establishments. Once a suitably large number of 

loans have been originated, the loans are often packaged as a portfolio and moved into securitization vehicles owned by a third party. 

The securitization vehicle then issues mortgage-backed securities, 

often referred to as ‘‘MBS.’’ The MBS generate revenues which finance the purchase of loans by the securitization vehicle. 

The decision to buy loans from originating lenders for purposes 

of securitization is based on a determination of whether the lossadjusted yield that can be generated from the purchase of the 

asset, after paying for financing expenses in the MBS market, is 

commensurate with the risk of the loans. If the securitization sponsor elects to move forward with a purchase after making this determination, it will also conduct due diligence before acquiring the assets. The cashflows from the loans are then divided among debt 

classes. These debt classes are divided into senior, mezzanine, and 

subordinate, with ratings ranging from AAA to BB. Typically, any 

losses in the maligned loans are allocated to the lowest-rated bonds 


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initially and then moved up the rating scale as the face amount of 

each class is eroded due to higher and higher losses. 

The amount of MBS that can be issued is determined based on 

criteria established by the rating agencies. Typically, the amount 

of MBS that are issued is less than the par amount of the mortgage 

loans. This difference is referred to as overcollateralization. The 

claim of equity holders in the securitization is comprised of two 

components: the overcollateralization amount and the difference between the coupon net of servicing expenses and the weighted average cost of debt. The equity holder’s cash-flow entitlement is net of 

any current period losses. 

MBS are purchased by a wide variety of investors. For senior 

debt borrowers, MBS have provided a preferred alternative to other 

credit-risky instruments, such as corporate bonds. As a result, institutions with low funding costs, such as banks, view them with 

favor and have purchased many of them. In recent years, the 

lower-rated tranches have been bought primarily by collateralized 

debt obligations. CDOs in turn issue debt to finance the purchase 

of these bonds. There has been significant foreign investment in 

CDOs that further spreads market risk. 

Finally, at the lower end of the capital structure, hedge funds to 

purchase the speculative grade and unrated equity portion of the 

MBS. In making purchase determinations, hedge funds tend to employ the same risk-adjusted calculus as used by the original buyer 

of the loans. 

You have also asked about the effect of increases in defaults and 

delinquencies. Without doubt, the rise in defaults and delinquencies has had a significant impact recently in the nonprime 

securitization market. At this juncture we are witnessing a significant correction in the MBS market of nonprime loans. A number 

of originators have exited the industry. The risk profile of the loans 

being considered in the nonprime market today has generally improved as loan originators have moved to change loan-to-value limits, requiring multiple appraisals on collateral and enhanced 

verification of borrower income. Valuations appear to have stabilized at this juncture, albeit at lower levels, since the beginning 

of the year. 

For those that remain in the market, significant challenges will 

persist. Managing the credit risk of a nonprime portfolio in an environment of stagnant or even declining real estate prices will require a different strategy than that used in the last 5 years. From 

an economic value perspective, it is in the interest of all parties in 

a securitization vehicle that the value of the maligned loans in the 

securitization is maximized. Accordingly, services will have strong 

incentives to offer loss mitigation options to borrowers that have a 

reasonable chance of succeeding. This is particularly true given 

that the alternative will be to foreclose upon and ultimately attempt to sell the property in an unfavorable housing market. 

The Subcommittee has asked me to discuss impediments in the 

securitization process that would make it more difficult to mitigate 

potential foreclosures. Loan modifications present one of the most 

viable vehicles for mitigating foreclosures under appropriate circumstances. However, it is important to note that there is considerable variation based on tax law and contractual requirements 


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across transactions with respect to the scope of permissible modifications. 

Despite these various limitations, services are indicating various 

loss mitigation steps within the flexibility that they have under existing securitization agreements. 

I think my time is up. 

Chairman REED. If you have a minute more, you may finish. 

Mr. SINHA. OK. Thank you. 

The Subcommittee has also asked, finally, about credit risk assessment. I think there are two members on the panel that are better equipped from the rating agencies to deal with that. I will skip 

that in the interest of time. 

In closing, I would like to emphasize that while the issues surrounding the recent events in the nonprime market warrant serious attention, the securitization process that has occurred for over 

25 years has resulted in considerable benefits to borrowers in the 

broader economy. This market has allowed American homebuyers 

to tap into a rising global pool of savings through increased credit 

availability, raising overall homeownership rates in the United 

States. At the same time, securitization has also allowed this increase in mortgage lending to be achieved without an excessive 

concentration of risk. This has permitted any shocks to the system, 

such as the current one, to be absorbed without major disruption 

to the broader economy. Thus, it is important in evaluating any potential responses to the current concerns to ensure that the availability of mortgage credit is not unduly restricted and the historic 

benefits provided by the securitization process are not eroded. 

I would be happy to answer any questions that you may have. 

Thank you. 

Chairman REED. Thank you very much, Mr. Sinha. 

Mr. Sherr, and if you could bring that microphone up close so everyone can hear. 

STATEMENT OF DAVID SHERR, MANAGING DIRECTOR AND 

GLOBAL HEAD OF SECURITIZED PRODUCTS, LEHMAN 

BROTHERS, INC. 

Mr. SHERR. Chairman Reed, Ranking Member Allard, and Members of the Subcommittee. I am David Sherr, Managing Director 

and Global Head of Securitized Products at Lehman Brothers. I appreciate the opportunity to appear before the Subcommittee today 

on behalf of Lehman Brothers. Lehman, an innovator in global finance, serves the financial needs of corporations, governments, and 

municipalities, institutional clients, and high-net-worth individuals 

worldwide. Lehman is pleased to share with the Subcommittee its 

experience in the subprime mortgage securitization process. 

The subprime mortgage securitization market is a subset of the 

broader mortgage securitization market. Mortgage securitization 

was developed approximately 30 years ago. Since then, the mortgage-backed securities market has grown to become the largest 

fixed-income segment of the Nation’s capital markets, with approximately $6.5 trillion of securitized mortgage debt outstanding as of 

the end of 2006. 

While the Subcommittee is focused on very recent instances of 

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backed securities have provided and continue to provide great benefits to the average American. Because of mortgage securitization, 

loans for home purchases have become more widely available for all 

borrowers, including those considered subprime. If not for the innovation of the mortgage securitization, the United States would not 

have become the Nation of homeowners that it is today, with homeownership close to its highest level in our history, almost 70 percent. 

Before securitization became widespread, banks had relatively 

limited capital available to make loans to prospective homeowners. 

Their lending activities were constrained because they had no effective means to convert their existing loan portfolios to cash that 

could be used to make additional loans. There was no liquid market for mortgage loans. 

With the advent of securitization, banks and other financial institutions have been able to monetize their existing loan portfolios 

and to transfer the risks associated with those loans to sophisticated investors. As a result, more money is available to borrowers 

who wish to buy their own homes or to refinance their existing 

mortgage loans on more attractive terms. 

Securitization represents a new way to fund America’s demand 

for home mortgages by accessing the significant liquidity of the 

capital markets. Borrowers continue to take out loans with local 

banks and State-regulated mortgage companies, just as they always have. Those lenders determine if they want to retain mortgage loans or transfer them into the secondary market, either in 

whole loan form or through securitization. If a lender elects 

securitization, the loans are assembled into pools by sponsors, such 

as Lehman. 

The lenders continue to stand behind their decision to make a 

loan by making representations about the loan quality. After the 

rating agencies have completed their review of the pool, the loans 

are conveyed into a securitization trust and interests in the loans 

are sold to investors in the form of securities. From then on, payments made by borrowers on their mortgage loans flow through to 

make payments on these securities. 

It should be noted that sponsors of mortgage-backed 

securitizations such as Lehman are careful about choosing the 

lenders with whom they do business. All the lenders selling loans 

to Lehman are either federally chartered banks or State-regulated 

originators. Prior to establishing a business relationship with a 

particular lender, Lehman spends time learning about that lender, 

its past conduct and its lending practices and standards. Further, 

Lehman, like other securitization sponsors, performs a quality 

check on the mortgage loans before purchase them. These reviews 

include sample testing to confirm that loans were underwritten in 

accordance with designated guidelines and complied with applicable law. 

The Subcommittee has asked about the incentives of the participants in the subprime mortgage securitization process. Consumers 

benefit because they are able to obtain loans with a greater variety 

of payment structures. This is especially true for borrowers considered to be subprime, many of whom who did not have access to 

mortgage loans and so could not purchase their own homes prior 


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to the creation of the securitization market. Lenders benefit because they are able to free up capital to make additional loans, and 

investors benefit because mortgage-backed securities present a diverse range of investment options, with investors able to choose the 

type of product and the risk-reward profile appropriate for their 

needs. 

It cannot be emphasized enough that no participant in the 

securitization process has any incentive to encourage the origination of loans that are expected to become delinquent. No financial 

institutions would knowingly want to make or securitize a loan 

that it expected would go into default; rather, the success of mortgage-backed securities as an investment vehicle depends upon the 

expectation that homeowners generally will make their monthly 

payments since those payments form the basis for the cashflow to 

bondholders. 

As it relates to the impact of recent increasing defaults on the 

market, the market currently is adapting to changes in the performance of subprime loans, just as it adapts to other changes that 

significantly affect participants in the mortgage securitization process. Importantly, the interest of all market participants, from the 

borrower to the investor, are generally aligned with regard to reducing the number of defaults and delinquency. Everybody loses 

when the only viable option for managing loans is foreclosure. 

Given the general alignment of interest, it is not surprising that 

the market is adjusting rapidly to minimize foreclosures and improve the performance of securitized loans. 

For example, mortgage loans to subprime borrowers are now 

being underwritten according to stricter guidelines to reflect current market conditions. At the same time, the volume of 

securitizations has been reduced, as has the range of mortgage 

products being offered to consumers. Further, financial intermediaries are pushing forward new practices, including contacting 

borrowers early when their loans appear to be at risk for default. 

All these adjustments in the market are being driven by the fact 

that nobody benefits from the underwriting of loans that do not ultimately perform. We must be careful, however, not to overreact to 

the increased number of delinquencies and defaults which could 

lead to an undue tightening of credit availability to prospective 

homeowners. 

At the same time that we consider how the market has changed, 

we should also keep in mind how it has stayed the same. The vast 

majority of subprime borrowers remain current in their loan obligations, and the mortgage securitization process continues to provide 

unprecedented access to the capital markets so that others can purchase their own homes. 

So how do we mitigate potential foreclosures? Mortgage 

securitization structures do provide flexibility to avoid foreclosure. 

Much of that flexibility rests in the hands of the financial institutions that service mortgage pools. Servicers collect principal and interest payments from borrowers and also make decisions on the administration of the pooled home loans. They have flexibility to work 

with borrowers so that loan payments will be made while exercising the right to foreclosure only as a last resort. 


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Notably, many of the largest servicers are commercial banks, 

which also hold substantial mortgage loans in their own portfolios. 

Regardless of whether these banks are managing their own portfolios or servicing loans in a securitized pool, we expect they generally will follow the same prudent home retention practices in an 

effort to avoid foreclosure. 

The title of this hearing speaks to the role of securitization in the 

subprime mortgage market turmoil. Because none of the participants in the securitization process benefits from foreclosure, the 

market has evolved and will continue to evolve so as to minimize 

the number of foreclosures. Servicers are ramping up their home 

retention teams, both with respect to early intervention for at-risk 

borrowers and loan modification programs for borrowers that are in 

financial distress. To the extent that the servicer currently lacks 

any necessary powers to reduce the number of foreclosures in a 

prudent manner—and Lehman does not believe that such powers 

are materially lacking—the market will adjust by enhancing the 

servicer’s flexibility in future contracts. In short, we expect that the 

subprime mortgage securitization process will continue to create 

opportunities for a long-ignored segment of the population to join 

and remain in the ranks of American homeowners. 

Thank you again for the opportunity to be here today, and I also 

welcome any questions you might have. 

Chairman REED. Thank you. 

Ms. Barnes, and if you could bring the microphone close to you. 

STATEMENT OF SUSAN BARNES, MANAGING DIRECTOR, 

STANDARD & POOR’S RATINGS SERVICES 

Ms. BARNES. Thank you, Mr. Chairman, Members of the Subcommittee. Good afternoon. I am Susan Barnes, Managing Director 

of the U.S. Residential Mortgage-Backed Securities Group for 

Standard & Poor’s. S&P recognizes the hardship the current 

subprime situation is placing on certain homeowners. However, as 

requested by this Subcommittee, my testimony is focused on the effects the subprime market has had on the financial sector. 

Today I will discuss our ratings analysis for these transactions, 

including the factors we consider when evaluating mortgage securities backed by subprime mortgage loans and the impact the current 

mortgage loan delinquencies and defaults on the performance of 

RMBS transactions based by subprime mortgage loans. As described more fully in my written testimony, S&P’s rating process 

for these transactions includes a loan-level collateral analysis, a review of the cash-flow within the transaction, a review of the originator and servicer operational procedures, and a review of the 

transactional documents for legal and structural provisions. 

First, S&P performs a loan-level collateral analysis on these 

transactions. Specifically, we evaluate the loan characteristics, 

quantify multiple risk factors, and assess the default probability 

associated with each factor. This helps us determine how much 

credit enhancement is, the amount of additional assets or funds 

needed to support the rated bonds and cover losses. 

In 2006, using this analysis we identified the deteriorating credit 

quality of the mortgage loans and consequently increased the credit 

enhancement requirements necessary to maintain a given rating on 


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a mortgage-backed security. Next, we assessed the cash flow availability generated by mortgage loans through a proprietary model 

which assumed certain stresses related to the timing of payments 

and prepayments on the mortgage loans and uses the S&P mortgage default and loss assumptions to simulate the cash-flow of an 

RMBS transaction’s underlying loans under these stresses. 

We then evaluate the availability and impact of various credit 

enhancement mechanisms on the transaction. We also perform a 

review of the practices and policies of the originators and servicers 

to gain comfort with the ongoing performance of the transaction. 

Included within this review is an evaluation of the monthly 

servicer report. 

Additionally, we review legal documents and opinions of thirdparty counsel to assess whether the transaction will pay interest as 

promised and whether the bondholders will receive the promised 

principal payments before the stated maturity of the bonds. 

Now to the current market. The poor performance of subprime 

mortgages originated in 2006 dampened investor appetite for such 

mortgages, causing the interest rate sought by investors to increase 

as compared to mortgage-backed bonds issued in prior years. 

Therefore, the securitization of subprime loans has become less economical, resulting in fewer subprime mortgage loan originations in 

2007. 

While delinquencies for the 2006 vintage are much higher than 

what the market has experienced in recent years, they are not 

atypical with past long-term performance of the RMBS market, 

such as the delinquencies reported for the 2000 vintage after similar seasoning. 

Regardless, subprime loans and transactions rated in 2006 have 

been performing worse than previous recent vintages. This performance may be attributed to a variety of factors, such as lenders’ 

underwriting guidelines that stretch too far, this falling of home 

price appreciation rates, and ARM loans that in rising interest rate 

environments create a heightened risk of delinquencies. 

Due to minor home price declines in 2007, we expect losses and 

negative rating actions to keep increasing in the near term relative 

to previous years. However, as long as interest rates and unemployment remain at historical lows and income growth continues to 

be positive, we believe there is sufficient protection for the majority 

of investment grade bonds. As of April 12, 2007, only 0.3 percent 

of the outstanding subprime ratings issued in 2006 have been 

downgraded or placed on Creditwatch. 

S&P views loss mitigation efforts, such as forbearance and loan 

restructuring, as an important part of servicing securitized mortgage loans. Generally, servicers have the ability to mitigate losses 

by a variety of techniques so long as they act in the best interest 

of investors and in accordance with the standard servicing industry 

practices. So long as these standards are met, S&P believes that 

the current ratings on the RMBS securities will not be negatively 

affected. 

We do need to be sensitive, however, to the balance between the 

negative effect of the potential reductions in prepayments received 

from borrowers and available to pay investors, with the positive 

impact of fewer borrower defaults. 


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Let me conclude by stating S&P does not anticipate pervasive 

negative rating actions on financial institutions due to rising credit 

stresses in the subprime mortgage sector since the majority of 

rated financial institutions have diversified assets and mortgage 

lending and servicing operations aligned with strong interest rate 

and credit risk management oversight. Specialty finance companies 

that focus solely on the subprime market, however, do not enjoy 

the same protection and have felt the effects of the current 

subprime credit stresses. 

We thank you again for the opportunity to participate in these 

hearings and are happy to answer any questions you may have. 

Chairman REED. Thank you, Ms. Barnes. 

Mr. Kornfeld. 

STATEMENT OF WARREN KORNFELD, MANAGING DIRECTOR, 

RESIDENTIAL MORTGAGE-BACKED SECURITIES RATING 

GROUP, MOODY’S INVESTORS SERVICE 

Mr. KORNFELD. Thank you. Good afternoon, Chairman Reed and 

Members of the Subcommittee. I appreciate the opportunity to be 

here on behalf of my colleagues at Moody’s Investors Service. 

By way of background, Moody’s publishes rating opinions that 

speak only to one aspect of the subprime securitization market, 

which is the credit risk associated with the bonds that are issued 

by the securitization structures. 

The use of securitization has grown rapidly both in the U.S. and 

abroad since its inception approximately 30 years ago. Today it is 

an important source of funding for financial institutions and corporations. Securitization is essentially the packaging of a collection 

of assets, which can include loans, into a security that can be sold 

to bond investors. Securitization transactions vary in complexity 

depending on specific structural and legal considerations, as well as 

in the type of asset that is being securitized. 

Through securitization, mortgages of many different kinds can be 

packaged into bonds, commonly referred to as ‘‘mortgage-backed securities,’’ which are then sold into the market like any other bond. 

The total mortgage loan origination volume in 2006 was approximately $2.5 trillion, and of this, approximately $1.9 trillion was 

securitized. Furthermore, we estimate that roughly 25 percent of 

the total mortgage securitizations were backed by subprime mortgages. Securitizations use various features to protect bondholders 

from losses. These include overcollateralization, subordination, and 

excess spread. The more loss protection or credit enhancement a 

bond has, the higher the likelihood that the investors holding that 

bond will receive the interest and principal promised to them. 

When Moody’s is asked to rate a subprime mortgage-backed 

securitization, we first estimate the amount of cumulative losses 

that the underlying pool of subprime mortgage loans will experience over the lifetime of the loans. Moody’s considers both quantitative as well as qualitative factors to arrive at the cumulative 

loss estimate. We then analyze the structure of the transaction and 

the level of loss protection allocated to each tranche of bonds. 

Finally, based on all of this information, a Moody’s rating Committee determines the rating of each tranche. Moody’s regularly 

monitors its rating on securitization tranches through a number of 


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steps. We receive updated loan performance statistics, generally 

monthly. A Moody’s surveillance analyst will further investigate 

the status of any outlier transactions and consider whether a rating committee should be convened to consider a rating change. 

The majority of the subprime mortgages contained in the bonds 

that Moody’s has rated and that originated between 2002 and 2005 

have been performing better than historical experience might have 

suggested. In contrast, the mortgages that originated in 2006 are 

not performing as well. It should be noted, however, that the 2006 

loans are, on average, performing similarly to loans originated and 

securitized in 2002 and 2001. 

Pools of securitized mortgages from 2006 have experienced rising 

delinquencies and loans in foreclosure, but due to the typically long 

time to foreclose and liquidate the underlying property, actual 

losses are only beginning to be realized. Among several factors, we 

believe that the magnitude and extent of negative home price 

trends will have the biggest impact on future losses in subprime 

pools. Economic factors, such as interest rates and unemployment, 

will also play a significant role. 

From 2003 to 2006, as has already been noted, Moody’s cumulative loss expectations of subprime securitization steadily increased by approximately 30 percent in response to the increasing 

risk characteristics of the mortgage loans being securitized, as well 

as changes in our market outlook. As Moody’s loss expectations 

have steadily increased over the past few years, the amount of loss 

protection in bonds we have rated has also increased. We believe 

that performance of these mortgages will need to deteriorate significantly for the vast majority of the bonds we have rated singleA or higher to be at risk of loss. 

Finally, I want to give Moody’s view on loan modifications by 

servicers in the event of a borrower’s delinquency. Loan modifications are typically aimed at providing borrowers an opportunity to 

make good on the loan obligations. Some RMBS transactions, however, do have limits on the percentage of loans in any one 

securitization pool that the servicer may modify. Moody’s believes 

that restrictions in securitizations which limit a servicer’s flexibility to modify distressed loans are generally not beneficial to the 

holder of the bonds. We believe loan modifications can typically 

have positive credit implications for securities backed by subprime 

mortgage loans. 

With that, I thank you, and I would be pleased to answer any 

questions. 

Chairman REED. Thank you very much, Mr. Kornfeld. 

Professor Eggert. 

STATEMENT OF KURT EGGERT, PROFESSOR OF LAW, 

CHAPMAN UNIVERSITY SCHOOL OF LAW 

Mr. EGGERT. Thank you, Chairman Reed and Ranking Member 

Allard and other Members of the Committee. I would like to talk 

about how securitization has changed the mortgage industry as we 

know it, and some of those changes have not been beneficial to borrowers. 

Securitization has put subprime lending largely in the hands of 

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kers. Many of the companies doing subprime loans are non-banks 

regulated by State agencies, and without the underwriting standards imposed by regulators of, say, depository institutions. 

Securitization is designed to divert value away from the originator. That is the whole point of securitization: it allows banks to 

originate loan, quickly sell it to the secondary market and to investors, and that way the lender does not have to hold the mortgage. 

And to a large extent, it reduces its own risk if the loan goes bad. 

It also allows lenders to easily go belly up. We have seen even 

large subprime lenders go belly up recently, and because they are 

not holding all the loans that they have made for the last 5, 10, 

15 years, it is much easier for them to go out of business. 

If you look at the history of the subprime market, you see sort 

of waves of lenders going out of business and then coming back into 

business and going out of business. So many borrowers who took 

out loans find that their lender, when they go to discuss fraud, is 

no longer there for them to argue with. 

The secondary market is protected in large part from risk of default and from risk of fraud. It is protected in part because of the 

risk abatement aspects that the secondary market imposes in 

securitization so they ask for credit enhancements of various types 

to protect them against default. And it is also protected by something called the holder in due course doctrine, which provides that 

if a loan is purchased by a bona fide purchaser, many of the defenses that the originator has to the—that the borrower has to the 

originator are cut off, and so the borrower may be able to sue the 

lender but cannot sue the secondary market or the current holder 

for some aspects of fraud. And if the lender has gone belly up, that 

leaves the borrower kind of with its defenses cut off completely. 

Another thing that securitization has done is made the regulation of the subprime market a de facto regulation, really is by the 

securitizers. The rating agencies and the investment houses that 

assemble the pools by and large determine the underwriting criteria, by and large determine what kinds of products are being offered, and so they are the true regulators of the subprime industry, 

much more so than the State regulators that may supervise the 

non-bank entities. However, rating agencies and the securitizers 

are not monitored in the same way that a formal agency might be 

monitored. There is no congressional oversight of them, and so 

there are concerns about—I have greater concerns about turning 

over regulation to essentially private parties. 

Securitization also puts impediments in loan modifications. We 

have heard of some of those impediments already. Servicers may 

have limited flexibility—they may have flexibility, but it may be 

limited by the terms of the servicing agreements. These terms may 

be vaguely written so that the service area is not even sure how 

far it can go in making modifications. The pooling agreements may 

limit the number of loans that may be modified, and so loan pools 

that turn out to have a much higher risk of default may leave some 

borrowers unable to get their loans modified because so many other 

borrowers had the same problems. 

Servicers might be overwhelmed by an increasing number of defaults, and I would be interested to see how many servicers are 

going to add new staff that they will need to do loan modification. 


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Loan modification is much more time-intensive than merely collecting payments. Are servicers going to hire the new people that 

they need to do this kind of in-depth counseling? 

Another problem is that if you take a unitary interest in a loan 

and split it up among all the different tranches in a securitization, 

it makes it harder for the servicer to modify the loan. Servicers act 

in the best interests of investors, but investors may benefit differently by different loan modifications. Different tranches of the 

securitization may be helped or may be hurt by loan modifications. 

And so you might have a servicer engaging in what I call tranche 

warfare as they decide which tranche will benefit and which will 

be harmed. That kind of discretion may be difficult for servicers to 

use, concerned as they are about protecting all investors. 

Securitization also loosens underwriting. It has transformed underwriting from a very specific thing designed to protect a depository institution to a very automated process that can be objectively 

monitored, but also that can be altered depending on the market 

needs. If the market needs looser underwriting, we have looser underwriting. If a market needs tighter underwriting, we have tighter 

underwriting. But that kind of inconsistent underwriting can be 

very harmful to borrowers. 

And so I think we need to see the secondary market become more 

accountable and more responsible for what it has done to loans, 

and there are two ways to do that, and then I will be done. I am 

almost done. 

First is assignee liability. Have the current holders of market be 

liable where there has been fraud against the borrowers. And the 

other thing is I think we need to have regulatory oversight over the 

securitizers and the rating agencies who are actually regulating the 

subprime industry. 

Thank you. 

Chairman REED. Thank you very much, Mr. Eggert. 

Mr. Peterson. 

STATEMENT OF CHRISTOPHER L. PETERSON, ASSOCIATE 

PROFESSOR OF LAW, UNIVERSITY OF FLORIDA 

Mr. PETERSON. Mr. Chairman and Ranking Member Allard, 

thanks to the Committee for holding these hearings. It is a tremendous honor and a privilege to be here to speak with you today and 

share a few thoughts. And I would also like to, before I begin, express some empathy for the folks at Virginia Tech. It is a terrible 

tragedy. 

I would like to make three points in my 5 minutes: first, I would 

like to talk about maybe a very short historical overview of how I 

see the forces in the marketplace, in the mortgage marketplace 

working; second, the current state of what I think the law is; and, 

third, what I think the law has to become at some point if we want 

to prevent the kinds of problems that we have seen in the past 

year. 

An overview of the market. I think that in my view you can picture the American mortgage market in three periods. First was an 

era of two-party mortgage finance, and this was from the founding 

of the Republic probably up until the Great Depression was the 

predominant mode, where there was a lender and a borrower, two 


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people, they worked things out. The mortgagee gives a mortgage in 

exchange for borrowing money. And in that market the incentive 

is—the dominant incentive is the lender polices the underwriting 

because they want to get paid back. They receive their money out 

of the monthly payments on the loan. 

After the Great Depression, when that system broke down, we 

had to find some way to restart the economy, and so Congress, 

under the leadership of the administration, passed a variety of 

statutes that created programs that created what I think of as a 

three-party model of mortgage finance, which had a lender, an 

originator, a borrower, and also the Government acted in virtually 

all of the middle-class mortgage loans in some direct underwriting 

capability, in some way guaranteeing it or insuring it, some direct, 

active involvement of the Federal Government or an agency affiliated with the Federal Government. 

Although the lender did not get paid out of the proceeds of 

monthly payments, instead they got—there was still some force 

there that was policing the marketplace, and that was the sort of 

public institutional, public policy forces of the Government. So that 

substituted for the profit motive to some degree of the lenders. 

Since 1977, when the first private-label mortgage securitization 

took place, I think there has been a third era of mortgage finance, 

and I think of that as the private-label securitization markets. And 

in that era, which—the first was in 1997—or, excuse me, 1977, but 

it really did not take off, you know, get large until the 1990’s after, 

you know, the tax hurdles and some accounting hurdles were sort 

of cleared out of the way. And the problem, as I see it, is that the 

two core mechanisms of policing loan origination have broken down 

to some degree. The people that make the loans do not get paid out 

of the proceeds of the monthly payments on those loans. Instead, 

they get paid out of the fees and from selling the loan to somebody 

else. So there is less short-term, immediate incentive to make sure 

that the loan gets paid back on time. 

And the second thing that has broken down is that those folks— 

there is no Government involvement, there is no stable bureaucratic hand which is not—you know, a non-risk-seeking hand that 

is trying to act in the benefit of the public that is overseeing this 

process anymore. Those are the two forces, and to a large extent, 

they have been—they are gone. 

So what is left to try and make sure that things do not fall apart 

and get out of hand? Well, there is only one thing that is really left, 

and that is the rule of law. That is what I want to talk about next. 

So what is the current state of the law? And I do not want to 

be disrespectful or anything, but my sense is that, after having 

studied it for most of my adult life, it is really in shambles, particularly the Federal law is. It does not do much. You read through it 

all, and at the end of the day you find out, well, the Federal law 

does not really apply. And what has happened, I think, is that the 

market has evolved past the law. All of the statutes that we have 

passed, which were good statutes, good compromises from both 

sides of the aisle—the Truth in Lending Act, the Fair Debt Collection Practices Act, less by the Homeownership and Equity Protection Act. The vast majority of them were all basically conceived in 

an era that predated securitization by 10, 20 years. So their basic 


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scope and definitions and structure has not—does not even conceive of the type of lending that we are seeing now. 

Just to give an example, what is the most important definition 

in the entire Consumer Credit Protection Act? Well, that would be 

the definition of a creditor. What is a creditor? It is the person to 

whom a loan is initially payable. But the person to whom a loan 

is initially payable neither holds the loan nor does that person in 

today’s market actually ever talk to the person that is actually 

going to take out the money. 

The Truth in Lending Act, the statute was supposed to promote 

fair and efficient comparison and shopping, does not even apply to 

the mortgage brokers that actually talk to the borrower. That is a 

pretty serious breakdown in the law. And there are half a dozen 

other examples. You know, the Fair Debt Collection Practices Act 

does not even apply to debt collectors—or it only applies to debt 

collectors, which in most cases will not apply in the servicing market—the servicing for mortgage loans. 

I see I am already out of time. 

So the last bit is what should we do to try and fix that. In my 

view, I think that, you know, we could talk about all these trends 

that we can sort of do to try and fix things a little bit here and 

there, but I think honestly we need to have comprehensive reform 

of the Nation’s consumer credit law. We need to go back to the 

drawing board and re-update—update everything, and that is going 

to include comprehensive reform of the Truth in Lending Act and 

RESPA, trying to integrate those into a more coherent disclosure 

process. The Fair Debt Collection Practices Act needs to be revisited. I think that we need to figure out what we want to do finally 

about usury law and the Marquette Doctrine, which I think is a big 

problem, in my opinion. 

Finally, we need to reconsider how it is that various participants 

and middlemen in this market are going to be held liable for, I 

think, in some instances aiding and abetting the process of making 

predatory loans. 

If you want my opinion—you called me up here—we need to fix 

the whole legal system, or this is just going to happen again. So 

that is what I think. 

Chairman REED. Thank you very much, Mr. Peterson. 

What I propose to do is have 6-minute rounds, at least two 

rounds, I think, so if you do not get a chance to ask a question in 

the first round, my colleagues, stick around because we will go 

again. 

Let me open up a line of questioning for Mr. Sinha and Mr. 

Sherr. William Dallas, who is the CEO of Ownit, which was one 

of the mortgage companies that went out of business through bankruptcy, said, ‘‘The market is paying me to do a no-incomeverification loan more than it is paying me to do the full-documentation loan.’’ He said, ‘‘What would you do?’’ rhetorically. And, 

in fact, we have looked at some of the publicly filed documents and 

some of these subprime originators, and there is language very 

similar to the following in all of them: ‘‘We seek to increase our 

premiums on whole loan sales by closely monitoring requirements 

of institutional purchases and focusing on originating and purVerDate Nov 24 2008 05:10 Dec 12, 2009 Jkt 050315 PO 00000 Frm 00025 Fmt 6633 Sfmt 6602 E:\HR\OC\A315.XXX A315

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chasing the types of loans for which institutional purchases tend to 

pay higher premiums.’’ 

It raises the question, you know: Who is designing these products? Where are the incentives coming for some of these exotics? 

Is it coming from the Ownits, the creative originators? Or is it coming from Wall Street and the securitization process by saying this 

is what we want to buy and we are paying more for it? 

Your thoughts, Mr. Sinha. 

Mr. SINHA. Generally speaking, I think in the securitization markets, the securitization markets will effectively make a decision 

about whether to buy something or not to buy something and at 

what spread or price to buy it. So secondary market investors generally will not dictate what types of loans are effectively being 

made. The process effectively starts with the loans being presented 

to the rating agencies. The rating agencies will then take their own 

opinion about the risk of the pool which these loans effectively constitute and then will assign the enhancement levels appropriately 

at levels that they think are commensurate with the models that 

they run. And then that transaction is brought to the market, and 

the market then decides I will buy this at this spread. 

So, generally speaking, I think, you know, the pools are presented to the market. 

Chairman REED. So you see the role as very passive, the 

securitization—these originators come with apples and oranges and 

pears, and you look around and, you know, you pick—— 

Mr. SINHA. I think in general, as I look at these markets—and 

people do refer to these markets as effectively markets where you 

have risk-based pricing. Risk-based pricing is being done at the 

loan level itself. The loan is viewed as a mix of risks that have to 

be priced, and that is how the markets are pricing it, and that is 

how they are bringing it to the rating agencies. And then the markets are—ultimately, the capital markets are providing the final 

pricing level of which that risk would clear. 

Chairman REED. Mr. Sherr, your thoughts. 

Mr. SHERR. I think to a large degree these mortgage originators 

are relatively sophisticated, and they are clearly monitoring the 

capital markets to get a sense of what the value of the product they 

are originating is. And so there are loans—they are a running business. There are clearly loans that are probably more profitable for 

them to make, and there are clearly loans that cost them money 

to make. And I think part of their diligence is making sure they 

are originating loans that, one, they think they can transfer, and 

making sure they are not originating loans that ultimately, if their 

system breaks down, if they are losing money on every loan they 

originate. 

Chairman REED. The question here all throughout, because it is 

a very complicated process, is who is ultimately watching over to 

make sure that that loan that is made to the borrower is within 

the competence of that borrower to pay for. And the impression I 

got from, you know, the quote from this individual was that he was 

not looking much at the borrower’s capacity, he was looking at the 

highest premium he could get, the types of loans. Also, I think 

what—I do not want to put words in your mouth, but you are also 


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saying, you know, we are not looking either, I mean, because he 

is bring us this paper. Is that—— 

Mr. SHERR. No, that is not what I am saying. Ultimately, at the 

end of the day, if he is going to run a business and continue to 

think he has access to the capital markets, his loans have to perform as expected. And the market turns, as you are seeing—you 

talk about loan repurchase. The market turn very quickly when 

loans start to underperform and cuts off his capital and his ability 

to run his business. 

So I think there are lot of market-policing mechanisms across the 

board that prevent those abuses and make sure loans are originated to guidelines. 

Chairman REED. Thank you. 

I want to turn now to Ms. Barnes and Mr. Kornfeld about the 

rating agencies, and you gave very detailed testimony about the 

process. You indicated clearly you have been downgrading some of 

the paper that you previously had rated. 

There was a comment made by Jeanette Tavakoli of Tavakoli 

Structured Finance pointing out that AA-rated tranches of CDOs 

backed by subprime mortgage paper now yield far more than AArated debt backed by other assets, which is suggesting that maybe 

these ratings are not as—they are not being believed by the marketplace. 

Is there a problem with the model right now? You do not have 

enough historic data or these new products came on so quickly? Or 

are you looking carefully and reviewing your models to make sure 

they are accurate? Ms. Barnes. 

Ms. BARNES. As with any mortgage product or any product within structured finance, as new products come to the market—you 

know, mortgages are not new. The characteristics are new. And 

what is new in the paradigm here is this combination of characteristics. It is this low-doc, high LTV, the piggy-back loans to a 

subprime borrower. That is really what is the new paradigm that 

we are seeing here. So while all those characteristics are not new 

to us, it was that combination. 

So what we typically do, in developing our default probabilities 

and ultimate losses, is look back on historical performance and 

then gauge what would happen in the future. As we cited, what we 

saw was the performance was actually deteriorating earlier than 

we had expected. And that is why back in 2006, when we saw this 

high-risk characteristics coming in with higher early payment defaults—that is really what is different here. It is not the delinquencies themselves. It is the amount of loans that are defaulting 

within the first few months of the loans. 

We actually increased our enhancement levels and default probabilities to protect the bond holders because of that likelihood. 

But to answer your question specifically about the CDO buyers, 

the CDO buyers are going to base their determination on the 

spreads and what is available in the marketplace. So I would not 

say it is a fundamental disbelief but it is that concern in the marketplace with the higher yields that people are asking for. It is no 

longer economical for people to keep putting their money into mortgages and they are just shifting it to the next product. 


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Chairman REED. Mr. Kornfeld quickly, because my time has expired. 

Mr. KORNFELD. Our focus once again is credit, which is only one 

part of what goes into spreads. There are a lot of different things 

as far as in spreads. 

We do take, however, we have a lot of discussions, a lot of participants out in the marketplace. And we look at spreads as far as 

what investors are saying in regards to whether it is a tactical, 

whether it is a fundamental credit evaluation that those spreads 

are indicating. 

Chairman REED. Thank you. 

Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. 

I think we understand that when you have a primary lender 

dealing with somebody who wants to borrow money, and then he 

goes ahead and securitizes it out, there is a spreading of the risk. 

So ultimately, where does the accountability rise? I think that is— 

does somebody maybe want to respond to that? Mr. Kornfeld, 

maybe? 

Mr. KORNFELD. From our standpoint, once again, I am not sure 

if that is really a question for a rating agency for a policy, almost 

in a way somebody would have a policy standpoint. 

Our role is a specific role. We have been rating credit, assessing 

credit worthiness in regards to a likelihood of a bond, as to whether 

a bond is going to pay or not. We do not look at ourselves in regard 

to that from that sort of type of role. 

What we have to do, though, is our reputation is obviously very, 

very important. We continually publish how we are going and performing in regards to the ratings. We want a single-A rating to perform like a single-A rating. We do not want it to perform like a 

AAA. We do not want it to perform like something lower. 

Senator ALLARD. Now, will certain investors say that we want a 

certain particular type of loan coming to us? And does this drive 

subprime mortgage instruments that perhaps are of questionable 

value as far as the borrower is concerned? 

Mr. KORNFELD. There is a discipline. The investors generally 

would not specify specifically of a typical loan type. But there is a 

balance in the marketplace that sometimes as far as the marketplace will view as we are too conservative. Frequently, actually, we 

are viewed in the mortgage market as the most conservative rating 

agency. Many market participants view us, in general, as being 

conservative. But that is not our goal. Our goal is, once again, from 

a credit standpoint, to be relatively accurate. 

So sometimes, yes, investors are going to believe that we are 

right on a risk and other times they are going to believe that we 

are either over and under. And they will price it accordingly in regards to spreads as part of their overall investment decision. 

Senator ALLARD. I wonder who would buy a BB rating security 

rating today. Does anybody want to answer that question? Mr. Peterson? 

Mr. PETERSON. If I were a servicer and if I bought that, it would 

help me get the servicing rights. And then I have a lot of opportunities to tap fees out of the borrowers and make my money out of 

those fees instead of the BBB bond. And I would want to do it. 


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Senator ALLARD. But the people that are buying the security, 

who would buy that kind of security? 

Mr. PETERSON. The servicer. 

Senator ALLARD. The servicer would? 

Mr. PETERSON. Right. 

Senator ALLARD. Well then, is that—do you think, is that a limited market today? How would that compare to a AA rating, as a 

BB rating? 

Mr. PETERSON. I am sure that the folks on that side of the table 

would be better able to answer that than me. 

Senator ALLARD. I can understand the fees driving that. Who 

would buy a BB, I guess, when you look at it as an investment vehicle? I mean, they are on the market. Somebody is buying them? 

Mr. SHERR. There are a fair amount of sophisticated investors 

who participate in this space, and it all gets down to price. Am I 

being compensated for the risk that I am taking in buying that security? 

Certain securities rating BB trade at different prices. The market for a certain vintage of mortgage loans is repriced to reflect the 

additional risk that the investor is taking. And investors to the 

market—the market and investors find that appropriate—— 

Senator ALLARD. So they are rather sophisticated investors—— 

Mr. SHERR. By and large—— 

Senator ALLARD [continuing]. That understand the risk. And so 

if things go bad, they understand the risks? 

Mr. SHERR. By and large, the lower rate mortgage investors, I 

would say, are a relatively sophisticated group of investors. 

Senator ALLARD. Now those that buy the AAA or the AA, those 

are probably the—would you describe them as less sophisticated 

type of investor? 

Mr. SHERR. I do not know if it is less sophisticated, because certainly very sophisticated investors participate in investment grade 

and high rated bonds. I would say the risk those investors are taking is significantly less, and therefore they are getting paid significantly less on that security to take that risk. 

Senator ALLARD. I am going to yield back the balance of my time. 

I will let the rest of the committee ask questions. 

Chairman REED. Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

A quick question, a yes or no would do, to Mr. Sinha and Mr. 

Sherr. Any responsibility from the securitizers for what has happened in the secondary market in the defaults and foreclosures? 

Mr. SHERR. I do not think there—I mean, I think we spent, at 

Lehman, a tremendous amount of time trying to diligence the 

counterparties that we deal with. And we have done a tremendous 

amount of work, both on the investor side and the originator side, 

making sure we are dealing with reputable counterparties and 

doing everything within our means to make sure that the loans 

that we are buying and the transactions that we are doing in the 

marketplace conform to the guidelines as represented when we 

went into the transaction. 

Senator MENENDEZ. Meaning? 

Mr. SHERR. Meaning no. 

Senator MENENDEZ. Thank you. 


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Mr. Sinha, can you be more succinct? Yes or no? 

Mr. SINHA. No. 

Senator MENENDEZ. No, thank you. 

Ms. Barnes, Mr. Kornfeld, any responsibility from the credit rating agencies? Yes or no? 

Ms. BARNES. No. 

Senator MENENDEZ. No? Mr. Kornfeld? 

Mr. KORNFELD. For a simple yes or no, no. It is a difficult question, though, in terms of simple yes or no. 

What the rating agency does is to express our opinion. What we 

are trying to do is do our best opinion—— 

Senator MENENDEZ. Your opinion matters in the terms of investors and what it means in terms of them willing to make commitments and then fuel the secondary market, does it not? 

Mr. KORNFELD. But rating is not a pass/fail. A rating is trying 

to do what the probability of the potential losses to a bond holder. 

Senator MENENDEZ. So the answer is no for you, as well? 

Mr. KORNFELD. Yes. 

Senator MENENDEZ. Now no one has any responsibility at the 

table. 

Let me ask this: Mr. Sherr, what is an acceptable percentage of 

default rates and foreclosures in the market, as far as from a market perspective? 

Mr. SHERR. Different loans carry different loan level characteristics and different loans have different frequencies of default. So it 

is hard to say that there is an acceptable standard for delinquencies. 

Senator MENENDEZ. Is 20 percent acceptable? 

Mr. SHERR. No, it is not acceptable. 

Senator MENENDEZ. That is what we have right now going. 

I asked you that question because, as I listened to your testimony, it sounds that you are as chagrined about defaults and you 

suggest that for securitizers that is clearly not a good thing. But 

it certainly seems to me that the securitizers have looked the other 

way, fueling a market that has very little discipline over itself, and 

therefore not so concerned about the rate of default looking at it 

in a mass way, well, X percent is fine and we will take that as part 

of the risk in an equation of investing. 

Is that a fair statement? 

Mr. SHERR. I do not think so. I think the market—think about 

the recourse. You mentioned pretty much every independent 

subprime originator who has been forced out of business. So clearly 

there are ramifications for running a business the wrong way. 

Senator MENENDEZ. Well, those are the originators. I am talking 

about the securitizers. Isn’t there a good part of what happens to 

the securitizer is that if the loan defaults the originator has to buy 

it back? Isn’t that a good part of what happens? 

Mr. SHERR. I do not know if it is a good part. No one wants to 

see loans go down. 

Senator MENENDEZ. No, I say a good part meaning isn’t it a significant part of what happens in the marketplace, that the originator, as part of the agreement with the securitizer, has to buy it 

back? 


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Mr. SHERR. The originator makes representations around his 

loan and he typically reps that the loan will not default on their 

first payment. 

Senator MENENDEZ. So what I am saying is the securitizer has 

a much more limited liability here at the end of the day. Between 

that and the credit rating agencies, it seems to me that while you 

say you are chagrined about defaults, you actually fuel the marketplace in a way that has no controls, largely speaking, over it as defined by the two professors here. And ultimately, when you talked 

in response to the Chairman’s questions and you said market 

mechanisms are in place. But they are in place only when we are 

at the default stage. Isn’t that a little late for market mechanisms 

to take place? 

Mr. SINHA. Senator, if I can just add to this, I think at the end 

of the day ex poste, every loan that defaults is effectively something that is not the favorable outcome for the people that effectively advance the funds for that. The real question is in a market 

where there is greater risk if credit is going to be advanced to those 

borrowers, what is the right level of pricing or spread that has to 

be charged to make it worthwhile for capital to be advanced into 

that sector? 

And I think the big attempt over the 10 years has been to get 

capital into markets that were otherwise perceived as risky, that 

conventional lending would not go to but where the introduction of 

a balance between risks and spread has allowed funding to go to. 

So at the end of the day, I think the people that are funding 

these loans have a tremendous amount at stake because they are 

responsible. They have their own fiduciary duties to their investors. 

And if they make a loan and that loan does not perform, they are 

just as much hurt by that loan going bad. 

So the real challenge, I think, is for us to figure out—and there 

is no perfect situations in the world and there are no perfect solutions. But the question is, on balance, the fact that we are able to 

make loans to people that were perceived as risky, and risky 

enough 10 years ago that they were delegated to the outer reaches 

of the finance markets and have become much more mainstream, 

is that benefit sufficient to alter the fact that yes, there have been 

some issues in terms of the fact that an above larger number of 

borrowers are going into foreclosure than was otherwise expected? 

I think that is part of the reason why you are seeing the kind 

of correction that you are seeing in the markets, in terms of people 

re-evaluating the types of risks they were taking on. 

But I think that is the mechanism for ensuring that mid-course 

corrections are made, is when people do not get their money back 

or their bonds get downgraded. That has real consequences for 

those folks that are have. We are also accountable. 

Senator MENENDEZ. When you have lost your home, a mid-course 

correction is a little late. 

Mr. Chairman, I have plenty of other questions. I will wait for 

the second round. 

Chairman REED. Thank you. 

Senator Crapo. 

Senator CRAPO. Thank you very much, Mr. Chairman. 


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I think this question is probably for Mr. Sinha and Mr. Sherr 

and Mr. Eggert and Mr. Peterson, on different sides of the question. 

That is what are the benefits and drawbacks of requiring borrowers to be qualified at the fully indexed rate, which is suggested 

in the proposed interagency subprime mortgage lending statement? 

Mr. SINHA. Senator Crapo, I think the benefit would be that to 

the extent that there are dangers put on or risks put on borrowers 

from a payment shock perspective by allowing them to qualify, or 

effectively qualifying them at the fully indexed fully amortizing 

rate, you’ve clearly removed that risk from the table. 

The drawback would be that there may be some borrowers that 

are truly able to handle the payment shock that would not then be 

able to afford that mortgage anymore because the bar has been 

raised. 

So I think, as I said earlier, there are never any perfect solutions. I think what the right balance is in terms of the right 

amount of time that you need to provide to that borrower such that 

there would be a reasonable expectation that he or she would be 

able to handle the payment shock if that comes. That probably is 

the right solution. I do not know what the answer to that question 

is. 

And I think it is specific to every borrower in terms of their own 

financial and individual circumstances. 

Senator CRAPO. Mr. Sherr, did you want to add to that? 

Mr. SHERR. No, I would agree. I think that clearly, by qualifying 

potential borrowers to the fully index rate, you create a pool of 

loans that arguably perform better. On the other hand, you are 

going to restrict credit potentially. And typically there are 

mitigants that would allow an underwriter to make a loan that otherwise may not qualify at a fully indexed rate. But we run the risk 

of not providing credit to that group of potential borrowers. 

Senator CRAPO. So it would shrink credit and, if I understand 

you right, in your opinion it would probably shrink it more than 

we would need to to solve the problem we are dealing with here? 

Mr. SHERR. I would agree with that. 

Senator CRAPO. Thank you. 

Mr. Eggert or Mr. Peterson, do either of you want to respond? 

Mr. EGGERT. I think one of the advantages of forcing you to underwrite to the full rate is some of what we are seeing are borrowers who do not realize how high the rates on their loans are 

going to go or could go. And when they are being sold these loans, 

they are being sold them based on the teaser rate. 

If you look at the ads for a lot of the subprime loans, it is ‘‘reduce your loan payments by $500’’ and all they are advertising is the 

teaser rate. When they sit down with the mortgage broker, the 

mortgage broker talks about the teaser rate. 

Many of the borrowers do not see the full rates at all until closing, and may not understand it at that point. 

Senator CRAPO. And this proposal would solve that? 

Mr. EGGERT. It would mitigate it because while it would not 

solve the problem completely, at least you would get borrowers into 

loans that they could afford when they are fully indexed. 

Senator CRAPO. Thank you. 


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Mr. Peterson. 

Mr. PETERSON. I think it is a reasonable, decent idea. But I think 

it is a Band-aid. I mean, if you do that, then it will help tighten 

up credit a little bit. There will be a few less really dangerous poorly underwritten loans. But my sense is that you could probably 

start to think of ways to make the same sort of things happen with 

different contract mechanisms and contract around that rule. 

So ultimately, I do not know that it would necessary prevent the 

types of things we have seen. 

Senator CRAPO. Thank you. 

And with the couple of minutes I have left, I will come back to 

Mr. Sinha and Mr. Sherr. What would be the impact on the secondary market if Congress or the—well, if Congress, imposed assignee liability standards similar to the Georgia or New Jersey 

State laws? What has been your experience with these laws? And 

what do you think would happen? 

Mr. SINHA. Senator, we actually have had an experience with assignee liability in two states, Georgia and New Jersey, and in the 

State of New Jersey, in the high cost market. From the investor’s 

perspective, and that is predominantly the client base that I serve, 

if you think about the securitization process, anything that makes 

the process inherently unpredictable in terms of how you adhere to 

a particular standard or what the particular sort of consequential 

losses might be as a result of any piece of legislation makes the 

rating process fundamentally not possible. 

So as a result of that, when we have seen this type of risk come 

into the market, what we have seen are investors effectively saying 

that we do not have the ability anymore to understand the type of 

risk that we are buying. 

I do not want to necessarily speak for the rating agencies, but 

I think that has been that same argument that has been applied, 

as well. 

So it comes back down to if it is a risk that is quantifiable and 

that one can sort of rate around or structure around. Markets can 

price it. But if it is completely up in the air and it is completely 

indeterminate, and there is no real way of objective standard of determining whether you are in compliance with it or not, then it becomes very hard for the capital markets to deal with. 

Senator CRAPO. Quickly, Mr. Sherr. 

Mr. SHERR. I would say why not get at the problem more directly? If the goal is to cut out predatory lending, which I think 

every responsible lender would support, why not define clearly 

what is a predatory loan and create a national standard that would 

regulate those loans being made? As opposed to trying to transfer 

that risk to second and third order investors who may not be close 

enough to the transaction to fully understand what risk he is taking. And therefore, I do think you will find that it may have significant impacts on the capital available for borrowers. 

Senator CRAPO. Thank you. 

Chairman REED. Thank you very much, Senator Crapo. 

Senator Casey. 

Senator CASEY. Mr. Chairman, thank you very much, and I want 

to thank the witnesses for your testimony. 


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I want to focus on where do we go from here? What are solutions 

or proposed solutions? 

I am going to start with both Professors Eggert and Peterson. 

Professor Eggert, I was looking at your testimony and, in particular, I know sometimes when you have limited time you do not 

have the ability to go through all of it. These are pretty significant 

pieces of work here. 

But I wanted to reiterate and have you reiterate, if you have covered a lot of this already, but especially if you have not, some of 

the conclusory statements that you make. I am looking at page 29. 

I was struck by one of the last sentences in your testimony. It 

said, and I quote from page 29, ‘‘To be effective, any regulation that 

protects consumers from inappropriate loans, must affect the actions of the Wall Street players that direct the securitization of 

subprime loans. A regulatory regime that purports to limit the 

harmful effects of predatory loans or loans unsuited to borrowers 

must include not only the lenders that originate the loans, but also 

the rating agencies and investment houses that create the loan 

products, determine the underwriting standards’’ and it goes on 

from there. 

I just wanted to have you comment on that, in terms of specific 

focus of reform, based upon not just your testimony but your experience. 

Mr. PETERSON. I think the reason I say that is if you look at how 

this process works, I think we have had a presentation as the secondary market are mere passive purchasers of loans and oh, they 

may select a loan but it is really the lenders who decide loans. 

But if you talk to people on the origination side, they will tell you 

the complete opposite. They will say our underwriting criteria are 

set by the secondary market. They tell us what kinds of loans they 

want to buy. They tell us what underwriting criteria they want us 

to use. And that is what we do because we are selling to them. 

So the securitizers and the rating agencies really are the de facto 

regulators. If you are going to fix the problem so that we do not 

have the high levels of default we have seen, I think you have to 

involve the de facto regulators. There are, I think, two ways to do 

that. 

One, I think, is assignee liability. Rating agencies and the investment houses are really looking out for the investors. They are not 

looking out for the borrowers. If you want to make them decrease 

the amount of inappropriate lending, the way to do that is to make 

inappropriate lending hurt the investors. If investors are on the 

hook when somebody is defrauded, then the securitizers are going 

to make sure fewer people are defrauded and that fewer defrauded 

people’s loans get securitized. Assignee liability is the way to make 

the secondary market do real monitoring of the originators. 

And also, I think the other thing is that there should be more 

regulatory purview over the rating agencies and the investment 

houses. I have not quite—I have come to this conclusion recently 

and I cannot sit here and tell you exactly how that should work. 

But we are used to having our national mortgage market regulated. I think we all want it to be regulated. 


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But at the current moment, it is not really regulated other than 

by these private de facto regulators, as far as the subprime industry. 

And so we need to figure out a way to pull back the subprime 

market under real regulation. Exactly how that will work, I think 

will take some thinking. But I think that should be something that 

should be on the agenda. 

Senator CASEY. Thank you. If we have more time later, I will ask 

your colleagues at the witness table to respond. 

But I do want to ask Professor Peterson, in terms of, as you say 

in your testimony, not believing in a wait and see attitude but having specific steps. Can you outline, you have got about four or five 

specific recommendations. Can you summarize those for us? 

Mr. PETERSON. Sure. 

Senator CASEY. Or highlight one. 

Mr. PETERSON. Yes. I can fill up a little booklet of things that 

I think that need to probably be fixed with the Federal consumer 

lending regulations. 

But specifically related to this problem, if I could just pick two 

things that I would focus on, the first is that at a minimum, the 

bare minimum that we need to do is apply the Federal Trade Commission’s Holder in Due Course Notice Rule that is applied to say 

car lending ever since the 1970’s. That should apply to all home 

mortgages. The markets have been able to do that. That provides 

some assignee liability, but it is a cap level of assignee liability 

that I think that the rating agencies and the investment banks can 

live with. That is the first thing. 

The second thing is that I think it would be great if the Federal 

Government would step up and articulate some sort of standard of 

imputed liability for investment banks that package mortgage 

loans. Because remember, if you have assignee liability, that is just 

going to get the investors on the hook. But a lot of those investors 

are innocent parties and nobody wants to have uncapped liability 

for these innocent parties. 

But if you really want to have some deterrent mechanism, then 

you need to have some uncapped liability for the truly bad actors, 

the real predators that are out there. You have to have punitive 

damages or you will not ever be able to deter them. 

And the way that you need to do that is I think there has to be 

imputed liability for the investment banks that are facilitating it. 

If the investment banks know or should have known that there is 

predatory loans or unsuitable loans being packaged in those securities, those investment banks should be liable. 

Senator CASEY. I know I am out of time. Thank you. 

Chairman REED. Thank you very much, Senator Casey. 

Let me begin the second round and address follow-on questions 

to Mr. Sinha and Mr. Sherr. 

Both Bear Stearns and Lehman Brothers not only are 

securitized, they also originate. You have got vertical integration. 

I am wondering, in your origination, were you involved in low-doc 

and no-doc loans and some of the more exotic products? 


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Mr. SINHA. Senator, yes. I should point out, though, that I am 

head of research. And what I know about Bears’ operations are 

what are publicly available to everybody. 

I think lim-doc loans were a commonplace aspect of the markets 

over the last couple of years. So to that extent, yes. 

Chairman REED. It goes back to my original question. What 

made it attractive to Bear Stearns? Was it the origination fees or 

the securitization fees? It goes back, I think, to who was driving 

the train here, my initial question? Do you have any notion about 

that? 

Mr. SINHA. Again, I cannot speak specifically about the decisions 

at Bear. But I think generally speaking the market throws out a 

menu of alternatives into the marketplace. At any given point in 

time you will see a variety of mortgages being offered out. And it 

is really sort of—you know, the demand in terms of the borrower 

base that will determine any one particular type of instrument that 

does decide to come in. 

What we have seen is overall broader market participants is that 

the increasing levels of home price appreciation over the last couple 

of years did, in and of themselves, create sort of a feedback mechanism in terms of what people refer to as affordability products. And 

so I think the last couple of years of very high home price appreciation rates are also responsible, to some extent, in terms of broadening the menu of offerings that get thrown out there. 

Chairman REED. Mr. Sherr, the same question. Since your company dos originations as well as securitizations, what was driving 

these low-doc loans? 

Mr. SHERR. You know, I think we tried to identify an underserved market. And if you think about the entire Alt-A market, for 

example, that is a documentation market, for the most part. We 

found there were a number of borrowers who were denied—who 

could not access credit for whatever reason, they were self-employed. There were a number of reasons why they could not provide 

the full documentation or chose not to provide the full documentation that a traditional bank may have wanted. And we found a 

market segment that we thought made sense from a risk-adjusted 

basis and provided capital to borrowers who otherwise could not 

get it. 

Chairman REED. You know, one of the points that were made 

when we looked at this, so many of these no-doc or low-doc loans 

did not routinely escrow taxes or insurance, which suggests to me, 

you know, this is a segment of the economy who probably would 

be well advised to save some money for taxes. And yet, with that 

characteristic, would that not suggest to you that this loan could 

be bad? Or that there would be other demands on the salaries of 

these individuals? 

Mr. Sherr. 

Mr. SHERR. I think all of those characteristics were taken into account when you underwrite the loan. I think it is important to understand that when you make the loan it is in everyone’s interest 

that the borrower can afford to pay that loan back. 

Chairman REED. Let me just go back to the rating agencies. You 

have already begun to downgrade some of this paper. You suggest, 

though, I think you are confident. Do not—let me have you reafVerDate Nov 24 2008 05:10 Dec 12, 2009 Jkt 050315 PO 00000 Frm 00036 Fmt 6633 Sfmt 6602 E:\HR\OC\A315.XXX A315

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firm that that issue go forward, unless there is a tremendous deceleration in wages or economic activity, that it is not going to have 

serious systemic repercussions. Is that fair? 

Ms. BARNES. We believe that there is sufficient credit enhancement, given the current economic stresses, for the vast majority of 

the investment grade tranches. The speculative grade tranches obviously would experience a higher downgrade ratio. That is what 

they are designed for. 

Chairman REED. So to the extent of the non-investment grade 

tranches, who is holding those? That would be hedge funds, principally? 

Ms. BARNES. Typically, yes. Those were those people you were 

addressing earlier. 

Chairman REED. Have you, either through some analysis or 

through a gut check about what is the impact if these investment 

grade or non-investment grade securities go down, is there going 

to be an impact? For example, pension funds are invested in hedge 

funds. Is there a domino effect? 

Ms. BARNES. Pension funds are typically investors in the higher 

rated tranches, the teachers retirement fund and others. Those are 

your AAA investors, so fairly insulated from this. 

A domino effect, the speculative grade investors do expect and 

are paid for the higher yields, so do have a higher downgrade ratio 

or default probability. And it is baked into their overall return expectations. 

Chairman REED. Quick comment, Mr. Kornfeld? 

Mr. KORNFELD. No. 

Chairman REED. Let me ask another question which goes to 

something Senator Schumer raised initially. And that is at this 

point there is a recognition by everyone on this panel, everyone in 

the room, everyone across the country, that foreclosure is bad. It 

is bad for people who lose their homes. It is probably bad for the 

financial institutions that do not come out whole after the transaction. 

And yet, there seems to be some inhibitions because of the 

securitization process and how flexible the servicer or whoever is 

holding the paper can be in terms of working out—Professor Eggert 

pointed out, where are these people that go into the field and start 

talking one-on-one with the homeowners to work this out? 

So I just want to get a sense. Mr. Sinha, you suggest in some 

of your comments that there are different REMIC rules, which are 

tax rules. There are accounting rules such as FAS 140. There are 

covenants within all these documentations with respect to how 

much leeway they have. 

Given all of this cross-cutting restrictions realistically, if someone 

did have a pool of $1 billion, like some financial institutions are 

proposing, how effectively could they deploy that money to help individuals? What are the transaction costs? Do you have a—I am 

going to ask everyone. Do you have a notion of that? 

Mr. SINHA. Sure. I mean, not to downplay the significance of 

some of those restrictions, but I do not think they are insurmountable. And certainly, in some instances, they are a lot easier. In others they may be more difficult. 


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But I think the issue that would be faced by everybody in the 

market is that there is a cohort of borrowers that are going to be 

facing stagnant housing markets and potentially a reset coming up. 

And not dealing with them in a sensible way, considering the fact 

that the market’s risk profile has changed, would be shooting oneself in the foot fundamentally. 

So I think my perception, this is my opinion, is that I think when 

people are faced with the gravity of the situation, to some extent, 

I think it should be easier to arrive at a consensus in terms of the 

right thing to do. I mean, the right thing for investors and borrowers is that borrowers stay in their homes and keep making 

their payments. And the more of that we can generate, the better 

off everybody is. 

So I think from that perspective, in my opinion, I am more optimistic about that aspect. 

Chairman REED. Mr. Sherr. 

Mr. SHERR. Although, I would agree there are rules and guidelines for how securitization should be serviced, I would agree with 

Mr. Sinha that at the end of the day the servicer has a tremendous 

amount of flexibility to do what is in the best interest of that 

securitization. 

I think, again, it is very important to understand that in this environment the interests of the borrower and the interests of the 

lender are very much aligned. The interests of the securitization 

and the interests of the lender are very much aligned. No one wins 

in a foreclosure. 

Mr. Schumer represented the disparity between loss, between 

putting someone on forbearance or loan modification plan and actually trying to sell that home in a down market. It is in everyone’s 

best interest to accommodate that borrower and keep him in his 

loan for as long as possible. 

Chairman REED. Ms. Barnes, Mr. Kornfeld, comments from your 

perspective? 

Ms. BARNES. I agree with the comments. It is in everyone’s best 

interest to have the loans repay. But in applying the forbearance 

process, the servicers will first need to determine is it even feasible 

for the people to even repay these terms. Because there is no point 

in setting a new interest rate if they are going to default again. So 

that is one aspect. 

And then two, as far as applying widespread loss mitigation efforts, it does put a sense of uncertainty in the repayment of bonds. 

Because as servicers had the ability then to change interest rates, 

change terms, it is then something that needs to be factored into 

the ultimate return profile for the investors on the individual 

bonds. 

Chairman REED. You earlier, limits in terms of the modification 

is based upon your credit evaluation? 

Ms. BARNES. No. Some documents do require or limit the percentage. But that is not a Standard & Poor’s requirement or limitation. 

Chairman REED. But some credit rating agencies would have 

that? 

Ms. BARNES. I do not know who is driving it. It is in some of the 

documents. 


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Mr. KORNFELD. It is not, as far as in terms of a requirement that 

we have put. We do not advocate having the caps, as I mentioned 

in my initial remarks, in terms of anything that would reduce the 

servicer’s flexibility we do not think is a benefit to bond holders. 

Nor do we think it is obviously a benefit to borrowers. 

Do concur that we do not think that this is insurmountable. We 

do think that if all the various groups get together, we think there 

is some communication, we think there is some education. 

Chairman REED. Mr. Eggert and Mr. Peterson. Everyone gets a 

chance. 

Mr. EGGERT. First, I would like to react to a statement we have 

heard a couple of times, that the interests of the investors and the 

interests of the borrowers are congruent and so the people taking 

care of the investors will take care of borrowers. 

I do not think that is true. They diverge in one significant way. 

Both sides do not want higher defaults but investors are willing to 

accept higher defaults as long as they also obtain higher interest 

rates in return. The more the risk, the more return they want. In 

other words, they are willing to accept one bad thing for borrowers, 

which is higher defaults, as long as the borrowers get the double 

whammy of also getting higher interest rates. 

So the interests are not congruent. And what we have seen recently is that the investors, faced with these higher default rates, 

have said we need higher returns and so we need subprime loans 

to cost borrowers more, which I think also makes them more likely 

to be defaulted. 

As far as the difficulty in giving servicers flexibility, I think one 

study found that the terms, that about 30 percent of bond deals 

had the kinds of terms saying you cannot have more than X number of loan modifications. 

But the real question, I think, is who is going to be giving 

servicers their marching orders? Who is going to be telling them 

how to deal with these loan modifications? If these were loans held 

by national banks, we would be looking to Federal regulators to 

give the banks an idea of how to respond to increased default rates. 

Here we do not have that. We do not have the kind of regulation 

that I think could help us respond to this kind of problem. 

Chairman REED. Professor Peterson, finally. 

Mr. PETERSON. The thing I want to respond to is I am not so 

sure that I agree with the statement that it is in everybody’s best 

interests to avoid foreclosure. I am not sure that that is true. It is 

certainly in the investor’s interest, by and large, and in the investment bank’s interest, by and large. But if you are the servicer, it 

may be in your best interest to foreclose, in some cases. For example, if there is a divergence in the incentives of the investors and 

you, if you look at the contract and there is the potential for you 

to get a lot of fees—if you have a fee generating opportunity at a 

foreclosure, it may be more profitable for you to foreclose than not 

foreclose. 

So the question that I would want to know is whether or not the 

insistence on foreclosure is because of a lack of flexibility because 

of conflicts with tranches in the pooling servicing agreement or if 

it is because the servicer is reluctant to give up the windfall of fees 

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rower reformulate the loan or repattern the loan and work it out. 

Because that is going to be a difficult, time consuming thing. Do 

you take the fees or do you help them work it out? It may be possibly in the interests of the servicer not to work it out, and instead 

take the fees. 

And I would have to look at some hard numbers to know which 

that is. And it may be different in different cases. But I have not 

seen—I have never seen anything that convinced me that the 

servicers do not have an incentive to foreclose. 

Chairman REED. Well, thank you. This is very revealing to me. 

Again, I think there is the issue of the congruence of the incentives 

to foreclose, not foreclose, forbear, not forbear. But then there is 

also the issue of the capacity to communicate and get it done and 

who is going to take the lead to get it done, if in fact there is either 

a pool of private money or public money or any other mechanism 

to help these people. 

So I think that we have explored and exposed a very significant 

issue. 

Senator Crapo, do you have additional questions? 

Senator CRAPO. No. 

Chairman REED. Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Let me ask you, Mr. Sinha and Mr. Sherr, do you know if your 

companies have purchased tranches of mortgages from New Jersey? 

Mr. SHERR. From who? 

Senator MENENDEZ. New Jersey. Mortgages that originated in 

New Jersey, properties in New Jersey? 

Mr. SINHA. Frankly, I would refer the—I do not know. It is possible that we do have New Jersey loans. 

Senator MENENDEZ. Would you know, Mr. Sherr? 

Mr. SHERR. I believe we have. 

Senator MENENDEZ. And the reason I ask that question, because 

in response to Senator Crapo’s question about assignee liability, 

you gave a negative response of view of assignee liability. Yet, New 

Jersey has assignee liability under its law and it is the 13th State, 

in terms of Senator Schumer’s joint economic study, in the number 

of defaults that have taken place across the country. So obviously, 

there is a lot of people buying those mortgages, notwithstanding assignee liability. 

So I think it is fair to say that notwithstanding assignee liability, 

there is still clearly a marketplace to buy those mortgages. Yet, it 

creates some recourse to the borrower at the end of the day. 

Let me ask you this: in the purchases of these tranches of mortgages, you never had any sense that there was any predatory lending loans within them? 

Mr. SHERR. If we purchased a loan, it was our opinion there were 

no predatory loans in that tranche or in that pool. And we do that 

via diligence and compliance checks. 

Senator MENENDEZ. Mr. Sinha. 

Mr. SINHA. I mean, I would generally, again, agree with that 

statement. I think nobody knowingly would want to purchase a 

predatory loan. 


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Senator MENENDEZ. But with the number or percentages of loans 

that are falling within that category—and I agree with you, Mr. 

Sherr. You said let’s have a national law that defines predatory 

lending and let’s have a consequence. I agree with you. 

And I do not believe every subprime loan is a bad thing, either. 

But I also do not buy the general statement that if we do anything 

we are going to find ourselves with limiting access to capital to all 

of these people who might not otherwise have the wherewithal. 

Well, getting that access and then having your home foreclosed 

not only has a direct consequence on your life, but it also has a direct consequence on your credit for a long period of time. So striking a balance here is, I think, what is important. 

What I do not hear the industry as coming forth—other than saying we have no responsibility, we have done what we need to do— 

I do not hear the industry coming forth and being proactive in this. 

And I think that is a mistake on behalf of the industry’s part. 

But is it not true that market investors are really in the best— 

at least under the existing system—they are in the best position 

not only to keep bad players and products out of the market in the 

first place by not funding them? And also in a better position to 

make originating offenders accountable. 

It seems to me that you have a responsibility with your underwriting standards that would work a long way, both for your investors as well as for the marketplace and for the people who are losing their homes. Don’t you think that you, in fact, have by virtue 

of the power—I mean, you know, if you cannot securitize it, it will 

not sell. 

Mr. SINHA. That is correct, Senator. I think, if you couch the 

issue, I think, in terms of better disclosure to borrowers, better 

education for borrowers, better up front education about the types 

of products and the types of risks the borrowers are taking, better 

enforcement of existing practices, marketing practices, et cetera, I 

think they would go—— 

Senator MENENDEZ. I agree with you all of those things. Those 

are the downstream things. 

I am asking you, from your perspective, isn’t there a role for you 

to have a stronger, more—I do not want to use the word stringent 

because that can go overboard—but a stronger standard that understands that some of these products that are being purchased are 

products that ultimately are leading to the number of foreclosures 

that we have? 

Because if you would not securitize them, they would not be able 

to be out there loaning it. 

Mr. SINHA. That is correct, Senator, but I think traditionally 

there is a certain expectation that loans that have certain sets of 

characteristics behave in a certain way. That is where the disconnect comes about. It is not that everybody sort of knowingly 

knows that—understands that that is a bad loan. It is just at the 

end of the day, in hindsight, the loan does not turn out to be as 

it was supposed to be. 

Senator MENENDEZ. Let me just turn to the rating agencies for 

a moment. As I understand it, 97.9 percent of all subprime deals 

over the last 3 years has been rated by S&P and jointly, often a 


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second rating, as well. So really, your respective agencies have 

been out there doing all this rating. 

I asked you a question earlier and, of course, you gave me the 

answer that you really do not see any responsibility. With all the 

information that has been coming to light in these hearings, can 

you explain to me how you could have possibly given and continue 

to give strong ratings to these inherently flowed investment vehicles? Didn’t you have some earlier signs that this market segment 

was writing checks that you simply could not cash? 

And don’t you think that you have any responsibility in this regard? 

Ms. BARNES. Well, to address your first couple of points, in looking at those loan characteristics, we did identify them as being 

riskier and, in doing so, increased our enhancement levels by 50 

percent in 2006. So in essence, making those loans more costly to 

be originated because we do believe that the default rate was higher. And we went out publicly with that in the middle of last year. 

Senator MENENDEZ. Mr. Kornfeld. 

Mr. KORNFELD. Obviously, in terms of the magnitude of the situation is very, very serious. But to a certain extent we want to 

frame somewhat of the issue. It is not all subprime loans. It is 

mostly confined to 2006. And it is also not all of 2006’s originations. 

There are a significant portion of 2006 originations that are performing. 

But once again I do not want to, by any means, it is a very good 

question, it is a very proper question to be asking. 

Part of the areas are certain specific areas. It is the areas as far 

as—it is not even completely the stated documentation loans. It is 

the loans to wage earners. And the significant growth over the last 

year or two have been to salaried borrowers. And that is where, in 

terms of from a risk standpoint, things have performed somewhat 

worse than expectation. 

It is also, it is very much in where you combine those risk characteristics all together where you take a no equity loan, you take 

it as maybe stated documentation and maybe it is a stated wager 

earner. And then you combine it with a borrower with either a 

first-time borrower or a borrower with limited mortgage history. 

And you bring all of those together and, as far as the overall risk, 

it is not complete. 

From our standpoint, once again, what the market judges us on 

that if we are incorrect in regards to consistently whether we 

under or basically over, in regards to the risk estimation, then as 

far as the market is going to no longer be utilizing and relying on 

our ratings. 

Ms. BARNES. I am sorry, Senator. I just wanted to answer your 

question about how we could give high ratings to these poorer quality loans. I just wanted to make sure that it is understood that we 

do not make the loans, we do not give the approval of these loans. 

We simply assess the risk of these loans, and in doing so those individual tranches. 

And when I mentioned that our enhancement levels were increased by 50 percent, the ratings are asked of us from the issuer. 

So if they say they want to issue a BBB bond, we reply based on 

our credit assessment what enhancement level of protection to 


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cover losses would be to achieve that BBB. So in essence, we can 

give the same rating but it will become much more costly because 

that enhancement level or the amount of protection increased by 50 

percent over that period. 

Senator MENENDEZ. And you believe that the ratings that you 

gave, at the end of the day, covered more than sufficiently the risk 

in the marketplace? 

Ms. BARNES. For the majority of the investment grade bonds, 

yes. 

Senator MENENDEZ. Mr. Chairman, if I may, one last question? 

Let me turn to the two professors. If it was moot court and you 

heard all of this testimony, can you give me a verdict on no responsibility by the securitizers or the credit rating agencies? 

Mr. PETERSON. I think that there is some responsibility, obviously. And I do not mean to be rude or disrespectful, but I do. 

And if I could encapsulate it, the sentence that was said earlier 

was that no one would want to purchase a predatory loan. I think 

that that is false. Sure you would. If you could purchase it and 

then, especially if you could purchase it through a shell company 

that did not have your fingerprints all over it, and then you sold 

it to some sucker at a profit, then you would want to do it; right? 

And you would pretend that you did not know that it was a predatory loan. 

Or you would actually not know that it was a predatory loan because you did not check. That is the situation when you would 

want to buy a predatory loan. And I think that is what has been 

happening. 

As far as the yes or no question that you asked earlier, responsibility? I would give, for the rating agencies, maybe they did not do 

as good a job as they could. But ultimately I do not, in the end, 

see them as the primary culprit. They are trying to sell a product, 

accurate ratings. And maybe I will regret this statement later, but 

I would probably give them more or less a pass. 

But I do think that the investment banks are very much responsible for this. I think that a lot of them knew or should have known 

that this sort of thing could happen and they were profiting from 

the transaction fees in packaging and selling these loans. 

If they find out that it is a predatory loan or that it does not suit 

the borrower’s needs, that just means they cannot go through with 

the deal and they are going to lose all the revenue they would have 

made in going through with the deal. 

If the loan does not pay out, well, it is bad for the investors. But 

ultimately that does not come out of the investment bank’s pocket. 

So I think they are very much responsible. 

Mr. EGGERT. I think there are sort of two levels of responsibility, 

since if I were in moot court there would have to be two of everything. 

The first level of responsibility is what has been done with the 

loans the last year or two? And I think we do see responsibility. 

I think there could have been a lot more done to look at the individual loans. I think there has been—what securitization does is it 

values quantity over quality. And as long as there were a lot of 

loans going through and they could push the risk off in various 


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ways, then it did not matter if many of these loans, objectively 

looking at them, were bad loans. 

But I think the other aspect of responsibility is in designing the 

market. If you look at predatory lending laws, you see that the rating agencies have, to some extent, fought against good assignee liability, have essentially told the States if you have assignee liability that we do not like, we are not going to rate in your State, and 

have to some extent attempted to act as a super legislator deciding 

what our assignee liability laws should be. 

As a result, I think in some places we have had less strong predatory lending laws than we might have had. 

Securitizers and that industry can do better than borrowers and 

should bear the responsibility for predatory loans. They have better 

access to information about who the bad lenders are, about what 

the bad scams are. They are better able to determine if a loan is 

above market interest, which many loans—the essence of a predatory loan often is that it is way too expensive. And the secondary 

market can see which loans are way too expensive and want to buy 

loans that are too expensive because they are more profitable. Not 

that they want to seek out predatory loans, but if they have abovemarket loans, that is good. 

And so I think we need to put the onus on them to stop the problem because they are better able to do it, certainly than the borrowers are. 

Mr. KORNFELD. Mr. Chairman, could I just respond to the one 

statement in regards to the rating agencies? 

Chairman REED. Absolutely, Mr. Kornfeld. Yes, you may. 

Mr. KORNFELD. Thank you. 

Chairman REED. This is not a debate, but please. 

Mr. KORNFELD. I understand it is not a debate. 

The rating agencies do not opine whether law is good, whether 

law is bad, whether this predatory lending law is a good thing or 

a bad thing. 

What we are looking for, in terms of on the predatory, and we 

have both published in terms of on this, is can the risk be quantified? As long as the risk can be quantified, we are able to rate 

the other securities. 

I am not, off the top of my head, I am not the expert in terms 

of within Moody’s on New Jersey’s law. But for instance, New Jersey does have a law which has been clearly defined and has, as 

Senator Menendez has pointed out, has still allowed for lending to 

be done within the State. 

Chairman REED. Ms. Barnes, yes. 

Ms. BARNES. I would echo a lot of the comments that Warren has 

just stated. Standard & Poor’s would just like to go on record that 

we support all of the predatory lending laws that are—in fact, as 

long as the damages are quantifiable and that the terms are clear, 

meaning people can definitively determine whether they are adhering to the law or breaking the law. So terms like net tangible benefit are the ones that put into question that cause the secondary 

markets concern. 

Chairman REED. Thank you very much. I want to thank my colleagues. This has been a very serious and a very thoughtful discussion about a problem that is affecting many, many Americans 


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across the country. And I think it has given us all an opportunity 

to reflect, and also to think of ways in which we might be helpful. 

And I think the first response, and the best response, will come 

from the industry. So I would hope in this case these discussions 

might prompt some serious thought about continued efforts by the 

industry, all segments in the industry, to respond. And perhaps we 

can be helpful in that regard, too. 

But thank you all for your very fine testimony, and thank my 

colleagues. 

I would just say that some of my colleagues will have written 

questions, additional written questions. I will ask them to get them 

into the committee by April 26th, and within 10 days after that if 

you could respond, I would appreciate it. 

Thank you very much. 

The hearing is adjourned. 

[Whereupon, at 5:10 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions for the 

record follow:] 


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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM DAVID SHERR 

Q.1. We are aware that there are various parties involved in 

securitization structures, and it has been said that at times the interests of one party might vary from the interests of others. Are 

there situations where the best interest of the borrower (remaining 

in their home) might be in conflict with the interest of another participant? Can you explain a situation where that might be the case? 

What are some ways in which we can ensure that parties work toward a common solution that benefits both the borrower and the 

investor? 

A.1. The interests of all participants in the mortgage securitization 

process are generally aligned. Everyone wants homeowners to be 

able to make the monthly payments on their mortgage loans. Nobody wins when the only viable option for managing a loan is foreclosure, not borrowers who could lose their home, nor bondholders 

who rely upon loan payments as the basis for returns on their investments. 

Typically interests remain aligned even when a loan is in distress. Because foreclosure hurts everyone, the interested parties already are motivated to do exactly what your questions ask—work 

toward a common solution that benefits both the borrower and the 

investor. For example, loan servicers currently are engaging in 

early intervention for ‘‘at risk’’ borrowers, and are modifying loan 

terms when possible so as to increase the likelihood that borrowers 

will be able to make their monthly payments. 

Notwithstanding all the efforts to avoid foreclosures, there unfortunately are situations where no reasonable modification of a loan 

can be made that would increase the likelihood of borrower repayment, and foreclosure becomes the only practical option. At that 

point, the interests of borrowers may diverge from the interests of 

other participants in the securitization process who depend upon 

some payment flow from borrowers. But that divergence is reached 

only after a long road on which everybody works together to keep 

borrowers in their homes. 

Q.2. What do you view as the major impediments towards you 

being able to work out flexible arrangements with troubled borrowers whose loans reside in securitization structures? For example, some have referred to the REMIC rules, others have mentioned 

accounting rules, while others have pointed to limitations in the 

deal documents. Can you provide further clarity on this subject? 

A.2. Certain impediments to loan modifications already have been 

removed. For example, the securitization industry was concerned 

about the accounting treatment of loan modifications under Financial Accounting Standard 140, but guidance issued by the Securities and Exchange Commission this past July has eliminated that 

concern. Other factors that have been pointed to as potentially creating impediments do not in practice hinder loan modifications. 

The REMIC rules permit modification as long as a loan is in default or reasonably likely to go into default. Similarly, most deal 

documents do not impede modifications, as they provide servicers 

with ample flexibility to work with borrowers. To the extent that 


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servicers have lacked any significant powers to modify, market 

forces will lead to enhanced flexibility in future contracts. 

As for ways that the government could increase flexibility to 

modify loans, it has been suggested that tax treatment should be 

modified to provide that forgiveness of principal is not taxable to 

borrowers. 

Q.3. There has been considerable discussion in the financial press 

about loan putbacks due to early payment default. Please provide 

a definition of an early payment default putback. Why would investors who are being paid to assume the risk in these securitization 

structures be allowed to ‘‘put’’ these loans back to another party? 

Can you give us some idea as to how many loans were put back 

during 2006 because of early payment default? In your view, what 

does an increase in early payment default putbacks tell us about 

the underwriting standards used in making these loans? Also, what 

percentage of loan purchase agreements is made with recourse? 

How many loans were put back during 2006 because of recourse 

agreements? 

A.3. Contractual provisions for ‘‘early payment default’’ putbacks 

vary, so there is no single definition. In general, such provisions require the seller of a loan to repurchase it from the purchaser when 

the purchaser does not timely receive the first and/or second 

monthly payment on that loan following the sale. A rationale for 

such provisions is that an early payment default could be an indication of fraud in the lending process, and that responsibility for 

detecting and avoiding such fraud should lie with the seller of the 

loan. In addition to the possibility of fraud, an increase in early 

payment defaults could reflect a deteriorating economy, a declining 

housing market, or insufficiently rigorous underwriting standards. 

With respect to loans acquired or otherwise owned by Lehman 

during 2006, Lehman estimates that approximately 2.0% of such 

loans have been subject to repurchase claims as a result of 

breaches of representations or warranties made in connection with 

the origination or sale of such mortgage loans. Most of such repurchase claims would be the result of ‘‘early payment defaults.’’ 

Substantially all of the mortgage loans that are purchased by 

Lehman are purchased subject to recourse agreements pursuant to 

which the seller makes certain representations and warranties regarding the mortgage loans. The pool of residential loans purchased by Lehman during 2006, without recourse to representations and warranties, would be de minimis. 

Q.4. An examination of Pooling and Servicing agreements outlining the contractual duties of mortgage servicers for securitized 

loans reveals, for example, a 5–10% cap on loan mediation generally based on the total number of loans in the pool as of the closing date. Please explain the rationale behind these caps. Are you 

aware of any specific loan pools where these caps were maxed out 

and whether rating agency permission would have been necessary 

to exceed the caps? When caps are maximized, what is the process 

and likelihood for obtaining permission to exceed the caps? 

A.4. Lehman typically does not use caps for loan modifications on 

its residential mortgage deals. Nor is it aware of any other deals 

where a cap on modifications has been exceeded. 


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Q.5. When mortgage originations and securitization are done by 

vertically integrated firms, where are the checks and balances to 

prevent inappropriate actions that could harm borrowers and investors? 

A.5. Vertical integration in the mortgage securitization business 

benefits both consumers and investors. When a financial institution, such as Lehman, sells mortgage-backed securities to sophisticated investors, its success depends largely upon the quality and 

ultimate performance of the loans underlying those investments. 

By participating in the origination process through vertical integration, financial institutions are situated to implement origination 

controls that result in loans that are likely to perform over the long 

term. Moreover, financial institutions such as Lehman derive great 

value from maintaining their reputation in the business community. This reputational concern creates yet another incentive for 

such institutions to originate quality loan products. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER 

FROM DAVID SHERR 

FORECLOSURE PREVENTION STRATEGIES

Q.1. Last week, the Joint Economic Committee of Congress issued 

a report called ‘‘Sheltering Neighborhoods from the Subprime Foreclosure Storm’’ that found that foreclosure prevention is much less 

costly than actual foreclosures, for all parties involved. We found 

that one foreclosure can cost all stakeholders up to $80,000, while 

foreclosure prevention services by a non-profit can cost as little as 

$3,300 on average. In your testimonies today, we have learned that 

because half of these loans have been securitized, loan modifications of securitized sub-primes could be much more difficult, and 

perhaps even more costly. I have two questions that hope to get at 

the heart of this difficulty and figure out how we can better align 

incentives toward loan modifications that keep vulnerable families 

in their homes. 

Q.2. My follow-up question is to Mr. Sherr from Lehman Brothers: 

Mr. Sherr, you mentioned in your testimony that you expect the 

banks, as many of the largest sub-prime loan servicers and holders 

of mortgage loans, to engage in ‘‘home retention’’ practices in an effort to avoid foreclosures. 

Given the large percentage of exploding ARMs that were underwritten to borrowers that can not afford them at their fully-indexed 

rates, will these ‘‘home retention’’ practices include some form of 

debt forgiveness for borrowers that were proven victims of predatory lenders? In other words, when a loan modification results in 

a conclusion that the home owner was deceived into a loan that 

was mathematically designed to fail them after the teaser rate 

resets, is home retention even possible without forgiving the portion of the debt that the homeowner would have never qualified for 

under acceptable underwriting standards? 

A.1. & 2. Your question focuses specifically on loans originated 

fraudulently and without regard for the borrower’s ability to make 

payments after the initial interest rate resets to a higher rate. A 

borrower who was defrauded into entering into a loan could pursue 


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various legal remedies against the perpetrator of the fraud. Moreover, the borrower might be able to retain his or her home by exploring workout options. Where feasible, servicers could modify a 

loan that resets at a high interest rate, so as to increase the likelihood that the borrower could make reasonable monthly payments. 

Lehman is working with the servicing community to increase the 

number of borrowers who may be appropriate candidates for some 

form of loan modification. As a separate matter, financial institutions, such as Lehman, are helping to deter unscrupulous lending 

practices before they begin, through enhanced diligence of mortgage originators. 

Q.3. Finally, Mr. Sherr you spoke about the industry using ‘‘home 

retention’’ practices to avoid foreclosures. Can you and your colleague Mr. Sinha talk to us in more detail about particulars of 

what your firms are doing on the ‘‘home retention’’ front? 

Have you all discussed the need for a private market ‘‘rescue 

fund’’? 

A.3. Lehman has implemented an extensive set of ‘‘home retention’’ practices that emphasize early intervention and flexible options. For example, Lehman sends notification letters to borrowers 

in advance of a substantial increase in their interest rate. In those 

letters, Lehman encourages the borrowers to call Lehman’s Home 

Retention Department before the reset if they believe that they will 

not be able to make the increased payments. The Department also 

unilaterally reaches out to borrowers in delinquency to discuss 

workout options. In order to make sure that distressed borrowers 

get the help they need, Lehman recently has expanded the Home 

Retention Department’s hours of operation and is increasing staff 

to enhance counseling availability. 

As warranted by the circumstances, Lehman makes various 

strategies available to distressed borrowers. Forbearance plans 

allow delinquent borrowers to reinstate their accounts over several 

months by paying more than the monthly contractual payment. 

Special forbearance plans suspend or reduce contractual payments 

to allow borrowers to solidify arrangements to reinstate past due 

amounts. Loan modifications provide adjustments to note terms, 

such as reductions in interest rates and extension of maturity 

dates. These are but a few of the types of strategies offered to distressed borrowers by Lehman. 

As a separate matter, Lehman has committed to contribute $1.25 

million to the National Community Reinvestment Coalition during 

the next three years. NCRC will use this money to help distressed 

borrowers restructure their loans and to educate prospective borrowers about mortgages. 

REGULATION

Q.4. As you all know on the panel, federal banking regulators published guidance on alternative mortgage as well as sub-prime hybrid adjustable mortgage products last year and more recently have 

issued a new statement on these products for comment. Does the 

guidance apply to your firms in each of its capacities—lender, issuer, and underwriter of sub-prime and alternative mortgage products? 


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Given your status as a Consolidated Supervised Entity (a brokerdealer that meets certain minimum standards can apply for this 

status. It gives them the ability to use alternative methods of computing net capital), do you think the SEC should be involved in the 

process of developing future guidance on these mortgage products 

in order to ensure that securities companies that are non-bank regulated entities are covered? 

A.4. Lehman appreciates the leadership exercised by the federal financial regulatory agencies through their guidance on nontraditional mortgage products. That guidance applies to Lehman when 

it makes or purchases loans. Lehman also notes that, because 

much of its origination activities occur through Lehman Brothers 

Bank, those activities are subject to review by the Office of Thrift 

Supervision. 

Lehman believes that the agencies that issued the guidance, 

rather than the SEC, should continue to take the lead in regulating 

mortgage products. The SEC nonetheless has an important role 

with respect to the mortgage securitization process—protecting investors in mortgage-backed securities. And the SEC has been active in that area, especially through its adoption in 2005 of Regulation AB, which codified decades of guidance and practice in the regulation of publicly registered asset-backed securities. 

Q.5. What level of due diligence do purchasers of sub-prime loans 

conduct to ensure the products they are buying meet underwriting 

requirements and or state/federal laws? 

Follow up: 

Given the level of due diligence that is conducted, would the purchaser not be in a good position to guard against bad loans entering into investment pools from the very beginning? 

A.5. Purchasers of sub-prime loans, such as Lehman, start their 

diligence by examining the lenders themselves. Before Lehman enters into a relationship with a lender, it spends time learning about 

that lender, its past conduct and its lending practices. After that 

review is completed, Lehman’s diligence turns to the specific loans 

that are offered for sale, often relying on third party due diligence 

providers who have expertise in reviewing loan files. The percentage of a loan pool that gets tested is greater when Lehman first 

enters into a relationship with a lender than when Lehman has a 

longstanding relationship with a lender who has demonstrated 

good practices. The sample testing focuses on, among other things, 

whether the loans were underwritten in accordance with designated guidelines and complied with applicable laws. When loans 

fail the review, they generally are removed from the loan pool. 

All this diligence helps to detect poor lending practices. But the 

key to guarding against fraudulent or unduly aggressive loans lies 

with regulation of the interaction between loan originators and borrowers. Loan purchasers do not participate in those interactions. 

Because it is the originator, not the purchaser, who interacts directly with the borrower, it is that interaction that should be the 

focus of efforts to reduce unscrupulous practices. 


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CREDIT QUALITY

Q.6. As we all know, the sub-prime industry is an important one— 

sub-prime mortgage credit market has expanded access to credit for 

many Americans. Today, we have seen many Wall Street firms 

move from not only providing capital for sub-prime loans, but also 

to owning sub-prime lending companies outright. My question to 

the investment banks on the panel is do you believe this shift to 

ownership is improving credit quality and performance of subprime loans? What more can the industry do to improve credit 

quality and the performance of sub-prime loans? 

A.6. As discussed in response to Senator Reed’s question about 

vertical integration, Lehman believes that ownership of subprime 

loan originators by financial institutions increases the integrity of 

mortgage loan products, thereby benefiting borrowers and investors 

alike. That said, since the original hearing on this matter, there 

have been significant changes in the mortgage industry, particularly in the subprime segment. The volume of new subprime loans 

has decreased substantially. In connection with that pullback in 

the market, Lehman has closed the operations of its subprime 

originator, BNC Mortgage. Nonetheless, as an industry observer, 

Lehman believes that credit quality in the subprime area has been 

improving due to the tightening of underwriting criteria. 

LIABILITY

Q.7. There has been a significant amount of discussion about the 

role Wall Street has in the sub-prime market. There has also been 

a great deal said about the imposition of assignee liability to purchasers of loans. Do you feel assignee liability would play a significant role in guarding against ‘‘bad’’ loans being made by lenders 

and ultimately ending up in investor pools? If so, what level of ‘‘assignee liability’’ do you feel is appropriate? 

A.7. Imposition of assignee liability would lead to an undesirable 

tightening of credit for prospective homeowners. The State of Georgia’s experience with its assignee liability law illustrates this point. 

Soon after that law was passed, a major rating agency announced 

that it would no longer rate mortgage-backed securities subject to 

Georgia law. The rating agency reasoned that the assignee liability 

law created unquantifiable risk for anybody who touched the loans, 

including issuers and investors. Without sufficiently high ratings, 

mortgage-backed securities would not be purchased by investors, 

many of whom, such as pension funds, can only purchase investment grade securities. In light of the prospect that credit availability would be severely reduced for its citizens, Georgia amended 

its law to delete assignee liability. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM WARREN KORNFELD 

Q.1. How do the credit risk profiles of recent subprime borrowers 

differ from past borrowers? 

A.1. As we discussed in our written testimony, the risk profiles of 

recent subprime borrowers differ from those in the past. Through 


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2005 and 2006, in an effort to maintain or increase loan volume, 

many lenders made it easier for borrowers to obtain loans. For example, borrowers could: 

• obtain a mortgage with little or no money down; 

• choose to provide little or no documented proof of income or assets on their loan application; 

• obtain loans with low initial ‘‘teaser’’ interest rates that would 

reset to new, higher rates after two or three years; 

• opt to pay only interest and no principal on their loans for several years, which lowered their monthly payments but prevented the build-up of equity in the property; or 

• take out loans with longer terms, for example of 40 years or 

more, which have lower monthly payments that are spread out 

over a longer period of time and result in slower build-up of 

equity in the property. 

Often a loan was made with a combination of these characteristics, which is also known as ‘‘risk layering’’. The weaker performance of 2006 subprime mortgage loans in part has been due to the 

increasing risk characteristics of those mortgages. 

Q.2. Do rating agencies have adequate data to assess credit and 

market risk posed by recent subprime borrowers and some of these 

exotic or experimental products? If so, what new types of data are 

you using? Do you examine from what entities the loans are originated? 

A.2. Moody’s cannot represent what types of data other rating 

agencies attain in analyzing subprime mortgage securitizations. 

For Moody’s part, it is important to note that, in the course of 

rating a transaction, we do not see loan files or data identifying 

borrowers or specific properties. Rather, we rely on the information 

provided by the originators or the intermediaries, who in the underlying deal documents provide representations and warranties on 

numerous items including various aspects of the loans, the fact 

that they were originated in compliance with applicable law, and 

the accuracy of certain information about those loans. The originators of the loans issue representations and warranties in every 

transaction. While these ‘‘reps and warranties’’ will vary somewhat 

from transaction to transaction, they typically stipulate that, prior 

to the closing date, all requirements of federal, state or local laws 

regarding the origination of the loans have been satisfied, including 

those requirements relating to: usury, truth in lending, real estate 

settlement procedures, predatory and abusive lending, consumer 

credit protection, equal credit opportunity, and fair housing or disclosure. 

Moody’s would not rate a security unless the originator or intermediary had made reps and warranties such as those discussed 

above. In rating a subprime mortgage backed securitization, 

Moody’s estimates the amount of cumulative losses that the underlying pool of subprime mortgage loans are expected to incur over 

the lifetime of the loans (that is, until all the loans in the pool are 

either paid off or default). Because each pool of loans is different, 

Moody’s cumulative loss estimate, or ‘‘expected loss,’’ will differ 

from pool to pool. 


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1 As noted earlier, we do not receive any personal information that identifies the borrower or 

the property. 2Please see, ‘‘Moody’s Revised US Mortgage Loan-by-Loan Data Fields,’’ Special Report, April 

3, 2007. 

In arriving at the cumulative loss estimate, Moody’s considers 

both quantitative and qualitative factors. First, we analyze many 

characteristics of the loans in a pool,1 which help us project the future performance of the loans under a large number of different 

projected future economic scenarios. 

The quality and depth of the loan-level data provided by prospective mortgage securitizers are important elements of Moody’s rating process. For each new transaction, a data tape providing key 

information for each loan is processed through our proprietary rating model, Moody’s Mortgage Metrics. 

As new products are introduced in the market and as originators 

capture more data, Moody’s periodically expands the loan level 

data that we review to increase the granularity of our analysis; the 

most recent expansion was April 2007.2 Generally, in the absence 

of key information, assumptions are utilized. 

The key fields currently used in our standard analysis are listed 

below in the Appendix. The fields are divided into three groups: 

‘‘primary’’, ‘‘highly desirable’’ or ‘‘desirable’’ based on their overall 

risk weights. For instance, ‘‘FICO’’ is a primary field, while ‘‘pay 

history grade’’, if provided, would be used to supplement our understanding of a borrower’s risk profile. Other highly desirable fields 

such as cash reserves or escrow help us in further assessing the 

risk of a loan especially when we try to determine where a loan 

falls along the Alt-A to subprime continuum. 

Another example of a set of highly desirable fields, are the characteristics of the corresponding first lien when analyzing a second 

lien loan. The characteristics of the first lien have a strong impact 

on the credit risk and performance of the second lien loan. Moody’s 

expects a closed-end second lien loan behind a fixed-rate first lien 

loan to have a lower probability of default than a second lien loan 

behind a first lien Option ARM loan. Again, absent such information about the respective underlying first lien mortgage, conservative assumptions would be utilized to size for the unknown risks. 

Next, we consider the more qualitative factors of the asset pool 

such as the underwriting standards that the lender used when deciding whether to extend a mortgage loan, past performance of 

similar loans made by that lender, and how good the servicer has 

been at collection, billing, record-keeping and dealing with delinquent loans. We then analyze the structure of the transaction and 

the level of loss protection allocated to each tranche of bonds. Finally, based on all of this information, a Moody’s rating committee 

determines the rating of each tranche. 

Q.3. Have you analyzed the impact loan modifications would have 

on mortgage backed securities and the threshold needed to stabilize 

the portfolios into performing loans? 

A.3. To date, the level of modified loans in securitizations that we 

have rated has been low. We however expect this to change as interest rates on many hybrid adjustable rate loans originated during 


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3For a more detailed discussion, please see ‘‘Loan Modifications in U.S. RMBS: Frequently 

Asked Questions,’’ Special Report, June 6, 2007. 

the past few years approach their reset dates.3 Furthermore, in an 

environment with fewer refinancing opportunities for borrowers 

and a slowing housing market, loan modifications are likely to become more prevalent. 

A servicer’s flexibility in modifying loans that have been 

securitized is determined by each securitization’s legal documentation and by accounting and tax rules. Most securitization governing 

documents give servicers a degree of flexibility to modify loans if 

the loan is in default or default is ‘‘reasonably foreseeable,’’ but the 

exact provisions differ from one transaction to another. Moody’s recently reviewed the governing documents for the subprime 

securitizations that it rated in 2006. The vast majority of transactions permit the use of modifications—only approximately 5% of 

the securitizations contain specific language that does not permit 

the servicer to modify loans. For transactions where the servicer is 

allowed to modify loans, approximately 30% to 35% specify that 

modifications may not exceed 5% of the original pool loan balance 

or, alternatively, of the cumulative number of loans in the transaction. The balance of the transactions that permitted modifications contained no such cumulative restrictions. Moody’s believes 

that restrictions that limit a servicer’s flexibility to modify loans 

are generally not beneficial to bondholders. 

Moreover, in deciding whether to modify the terms of a loan, a 

servicer will assess whether the loss expected from modifying a 

loan will be lower than the loss expected from other loss mitigation 

options or from foreclosure. If so, then a loan modification would 

lead to higher cash flows for the securitization as a whole and 

therefore the judicious use of modifications should lead to lower cumulative losses on loan pools backing securitizations. Therefore, 

the ‘‘threshold needed to stabilize the portfolios’’ is necessarily a 

case-by-case determination. 

Since the purpose of a loan modification is to reduce the loss expected to be incurred on a loan that could potentially go into foreclosure, loan modifications should improve the credit profile of a 

securitization as a whole. The credit impact of loan modifications 

on any given class of bonds within a securitization, however, will 

vary and depend not only on the level of losses that is incurred by 

the pool, but also by the timing of those losses, by the bond’s position in the securitization’s capital structure and by the impact of 

loan modifications on any performance triggers that may exist in 

the securitization. 

Q.4. Could loan modifications help stabilize the housing market 

generally? 

A.4. Moody’s does not have the expertise to opine on the impact of 

loan modifications on the overall housing market. 

Q.5. Would you agree that the poorly underwritten exploding 

ARMs in the Mortgage-Backed Securities make default ‘‘reasonably 

foreseeable’’? If not, why not? What analysis has been done to identify what characteristics more specifically define loans with high 

probabilities of default? 


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4Please see, ‘‘An Update to Moody’s Analysis of Payment Shock Risk in Sub-Prime Hybrid 

ARM Products,’’ Rating Methodology, May 16, 2005. 

A.5. We assume that this question is referring to the probability 

of default for the individual ARM mortgages rather than the securities that are issued by a structured finance product where the underlying assets are such mortgages. As discussed earlier, when 

riskier loan characteristics are combined or ‘‘layered’’ the credit 

risk associated with that loan can increase. (In May 2005, we published on the significant increase in risk posed by the increasing 

difference between the fully indexed rate and the original rate or 

the amount of teasing of newly originated loans.4) However, the 

analysis of the default probability of a particular loan is in large 

part based on historical data with respect to similar types of loans. 

Importantly, the default probability of such loans will depend not 

only on the loan characteristics but on the macro-economic environment and the overall state of the housing market. Consequently, 

MIS believes that while ‘‘exploding ARMs’’ may have riskier characteristics, that fact alone does not determine whether the borrower will default on his mortgage. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR 

SCHUMER FROM WARREN KORNFELD 

Q.1. As you all know on the panel, federal banking regulators published guidance on alternative mortgage as well as sub-prime hybrid adjustable mortgage products last year and more recently have 

issued a new statement on these products for comment. Does the 

guidance apply to your firms in each of its capacities—lender, 

issuer, and underwriter of sub-prime and alternative mortgage 

products? 

Given your status as a Consolidated Supervised Entity (a brokerdealer that meets certain minimum standards can apply for this 

status. It gives them the ability to use alternative methods of computing net capital), do you think the SEC should be involved in the 

process of developing future guidance on these mortgage products 

in order to ensure that securities companies that are non-bank regulated entities are covered? 

A.1. These series of questions are not applicable to rating agencies. 

Q.2. What level of due diligence do purchasers of sub prime loans 

conduct to ensure the products they are buying meet underwriting 

requirements and/or state/federal laws? 

A.2. While this question is for the most part outside our area of 

credit expertise, as a general matter, we believe that purchasers of 

whole loans have an ability to conduct a certain level of due diligence on the loans and the loan files that they are purchasing. In 

contrast, investors in the mortgage backed securities do not have 

the appropriate level of expertise or resources to verify whether 

loans in a particular pool have satisfied underwriting requirements 

and or state/federal laws. 

Whole-loan purchasers may conduct due diligence on and re-underwrite anywhere from a small portion to 100% of the loans that 

they are purchasing, and may either use their own staff or a third 


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party to review loan files. However, they typically do not verify information directly with the borrower. Therefore, the whole-loan 

purchaser will not know whether any documents have been altered 

or are missing; and, will not know about the verbal communications between the originator, the broker and the borrower. 

Mortgage backed securities investors typically rely on the originator’s and/or securitization seller’s representations and warranties 

that the loans are in compliance with all regulations and all laws. 

However, it is our understanding that more and more mortgage 

backed securities investors are receiving some non-identifying loan 

level information and that the larger investors meet periodically 

with the management of the originators and may conduct on site 

visits (perhaps annually). 

Q.3. Additional Follow-up questions: Given the level of due diligence that is conducted, would the purchaser not be in a good position to guard against bad loans entering into investment pools from 

the very beginning? 

A.3. Moody’s does not have sufficient information or expertise to 

adequately respond to this question. 

Q.4. Liability: There has been a significant amount of discussion 

about the role Wall Street has in the subprime market. There has 

also been a great deal said about the imposition of assignee liability to purchasers of loans. Do you feel assignee liability would play 

a significant role in guarding against ‘‘bad’’ loans being made by 

lenders and ultimately ending up in investor pools? If so, what 

level of ‘‘assignee liability’’ do you feel is appropriate? 

A.4. Moody’s role in the market is to provide independent opinions 

on the creditworthiness of structures or securities. It is not Moody’s 

position or expertise to opine on the appropriateness of legislative 

action. Our role in the capital markets leads our residential mortgage backed securities (‘‘RMBS’’) team to take a narrow focus on 

legislation—namely, can the impact of the legislation be quantified. 

With respect to assignee liability laws, in certain circumstances 

such laws create unlimited assignee liability exposure or vague 

definitions which, in turn, make analyzing the credit risk associated with a pool of such loans difficult if not impossible. As we 

have said on previous occasions, laws that provide clear and objective standards and that define the thresholds for exposure are ones 

that can more readily be dimensioned and analyzed. 


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