Sunday, September 4, 2011


1009 “The Roots of the Financial Crisis: Who is to Blame?” The Center for Public Integrity (5/6/2009),
1010 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the
Foreclosure Crisis,” at 7.
1011 1/25/2010, “Mortgage Subprime Origination,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-0001-
21, at 4.
To enable subprime borrowers to buy homes that they would not traditionally qualify for,
lenders began using exotic mortgage products that reduced or eliminated the need for large down
payments and allowed monthly mortgage payments that reflected less than the fully amortized
cost of the loan. For example, some types of mortgages allowed borrowers to obtain loans for
100% of the cost of a house; make monthly payments that covered only the interest owed on the
loan; or pay artificially low initial interest rates on loans that could be refinanced before higher
interest rates took effect. In 2006, Barron’s reported that first-time home buyers put no money
down 43% of the time in 2005; interest only loans made up approximately 33% of new
mortgages and home equity loans in 2005, up from 0.6% in 2000; by 2005, 15% of borrowers
owed at least 10% more than their home was worth; and more than $2.5 trillion in adjustable rate
mortgages were due to reset to higher interest rates in 2006 and 2007.1012
These new mortgage products were not confined to subprime borrowers; they were also
offered to prime borrowers who used them to purchase expensive homes. Many borrowers also
used them to refinance their homes and take out cash against their homes’ increased value.
Lenders also increased their issuance of home equity loans and lines of credit that offered low
1012 “The No-Money-Down Disaster,” Barron’s (8/21/2006).
initial interest rates or interest-only features, often taking a second lien on an already mortgaged
Subprime loans, Alt A mortgages that required little or no documentation, and home
equity loans all posed a greater risk of default than traditional 30-year, fixed rate mortgages. By
2006, the combined market share of these higher risk home loans totaled nearly 50% of all
mortgage originations.1014
At the same time housing prices and high risk loans were increasing, the National
Association of Realtors’ housing affordability index showed that, by 2006, housing had become
less affordable than at any point in the previous 20 years, as presented in the graph below.1015
The “affordability index” measures how easy it is for a typical family to afford a typical
mortgage. Higher numbers mean that homes are more affordable, while lower numbers mean
that homes are generally less affordable.
By the end of 2006, the concentration of higher risk loans for less affordable homes had set the
stage for an unprecedented number of credit rating downgrades on mortgage related securities.
1013 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the
Foreclosure Crisis,” at 8.
1014 Id.
1015 11/7/2007 “Would a Housing Crash Cause a Recession?” report prepared by the Congressional Research
Service, at 3-4.
(2) Mass Downgrades
Although ratings downgrades for investment grade securities are supposed to be
relatively infrequent, in 2007, they took place on a massive scale that was unprecedented in U.S.
financial markets. Beginning in July 2007, Moody’s and S&P downgraded hundreds and then
thousands of RMBS and CDO ratings, causing the rated securities to lose value and become
much more difficult to sell, and leading to the subsequent collapse of the RMBS and CDO
secondary markets. The massive downgrades made it clear that the original ratings were not
only deeply flawed, but the U.S. mortgage market was much riskier than previously portrayed.
Housing prices peaked in 2006. In late 2006, as the increase in housing prices slowed or
leveled out, refinancing became more difficult, and delinquencies in subprime residential
mortgages began to multiply. By January 2007, nearly 10% of all subprime loans were
delinquent, a 68% increase from January 2006.1016 Housing prices then began to decline,
exposing more borrowers who had purchased homes that they could not afford and could no
longer refinance. Subprime lenders also began to close their doors, which the U.S. Department
of Housing and Urban Development marked as the beginning of economic trouble:
“Arguably, the first tremors of the national mortgage crisis were felt in early December
2006 when two sizeable subprime lenders, Ownit Mortgage Solutions and Sebring
Capital, failed. The Wall Street Journal described the closing of these firms as ‘sending
shock waves’ through the mortgage-bond market. …By late February 2007 when the
number of subprime lenders shuttering their doors had reached 22, one of the first
headlines announcing the onset of a ‘mortgage crisis’ appeared in the Daily Telegraph of
During the first half of 2007, despite the news of failing subprime lenders and increasing
subprime mortgage defaults, Moody’s and S&P continued to issue AAA credit ratings for a large
number of RMBS and CDO securities. In the first week of July 2007 alone, S&P issued over
1,500 new RMBS ratings, a number that almost equaled the average number of RMBS ratings it
issued in each of the preceding three months.1018 From July 5 to July 11, 2007, Moody’s issued
approximately 675 new RMBS ratings, nearly double its weekly average in the prior month.1019
1016 1/25/2010 “60 Day+Delinquency and Foreclosure,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-
0001-21, at 15. Subcommittee interview of Sihan Shu (2/24/2010).
The timing of this surge of new ratings on the eve of the mass downgrades is troubling, and
raises serious questions about whether S&P and Moody’s quickly pushed these ratings through
to avoid losing revenues before the mass downgrades began.
1017 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the
Foreclosure Crisis,” at 2 [citations omitted].
1018 6/24/2010 supplemental response from S&P to the Subcommittee, at 12, Hearing Exhibit 4/23-108.
1019 Data compiled by the Subcommittee using 6/14/2007 “Structured Finance New Ratings: May 28, 2007 through
June 13, 2007,” Moody’s; 6/28/2007 “Structured Finance New Ratings: June 11, 2007 through June 27, 2007,”
Moody’s; 7/5/2007 “Structured Finance New Ratings: June 18, 2007 through July 4, 2007,” Moody’s; and
7/12/2007 “Structured Finance New Ratings: June 25, 2007 through July 11, 2007,” Moody’s.
In the second week of July 2007, S&P and Moody’s initiated the first of several mass
rating downgrades, shocking the financial markets. On July 10, S&P placed on credit watch, the
ratings of 612 subprime RMBS with an original value of $7.35 billion,1020 and two days later
downgraded 498 of these securities.1021 On July 10, Moody’s downgraded 399 subprime RMBS
with an original value of $5.2 billion.1022 By the end of July, S&P had downgraded more than
1,000 RMBS and almost 100 CDO securities.1023 This volume of rating downgrades was
unprecedented in U.S. financial markets.
The downgrades created significant turmoil in the securitization markets, as investors
were required to sell off RMBS and CDO securities that had lost their investment grade status,
RMBS and CDO securities in the investment portfolios of financial firms lost much of their
value, and new securitizations were unable to find investors. The subprime RMBS secondary
market initially froze and then collapsed, leaving financial firms around the world holding
suddenly unmarketable subprime RMBS securities that were plummeting in value.1024
Neither Moody’s nor S&P produced any meaningful contemporaneous documentation
explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass
downgrades by the two companies happened to occur two days apart, or analyzing the possible
impact of their actions on the financial markets. When Moody’s CEO, Raymond McDaniel, was
asked about the July downgrades, he indicated that he could not recall any aspect of the decisionmaking
process.1025 He told the Subcommittee that he was merely informed that the downgrades
would occur, but was not personally involved in the decision.1026
1020 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108
(7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions
Announced,” S&P RatingsDirect (correcting the original version issued on 7/10/2007)).
1021 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit I, Hearing Exhibit 4/23-108
(7/12/2007 “Various U.S. First-Lien Subprime RMBS Classes Downgraded,” S&P’s RatingsDirect).
1022 7/30/2010 supplemental response from Moody’s to the Subcommittee, Hearing Exhibit 4/23-106 (7/12/2007
Moody’s Structured Finance Teleconference and Web Cast, “RMBS and CDO Rating Actions,” at MOODYSPSI2010-
0046899-900). The $5.2 billion also included the original value of 32 tranches that were put on review for
possible downgrade that same day.
1023 6/24/2010 supplemental response from S&P to the Subcommittee, at 3, 6, Hearing Exhibit 4/23-108. According
to this letter, the July downgrades were not the first to take place during 2007. The letter reports that, altogether in
the first six months of 2007, S&P downgraded 739 RMBS and 25 CDOs. These downgrades, however, took place
on multiple days over a six-month period. Prior to July, Moody’s had downgraded approximately 480 RMBS
during the first six months of 2007 (this figure was calculated by the Subcommittee based on information from
Moody’s “Structured Finance: Changes & Confirmations” reports for that time period).
1024 See 3/19/2007 “Subprime Mortgages: Primer on Current Lending and Foreclosure Issues,” report prepared by
the Congressional Research Service, Report No. RL33930; 5/2008 “The Subprime Lending Crisis: Causes and
Effects of the Mortgage Meltdown,” report prepared by CCH, at 13.
1025 Subcommittee interview of Ray McDaniel (4/6/2010).
1026 Id. At S&P, no emails were produced that explained the decision-making process, but a few indicated that, prior
to the mass downgrades, the RMBS Group was required to make a presentation to the chief executive of its parent
company about “how we rated the deals and are preparing to deal with the fallout (downgrades).” 3/18/2007 email
from Michael Gutierrez to William LeRoy, Hearing Exhibit 4/23-52a; 3/2007 S&P internal email chain, “Preempting
bad press on the subprime situation,” Hearing Exhibit 4/23-52c.
Although neither Moody’s nor S&P produced documentation on its internal decisionmaking
process related to the mass downgrades, one bank, UBS, produced an email in
connection with a court case indicating that Moody’s was meeting with a series of investment
banks to discuss the upcoming downgrades. In an email dated July 5, 2007, five days before the
mass downgrades began, a UBS banker sent an email to a colleague about a meeting with
“I just got off the phone with David Oman …. Apparently they’re meeting w/ Moodys to
discuss impacts of ABS subprime downgrades, etc. Has he been in contact with the
[UBS] Desk? It sounds like Moodys is trying to figure out when to start downgrading,
and how much damage they’re going to cause – they’re meeting with various investment
It is unclear how much notice Moody’s or S&P provided to investment banks regarding their
planned actions.
One senior executive at S&P, Ian Bell, the head of European structured finance ratings,
provided his own views in a post-mortem analysis a few days after the initial downgrades. He
expressed frustration and concern that S&P had mishandled its public explanation of the mass
downgrades, writing:
“[O]ne aspect of our handling of the subprime that really concerns me is what I
see as our arrogance in our messaging. Maybe it is because I am away from the
center of the action and so have more of an ‘outsider’s’ point of view. …
I listened to the telecon TWICE. That guy [who asked a question about the
timing of the mass downgrades] was not a ‘jerk’. He asked an entirely legitimate
question that we should have anticipated. He then got upset when we totally
fluffed our answer. We did sound like the Nixon White House. Instead of
dismissing people like him or assuming some dark motive on their part, we should
ask ourselves how we could have so mishandled the answer to such an obvious
I have thought for awhile now that if this company suffers from an Arthur
Andersen event, we will not be brought down by a lack of ethics as I have never
seen an organisation more ethical, nor will it be by greed as this plays so little role
in our motivations; it will be arrogance.”1028
In August 2007, Eric Kolchinsky, a managing director of Moody’s CDO analysts, sent an
urgent email to his superiors about the pressures to rate still more new CDOs in the midst of the
mass downgrades:
1027 7/5/2007 email from David Goldsteen (UBS) to Dayna Corlito (UBS), “ABS Subprime & Moody’s
downgrades,” UBS-CT 021485, Hearing Exhibit 4/23-94o.
1028 7/13/2007 internal S&P email from Ian Bell to Tom Gillis and Joanne Rose, Hearing Exhibit 4/23-54a.
“[E]ach of our current deals is in crisis mode. This is compounded by the fact that we
have introduced new criteria for ABS CDOs. Our changes are a response to the fact that
we are already putting deals closed in the spring on watch for downgrade. This is
unacceptable and we cannot rate the new deals in the same away [sic] we have done
before. ... [B]ankers are under enormous pressure to turn their warehouses into CDO
Both Moody’s and S&P continued to rate new CDO securities despite their companies’
accelerating downgrades.
In October 2007, Moody’s began downgrading CDOs on a daily basis, using the month to
downgrade more than 270 CDO securities with an original value of $10 billion.1030 In December
2007, Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on
credit watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were
downgraded and 1954 ratings from 732 deals were upgraded,” which means it issued four times
as many downgrades as upgrades.1031 S&P calculated that, during the second half of 2007, it
downgraded over 9,000 RMBS ratings.1032
The downgrades continued into 2008. On January 30, 2008, S&P took action on over
6,300 subprime RMBS securities and over 1,900 CDO securities—meaning it either downgraded
their ratings or placed the securities on credit watch with negative implications. The affected
RMBS and CDO securities represented issuance amounts of approximately $270.1 billion and
$263.9 billion, respectively.1033
The rating downgrades affected a wide range of RMBS and CDO securities. Some of the
downgraded securities had been rated years earlier; others had received AAA ratings less than 12
months before. For example, in April 2007, both Moody’s and S&P gave AAA ratings to three
tranches of approximately $1.5 billion in a cash CDO known as Vertical ABS CDO 2007-1. Six
months later, the majority of the CDO’s tranches were downgraded to junk status; in 2008, the
CDO’s ratings were withdrawn, it assets were liquidated, and the AAA rated securities became
worthless. In another case, in February and March 2007, Moody’s and S&P gave AAA ratings
to 5 tranches of about a $1 billion RMBS securitization known as GSAMP Trust 2007-FM2. In
late 2007, both credit rating agencies began downgrading the securities; by 2008, they began
1029 8/22/2007 email from Moody’s Eric Kolchinsky, “Deal Management,” Hearing Exhibit 4/23-42.
1030 7/30/2010 supplemental response from Moody’s to the Subcommittee, at 9, Hearing Exhibit 4/23-106. In an
email sent in the midst of these CDO downgrades, one Moody’s analyst commented to a colleague: “You’re right
about CDOs as WMD – but it’s only CDOs backed by subprime that are WMD.” 11/27/2007 email from William
May to Deepali Advani, Hearing Exhibit 4/23-58.
1031 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by
Moody’s, at 4.
1032 6/24/2010 supplemental response from S&P to the Subcommittee, at 6, Hearing Exhibit 4/23-108.
1033 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108
(1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s
downgrading the AAA rated securities, and by August 2009 S&P had downgraded all its
tranches to noninvestment grade or junk status.
One more striking example involved a $1.6 billion hybrid CDO known as Delphinus
CDO 2007-1, Ltd., which was downgraded a few months after its rating was issued. Moody’s
gave AAA ratings to seven of its tranches and S&P to six tranches in July and August 2007,
respectively, but began downgrading its securities by the end of the year, and by the end of 2008,
had fully downgraded its AAA rated securities to junk status.1034
Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued
in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and
Percent of the Original AAA Universe
Currently Rated Below Investment Grade
Source: BlackRock Solutions as of February 8, 2010.
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010.
D. Ratings Deficiencies
The Subcommittee’s investigation uncovered a host of factors responsible for the
inaccurate credit ratings assigned by Moody’s and S&P to RMBS and CDO securities. Those
factors include the drive for market share, pressure from investment banks to inflate ratings,
inaccurate rating models, and inadequate rating and surveillance resources. In addition, federal
regulations that limited certain financial institutions to the purchase of investment grade financial
instruments encouraged investment banks and investors to pursue and credit rating agencies to
provide those top ratings. All these factors played out against the backdrop of an ongoing
conflict of interest that arose from how the credit rating agencies earned their income. If the
1034 For more details about these three examples, see “Fact Sheet for Three Examples of Failed AAA Ratings,”
prepared by the Subcommittee based on information from S&P and Moody’s websites.
1035 See “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by the
Subcommittee using data from BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the
Securitization of Subprime Mortgage Credit,” report prepared by Federal Reserve Bank of New York staff, no. 318,
at 58 and table 31 (“92 percent of 1st-lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien
deals originated in 2006 have been downgraded.”). See also “Regulatory Use of Credit Ratings: How it Impacts the
Behavior of Market Constituents,” University of Westminster - School of Law International Finance Review
(2/2009), at 65-104 (citations omitted) (“As of February 2008, Moody’s had downgraded at least one tranche of
94.2% of the subprime RMBS issues it rated in 2006, including 100% of the 2006 RMBS backed by second-lien
loans, and 76.9% of the issues rated in 2007. In its rating transition report, S&P wrote that it had downgraded
44.3% of the subprime tranches it rated between the first quarter of 2005 and the third quarter of 2007.”)
Vintage Prime
2004 3% 9% 10% 17% 50% 11%
2005 39% 58% 73% 81% 76% 53%
2006 81% 90% 96% 98% 97% 93%
2007 92% 90% 98% 96% 97% 91%
credit rating agencies had issued ratings that accurately exposed the increasing risk in the RMBS
and CDO markets, they may have discouraged investors from purchasing those securities,
slowed the pace of securitizations, and as a result reduced their own profits. It was not in the
short term economic self-interest of either Moody’s or S&P to provide accurate credit risk
ratings for high risk RMBS and CDO securities.
(1) Awareness of Increasing Credit Risks
The evidence shows that analysts within Moody’s and S&P were aware of the increasing
risks in the mortgage market in the years leading up to the financial crisis, including higher risk
mortgage products, increasingly lax lending standards, poor quality loans, unsustainable housing
prices, and increasing mortgage fraud. Yet for years, neither credit rating agency heeded
warnings – even their own about the need to adjust their processes to accurately reflect the
increasing credit risk.
Moody’s and S&P began issuing public warnings about problems in the mortgage market
as early as 2003, yet continued to issue inflated ratings for RMBS and CDO securities before
abruptly reversing course in July 2007. Moody’s CEO testified before the House Committee on
Oversight and Government Reform, for example, that Moody’s had been warning the market
continuously since 2003, about the deterioration in lending standards and inflated housing prices.
“Beginning in July 2003, we published warnings about the increased risks we saw and
took action to adjust our assumptions for the portions of the residential mortgage backed
securities (“RMBS”) market that we were asked to rate.”1036
Both S&P and Moody’s published a number of articles indicating the potential for deterioration
in RMBS performance.1037 For example, in September 2005, S&P published a report entitled,
“Who Will Be Left Holding the Bag?” The report contained this strong warning:
“It’s a question that comes to mind whenever one price increase after another – say, for
ridiculously expensive homes – leaves each succeeding buyer out on the end of a longer
1036Prepared statement of Raymond W. McDaniel, Moody’s Chairman and Chief Executive Officer, “Credit Rating
Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and
Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 1 (hereinafter “10/22/2008 McDaniel prepared
1037 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Hearing Exhibit 4/23-108
(4/20/2005 Subprime Lenders: Basking in the Glow of A Still-Benign Economy, but Clouds Forming on the
Horizon” S&P; 9/13/2005 “Simulated Housing Market Decline Reveals Defaults Only in Lowest-Rated U.S. RMBS
Transactions,” S&P; and 1/19/2006 “U.S. RMBS Market Still Robust, But Risks Are Increasing and Growth
Drivers Are Softening” S&P). “Housing Market Downturn in Full Swing,” Moody’s (10/4/2006);
1/18/2007 “Special Report: Early Defaults Rise in Mortgage Securitization,” Moody’s ; and 9/21/2007 “Special
Report: Moody’s Subprime Mortgage Servicer Survey on Loan Modifications,” Moody’s. See 10/22/2008
McDaniel prepared statement at 13-14. In addition, in March 2007 Moody’s warned of the possible effect that
downgrades of subprime mortgage backed securities might have on its structured finance CDOs. See 3/2007 “The
Impact of Subprime Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A
Preliminary Review,” Moody’s.
and longer limb: When the limb finally breaks, who’s going to get hurt? In the red-hot
U.S. housing market, that’s no longer a theoretical riddle. Investors are starting to ask
which real estate vehicles carry the most risk – and if mortgage defaults surge, who will
end up suffering the most.”1038
Internal Moody’s and S&P emails further demonstrate that senior management and
ratings personnel were aware of the deteriorating mortgage market and increasing credit risk. In
June 2005, for example, an outside mortgage broker who had seen the head of S&P’s RMBS
Group, Susan Barnes, on a television program sent her an email warning about the “seeds of
destruction” in the financial markets. He noted that no one at the time seemed interested in
fixing the looming problems:
“I have contacted the OTS, FDIC and others and my concerns are not addressed. I have
been a mortgage broker for the past 13 years and I have never seen such a lack of
attention to loan risk. I am confident our present housing bubble is not from supply and
demand of housing, but from money supply. In my professional opinion the biggest
perpetrator is Washington Mutual. 1) No income documentation loans. 2) Option ARMS
(negative amortization) ... 5) 100% financing loans. I have seen instances where WAMU
approved buyers for purchase loans; where the fully indexed interest only payments
represented 100% of borrower’s gross monthly income. We need to stop this
Several email chains among S&P employees in the Servicer Evaluation Group in
Structured Finance demonstrate a clear awareness of mortgage market problems. One from
September 2006, for example, with the subject line “Nightmare Mortgages,” contains an
exchange with startling frankness and foresight. One S&P employee circulated an article on
mortgage problems, stating: “Interesting Business Week article on Option ARMs, quoting
anecdotes involving some of our favorite servicers.” Another responded: “This is frightening. It
wreaks of greed, unregulated brokers, and ‘not so prudent’ lenders.”1040 Another employee
commenting on the same article said: “I’m surprised the OCC and FDIC doesn’t come
downharder [sic] on these guys - this is like another banking crisis potentially looming!!”1041
Another email chain that same month shows that at least some employees understood the
significance of problems within the mortgage market nine months before the mass downgrades
began. One S&P employee wrote: “I think [a circulated article is] telling us that underwriting
fraud; appraisal fraud and the general appetite for new product among originators is resulting in
loans being made that shouldn’t be made.… [I]f [Eliot] Spitzer [then-New York Attorney
General] could prove coercion this could be a RICO offense!” A colleague responded that the
1038 “Economic Research: Who Will be Left Holding the Bag?” S&P’s RatingsDirect (9/12/2005).
1039 7/22/2005 email from Michael Blomquist (Resource Realty) to Susan Barnes (S&P), “Washington Mutual,”
Hearing Exhibit 4/23-45.
1040 9/2/2006 email from Robert Mackey to Richard Koch, “Nightmare Mortgages,” Hearing Exhibit 4/23-46a.
1041 9/5/2006 email from Michael Gutierrez to Richard Koch and Edward Highland, “RE: Nightmare Mortgages,”
Hearing Exhibit 4/23-46b.
head of the S&P Surveillance Group “told me that broken down to loan level what she is seeing
in losses is as bad as high 40’s – low 50% I’d love to be able to publish a commentary with this
data but maybe too much of a powder keg.”1042
In a third email chain from August 2006, commenting on an article about problems in the
mortgage market, a director in the S&P Servicer Evaluation Group wrote: “I’m not surprised;
there has been rampant appraisal and underwriting fraud in the industry for quite some time as
pressure has mounted to feed the origination machine.”1043 Another S&P director in the same
group wrote in an October 2006 internal email about a news article entitled, “More Home Loans
Go Sour – Though New Data Show Rising Delinquencies, Lenders Continue to Loosen
Mortgage Standards”: “Pretty grim news as we suspected – note also the ‘mailing in the keys
and walking away’ epidemic has begun – I think things are going to get mighty ugly next
year!”1044 Still another S&P email the same month circulated an article entitled, “Home Prices
Keep Sliding; Buyers Sit Tight,” and remarked: “[J]ust curious...are there ever any positive
repo[r]ts on the housing market?”1045
An email among several S&P employees a few months later circulated an article entitled,
“The Mortgage Mess Spreads” with one person noting ominously: “This is like watching a
hurricane from FL [Florida] moving up the coast slowly towards us. Not sure if we will get hit
in full or get trounced a bit or escape without severe damage...”1046
Government Warnings. At the same time the credit rating agencies were publishing
reports and circulating articles internally about the deteriorating mortgage market, several
government agencies issued public warnings about lax lending standards and increasing
mortgage fraud. A 2004 quarterly report by the FDIC, for example, sounded an alarm over the
likelihood of more high risk loan delinquencies:
“[I]t is unlikely that home prices are poised to plunge nationwide, even when mortgage
rates rise .... The greater risk to insured institutions is the potential for increased credit
delinquencies and losses among highly leveraged, subprime, and ARM borrowers. These
1042 9/29/2006 email from Michael Gutierrez, Director at S&P, PSI-S&P-RFN-000029.
1043 8/7/2006 email from Richard Koch, Director at S&P, Hearing Exhibit 4/23-1d.
1044 10/20/2006 email from Michael Gutierrez to Richard Koch and others, Hearing Exhibit 4/23-47.
1045 10/26/2006 email from Ernestine Warner to Robert Pollsen, Hearing Exhibit 4/23-48.
1046 3/9/2007 email from KP Rajan, Hearing Exhibit 4/23-51. See also 2/14/2006 email from Robert Pollsen, PSIS&
P-RFN-000038 (forwarding “Coming Home to Roost,” Barron’s (2/13/2006), which includes the sentences “The
red-hot U.S. housing market may be fast approaching its date with destiny .... much anxiety is being focused on a
looming ‘reset problem.’”); see also 3/25/2007 S&P internal email chain, PSI-S&P-RFN-000006 (forwarding
“Slow-Motion Train Wreck Picks Up Speed,” Barron’s (3/26/2007)). 3/26/2007 Moody’s internal email, PSI-S&PRFN-
000003 (forwarding “Slow-Motion Train Wreck Picks Up Speed,” Barron’s (3/26/2007)); 10/19/2006
Moody’s internal email, PSI-MOODYS-RFN-000009 (forwarding “More Home Loans Go Sour—Though New
Data Show Rising Delinquencies, Lenders Continue to Loosen Mortgage Standards,” The Wall Street Journal
(10/19/2006)); 9/6/2006 Moody’s internal email, PSI-MOODYS-RFN-000001 (forwarding “The No-Money-Down
Disaster.” Barron’s (8/21/2006)).
high-risk segments of mortgage lending may drive overall mortgage loss rates higher if
home prices decline or interest rates rise.”1047
In 2005, in its 11th Annual Survey on Credit Underwriting Practices, the Office of the
Comptroller of the Currency (OCC), which oversees nationally chartered banks, described a
significant lowering of retail lending standards, noting it was the first time in the survey’s history
that a net lowering of retail lending practices had been observed. The OCC wrote:
“Retail lending has undergone a dramatic transformation in recent years as banks have
aggressively moved into the retail arena to solidify market positions and gain market
share. Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum
payments, more revolving debt, less documentation and verification, and lengthening
amortizations - have introduced more risk to retail portfolios.”1048
Starting in 2004, federal law enforcement agencies also issued multiple warnings about
fraud in the mortgage marketplace. For example, the Federal Bureau of Investigation (FBI)
made national headlines when it warned that mortgage fraud had the potential to be a national
epidemic,1049 and issued a 2004 report describing how mortgage fraud was becoming more
prevalent. The report noted: “Criminal activity has become more complex and loan frauds are
expanding to multitransactional frauds involving groups of people from top management to
industry professionals who assist in the loan application process.”1050 The FBI also testified
about the problem before Congress:
“The potential impact of mortgage fraud on financial institutions and the stock market is
clear. If fraudulent practices become systemic within the mortgage industry and
mortgage fraud is allowed to become unrestrained, it will ultimately place financial
institutions at risk and have adverse effects on the stock market.”1051
In 2006, the FBI reported that the number of Suspicious Activity Reports describing mortgage
fraud had risen significantly since 2001.1052
1047 “Housing Bubble Concerns and the Outlook for Mortgage Credit Quality,” FDIC Outlook (Spring 2004),
available at
1048 6/2005 “Survey of Credit Underwriting Practices,” report prepared by the Office of the Comptroller of the
Currency, at 6, available at
1049 “FBI: Mortgage Fraud Becoming an ‘Epidemic,’” USA Today (9/17/2004).
1050 FY 2004 “Financial Institution Fraud and Failure Report,” prepared by the Federal Bureau of Investigation,
available at
1051 Prepared statement of Chris Swecker, Assistant Director of the Criminal Investigative Division, Federal Bureau
of Investigation, “Mortgage Fraud and Its Impact on Mortgage Lenders,” before the U.S. House of Representatives
Financial Services Subcommittee on Housing and Community Opportunity, Cong.Hrg. 108-116 (10/7/2004), at 2.
1052 “Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006,” prepared by
the Federal Bureau of Investigation, available at
The FBI’s fraud warnings were repeated by industry analysts. The Mortgage Bankers
Association’s Mortgage Asset Research Institute (MARI), for example, had been reporting
increasing fraud in mortgages for years. In April 2007, MARI reported a 30% increase in 2006
in loans with suspected mortgage fraud. The report also noted that while 55% of overall fraud
incidents reported to MARI involved loan application fraud, the percentage of subprime loans
with loan application fraud was even higher at 65%.1053
Press Reports. Warnings in the national press concerning the threat posed by
deteriorating mortgages and unsustainable housing prices were also prevalent. A University of
Florida website has collected dozens of these articles, many of which were published in 2005.
The headlines include: “Fed Debates Pricking the U.S. Housing ‘Bubble’,” New York Times,
May 31, 2005; “Yale Professor Predicts Housing ‘Bubble’ Will Burst,” NPR, June 3, 2005;
“Cover Story: Bubble Bath of Doom” [warning of overheated real estate market], Washington
Post, July 4, 2005; “Housing Affordability Hits 14-Year Low,” The Wall Street Journal,
December 22, 2005; “Foreclosure Rates Rise Across the U.S.,” NPR, May 30, 2006; “For Sale
Signs Multiply Across U.S.,” The Wall Street Journal, July 20, 2006; and “Housing Gets Ugly,”
New York Times, August 25, 2006.1054
Had Moody’s and S&P heeded their own warnings as well as the warnings in government
reports and the national press, they might have issued more conservative, including fewer AAA,
ratings for RMBS and CDO securities from 2005 to 2007; required additional credit
enhancements earlier; and issued ratings downgrades earlier and with greater frequency,
gradually letting the air out of the housing bubble instead of puncturing it with the mass
downgrades that began in July 2007. The problem, however, was that neither company had a
financial incentive to assign tougher credit ratings to the very securities that for a short while
increased their revenues, boosted their stock prices, and expanded their executive compensation.
Instead, ongoing conflicts of interest, inaccurate credit rating models, and inadequate rating and
surveillance resources made it possible for Moody’s and S&P to ignore their own warnings about
the U.S. mortgage market. In the longer run, these decisions cost both companies dearly.
Between January 2007 and January 2009, the stock price for both The McGraw-Hill Companies
(S&P’s parent company) and Moody’s fell nearly 70%, and neither share price has fully
(2) CRA Conflicts of Interest
In transitioning from the fact that the rating agencies issued inaccurate ratings to the
question of why they did, one of the primary issues is the conflicts of interest inherent in the
“issuer-pays” model. Under this system, the firm interested in profiting from an RMBS or CDO
security is required to pay for the credit rating needed to sell the security. Moreover, it requires
the credit rating agencies to obtain business from the very companies paying for their rating
1053 4/2007 “Ninth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association,” prepared by the
Mortgage Asset Research Institute, LLC, at 10.
1054 “Business Library – The Housing Bubble,” University of Florida George A. Smathers Libraries,
judgment. The result is a system that creates strong incentives for the rating agencies to inflate
their ratings to attract business, and for the issuers and arrangers of the securities to engage in
“ratings shopping” to obtain the highest ratings for their financial products.
The conflict of interest inherent in an issuer-pay setup is clear: rating agencies are
incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order
to attract business. It is much like a person trying to sell a home and hiring a third-party
appraiser to make sure it is worth the price. Only, with the credit rating agencies, it is the seller
who hires the appraiser on behalf of the buyer – the result is a misalignment of interests. This
system, currently permitted by the SEC, underlies the “issuers-pay” model.
The credit rating agencies assured Congress and the investing public that they could
“manage” these conflicts, but the evidence indicates that the drive for market share and
increasing revenues, ratings shopping, and investment bank pressures have undermined the
ratings process and the quality of the ratings themselves. Multiple former Moody’s and S&P
employees told the Subcommittee that, in the years leading up to the financial crisis, gaining
market share, increasing revenues, and pleasing investment bankers bringing business to the firm
assumed a higher priority than issuing accurate RMBS and CDO credit ratings.
(a) Drive for Market Share
Prior to the explosive growth in revenues generated from the ratings of mortgage backed
securities, the credit rating agencies had a reputation for exercising independent judgment and
taking pride in requiring the information and performing the analysis needed to issue accurate
credit ratings. A journalist captured the rating agency culture in a 1995 article when she wrote:
“Ask a [company’s] treasurer for his opinion of rating agencies, and he’ll probably rank them
somewhere between a trip to the dentist and an IRS audit. You can’t control them, and you can’t
escape them.”1055
But a number of analysts who worked for Moody’s during the 1990s and into the new
decade told the Subcommittee that a major cultural shift took place at the company around 2000.
They told the Subcommittee that, prior to 2000, Moody’s was academically oriented and
conservative in its issuance of ratings. That changed, according to those interviewed, with the
rise of Brian Clarkson who worked at Moody’s from 1990 to 2008, and rose from Group
Managing Director of the Global Asset Backed Finance Group to President and Chief Operating
Officer of Moody’s. These employees indicated that during Mr. Clarkson’s tenure Moody’s
began to focus less on striving for accurate credit ratings, and more on increasing market share
and “servicing the client,” who was identified as the investment banks that brought business to
the firm.
This testimonial evidence that increasing revenues gained importance is corroborated by
documents obtained by the Subcommittee during the course of its investigation. For example, in
a March 2000 email, the head of Moody’s Structured Finance Group in Paris wrote that she was
1055 “Rating the Rating Agencies,” Treasury and Risk Management (7/1995).
leaving the firm, because she was uncomfortable with “the lack of a strategy I can clearly
understand, other than maximize the market share and the gross margin with insufficient
resources.”1056 A 2002 Moody’s survey of the Structured Finance Group (SFG) also documents
the shift, finding that most employees who responded to the survey indicated that SFG business
objectives included: generating increased revenue; increasing market share; fostering good
relationships with issuers and investors; and delivering high quality ratings and research.
According to the survey results: “When asked about how business objectives were translated
into day-to-day work, most agreed that writing deals was paramount, while writing research and
developing new products and services received less emphasis. Most agreed that there was a
strong emphasis on relationships with issuers and investment bankers.”1057
A 2003 email sent by Mr. Clarkson to one of his senior managers about the performance
of the Structured Finance Real Estate and Derivatives Group further demonstrates the firm’s
emphasis on market share. Mr. Clarkson wrote:
“Noel and his team handled the increase and met or exceeded almost every financial and
market share objective and goal for his Group. … Through November total revenue for
Noel’s Group has grown 16% compared with budgeted growth of 10% with CMBS
[Commercial Mortgage Backed Securities] up 19% and Derivatives up 14%. This was
achieved by taking advantage of increased CMBS issuance volumes and by meeting or
slightly exceeding market share objectives for the Group. The Derivatives team has
achieved a year to date 96% market share compared to a target share of 95%. This is
down approximately 2% from 2002 primarily due to not rating Insurance TRUP CDO’s
and rating less subordinated tranches. Noel’s team is considering whether we need to
refine our approach to these securities. The CMBS team was able to meet their target
share of 75%. However this was down from 84% market share in 2002 primarily due to
competitor’s [sic] easing their standards to capture share.”1058
This performance analysis notes that the team being reviewed put up a strong performance
despite competitors “easing their standards to capture [market] share.” It also notes that for
certain CDOs and “less subordinated tranches,” Moody’s might “need to refine our approach.”
The clear emphasis of the analysis is increasing revenues and meeting “market share objectives,”
and appears silent with regard to issuing accurate ratings.
One former Moody’s senior vice president, Mark Froeba, told the Subcommittee that Mr.
Clarkson used fear and intimidation tactics to make analysts spend less time on the ratings
process and work more cooperatively with investment bankers.1059
1056 3/19/2000 email from Catherine Gerst to Debra Perry, Moody’s Chief Administrative Officer, PSI-MOODYSRFN-
At the Subcommittee
hearing, another former Moody’s senior analyst, Richard Michalek, described a meeting that he
1057 5/2/2002 Moody’s SFG 2002 Associate Survey, prepared by Metrus Group, at 4, Hearing Exhibit 4/23-92a.
1058 12/1/2003 email from Brian Clarkson to Noel Kirnon, Managing Director of Real Estate and Derivatives Group,
Hearing Exhibit 4/23-15.
1059 Subcommittee interview of Mark Froeba (10/27/2010). See also 6/2/2010 statement of Mark Froeba submitted
by request to the Financial Crisis Inquiry Commission.
had with Mr. Clarkson shortly after he was promoted to head of the Structured Finance Group.
Mr. Michalek stated:
“In my ‘discussion,’ I was told that he [Mr. Clarkson] had met with the investment banks
to learn how our Group was working with the various clients and whether there were any
analysts who were either particularly difficult or particularly valuable. I was named … as
two of the more ‘difficult’ analysts who had a reputation for making ‘too many’
comments on the deal documentation.
The conversation was quite uncomfortable, and it didn’t improve when he described how
he had previously had to fire [another analyst], a former leader of the Asset-Backed
group who he otherwise considered a ‘good guy.’ He described how, because of the
numerous complaints he had received about [that analyst’s] extreme conservatism,
rigidity and insensitivity to client perspective, he was left with no choice. … He then
asked me to convince him why he shouldn’t fire me. … [T]he primary message of the
conversation was plain: further complaints from the ‘customers’ would very likely
abruptly end my career at Moody’s.”1060
Several former Moody’s employees have testified that Moody’s employees were fired
when they challenged senior management with a more conservative approach to rating RMBS
and CDO securities. According to Mr. Froeba:
“[T]he fear was real, not rare and not at all healthy. You began to hear of analysts, even
whole groups of analysts, at Moody’s who had lost their jobs because they were doing
their jobs, identifying risks and describing them accurately.”1061
A former Managing Director, Eric Kolchinsky, one of the senior managers in charge of the
business line which rated subprime backed CDOs at Moody’s stated:
“Managers of rating groups were expected by their supervisors and ultimately the Board
of Directors of Moody’s to build, or at least maintain, market share. It was an unspoken
understanding that loss of market share would cause a manager to lose his or her job.”1062
He described how market share concerns were addressed:
“Senior management would periodically distribute emails detailing their departments’
market share. These emails were limited to Managing Directors only. Even if the market
share dropped by a few percentage points, managers would be expected to justify
1060 Michalek prepared statement, at 13-14.
1061 6/2/2010 statement of Mark Froeba, submitted by request to the Financial Crisis Inquiry Commission, at 4.
1062 Prepared Statement of Eric Kolchinsky, Former Managing Director at Moody’s Investor Service, April 23, 2010
Subcommittee Hearing, at 1.
‘missing’ the deals which were not rated. Colleagues have described enormous pressure
from their superiors when their market share dipped.”1063
A Moody’s email sent in early October 2007 to Managing Directors of the CDO Group
illustrates the intense pressure placed on CDO analysts to retain or increase market share, even in
the midst of the onset of the financial crisis.1064 This email reported that for CDOs:
“Market share by deal count [had] dropped to 94%, though by volume it’s 97%. It’s
lower than the 98+% in prior quarters. Any reason for concern, are issuers being more
selective to control costs (is Fitch cheaper?) or is it an aberration[?]”1065
This email was sent during the same period when Moody’s began downgrading CDOs on a daily
basis, eventually downgrading almost 1,500 CDO securities with an original value likely in the
tens of billions in the last three months of 2007 alone. Despite the internal recognition at
Moody’s that previously rated CDOs were at substantial risk for downgrades, the email shows
management pressing the CDO Managing Directors about losing a few points of market share in
the middle of an accelerating ratings disaster.
The drive for market share was similarly emphasized at S&P. One former S&P
Managing Director in charge of the RMBS Ratings Group described it as follows:
“By 2004 the structured finance department at S&P was a major source of revenue and
profit for the parent company, McGraw-Hill. Focus was directed at collecting market
share and revenue data on a monthly basis from the various structured finance rating
groups and forwarded to the finance staff at S&P.”1066
Numerous internal emails illustrate not only S&P’s drive to maintain or increase market share,
but also how that pressure negatively impacted the ratings process, placing revenue concerns
ahead of ratings quality. For example, in a 2004 email, S&P management discussed the
possibility of changing its CDO ratings criteria in response to an “ongoing threat of losing
“We are meeting with your group this week to discuss adjusting criteria for rating
CDOs of real estate assets this week because of the ongoing threat of losing
1063 Id. at 2.
1064 10/5/2007 email from Sunil Surana to Yuri Yoshizawa, and others, “RE: 3Q Market Coverage-CDO,” Hearing
Exhibit 4/23-24a.
1065 Id.
1066 Prepared statement of Frank Raiter, Former Managing Director at S&P, April 23, 2010 Subcommittee Hearing,
at 5.
1067 8/17/2004 email from S&P manager, “RE: SF CIA: CDO methodology invokes reactions,” Hearing Exhibit
4/23-3 [emphasis in the original].
On another occasion, in response to a 2005 email stating that S&P’s ratings model
needed to be adjusted to account for the higher risks associated with subprime loans, a director in
RMBS research, Frank Parisi, wrote that S&P could have released a different ratings model,
LEVELS 6.0, months ago “if we didn’t have to massage the sub-prime and Alt-A numbers to
preserve market share.”1068 This same director wrote in an email a month later: “Screwing with
criteria to ‘get the deal’ is putting the entire S&P franchise at risk it’s a bad idea.”1069
A 2004 email chain among members of the S&P Analytical Policy Board, which set
standards to ensure integrity for the ratings process, provides additional evidence of how market
share concerns affected the credit ratings process. In that chain of emails, a senior S&P
manager, Gale Scott, openly expressed concern about how a criteria change could impact market
share and cause S&P to lose business. Ms. Scott wrote: “I am trying to ascertain whether we
can determine at this point if we will suffer any loss of business because of our decision and if
so, how much? We should have an effective way of measuring the impact of our decision over
time.”1070 After a colleague reassured her that he did not believe it would cause a loss of
business, she reiterated her concerns, noting, “I think the criteria process must include
appropriate testing and feedback from the marketplace.”
On another occasion, an August 2006 email reveals the frustration that at least one S&P
employee in the Servicer Evaluation Group felt about the dependence of his employer on the
issuers of structured finance products, going so far as to describe the rating agencies as having “a
kind of Stockholm syndrome” – the phenomenon in which a captive begins to identify with the
“They’ve become so beholden to their top issuers for revenue they have all developed a
kind of Stockholm syndrome which they mistakenly tag as Customer Value creation.”1071
In October 2007, Moody’s Chief Credit Officer explicitly raised concerns at the highest
levels of the firm that it was losing market share “[w]ith the loosening of the traditional duopoly”
between Moody’s and S&P, noting that Fitch was becoming an “acceptable substitute.”1072 In a
memorandum entitled, “Credit Policy issues at Moody’s suggested by the subprime/liquidity
crisis,” the author set out to answer the question, “how do rating agencies compete?” 1073
1068 3/23/2005 email from Frank Parisi to Thomas Warrack, and others, Hearing Exhibit 4/23-5.
candid reflection noted that in an ideal situation “ratings quality” would be paramount, but the
need to maintain, and even increase, market share, coupled with pressures exerted by the
companies seeking credit ratings, were also affecting the quality of its ratings. Moody’s Chief
Credit Officer wrote the following lament:
1069 6/14/2005 email from Frank Parisi to Frank Bruzese, and others, Hearing Exhibit 4/23-6.
1070 11/9/2004 email from Gale Scott to Perry Inglis, Hearing Exhibit 4/23-4.
1071 8/8/2006 email from Michael Gutierrez to Richard Koch, “RE: Loss Severity vs gross/net proceeds,” Hearing
Exhibit 4/23-14.
1072 10/21/2007 Moody’s internal email, Hearing Exhibit 4/23-24b. Although this email is addressed to and from the
CEO, the Chief Credit Officer told the Subcommittee that he wrote the memorandum attached to the email.
Subcommittee interview of Andy Kimball (4/15/2010).
1073 Id.
“Analysts and MDs [Managing Directors] are continually ‘pitched’ by bankers, issuers,
investors all with reasonable arguments whose views can color credit judgment,
sometimes improving it, other times degrading it (we ‘drink the kool-aid’). Coupled with
strong internal emphasis on market share & margin focus, this does constitute a ‘risk’ to
ratings quality.”1074
By the time his memorandum was written, both Moody’s and S&P were already issuing
thousands of RMBS and CDO rating downgrades, admitting that their prior investment grade
ratings had not accurately reflected the risk that these investments would fail.
(b) Investment Bank Pressure
At the same time Moody’s and S&P were pressuring their RMBS and CDO analysts to
increase market share and revenues, the investment banks responsible for bringing RMBS and
CDO business to the firms were pressuring those same analysts to ease rating standards. Former
Moody’s and S&P analysts and managers interviewed by the Subcommittee described, for
example, how investment bankers pressured them to get their deals done quickly, increase the
size of the tranches that received AAA ratings, and reduce the credit enhancements protecting
the AAA tranches from loss. They also pressed the CRA analysts and managers to ignore a host
of factors that could be seen as increasing credit risk. Sometimes described as “ratings
shopping,” the analysts described how some investment bankers threatened to take their business
to another credit rating agency if they did not get the favorable treatment they wanted. The
evidence collected by the Subcommittee indicates that the pressure exerted by investment banks
frequently impacted the ratings process, enabling the banks to obtain more favorable treatment
than they otherwise would have received.
The type of blatant pressure exerted by some investment bankers is captured in a 2006
email in which a UBS banker warned an S&P senior manager not to use a new, more
conservative rating model for CDOs. He wrote:
“[H]eard you guys are revising your residential mbs [mortgage backed security] rating
methodology - getting very punitive on silent seconds. [H]eard your ratings could be 5
notches back of [Moody’s] equivalent. [G]onna kill your resi[dential] biz. [M]ay force
us to do moodyfitch only cdos!”1075
When asked by his colleague about the change in the model, an S&P senior manager, Thomas
Warrack, noted that the new model “took a more conservative approach” that would result in
“raising our credit support requirements going forward,” but Mr. Warrack was also quick to add:
“We certainly did [not] intend to do anything to bump us off a significant amount of deals.”1076
1074 Id.
1075 5/3/2006 email from Robert Morelli (UBS) to Peter Kambeseles (S&P), Hearing Exhibit 4/23-11.
1076 Id.
In another instance in May 2007, an S&P analyst reported to her colleagues about
attempting to apply a default stress test to a CDO transaction proposed by Lehman Brothers. She
“[T]hey claim that their competitor investment banks are currently doing loads of deals
that are static in the US and where no such stress is applied. … [W]e’d initially
calculated some way of coming up with the stresses, by assuming the lowest rated assets
default first …. [T]hey claim that once they have priced the whole thing, it is possible
that the spreads would change …. We suggested that it was up to them to build up some
cushion at the time they price, but they say this will always make their structures
uneconomic and is basically unmanageable => I understand that to mean they would not
take us on their deals.”1077
Her supervisor responded in part: “I would recommend we do something. Unless we have too
many deals in US where this could hurt.”
On still another occasion in 2004, several S&P employees discussed the pressure to make
their ratings profitable rather than just accurate, especially when their competitor employed
lower rating standards:
“We just lost a huge Mizuho RMBS deal to Moody’s due to a huge difference in the
required credit support level. It’s a deal that six analysts worked through Golden Week
so it especially hurts. What we found from the arranger was that our support level was at
least 10% higher than Moody’s. … Losing one or even several deals due to criteria
issues, but this is so significant that it could have an impact in the future deals. There’s
no way we can get back on this one but we need to address this now in preparation for the
future deals.”1078
Other emails illustrate the difficulty of upgrading the ratings models, because of the
potential disruption to securitizations in the process of being rated. Some investment banks
applied various types of pressure to maintain the status quo, despite the fact that the newer
models were considered more accurate. In a February 2006 email to an S&P analyst, for
example, an investment banker from Citigroup wrote:
“I am VERY concerned about this E3 [new CDO rating model]. If our current
struc[ture], which we have been marketing to investors … doesn’t work under the new
assumptions, this will not be good. Happy to comply, if we pass, but will ask for an
exception if we fail.”1079
1077 5/23/2007 email from Claire Robert to Lapo Guadagnuolo, and others, Hearing Exhibit 4/23-31.
1078 5/25/2004 email from Yu-Tsung Chang to Joanne Rose and Pat Jordan, “Competition with Moody’s,” Hearing
Exhibit 4/23-2.
1079 2/16/2006 email from Edward Tang (Citigroup) to Lina Kharnak (S&P), Hearing Exhibit 4/23-8.
In another instance from May 2005, an investment banker from Nomura in the middle of
finalizing a securitization raised concerns that S&P was not only failing to provide the desired
rating, but that a new model could make the situation worse. He wrote:
“My desire is to keep S&P on all of my deals. I would rather not drop S&P from the
upcoming deal, particularly if it ends up being for only a single deal until the new model
is in place. Can you please review the approval process on this deal?”1080
Initially hesitant, S&P analysts ultimately decided to recommend approval of the deal in line
with the banker’s proposal.
The same pressure was applied to Moody’s analysts. In an April 2007 email, for
example, a SunTrust Bank employee told Moody’s:
“SunTrust is disconcerted by the dramatic increase in Moody’s loss coverage levels given
initial indications. … Our entire team is extremely concerned. ... Each of the other
agencies reduced their initial levels, and the material divergence between Moody’s levels
and the other agencies seems unreasonable and unwarranted given our superior collateral
and minimal tail risk.”1081
On another occasion in March 2007, a Moody’s analyst emailed a colleague about
problems she was having with someone at Deutsche Bank after Moody’s suggested adjustments
to the deal: “[The Deutsche Bank investment banker] is pushing back dearly saying that the deal
has been marketed already and that we came back ‘too late’ with this discovery .… She claims
it’s hard for them to change the structure at this point.”1082
Special Treatment. Documents obtained by the Subcommittee indicate that investment
bankers who complained about rating methodologies, criteria, or decisions were often able to
obtain exceptions or other favorable treatment. In many instances, the decisions made by the
credit rating agencies appeared to cross over from the healthy give and take involved in complex
analysis to concessions made to prevent the loss of business. While the former facilitates
efficient transactions, the second distorts the market and hurts investors.
In a February 2007 email directed to Moody’s, for example, a Chase investment banker
complained that a transaction would receive a significantly lower rating than the same product
was slated to receive from another rating agency: “There’s going to be a three notch difference
when we print the deal if it goes out as is. I'm already having agita about the investor calls I’m
going to get.” Upon conferring with a colleague, the Moody’s manager informed the banker that
Moody’s was able to make some changes after all: “I spoke to Osmin earlier and confirmed that
1080 5/6/2005 email from Robert Gartner (Nomura) to Thomas Warrack (S&P), PSI-S&P-RFN-000024-28, at 28.
1081 4/12/2007 email from Patrick DellaValle (SunTrust) to David Teicher (Moody’s), and others, PSI-MOODYSRFN-
1082 3/8/2007 email from Karen Ramallo to Yakov Krayn, Hearing Exhibit 4/23-22.
Jason is looking into some adjustments to his [Moody’s] methodology that should be a benefit to
you folks.”1083
In another instance, a difference of opinion arose between Moody’s and UBS over how to
rate a UBS transaction known as Lancer II. One senior Moody’s analyst wrote to her colleagues
that, given the “time line for closing” the deal, they should side with the investment bank: “I
agree that what the [Moody’s rating] committee was asking is reasonable, but given the other
modeling related issues and the time line for closing, I propose we let them go with the CDS Cp
criteria for this deal.”1084
S&P made similar concessions while rating three deals for Bear Stearns in 2006. An
analyst wrote:
“Bear Stearns is currently closing three deals this month which ha[ve] 40 year mortgages
(negam) …. There was some discrepancy in that they were giving some more credit to
recoveries than we would like to see. … [I]t was agreed that for the deals this month we
were OK and they would address this issue for deals going forward.”1085
While the rating process involved some level of subjective discretion, these electronic
communications make it clear that in many cases, close calls were made in favor of the customer.
An exception made one time often turned into further exceptions down the road. In
August 2006, for example, an investment banker from Morgan Stanley tried to leverage past
exceptions into a new one, couching his request in the context of prior deals:
“When you went from [model] 2.4 to 3.0, there was a period of time where you would
rate on either model. I am asking for a similar ‘dual option’ window for a short period. I
do not think this is unreasonable.”
A frustrated S&P manager resisted, saying: “You want this to be a commodity relationship and
this is EXACTLY what you get.” But even in the midst of his defense, the same S&P manager
reminded the banker how often he had granted exceptions in other transactions: “How many
times have I accommodated you on tight deals? Neer, Hill, Yoo, Garzia, Nager, May, Miteva,
Benson, Erdman all think I am helpful, no?”1086
1083 2/20/2007 email from Mark DiRienz (Moody’s) to Robert Miller (Chase), PSI-MOODYS-RFN-000031. See
also 4/27/2006 email from Karen Ramallo to Wioletta Frankowicz and others, Hearing Exhibit 4/23-18 (“For
previous synthetic deals this wasn’t as much of an issue since the ARM % wasn’t as high, and … at this point, I
would feel comfortable keeping the previously committed levels since such a large adjustment would be hard to
explain to Bear .… So unless anybody objects, Joe and I will tell Bear that the levels stand where they were
1084 5/23/2007 email from Yvonne Fu to Arnaud Lasseron, PSI-MOODYS-RFN-000013.
1085 2/23/2006 email from Errol Arne to Martin Kennedy, and others, “Request for prioritization,” PSI-S&P-RFN-
1086 8/1/2006 email from Elwyn Wong (S&P) to Shawn Stoval (Morgan Stanley) and Belinda Ghetti (S&P), Hearing
Exhibit 4/23-13.
Some rating analysts who granted exceptions to firm policies, and then tried to limit those
exceptions in future deals, found it difficult to do. In June 2007, for example, a Moody’s analyst
agreed to an exception, while warning that no exceptions would be made in future transactions:
“This is an issue we feel strongly about and it is a published Moody’s criteria. We are
making an exception for this deal only. … Going forward this has to be effective date
level. I would urge you to let your colleagues know as well since we will not be in a
position to give in on this issue in future deals.”1087
A similar scenario played out at S&P. A Goldman Sachs banker strongly objected to a
rating decision on a CDO called Abacus 2006-12:
“I would add that this scenario is very different from an optional redemption as you point
out below since the optional redemption is at Goldman’s option and a stated maturity is
not. We therefore cannot settle for the most conservative alternative as I believe you are
The S&P director pushed back, saying that what Goldman wanted was “a significant departure
from our current criteria,” but then suggested an exception could be made if it were limited to the
CDO at hand and did not apply to future transactions:
“As you point out, it is a conservative position for S&P to take, but it is one we’ve taken
with all Dealers. Since time is of the essence, this may be another issue that we table for
2006-12 [the CDO under consideration], but would have to be addressed in future
But a Moody’s analyst showed how difficult it was to allow an exception once and
demand different conduct in the future:
“I am worried that we are not able to give these complicated deals the attention they
really deserve, and that they [Credit Suisse] are taking advantage of the ‘light’ review and
the growing sense of ‘precedent’.
As for the precedential effects, we had indicated that some of the ‘fixes’ we agreed to in
Qian’s deal were ‘for this deal only’… When I asked Roland if they had given further
thought to a more robust approach, he said (unsurprisingly) that they had no success and
could we please accept the same [stopgap] measure for this deal.”1089
1087 6/28/2007 email from Pooja Bharwani (Moody’s) to Frank Li (Citigroup), and others, PSI-MOODYS-RFN-
1088 4/23/2006 email from Chris Meyer (S&P) to Geoffrey Williams and David Gerst (Goldman Sachs), and others,
PSI-S&P-RFN-000002. See also 5/1/2006 email from Matthew Bieber (Goldman Sachs) to Malik Rashid (S&P),
and others, PSI-S&P-RFN-000008-11, at 9 (“GS has not agreed to this hold back provision in any of our previous
transactions (including the ABACUS deal that just closed last week) - and we cannot agree to it in this deal.”).
1089 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19; see also 5/23/2007 email
from Eric Kolchinsky to Yuri Yoshizawa and Yvonne Fu, PSI-MOODYS-RFN-000011 (“In that case, should we
Linking a Rating to a Fee. On at least one occasion, an investment bank seeking a
credit rating attempted to link the ratings it would receive with the amount of fees it would pay.
In June 2007, Merrill Lynch was seeking a rating from Moody’s for a CDO known as Belden
Point.1090 Moody’s agreed to rate the CDO, but only for a higher than usual fee using a
“complex CDO fee schedule.”1091 Merrill Lynch responded: “[N]o one here has ever heard or
seen this fee structure applied for any deal in the past. Could you point us to a precedent deal
where we have approved this?”1092 Moody’s replied:
“[W]e do not view this transaction as a standard CDO transaction and the rating process
so far has already shown that the analysis for this deal is far more involved and will
continue to be so. We have spent significant amount of resource[s] on this deal and it
will be difficult for us to continue with this process if we do not have an agreement on the
fee issue.”1093
The next day, Merrill Lynch wrote:
“We are okay with the revised fee schedule for this transaction. We are agreeing to this
under the assumption that this will not be a precedent for any future deals and that you
will work with us further on this transaction to try and get to some middle ground with
respect to the ratings.”1094
Moody’s responded:
“We agree that this will not be a precedent for future deals by default and we will discuss
with you on a case by case basis if [the] Complex CDO rating application should be
applied to future deals. We will certainly continue working with you on this transaction,
but analytical discussions/outcomes should be independent of any fee discussions.”1095
Vertical CDO. A transaction known as Vertical ABS CDO 2007-1 helps illustrate how
imbalanced the relationship between investment bankers and rating analysts became. In
connection with that CDO, an investment banker from UBS failed to cooperate with S&P rating
analysts requesting information to analyze the transaction.
On March 30, 2007, an S&P analyst wrote that UBS wanted to close the deal in ten days,
but was not providing the information S&P needed:
exclude any mention of the one notch rule from the general communication? Instead, we should give comm[ittee]
chairs the discretion to apply the rule as they see fit. In this way, there is less of a chance of it getting back to the
bankers as a ‘general rule’. They are more likely to know it as something that only applies, as a concession, on the
deal that they are working on.”).
1090 See 6/11/2007 email exchange between Merrill Lynch and Moody’s, Hearing Exhibit 4/23-23.
1091 Id.
1092 Id.
1093 Id.
1094 Id.
1095 6/12/2007 email from Moody’s to Merrill Lynch, Hearing Exhibit 4/23-23 Addendum.
“Sarah and I have been working with James Yao from UBS but we have not been getting
cooperation from him. He has told me that I am jeopardizing the deal. … This is the
third time that he refuses to model the cashflow according to the Indenture and
A few days later, in an April 5, 2007 instant message, one S&P analyst wrote: “[W]hat
happened? … [I] heard some fury.” His colleague responded that it was Mr. Yao, the UBS
banker.1097 Later the same day, an S&P manager wrote that the three analysts:
“[W]ould like to give us a heads-up with respect to the lack of
responsiveness/cooperation from UBS … on Vertical 2007-1. There seems to be a
general lack of interest to work WITH us, incorporate our comments, or modeling to our
criteria. Based on their collective difficult experience so far, our analysts estimate a
smooth closing is unlikely. (The behavior is not limited to this deal either.)” 1098
An S&P senior director responded:
“Vertical is politically closely tied to B of A – and is mostly a marketing shop – helping
to take risk off books of B o A. Don’t see why we have to tolerate lack of cooperation.
Deals likely not to perform.”1099
Despite the uncooperative investment banker and prediction that the CDO was unlikely to
perform, S&P analysts continued to work hard on the rating. One of the analysts sent an email to
her colleagues describing their efforts to get the CDO to pass tests for issuing investment grade
“Just wanted to let you know that this deal is closing and going Effective next Tuesday,
but our rated Equity tranche (BBB) is failing in our cashflow modeling.
“Sarah tried a lot of ways to have the model passed. Unfortunately we are still failing by
1bp [basis point], without any stress runs and without modeling certain fees (anticipated
to be minimal).
“In addition, we already incorporated the actual ramped up portfolio, and not a
hypothetical one, for this exercise.”1100
After another day of work, the analyst reported she had found a “mistake” that, when
corrected, would allow Vertical to get the desired investment grade credit ratings:
1096 3/30/2007 email from Lois Cheng, “Vertical ABS CDO 2007-1, Ltd. UBS,” Hearing Exhibit 4/23-94c.
1097 4/5/2007 instant message exchange between Brian Trant and Shannon Mooney, Hearing Exhibit 4/23-94a.
1098 4/5/2007 email from Bujiang Hu to Peter Kambeseles, and others, Hearing Exhibit 4/23-94b [emphasis in the
1099 4/5/2007 email from James Halprin to Bujiang Hu and others, Hearing Exhibit 4/23-94b.
1100 4/5/2007 email from Lois Cheng to Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c.
“Just wanted to update you guys on Vertical. The model is passing now. We found a
mistake in the waterfall modeling that was more punitive than necessary. James Yao [the
UBS investment banker] has been notified and is probably having a chuckle at our
expense. I still feel that his attitude toward our rating process and our team still needs to
be addressed in some way.”1101
These emails show S&P analysts expending great effort to provide favorable ratings to the UBS
CDO, despite concerns about its creditworthiness.1102
On April 10, 2007, just three months before the July 2007 mass downgrades of subprime
RMBS, S&P issued ratings for the Vertical securitization. All but one of the nine tranches were
given investment grade ratings, with the top three receiving AAA. Moody’s issued similar
Four months later in August 2007, all but the top three tranches were put on credit
watch.1104 Two months after that, in October, Moody’s downgraded all but one of the Vertical
securities to junk status.1105 In 2008, the CDO was liquidated.1106 The chart below shows how
the various tranches were originally rated by S&P, only to be downgraded to a D—the rating
given to securities in default.
1101 4/6/2007 email from Lois Cheng to Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c.
1102 For a similar situation involving an RMBS, see 2/8/2006 email exchange among S&P analysts, “EMC
Compares,” PSI-SP-000362, Hearing Exhibit 4/23-7 (describing how an analyst worked to find a way to reduce the
size of the cushion that an RMBS had to set aside to protect its investment grade tranches from loss, and found that
changing the way first loan payment dates were reported in LEVELS would produce a slight reduction; a colleague
responded: “I don’t think this is enough to satisfy them. What’s the next step?”).
1103 4/2007 Moody’s internal memorandum from Saiyid Islam and Peter Hallenbeck to the Derivatives Rating
Committee, Hearing Exhibit 4/23-94d. Moody’s gave investment grade ratings to seven of the eight tranches it
rated, including AAA ratings to the top three tranches.
1104 Moody’s downgrade of Vertical ABS CDO 2007-1, Hearing Exhibit 4/23-94k.
1105 Id.; 10/25/2007 “Moody’s Downgrades Vertical ABS CDO 2007-1 Notes; Further Downgrades Possible,”
Moody’s; 1/14/2008 and 6/23/2008 “Moody’s downgrades ratings of Notes issued by Vertical ABS CDO 2007-1,
Ltd.,” Moody’s; 9/11/2008 “Moody’s withdraws ratings of Notes issued by 34 ABS CDOs,” Moody’s. Moody’s
downgraded all but the super senior Vertical tranche to junk status in October 2007, just six months after giving
investment grade ratings to seven of the eight tranches it rated. See 10/24/2007 email from Jonathan Polansky to
Moody’s colleagues, Hearing Exhibit 4/23-94f. S&P followed suit on November 14, 2007, downgrading all but two
of Vertical’s tranches, with five falling to junk status. 11/14/2007 “112 Ratings Lowered on 21 U.S. Cash Flow,
Hybrid CDOs of ABS; $4.689B In Securities Affected,” S&P.
1106 9/11/2008 “Moody’s Withdraws Ratings of Notes Issued by 34 ABS CDOs,” Moody’s.
One of the purchasers of Vertical securities, a hedge fund called Pursuit Partners, sued
UBS, S&P, and Moody’s over the quick default. Both credit rating agencies filed successful
motions to be dismissed from the lawsuit, but the court ordered UBS to set aside $35 million for
a possible award to the investor. The investor had found internal UBS emails calling the
investment grade Vertical securities “crap.”1107
Barring Analysts. Rating analysts who insisted on obtaining detailed information about
transactions sometimes became unpopular with investment bankers who pressured the analysts’
directors to have them barred from rating their deals. One Moody’s analyst, Richard Michalek,
testified before the Subcommittee that he was prohibited from working on RMBS transactions
for several banks because he scrutinized deals too closely. He stated:
“During my tenure at Moody’s, I was explicitly told that I was ‘not welcome’ on deals
structured by certain banks. ... I was told by my then-current managing director in 2001
that I was ‘asked to be replaced’ on future deals by … CSFB [Credit Suisse First Boston],
and then at Merrill Lynch. Years later, I was told by a different managing director that a
CDO team leader at Goldman Sachs also asked, while praising the thoroughness of my
work, that after four transactions he would prefer another lawyer be given an opportunity
to work on his deals.”1108
This analyst’s claim was corroborated by the Moody’s Managing Director who was his superior
at the time.1109
At the Subcommittee’s April 23 hearing, Yuri Yoshizawa, the Senior Managing Director
of Moody’s Derivatives Group testified that the relationship between CDO analysts and
investment banks “could get very contentious and very abusive.”1110 She testified that she did
get complaints from investment banks who wanted analysts removed from conducting their
ratings, because they were unhappy with those analysts. She testified that “[t]here was always
pressure from banks, including [removing analysts from transactions].”1111 She stated that she
did, in fact, remove analysts from rating certain banks’ transactions, but claimed she did so to
protect the analysts from abuse rather than to appease the complaining bank.1112 When asked
whether she ever protected her analysts by instead banning the abusive bank employee from
Moody’s interactions, she could not recall taking that action.
1107 8/28/2007 email from Evan Malik (UBS) to Hugh Corcoran (UBS) regarding Pursuit Partners’ purchase of
Vertical securities, Hearing Exhibit 4/23-94n.
1108 Michalek prepared statement at 16.
1109 Prepared statement of Gary Witt, Former Managing Director, Moody’s Investors Service, submitted by request
to the Financial Crisis Inquiry Commission (6/2/2010) at 6-7.
1110 April 23, 2010 Subcommittee Hearing at 64. Employees from both Moody’s and S&P confirmed this abusive
conduct in interviews with the Subcommittee, which was also corroborated in emails. Subcommittee interviews of
Richard Michalek (1/18/2010) and Eric Kolchinsky (10/7/2009). See also, e.g., 4/6/2007 email from Lois Cheng to
Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c.
1111 April 23, 2010 Subcommittee Hearing at 65.
1112 Id. at 64, 66.
Ratings Shopping. It is not surprising that credit rating agencies at times gave into
pressure from the investment banks and accorded them undue influence in the ratings process.
The rating companies were directly dependent upon investment bankers to bring them business
and were vulnerable to threats that the investment bankers would take their business elsewhere if
they did not get the ratings they wanted. Moody’s Chief Credit Officer told the Subcommittee
staff that ratings shopping, the practice in which investment banks chose the credit rating agency
offering the highest rating for a proposed transaction, was commonplace prior to 2008.1113
Ratings shopping inevitably weakens standards as each credit rating agency seeks to
provide the most favorable rating to win business. It is a conflict of interest problem that results
in a race to the bottom – with every credit rating agency competing to produce credit ratings to
please its paying clients. Moody’s CEO described the problem this way: “What happened in ’04
and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts.
Everything was investment grade. It didn’t really matter.”1114
All of the witnesses who were questioned about ratings shopping during the
Subcommittee’s hearing confirmed its existence:
Senator Levin: Ms. Yoshizawa [Senior Managing Director, Moody’s Derivatives
Group], we were advised by Moody’s Chief Credit Officer that it was common
knowledge that ratings shopping occurred in structured finance. In other words,
investment bankers sought ratings from credit rating agencies who would give them their
highest ratings. Would you agree with that?
Ms. Yoshizawa: I agree that credit shopping does exist, yes.
Senator Levin: Ms. Barnes [Managing Director, S&P RMBS Group], would you agree
that the same thing existed in your area?
Ms. Barnes: Yes, Mr. Chairman.1115
Moody’s CEO, Ray McDaniel echoed this concern during the hearing:
Senator Levin: There are a lot of interesting things there that your Chief Credit Officer,
Mr. Kimball, wrote in October of 2007 …. One of the things he wrote, and this is under
market share, he says in paragraph five, ‘Ideally, competition would be primarily on the
basis of ratings quality’ that is ideally – ‘with a second component of price and a third
1113 Subcommittee interview of Andy Kimball (4/15/2010). See also 2007 Moody’s draft “2007 Operating Plan:
Public Finance, Global Structured Finance and Investor Services,” prepared by Brian Clarkson, MIS-OCIE-RMBS-
0419014-53, at 25. In a draft presentation Clarkson wrote: “Challenges for 2007 … Competitive issues (ex. Rating
inflation, successful rating shopping ....).” He also noted in the presentation “increased ‘rating shopping’ by market
1114 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, at 63, Hearing Exhibit 4/23-
1115 April 23, 2010 Subcommittee Hearing at 66-67.
component of service. Unfortunately, of the three competitive factors, rating quality is
proving the least powerful.’ … ‘It turns out that ratings quality has surprisingly few
friends; issuers want high ratings; investors don’t want rating downgrades; short-sighted
bankers labor short-sightedly to game the rating agencies for a few extra basis points on
execution.’ Would you agree with that?
Mr. McDaniel: In this section, he is talking about the issue of rating shopping, and I
agree that that existed then and exists now.1116
(3) Inaccurate Models
The conflict of interest problem was not the only reason that Moody’s and S&P issued
inaccurate RMBS and CDO credit ratings. Another problem was that the credit rating models
they used were flawed. Over time, from 2004 to 2006, S&P and Moody’s revised their rating
models, but never enough to produce accurate forecasts of the coming wave of mortgage
delinquencies and defaults. Key problems included inadequate performance data for the higher
risk mortgages flooding the mortgage markets and inadequate correlation factors.
In addition, the companies failed to provide their ratings personnel with clear, consistent,
and comprehensive criteria to evaluate complex structured finance deals. The absence of
effective criteria was particularly problematic, because the ratings models did not conclusively
determine the ratings for particular transactions. Instead, modeling results could be altered by
the subjective judgment of analysts and their supervisors. This subjective factor, while
unavoidable due to the complexity and novelty of the transactions being rated, rendered the
process vulnerable to improper influence and inflated ratings.
(a) Inadequate Data
CRA analysts relied on their firm’s quantitative rating models to calculate the probable
default and loss rates for particular pools of assets. These models were handicapped, however,
by a lack of relevant performance data for the high risk residential mortgages supporting most
RMBS and CDO securities, by a lack of mortgage performance data in an era of stagnating or
declining housing prices, by the credit rating agencies’ unwillingness to devote sufficient
resources to update their models, and by the failure of the models to incorporate accurate
correlation assumptions predicting how defaulting mortgages might affect other mortgages.
Lack of High Risk Mortgage Performance Data. The CRA models failed, in part,
because they relied on historical data to predict how RMBS securities would behave, and the
models did not use adequate performance data in the development of criteria to rate subprime
and other high risk mortgages that proliferated in the housing market in the years leading up to
the financial crisis. From 2004 through 2007, many RMBS and CDO securities were comprised
of residential mortgages that were not like those that had been modeled in the past. As one S&P
email observed:
1116 April 23, 2010 Subcommittee Hearing at 100-101.
“[T]he assumptions and the historical data used [in the models] … never included the
performance of these types of residential mortgage loans .… The data was gathered and
computed during a time when loans with over 100% LTV or no stated income were
In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates,
the new subprime, high risk products had little to no track record to predict their rates of default.
In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until
December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a
subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated.1118
Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the
models operated with subprime data for mortgages that had not been exposed to stagnant or
falling housing prices. As one February 2007 presentation from a Deutsche Bank investment
banker explained, the models used to calculate “subprime mortgage lending criteria and bond
subordination levels are based largely on performance experience that was mostly accumulated
since the mid-1990s, when the nation’s housing market has been booming.”1119 A former
managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like
observing 100 years of weather in Antarctica to forecast the weather in Hawaii.”1120 In
September 2007, after the crisis had begun, an S&P executive testified before Congress that:
“[W]e are fully aware that, for all our reliance on our analysis of historically rooted data
that sometimes went as far back as the Great Depression, some of that data has proved no
longer to be as useful or reliable as it has historically been.”1121
The absence of relevant data for use in RMBS modeling left the credit rating agencies
unable to accurately predict mortgage default and loss rates when housing prices stopped
climbing. The absence of relevant performance data for high risk mortgage products in an era of
stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also
CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings.
Lack of Investment. One reason that Moody’s and S&P lacked relevant loan
performance data for their RMBS models was not simply that the data was difficult to obtain, but
1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33.
1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-
0001-16, at 3.
1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc.,
DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen
Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data
is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against
drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign
period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”).
1120 “Triple-A Failure,” New York Times (4/27/2008).
1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in
the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47.
that both companies were reluctant to devote the resources needed to improve their modeling,
despite soaring revenues.
Moody’s senior managers even expressed skepticism about whether new loan data was
needed and, in fact, generally did not purchase new loan data for a four-year period, from 2002
to 2006.1122 In a 2000 internal email exchange, the head of Moody’s Structured Finance Group
at the time, Brian Clarkson, wrote the following regarding the purchasing of data for Moody’s
RMBS model:
“I have a wild thought also – let[’]s not even consider BUYING anymore data, programs,
software or companies until we figure out what we have and what we intend to do with
what we have. From what I have heard and read so far we have approaches (MBS,
Tranching and Spread) few use or understand (let alone being able to explain it to the
outside) and new data that we are unable to use. We want more data when most of the
time we rate MBS deals using arbitrary rule of thumb?!! …
“I suggest we spend less time asking for more data and software (I have not seen
anything that sets forth the gains in revenue from such spending -- it is easy to ask for $$
-- much harder to justify it against competing projects) and more time figuring out how to
utilize what we have by way of good analysis, a solid approach to this market a proper
staffing model.”1123
In response to Brian Clarkson’s email, a managing director wrote:
“As you know, I don’t think we need to spend a lot of $ or resources to improve the
model from an analytic perspective; but I’d need to defer to people more in the loop
(looks like you’re that person) on whether the marketing component mandates some
announcement of model and data improvement. …
Make sure you talk to Noel and maybe Fons about the decision to buy the data; I was
invited to the original meeting so that the powers that be (at the time) could understand
the data originally used. I felt that the arguments for buying the data and re-inventing the
model were not persuasive .… The most convincing argument for buying the data was
that it would be a cornerstone for marketing, that S&P touted the size of their database as
a competitive advantage and that this was why they had the market share advantage.”1124
Moody’s advised the Subcommittee that, in fact, it generally did not obtain any new loan
data for its RMBS model development for four years, from 2002 until 2006, although it
continued to improve its RMBS model in other ways.1125
1122 2/24/2011 Response from Moody’s to Subcommittee questions. The Subcommittee asked Moody’s to provide
information on any new data it had received or purchased for its models from 2002 to 2007.
In 2005, a Moody’s employee survey
1123 11/3/2000 email from Brian Clarkson to David Zhai and others, PSI-MOODYS-RFN-000007.
1124 11/13/2000 email from Jay Siegel to Brian Clarkson, PSI-MOODYS-RFN-000007.
1125 2/17/2011 and 2/24/2011 Responses from Moody’s to Subcommittee questions.
found that the company’s employees felt that Moody’s should have been spending more
resources on improving its models.1126 In 2006, Moody’s obtained new loan level data for use in
its new subprime model, M3 Subprime.1127
In contrast to Moody’s, S&P did purchase new loan data on several occasions from 2002
to 2006, but told the Subcommittee that this data did not provide meaningful results that could be
used in its RMBS model prior to 2006.1128 In 2002, for example, S&P said that it purchased data
on approximately 640,000 loans, including ARM and hybrid loans. S&P told the Subcommittee
that it developed an equation from that data set which predicted a lower default rate for ARM
and hybrid loans than for fixed rate loans. S&P considered this counter-intuitive and chose not
to incorporate it into its model.1129 In 2005, S&P purchased data on another 2.9 million loans
that included first and second liens for prime, subprime, Alt A, high LTV, and home equity
loans.1130 S&P claimed that it made “concerted efforts to analyze” this data, “both by employing
external consultants and dedicating resources within Standard & Poor’s to analyze the data for
criteria development.”1131
Contrary to S&P’s claim, the former head of the S&P RMBS Ratings Group, Frank
Raiter, who worked at S&P until 2005, told the Subcommittee that management did not provide
him with sufficient resources to analyze the data and develop improved criteria for the RMBS
model.1132 Mr. Raiter told the Subcommittee that he personally informed S&P’s senior
management about the need to update S&P’s model with better loan data several years before the
crisis.1133 Mr. Raiter also testified that the “analysts at S&P had developed better methods for
determining default which did capture some of the variations among products that were to
become evident at the advent of the crisis,”1134 but those methods were not incorporated into the
RMBS model before he left in 2005. Mr. Raiter said that “[i]t is my opinion that had these
models been implemented we would have had an earlier warning about the performance of many
of the new products that subsequently lead [sic] to such substantial losses.”1135
1126 4/7/2006 “Moody’s Investor Service, BES-2005: Presentation to Derivatives Team,” Hearing Exhibit 4/23-92b.
1127 2/24/2011 Response from Moody’s to Subcommittee questions. Moody’s also advised the Subcommittee that it
“generally receives, as part of the surveillance process, updated loan performance statistics on a monthly basis for
the collateral pools of the transactions it has rated.” Moody’s told the Subcommittee that its surveillance data
tracked the deterioration in the RMBS market, and its rating committee members were able to incorporate that
information into their rating considerations. 2/17/2011 Response from Moody’s to Subcommittee questions.
1128 2/10/2011 Response from S&P to Subcommittee questions.
1129 Id.
1130 Id.
1131 Id. S&P also told the Subcommittee that, between 2001 and 2008, it updated its RMBS model multiple times,
using other types of data and analytical improvements. 2/2010 Standard & Poor’s Presentation on LEVELS, PSIStandard&
Poor’s-04-0001–0025, at 6.
1132 Subcommittee interviews of Frank Raiter (7/15/2009 and 4/8/2010).
1133 Id. See also prepared statement of Frank Raiter, “Credit Rating Agencies and the Financial Crisis,” before the
U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008),
at 5.
1134 Prepared statement of Frank Raiter, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of
Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 5-6.

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