WaMu kept its 2 rating despite the five-year litany of lending, risk management,
appraisal, and Long Beach deficiencies identified by OTS examiners from 2004 to 2008. It was
only in February 2008, after the bank began to incur substantial losses, that OTS downgraded the
bank to a 3. When the FDIC urged a further downgrade to a 4 rating in the summer of 2008,
OTS disagreed. In September 2008, however, while still resisting the ratings downgrade, OTS
acknowledged internally that WaMu’s poor quality loans and poor risk management were the
source of its problems:
“The bank’s overall unsatisfactory condition is primarily the result of the poor
asset quality and operating performance in the bank’s major Home Loans
Group area of business. … The deteriorating asset quality in the Home Loans
Group is accompanied by inadequacies in risk management, internal controls,
and oversight that made more vulnerable to the current housing and economic
downturn. The examination criticized past liberal home loan underwriting
practices and concentrated delivery of nontraditional mortgage products to
higher risk geographic markets.”875
It was only on September 18, 2008, after the bank began to run out of the cash needed to
conduct its affairs and the FDIC independently downgraded the bank to a 4, that OTS
finally agreed to the downgrade. One week later, OTS placed the bank into receivership.
872 See Thorson prepared statement at 11, April 16, 2010 Subcommittee Hearing at 111.
873 April 16, 2010 Subcommittee Hearing at 24-26.
874 See, e.g., Rymer prepared statement at 5.
875 9/11/2008 OTS document, “WaMu Ratings of 3/343432,” Polakoff_Scott-00065325, Hearing Exhibit 4/16-48.
Hindsight establishes that the CAMELS ratings assigned to Washington Mutual
Bank were inflated. Whether the ratings inflation was attributable to the OTS culture of
deference to management, examiners who were too intimidated to downgrade the
agency’s largest institution, an overly narrow regulatory focus that was blinded by
WaMu’s short term profits and ignored systemic risk, or an absence of forward-looking
risk analysis, the WaMu collapse suggests that the CAMELS rating system did not work
as it should.
(e) Fee Issues
During the investigation, when asked why OTS senior officials were not tougher on
Washington Mutual Bank, several persons brought up the issue of fees – that WaMu supplied
$30 million or nearly 15% of the fees per year that paid for OTS’ operating expenses. WaMu’s
former Chief Risk Officer James Vanasek offered this speculation:
“I think you have to look at the fact that Washington Mutual made up a substantial
portion of the assets of the OTS and one wonders if the continuation of the agency would
have existed had Washington Mutual failed.”876
The issue was also raised by Treasury IG Thorson who warned that OTS should have been “very
clear from top to bottom” that WaMu’s payment of $30 million in fees per year to OTS was “not
a factor. It just [was] not.”877
The OCC and OTS are the only federal banking regulators reliant on fees paid by their
regulated entities to fund their operations. At OTS, Washington Mutual was far larger than any
other thrift overseen by the agency and was a far larger and more important contributor to the
agency’s budget. It is possible that the agency’s oversight was tempered by recognition of the
thrift’s unique importance to the agency’s finances and a concern that tough regulation might
cause WaMu to convert its charter and switch to a different regulator. Its dependence on WaMu
fees may have given OTS the incentive to avoid subjecting WaMu to regulatory enforcement
actions and ultimately compromised its judgments.
Conclusion. WaMu is the largest bank failure in the history of the United States. When
OTS seized it, WaMu had $307 billion in assets. By comparison, the next largest U.S. bank
failure was Continental Illinois, which had $40 billion in assets when it collapsed in 1984. OTS’
failure to act allowed Washington Mutual to engage in unsafe and unsound practices that cost
borrowers their homes, led to a loss of confidence in the bank, and sent hundreds of billions of
dollars of toxic mortgages into the financial system with its resulting impact on financial markets
at large. Even more sobering is the fact that WaMu’s failure was large enough that, if the bank
had not been purchased by JPMorgan Chase, it could have exhausted the entire Deposit
Insurance Fund which then contained about $45 billion. Exhausting the Deposit Insurance Fund
876 April 13, 2010 Subcommittee Hearing at 40 (Testimony of James Vanasek).
877 See April 16, 2010 Subcommittee Hearing at 25.
could have triggered additional panic and loss of confidence in the U.S. banking system and
(2) Other Regulatory Failures
Washington Mutual was not the only failed thrift overseen by OTS. In 2008, OTS closed
the doors of five thrifts with combined assets of $354 billion.878 Another seven thrifts holding
collective assets of $350 billion were sold or declared bankruptcy.879 Virtually all of these thrifts
conducted high risk lending, accumulated portfolios with high risk assets, and sold high risk,
poor quality mortgages to other financial institutions and investors. At the Subcommittee
hearing, the Treasury Inspector General testified that, after completing 17 reviews and working
on another 33 reviews of a variety of failed financial institutions, he could say that OTS’ lack of
enforcement action was “not unique to WaMu” and lax enforcement by the relevant federal
banking regulator was “not unique to OTS.”880
Mortgage lenders other than banks also failed. Many of these mortgage lenders had
operated as private firms, rather than as depository institutions, and were not overseen by any
federal or state bank regulator. Some were overseen by the SEC; others were not overseen by
any federal financial regulator. Some became large companies handling billions of dollars in
residential loans annually, yet operated under minimal and ineffective regulatory oversight.
When residential loans began to default in late 2006, and the subprime securitization market
dried up in 2007, these firms were unable to sell their loans, developed liquidity problems, and
went out of business. Together, these failed mortgage lenders, like the failed thrifts, contributed
to systemic risk that damaged the U.S. banking system, U.S. financial markets, and the U.S.
economy as a whole.
Countrywide Financial Corporation, now a division of Bank of America and known as
Bank of America Home Loans, was formerly the largest independent mortgage lender in the
United States and one of the most prolific issuers of subprime mortgages.881 For a number of
years, Countrywide operated as a national bank under the OCC. In March 2007, it converted to a
thrift charter and operated for its last 18 months under the regulatory supervision of OTS.882
878 1/2009 Center for Responsible Lending report, “The Second S&L Scandal,” at 1, Hearing Exhibit 4/16-84.
its height, Countrywide had approximately $200 billion in assets, 62,000 employees, and issued
in excess of $400 billion in residential mortgages each year. In 2008, Countrywide originated
880 April 16, 2010 Subcommittee Hearing at 18 (Testimony of Treasury IG Thorson). The Treasury IG also
reviewed, for example, failed banks overseen by the OCC.
881 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com,
http://www.mortgagedaily.com/MortgageLenderRanking.asp (indicating Countrywide was one of the top three
issuers of U.S. residential mortgages from 2003 to 2008); “A Mortgage Crisis Begins to Spiral, and the Casualties
Mount,” New York Times (3/5/2007).
882 3/5/2007 OTS press release, “OTS Approves Countrywide Application,”
nearly 20% of all mortgages in the United States.883 But in August 2008, after the collapse of the
subprime secondary market, Countrywide could no longer sell or securitize its subprime loans
and was unable to obtain replacement financing, forcing the bank into a liquidity crisis.884 By
the end of the summer of 2008, it would have declared bankruptcy, but for its sale to Bank of
America for $2.8 billion.885
Neither the OCC nor OTS ever filed a public enforcement action against the bank. In
June 2009, the SEC filed suit against the three most senior Countrywide executives, the chief
executive officer, the chief operating officer and president, and the chief financial officer,
charging them with fraudulently misleading investors by representing that Countrywide had
issued loans primarily to “prime” or low risk borrowers, when it had actually written
increasingly risky loans that senior executives knew would result in substantial defaults and
delinquencies.886 In addition, the SEC charged that CEO Angelo Mozilo had violated his federal
disclosure obligations and engaged in insider trading.887
The SEC complaint detailed the bank’s increasingly risky underwriting and lending
practices from 2005 to 2007, including its use of stated income loans, loan-to-value ratios in
excess of 95%, loans to borrowers with low FICO scores, frequent use of loan exceptions, and
willingness to match the loan terms of any competitor. Like WaMu, from 2003 to 2007, the
bank switched from issuing primarily low risk, 30-year loans, to subprime and other high risk
The complaint also described how Mr. Mozilo was internally alarmed and critical of the
increased credit risks that Countrywide was incurring, while at the same time telling investors
that the bank was more prudent than its competitors.889 The SEC complaint cited, for example,
an April 2006 email from Mr. Mozilo discussing Countrywide’s issuance of subprime 80/20
loans, which are loans that have no down payment and are comprised of a first loan for 80% of
the home’s value and a second loan for the remaining 20% of the value, resulting in a loan-tovalue
ratio of 100%. Mr. Mozilo wrote: “In all my years in the business I have never seen a
more toxic pr[o]duct.”890 In another email that same month, after being informed that most
borrowers were making the minimum payments allowed on Option ARM loans, Mr. Mozilo
wrote: “Since over 70% have opted to make the lower payment it appears it is just a matter of
time that we will be faced with much higher resets and therefore much higher delinquencies.”891
883 OCC, “Annual Report: Fiscal Year 2009,” http://www.occ.gov/static/publications/annrpt/2009AnnualReport.pdf.
884 See, e.g., SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 102-104
(hereinafter “SEC Complaint against Countrywide Executives”).
885 “Countrywide Financial Corporation,” New York Times (10/15/2010).
886 SEC Complaint against Countrywide Executives.
888 See, e.g., SEC Complaint against Countrywide Executives, at ¶¶ 17-19.
889 See, e.g., id. at ¶¶ 6-7.
890 Id. at ¶ 50.
891 Id. at ¶ 63.
Later he warned that the bank was “flying blind” on the ultimate delinquency rate and should
consider selling the loans.892
“Mozilo went on to write that he had ‘personally observed a serious lack of compliance
within our origination system as it relates to documentation and generally a deterioration
in the quality of loans originated versus the pricing of those loan[s].’ Mozilo noted that,
‘In my conversations with Sambol [Countrywide’s chief operating officer] he calls the
100% sub prime seconds as the ‘milk’ of the business. Frankly, I consider that product
line to be the poison of ours.”
The SEC complaint also stated:
On October 15, 2010, the SEC announced a record settlement with the three Countrywide
executives.894 Mr. Mozilo agreed to pay $22.5 million to settle the disclosure fraud allegations
and $45 million to settle the insider trading allegations, bringing his total settlement to $67.5
In June 2010, in a case brought by the Federal Trade Commission, Countrywide agreed to
pay penalties of $108 million for charging inflated mortgage servicing fees to homeowners in
delinquency, including excessive fees to inspect property or mow lawns for people struggling to
keep their homes.
He also agreed to be permanently barred from serving as an officer or director of a
publicly traded corporation. Countrywide’s former chief operating officer paid $5.5 million and
agreed to a three-year bar. The chief financial officer paid $130,000 and agreed to a one-year
bar on practicing before the SEC.
896 In August 2010, Countrywide and some former executives agreed to pay
$600 million to settle several class action lawsuits.897
IndyMac Bank was established in 1985 by Countrywide co-founders Angelo Mozilo and
David Loeb. While its lines of business changed over time, in 2000, it became a chartered thrift
overseen by OTS, and grew to become the country’s ninth-largest originator of residential
892 Id. at ¶ 68-69.
IndyMac specialized in two types of high risk home loans, Alt A loans which
did not require verification or documentation of the borrower’s income, assets or employment;
and Option ARM loans which allowed borrowers to pay less than the fully amortized cost of the
mortgage. From 2004 to 2006, Option ARMs made up 75% of IndyMac’s home loans and, in
2006, IndyMac allowed 75% of its Option ARM borrowers to make only the minimum payment
893 Id. at ¶ 49.
894 10/15/2010 SEC Press Release, “Former Countrywide CEO Angelo Mozilo to Pay SEC’s Largest-Ever Financial
Penalty Against a Public Company’s Senior Executive,” http://www.sec.gov/news/press/2010/2010-197.htm.
896 6/7/2010 U.S. Federal Trade Commission press release, “Countrywide Will Pay $108 Million for Overcharging
Struggling Homeowners; Loan Servicer Inflated Fees, Mishandled Loans of Borrowers in Bankruptcy,”
897 See, e.g., “$600 Million Countrywide Settlement,” Associated Press (8/3/2010).
898 2/26/2009 Office of Inspector General, Dept. of the Treasury Audit Report, “Safety and Soundness: Material
Loss Review of IndyMac Bank,” at 40, http://www.treasury.gov/about/organizationalstructure/
ig/Documents/oig09032.pdf (hereinafter “IG Report on IndyMac Bank”).
required by the loan, triggering negative amortization. In addition to originating loans, IndyMac
packaged them into securities and sold them on the secondary market.899
In July 2007, after the credit rating agencies downgraded the ratings on most subprime
mortgage backed securities and the subprime secondary market collapsed, IndyMac – like
WaMu – was left holding a large inventory of poor quality mortgage loans it could not sell. As
delinquencies increased and the value of the mortgages fell, IndyMac incurred substantial losses,
and its depositors began withdrawing funds. The withdrawals continued throughout 2007 and
into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank.900 In
July 2008, IndyMac collapsed and was seized by the FDIC, which had to pay more than $10
billion from the Deposit Insurance Fund to protect insured deposits and pay related expenses.901
As it did with WaMu, OTS gave IndyMac high CAMELS ratings until shortly before the
thrift’s failure, despite the fact that OTS had identified numerous problems with IndyMac’s
subprime mortgage business practices.902 Those problems included adopting an overly narrow
definition of “subprime,” so that IndyMac could maintain a lower level of capital reserves;903
poor underwriting and sloppy property appraisal practices;904 and improper risk mitigation.905
After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a
report evaluating OTS’ oversight efforts.
Neither OTS nor the FDIC ever took a public enforcement action against the bank.
906 The report attributed IndyMac’s collapse to its
strategy of rapid growth; originating and securitizing nontraditional, high risk loans; lack of
verification of borrowers’ income or assets; lax underwriting; and reliance on high interest loans
for its own operations.907 The Treasury IG found that OTS was aware of IndyMac’s problems,
but did not take sufficient enforcement action to correct them.908
899 Id. at 7.
According to the Inspector
900 Id. at 3.
901 Id. at 1.
902 Id. at 8.
903 Id. at 18.
904 Id. at 21-31.
906 Id. In addition to the Material Loss Review, the Treasury Inspector General investigated OTS’ conduct in
permitting thrifts, including IndyMac to backdate certain capital infusions. See 12/22/2008 Office of the Inspector
General, Dept. of the Treasury, Letter to Ranking Member Charles Grassley, Senate Committee on Finance,
business/documents/Indymac_Thorson_122308pdf.pdf?sid=ST2008122202386. Darrel Dochow was removed
from his position as Director of the OTS West Division for having allowed IndyMac to backdate a capital
contribution of $18 million, which made it appear stronger than it really was in the relevant financial statement.
Then Acting OTS Director Scott Polakoff was also placed on leave during the backdating investigation, but he
disputed that he directed anyone to allow backdated capital injections and asserted that the real impetus for his being
placed on leave was his Congressional testimony critical of the agency’s conduct related to AIG. Subcommittee
interview of Scott Polakoff (3/16/10).
907 3/31/2009 Office of the Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” at 15,
908 Id. at 31.
General, OTS typically relied on the “cooperation of IndyMac management to obtain needed
improvements” – which was usually not forthcoming – to remedy identified problems.909
In February 2011, the SEC charged three former senior IndyMac executives with
securities fraud for misleading investors about the company’s deteriorating financial
condition.910 The SEC alleged that the former CEO and two former CFOs participated in the
filing of false and misleading disclosures about the financial stability of IndyMac and its main
subsidiary, IndyMac Bank F.S.B. One of the executives – S. Blair Abernathy, former CFO – has
agreed to settle the SEC’s charges without admitting or denying the allegations for
approximately $125,000. The SEC’s complaint against former CEO Michael W. Perry and
former CFO A. Scott Keys seeks, among other things, disgorgement, financial penalties, and a
bar on their acting as an officer or director of a publicly traded corporation.911
IndyMac was the third-largest bank failure in U.S. history and the largest collapse of a
FDIC-insured depository institution since 1984.912 At the time of its collapse, IndyMac had $32
billion in assets and $19 billion in deposits, of which approximately $18 billion were insured by
the FDIC.913 IndyMac’s failure cost the FDIC $10.7 billion,914 a figure which, at the time,
represented over 10% of the federal Deposit Insurance Fund.915
(c) New Century
New Century Financial Corporation is an example of a failed mortgage lender that
operated largely without federal or state oversight, other than as a publicly traded corporation
overseen by the SEC. New Century originated, purchased, sold, and serviced billions of dollars
in subprime residential mortgages, operating not as a bank or thrift, but first as a private
corporation, then as a publicly traded corporation, and finally, beginning in 2004, as a publicly
traded Real Estate Investment Trust (REIT).916
909 Id. at 38.
By 2007, New Century had approximately 7,200
employees, offices across the country, and a loan production volume of $51.6 billion, making it
910 2/11/2011 SEC press release, “SEC Charges Former Mortgage Lending Executives With Securities Fraud,”
912 “The Fall of IndyMac,” CNNMoney.com (7/13/2008).
914 3/31/2010 Office of Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,”
915 “Crisis Deepens as Big Bank Fails; IndyMac Seized in Largest Bust in Two Decades,” Wall Street Journal
916 See SEC v. Morrice, Case No. SACV09-01426 (USDC CD Calif.), Complaint (Dec. 7, 2009), ¶¶ 12-13
(hereinafter “SEC Complaint against New Century Executives”). See also In re New Century, Case No. 2:07-cv-
00931-DDP (USDC CD Calif.), Amended Consolidated Class Action Complaint (March 24, 2008), at ¶¶ 55-58
(hereinafter “New Century Class Action Complaint”).
the second largest subprime lender in the country.917
In 2007, after the company announced its intent to restate its 2006 financial results,
investors lost confidence in the company, its stock plummeted, and New Century collapsed. In
April 2007, it filed for bankruptcy.
Because it did not accept deposits or have
insured accounts, it was not overseen by any federal or state bank regulator.
918 In February 2008, the bankruptcy examiner released a
detailed report that found New Century was responsible for “significant improper and imprudent
practices related to its loan originations, operations, accounting and financial reporting
After New Century’s bankruptcy, a 2007 class action complaint was filed by the New
York State Teachers’ Retirement System and others alleging that New Century executives had
violated federal securities laws and committed fraud.
Like WaMu, New Century had engaged in a number of harmful mortgage
practices, including “increasing loan originations, without due regard to the risks associated with
that business strategy”; risk layering in which it issued high risk loans to high risk borrowers,
including originating in excess of 40% of its loans on a stated income basis; allowing multiple
exceptions to underwriting standards; and utilizing poor risk management practices that relied on
the company’s selling or securitizing its high risk mortgages rather than retaining them.
920 Among other matters, the complaint
alleged that the company sold poor quality loans that incurred early payment defaults, received
numerous demands from third party buyers of the loans to repurchase them, and built up a huge
backlog of hundreds of millions of dollars in repurchase requests that the company deliberately
delayed paying to make its 2005 and 2006 financial results appear better than they actually
were.921 The complaint also alleged that New Century issued loans using lax underwriting
standards to maximize loan production,922 and “routinely and increasingly lent money to people
who were unable to repay the debt shortly after the loans were closed.”923 The suit took note of a
news article stating: “Loans made by New Century, which filed for bankruptcy protection in
March, have some of the highest default rates in the industry.”924
In December 2009, the SEC filed a civil complaint charging three former New Century
executives, the CEO, CFO, and controller, with fraudulent accounting that misled investors about
the company’s finances.925
917 In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.), 2/29/2008 Final
Report of Michael J. Missal, Bankruptcy Court Examiner, at 2,
http://graphics8.nytimes.com/packages/pdf/business/Final_Report_New_Century.pdf (hereinafter “New Century
Bankruptcy Report”). See also New Century Class Action Complaint at ¶ 59-60.
The SEC alleged that, while the company’s financial disclosures
painted a picture that the company’s performance exceeded that of its peers, its executives had
failed to disclose material negative information, such as significant increases in its loans’ early
918 In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.).
919 New Century Bankruptcy Report.
920 New Century Class Action Complaint.
921 Id. at ¶¶ 75-79.
922 Id. at ¶ 112. See also ¶¶ 126-130.
923 Id. at ¶ 113. See also ¶¶ 114-116.
924 Id. at ¶ 123.
925 SEC Complaint against New Century Executives; See also 12/7/2009 SEC Press Release, “SEC Charges Former
Offices of Subprime Lender New Century With Fraud.”
payment defaults and a backlog of loan repurchases, which had the effect of materially
overstating the company’s financial results. The SEC complaint also stated that, although New
Century had represented itself as a prudent subprime lender, it “soon became evident that its
lending practices, far from being ‘responsible,’ were the recipe for financial disaster.”926 The
complaint detailed a number of high risk lending practices, including the issuance of interest
only loans; 80/20 loans with loan-to-value ratios of 100%; and stated income loans in which the
borrower’s income and assets were unverified.927
In July 2010, the three former New Century executives settled the SEC complaint for
about $1.5 million, without admitting or denying wrongdoing.
The complaint charged the New Century
executives with downplaying the riskiness of the company’s loans and concealing their high
928 Each also agreed to be barred
from serving as an officer or director of any publicly traded corporation for five years. A larger
group of about a dozen former New Century officers and directors settled several class action
and other shareholder lawsuits for $88.5 million.929
In 2007, New Century reported publicly that it was under criminal investigation by the
U.S. Attorney’s Office for the Central District of California, but no indictment of the company or
any executive has been filed.930
Fremont Investment & Loan was once the fifth largest subprime mortgage lender in the
United States.931 At its peak in 2006, it had $13 billion in assets, 3,500 employees, and nearly
two dozen offices.932 Fremont Investment & Loan was neither a bank nor a thrift, but an
“industrial loan company” that issued loans and held insured deposits.933 It was owned by
Fremont General Credit Corporation which was owned, in turn, by Fremont General
Corporation. In 2007, the bank was the subject of an FDIC cease and desist order which
identified multiple problems with its operations and ordered the bank to cease its subprime
lending.934 In 2008, due to insufficient capital, the FDIC ordered Fremont General Corporation
to either recapitalize the bank or sell it. The bank was then sold to CapitalSource, Inc.935
926 SEC Complaint against New Century Executives at 3.
927 See, e.g., SEC Complaint against New Century Executives at ¶¶ 24-32.
928 See 7/30/2010 SEC Litigation Release No. 21609, “SEC Settles With Former Officers of Subprime Lender New
Century, “ http:www.sec.gov/litigation/litreleases/2010/lr21609.htm.
929 See, e.g., “New Century Ex-leaders to Pay $90 Million in Settlements,” Los Angeles Times (7/31/2010).
930 See 3/12/2007 New Century Financial Corporation Form 8-K, Item 8.01.
931 “Fremont Ordered by FDIC to Find Buyer; Curbs Imposed,” Bloomberg (3/28/2010),
932 3/2006 Fremont General Corporation Form 10-K filed with the SEC.
934 In re Fremont Investment & Loan, Order to Cease and Desist, Docket No. FDIC-07-035b (March 7, 2007)
(hereinafter “Fremont Cease and Desist Order”).
935 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069
PCAS (March 26, 2008); “CapitalSource, Inc.,” Hoover’s Company Records. See also “CapitalSource to Acquire
Fremont’s Retail Arm,” New York Times (4/14/2008).
2008, Fremont General Corporation declared bankruptcy under Chapter 11 and has since
reorganized as Signature Group Holdings, Inc.936
As a California based industrial loan company, Fremont Investment & Loan was
overseen by the California Department of Financial Institutions, a state bank regulator. Since it
had deposits that were federally insured, Fremont was also regulated by the FDIC.937 The March
2007 FDIC cease and desist order required the bank to end its subprime lending business, due to
“unsafe and unsound banking practices and violations of law,” including operating with “a large
volume of poor quality loans”; “unsatisfactory lending practices”; “excessive risk”; and
inadequate capital.938 The FDIC also determined that the bank lacked effective risk management
practices, lacked adequate mortgage underwriting criteria, and was “approving loans with loanto-
value ratios approaching or exceeding 100 percent of the value of the collateral.”939
Many of the specific practices cited in the cease and desist order mirror the FDIC and
OTS criticisms of WaMu. For example, the FDIC determined that Fremont was “marketing and
extending adjustable-rate mortgage (‘ARM’) products to subprime borrowers in an unsafe and
unsound manner that greatly increase[d] the risk that borrowers will default”; “qualifying
borrowers for loans with low initial payments based on an introductory or ‘start’ rate that will
expire after an initial period”; “approving borrowers without considering appropriate
documentation and/or verification of the their income”; and issuing loans with “features likely to
require frequent refinancing to maintain an affordable monthly payment and/or to avoid
foreclosure.”940 Fremont later reported receiving default notices on $3.15 billion in subprime
mortgages it had sold to investors.941
One year later, in March 2008, the FDIC filed another public enforcement action against
the bank, for failing to provide an acceptable capital restoration plan or obtaining sufficient
capital, and ordered the bank’s parent company to either adequately capitalize the bank within 60
days or sell it.942
The FDIC took action against Fremont much earlier – in March 2007 – than other
regulators did with respect to other financial institutions, including OTS’ nonpublic enforcement
actions against WaMu in March and September 2008; the FDIC’s seizure of IndyMac in July
2008; the SEC’s action against Countrywide in June 2009; and the SEC’s action against New
The bank was then sold to CapitalSource, Inc.
936 In re Fremont General Corporation, Case No. 8:08-bk-13421-ES (US Bankruptcy Court, CD Calif.), First Status
Report (July 30, 2010) (included in 7/30/2010 Fremont General Corporation 8K filing with the SEC).
937 2006 Fremont 10-K Statement with the SEC.
938 Fremont Cease and Desist Order at 1-3. See also 3/7/2007 FDIC press release, “FDIC Issues Cease and Desist
Order Against Fremont Investment & Loan, Brea, California, and its Parents.”
939 Fremont Cease and Desist Order at 2-4.
940 Id. at 3.
941 See 3/4/2008 Fremont General Corporation press release, “Fremont General Corporation Announces Receipt of
Notice of Covenant Default With Respect to Guaranties Issued in Connection With Certain Prior Residential Sub-
Prime Loan Sale Transactions,” http://media.corporate-ir.net/media_files/irol/10/106265/08-03-
04N%20FGCAnnouncesDefaultNoticewithRRELoanTransactions.pdf. See also “CapitalSource to Acquire
Fremont’s Retail Arm,” New York Times (4/14/2008).
942 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069
PCAS ( March 26, 2008).
Century in December 2009. By putting an early end to Fremont’s subprime lending, the FDIC
stopped it from selling additional poor quality mortgage backed securities into U.S. securitization
In November 2008, the OCC researched the ten metropolitan areas with the highest
foreclosure rates and identified the ten lenders in each area with the most foreclosed loans; Long
Beach, Countrywide, IndyMac, New Century, and Fremont all made the list of the “Worst Ten in
the Worst Ten.”943 Moody’s, the credit rating agency, later calculated that, in 2006 alone, Long
Beach, New Century, and Fremont were responsible for 24% of the residential subprime
mortgage backed securities issued, but 50% of the subsequent credit rating downgrades of those
E. Preventing Regulatory Failures
The fact is that each of these lenders issued billions of dollars in high risk, poor
quality home loans. By allowing these lenders, for years, to sell and securitize billions of dollars
in poor quality, high risk home loans, regulators permitted them to contaminate the secondary
market and introduce systemic risk throughout the U.S. financial system.
Regulators stood on the sidelines as U.S. mortgage lenders introduced increasingly high
risk mortgage products into the U.S. mortgage market. Stated income loans, NINA loans, and
so-called “liar loans” were issued without verifying the borrower’s income or assets. Alt A loans
also had reduced documentation requirements. Interest-only loans, Option ARMs, and hybrid
ARMs involved charging low introductory interest rates on loans that could be refinanced before
much higher interest rates took effect. Negative amortization loans – loans that became bigger
rather than smaller over time – became commonplace. Home equity loans and lines of credit,
piggybacks and silent seconds, 100% financing – all involved loans that required the borrower to
make virtually no down payment or equity investment in the property, relying instead on the
value of the property to ensure repayment of the loan. All of these loans involved higher risks
than the 30-year and 15-year fixed rate mortgages that dominated the U.S. mortgage market prior
to 2004. When property values stopped climbing in late 2006, these higher risk loans began
incurring delinquencies, losses, and defaults at record rates.
A number of new developments have occurred in the past several years to address the
problems highlighted throughout this Report.
(1) New Developments
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),
which the President signed into law on July 21, 2010, contains many changes in the law that will
be implemented over the next year. The Dodd-Frank changes include abolishing OTS, banning
stated income loans, and restricting negative amortization loans. Other developments include a
revised interagency agreement strengthening the FDIC’s ability to conduct examinations of
943 See 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the OCC, Hearing Exhibit 4/13-58.
944 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,”
prepared by Moody’s Investors Service, Hearing Exhibit 4/23-106.
insured depository institutions and a new FDIC deposit insurance pricing system that requires
higher risk institutions to pay higher insurance fees.
OTS Abolished. One significant new change brought about by the Dodd-Frank Act is
the abolishment of the Office of Thrift Supervision. Title III of the Dodd-Frank Act reassigned
OTS’ duties and personnel to other agencies, primarily the Office of the Comptroller of the
Revised Interagency Agreement. A second important change is that the interagency
agreement that guides when the FDIC can examine an insured institution was altered to give the
FDIC increased authority. Under federal law, the FDIC can conduct an examination of an
insured depository institution “whenever the [FDIC] Board of Directors determines a special
examination … is necessary to determine the condition of such depository institution for
Although some OTS officials claim the law intended OTS to be a merger
partner with the OCC, the statute is clear in its intent to abolish OTS, rather than effect a merger
In 2010, the FDIC renegotiated that agreement with the other financial regulators, and
they signed a revised version that will facilitate more cooperation on a less bureaucratic and
more timely basis.
Despite this broad statutory grant of examination authority, in 2002, the
FDIC agreed to limit the circumstances in which it would examine banks subject to regulation by
another agency. The resulting interagency agreement essentially required the FDIC to establish
that an institution was at “heightened risk” of causing loss to the Deposit Insurance Fund before
the FDIC could compel another banking regulator to allow the FDIC to participate in an
examination of its operations. OTS used that agreement to impede the FDIC’s participation in
examinations of WaMu.
945 See, e.g., Section 312 of the Dodd-Frank Act.
Compared to the 2002 version, the revised agreement explicitly provides
for special examinations of a broader scope of insured depository institutions. It also streamlined
the process for resolving differences in CAMELS ratings between financial regulators. In the
case of WaMu, this new process would have helped facilitate a quicker response to WaMu’s
deteriorating condition. Additionally, the new agreement establishes a continuous on-site FDIC
presence, with five or more examiners, at certain large institutions, including those that receive
ratings under the FDIC’s Large Insured Depository Institutions Program. This new provision
ensures the FDIC has consistent access to information about big banks that, by virtue of their
size, pose the most risk to the Deposit Insurance Fund. Finally, after first discussing it with the
primary federal regulator, the FDIC is permitted to gather information directly from financial
institutions. These provisions will help ensure that the FDIC can obtain the information needed
to safeguard the Deposit Insurance Fund.
946 12 U.S.C. § 1820(b)(3).
947 9/17/2010 letter from FDIC Chairman Sheila C. Bair to the Subcommittee, PSI-FDIC-13-000001 (“Enclosed
please find a signed copy of a revised and much-strengthened memorandum of understanding among the FDIC and
other bank regulators which will greatly enhance our ability to continually access and monitor information related to
our risks as deposit insurer. I believe this is a very strong agreement and one which we accomplished due in no
small part to the work of your Subcommittee in identifying weaknesses in the supervisory processes leading up to
the failure of Washington Mutual.”).
Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system
that takes effect in 2011, large depository institutions with higher risk activities will be required
to pay higher fees into the Deposit Insurance Fund.948 This new assessment system is designed
to “better capture risk at the time large institutions assume the risk, to better differentiate among
institutions for risk and take a more forward-looking view of risk, [and] to better take into
account the losses that the FDIC may incur if such an insured depository institution fails.”949 It
is the product of both past FDIC revisions and changes to the insurance fund assessment system
made by the Dodd-Frank Act.950 It is intended to impose higher assessments on large banks
“with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss
severity in the event of failure,” and impose those higher assessments when the banks “assume
these risks rather than when conditions deteriorate.”951
Financial Stability Oversight Council. The Dodd-Frank Act has also established a new
intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify
systemic risks and respond to emerging threats to the stability of the U.S. financial system.
Under this new system, banks with
higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and
allocate insurance costs more fairly, but also to help discourage high risk activities.
The council is comprised of ten existing regulators in the financial services sector, including the
Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the
Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is
intended to ensure that U.S. financial regulators consider the safety and soundness of not only
individual financial institutions, but also of U.S. financial markets and systems as a whole.
To further strengthen oversight of financial institutions to reduce risk, protect U.S.
financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report
makes the following recommendations.
1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)
should complete the dismantling of the Office of Thrift Supervision (OTS), despite
attempts by some OTS officials to preserve the agency’s identity and influence within
2. Strengthen Enforcement. Federal banking regulators should conduct a review of
their major financial institutions to identify those with ongoing, serious deficiencies,
and review their enforcement approach to those institutions to eliminate any policy of
deference to bank management, inflated CAMELS ratings, or use of short term profits
to excuse high risk activities.
948 See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064.
950 See Sections 331, 332 and 334 of the Dodd-Frank Act.
951 2/7/2011 FDIC press release, “FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and
Large Bank Pricing,” http://www.fdic.gov/news/news/press/2011/pr11028.html.
952 See Title I, Subtitle A, of the Dodd-Frank Act establishing the Financial Stability Oversight Council, including
Section 112(a) which provides its purposes and duties.
3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a
comprehensive review of the CAMELS ratings system to produce ratings that signal
whether an institution is expected operate in a safe and sound manner over a specified
period of time, asset quality ratings that reflect embedded risks rather than short term
profits, management ratings that reflect any ongoing failure to correct identified
deficiencies, and composite ratings that discourage systemic risks.
4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council
should undertake a study to identify high risk lending practices at financial
institutions, and evaluate the nature and significance of the impacts that these
practices may have on U.S. financial systems as a whole.
V. INFLATED CREDIT RATINGS:
CASE STUDY OF MOODY’S AND STANDARD & POOR’S
Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services
LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA
ratings that made residential mortgage backed securities (RMBS) and collateralized debt
obligations (CDOs) seem like safe investments, helped build an active market for those
securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings
to junk status.953 The July mass downgrades sent the value of mortgage related securities
plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps
more than any other single event triggered the financial crisis.
In the months and years of buildup to the financial crisis, warnings about the massive
problems in the mortgage industry were not adequately addressed within the ratings industry. By
the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a
massive ratings correction that was unprecedented in U.S. financial markets. The result was an
economic earthquake from which the aftershocks continue today.
Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s
and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO
securities issued in the United States, deeming them safe investments even though many relied
on subprime and other high risk home loans. In late 2006, high risk mortgages began to go
delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and
S&P continued for six months to issue investment grade ratings for numerous subprime RMBS
and CDO securities. In July 2007, as mortgage defaults intensified and subprime RMBS and
CDO securities began incurring losses, both companies abruptly reversed course and began
downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings,
some less than a year old. Investors like banks, pension funds, and insurance companies were
suddenly forced to sell off their RMBS and CDO holdings, because they had lost their
investment grade status. RMBS and CDO securities held by financial firms lost much of their
value, and new securitizations were unable to find investors. The subprime RMBS market
initially froze and then collapsed, leaving investors and financial firms around the world holding
unmarketable subprime RMBS securities plummeting in value. A few months later, the CDO
market collapsed as well.
Traditionally, investments holding AAA ratings have had a less than 1% probability of
incurring defaults. But in the financial crisis, the vast majority of RMBS and CDO securities
with AAA ratings incurred substantial losses; some failed outright. Investors and financial
institutions holding those AAA securities lost significant value. Those widespread losses led, in
turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major
U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA
953 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this
Report will refer to both ratings as “AAA.”
credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause
of the financial crisis.
The Subcommittee’s investigation uncovered a host of factors responsible for the
inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent
conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies
were paid by the Wall Street firms that sought their ratings and profited from the financial
products being rated. The rating companies were dependent upon those Wall Street firms to
bring them business and were vulnerable to threats that the firms would take their business
elsewhere if they did not get the ratings they wanted. Rating standards weakened as each credit
rating agency competed to provide the most favorable rating to win business and greater market
share. The result was a race to the bottom.
Additional factors responsible for the inaccurate ratings include rating models that failed
to include relevant mortgage performance data, unclear and subjective criteria used to produce
ratings, a failure to apply updated rating models to existing rated transactions, and a failure to
provide adequate staffing to perform rating and surveillance services, despite record revenues.
Compounding these problems were federal regulations that required the purchase of investment
grade securities by banks and others, thereby creating pressure on the credit rating agencies to
issue investment grade ratings. Still another factor were the Securities and Exchange
Commission’s (SEC) regulations which required use of credit ratings by Nationally Recognized
Statistical Rating Organizations (NRSRO) for various purposes but, until recently, resulted in
only three NRSROs, thereby limiting competition.954
Evidence gathered by the Subcommittee shows that credit rating agencies were aware of
problems in the mortgage market, including an unsustainable rise in housing prices, the high risk
nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead of
using this information to temper their ratings, the firms continued to issue a high volume of
investment grade ratings for mortgage backed securities. If the credit rating agencies had issued
ratings that accurately exposed the increasing risk in the RMBS and CDO markets and
appropriately adjusted existing ratings in those markets, they might have discouraged investors
from purchasing high risk RMBS and CDO 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 ratings for high risk RMBS and CDO securities,
because doing so would have hurt their own revenues. Instead, the credit rating agencies’ profits
became increasingly reliant on the fees generated by issuing a large volume of investment grade
954 See, e.g., 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities
Markets,” prepared by the SEC, at 5-6 (explaining how the SEC came to rely on NRSRO credit ratings); 9/3/2009
“Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service, Report No.
R40613 (revised report issued 4/9/2010) (finding that, prior to the 2006 Credit Rating Agency Reform Act, “[t]he
SEC never defined the term NRSRO or specified how a CRA might become one. Its approach has been described as
essentially one of ‘we know-it-when-we-see-it.’ The resulting limited growth in the pool of NRSROs was widely
believed to have helped to further entrench the three dominant CRAs: by some accounts, they have about 98% of
total ratings and collect 90% of total rating revenue.” 9/3/2009 version of the report at 2-3).
Looking back after the first shock of the crisis, one Moody’s managing director offered
this critical self analysis:
“[W]hy didn’t we envision that credit would tighten after being loose, and housing prices
would fall after rising, after all most economic events are cyclical and bubbles inevitably
burst. Combined, these errors make us look either incompetent at credit analysis, or like
we sold our soul to the devil for revenue, or a little bit of both.”955
A. Subcommittee Investigation and Findings of Fact
For more than one year, the Subcommittee conducted an in-depth investigation of the role
of credit rating agencies in the financial crisis, using as case histories Moody’s and S&P. The
Subcommittee subpoenaed and reviewed hundreds of thousands of documents from both
companies including reports, analyses, memoranda, correspondence, and email, as well as
documents from a number of financial institutions that obtained ratings for RMBS and CDO
securities. The Subcommittee also collected and reviewed documents from the SEC and reports
produced by academics and government agencies on credit rating issues. In addition, the
Subcommittee conducted nearly two dozen interviews with current and former Moody’s and
S&P executives, managers, and analysts, and consulted with credit rating experts from the SEC,
Federal Reserve, academia, and industry. On April 23, 2010, the Subcommittee held a hearing
and released 100 hearing exhibits.956
In connection with the hearing, the Subcommittee released a joint memorandum from
Chairman Levin and Ranking Member Coburn summarizing the investigation into the credit
rating agencies and the problems with the credit ratings assigned to RMBS and CDO securities.
The memorandum contained joint findings regarding the role of the credit rating agencies in the
Moody’s and S&P case histories, which this Report reaffirms. The findings of fact are as
1. Inaccurate Rating Models. From 2004 to 2007, Moody’s and S&P used credit
rating models with data that was inadequate to predict how high risk residential
mortgages, such as subprime, interest only, and option adjustable rate mortgages,
2. Competitive Pressures. Competitive pressures, including the drive for market share
and need to accommodate investment bankers bringing in business, affected the credit
ratings issued by Moody’s and S&P.
3. Failure to Re-evaluate. By 2006, Moody’s and S&P knew their ratings of RMBS
and CDOs were inaccurate, revised their rating models to produce more accurate
ratings, but then failed to use the revised model to re-evaluate existing RMBS and
955 9/2007 anonymous Moody’s Managing Director after a Moody’s Town Hall meeting on the financial crisis, at
763, Hearing Exhibit 4/23-98.
956 “Wall Street and the Financial Crisis: The Role of Credit Rating Agencies,” before the U.S. Senate Permanent
Subcommittee on Investigations, S.Hrg. 11-673 (4/23/2010) (hereinafter “April 23, 2010 Subcommittee Hearing”).
CDO securities, delaying thousands of rating downgrades and allowing those
securities to carry inflated ratings that could mislead investors.
4. Failure to Factor in Fraud, Laxity, or Housing Bubble. From 2004 to 2007,
Moody’s and S&P knew of increased credit risks due to mortgage fraud, lax
underwriting standards, and unsustainable housing price appreciation, but failed
adequately to incorporate those factors into their credit rating models.
5. Inadequate Resources. Despite record profits from 2004 to 2007, Moody’s and
S&P failed to assign sufficient resources to adequately rate new products and test the
accuracy of existing ratings.
6. Mass Downgrades Shocked Market. Mass downgrades by Moody’s and S&P,
including downgrades of hundreds of subprime RMBS over a few days in July 2007,
downgrades by Moody’s of CDOs in October 2007, and actions taken (including
downgrading and placing securities on credit watch with negative implications) by
S&P on over 6,300 RMBS and 1,900 CDOs on one day in January 2008, shocked the
financial markets, helped cause the collapse of the subprime secondary market,
triggered sales of assets that had lost investment grade status, and damaged holdings
of financial firms worldwide, contributing to the financial crisis.
7. Failed Ratings. Moody’s and S&P each rated more than 10,000 RMBS securities
from 2006 to 2007, downgraded a substantial number within a year, and, by 2010,
had downgraded many AAA ratings to junk status.
8. Statutory Bar. The SEC is barred by statute from conducting needed oversight into
the substance, procedures, and methodologies of the credit rating models.
9. Legal Pressure for AAA Ratings. Legal requirements that some regulated entities,
such as banks, broker-dealers, insurance companies, pension funds, and others, hold
assets with AAA or investment grade credit ratings, created pressure on credit rating
agencies to issue inflated ratings making assets eligible for purchase by those entities.
(1) Credit Ratings Generally
Credit ratings, which first gained prominence in the late 1800s, are supposed to provide
independent assessments of the creditworthiness of particular financial instruments, such as a
corporate bond, mortgage backed security, or CDO. Essentially, credit ratings predict the
likelihood that a debt will be repaid.957
957 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service,
Report No. R40613 (revised report issued 4/9/2010).
The United States has three major credit rating agencies: Moody’s, S&P, and Fitch
Rating Ltd., each of which is a NRSRO. By some accounts, these three firms issue about 98% of
total credit ratings and collect 90% of total credit rating revenue.958
Paying for Ratings. Prior to the 1929 crash, credit rating agencies made money by
charging subscription fees to investors who were considering investing in the financial
instruments being rated. This method of payment was known as the “subscriber-pays” model.
Following the 1929 crash, the credit rating agencies fell out of favor. As one academic expert
“Investors were no longer very interested in purchasing ratings, particularly given the
agencies’ poor track record in anticipating the sharp drop in bond values beginning in late
1929. … The rating business remained stagnant for decades.”959
In 1970, the credit rating agencies changed to an “issuer-pays” model and have used it since.960
In this model, the party seeking to issue a financial instrument, such as a bond or security, pays
the credit rating agency to analyze the credit risk and assign a credit rating to the financial
Credit Ratings. Credit ratings use a scale of letter grades, from AAA to C, with AAA
ratings designating the safest investments and the other grades designating investments at greater
risk of default.961 Investments with AAA ratings have historically had low default rates. For
example, S&P reported that its cumulative RMBS default rate by original rating class (through
September 15, 2007) was 0.04% for AAA initial ratings and 1.09% for BBB.962 Financial
instruments bearing AAA through BBB- ratings are generally called “investment grade,” while
those with ratings below BBB- (or Baa3) are referred to as “below investment grade” or
sometimes as “junk” investments. Financial instruments that default receive a D rating from
S&P, but no rating at all by Moody’s.
959 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San
Diego Law School Legal Studies Research Paper Series (5/2006), at 63.
960 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service,
Report No. R40613 (revised report issued 4/9/2010). A few small credit rating agencies use the “subscriber-pays”
model. However, 99% of outstanding credit ratings are issued by agencies using the “issuer-pays” model. 1/2011
“Annual Report on Nationally Recognized Statistical Rating Organizations,” report prepared by the SEC, at 6.
961 The Moody’s rating system is similar in concept but with a slightly different naming convention. For example its
top rating scale is Aaa, Aa1, Aa2, Aa3, A1, A2, A3.
962 Prepared statement of Vickie A. Tillman, Executive Vice President, Standard & Poor’s Credit Market Services,
“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 51. See also 1/2007 S&P document, “Annual 2006 Global Corporate
Default Study and Ratings Transitions.”
Investors often rely on credit ratings to gauge the safety of a particular investment. A
former senior credit analyst at Moody’s explained that investors use ratings to:
“satisfy any number of possible needs: institutional investors such as insurance
companies and pension funds may have portfolio guidelines or requirements, investment
fund portfolio managers may have risk-based capital requirements or investment
committee requirements. And of course, private investors lacking the resources to do
separate analysis may use the published ratings as their principal determinant of the risk
of the investment.”963
Legal Requirements. Some state and federal laws restrict the amount of below
investment grade bonds that certain investors can hold, such as pension funds, insurance
companies, and banks. Banks, for example, are limited by law in the amount of non-investment
grade bonds they can hold, and are sometimes required to post additional capital for those higher
risk instruments.964 Broker-dealers and money market funds that register with the SEC operate
under similar restrictions.965 The rationale behind these legal requirements is to require or
provide economic incentives for banks and other financial institutions to purchase investments
that have been identified as liquid and “safe” by an independent third party with a high level of
market expertise, such as a credit rating agency. Because so many federal and state statutes and
regulations require the purchase of investment grade ratings, issuers of securities and other
instruments work hard to obtain favorable credit ratings to ensure regulated financial institutions
can buy their products. As a result, those legal requirements not only increased the demand for
investment grade ratings, but also created pressure on credit rating agencies to issue top ratings
in order to make the rated products eligible for purchase by regulated financial institutions. The
legal requirements also generated more work and greater profits for the credit rating agencies.
CRA Oversight and Accountability. The credit rating agencies are currently subject to
regulation by the SEC. In September 2006, Congress enacted the Credit Rating Agency Reform
Act, P.L. 109-291, to require SEC oversight of the credit rating industry. Among other
provisions, the law charged the SEC with designating NRSROs and defined that term for the first
time. By 2008, the SEC had granted NRSRO status to ten credit rating agencies (CRA).966
963 Prepared statement of Richard Michalek, Former VP/Senior Credit Officer, Moody's Investors Service, April 23,
2010 Subcommittee Hearing, at 2 (hereinafter “Michalek prepared statement”). See also 8/29/2006 email from Greg
Lippmann, (Deutsche Bank), to Paolo Pellegrini (Paulson & Co.) and others, DBSI_PSI_EMAIL01625848 at 52
(“Since a CDO without a triple-A-rated senior tranche would be unmarketable, their imprimatur is
indispensable.”);11/13/2007 email from Ralph Silva (Goldman Sachs), GS MBS-E-010023525, Tri-Lateral
Combined Comments Attachment, GS MBS-E-01035693-715, at 713 (“Investors in subprime related securities,
especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are
purchased by structured investing vehicles.”); M&T Bank Corporation v. Gemstone CDO VII, Ltd., Index No.
200800764 (N.Y. Sup.), Complaint, (June 16, 2008) at 12.
964 See, e.g., Section 28 (d) and (e) of the Federal Deposit Insurance Act, codified at 12 U.S.C. § 1831e(d)-(e).
965 See, e.g., Rule 15c3-1 of the Securities Exchange Act of 1934 (allowing broker-dealers to avoid “haircuts” for net
capital requirements provided they hold instruments with investment grade credit ratings); and Rule 2a-7 of the
Investment Company Act of 1940 (limiting money market funds to investments in “high quality” securities).
966 The ten NRSROs are Moody’s; Standard & Poor’s; Fitch; A.M. Best Company, Inc.; DBRS Ltd.; Egan-Jones
Rating Company; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.; Rating and Investment Information,
Act also directed the SEC to conduct examinations of the CRAs, while at the same time
prohibiting the SEC from regulating the substance, criteria, or methodologies used in credit
Prior to the 2006 Reform Act, CRAs had been subject to uneven or limited regulatory
oversight by state and federal agencies. The SEC had developed the NRSRO system, for
example, but had no clear statutory basis for establishing that system or exercising regulatory
authority over the credit rating agencies. Because the requirements for the NRSRO designation
were not defined in law, the SEC had designated only three rating agencies, limiting competition.
No government agency conducted routine examinations of the credit rating agencies or the
procedures they used to rate financial products.
In addition, private investors have generally been unable to hold CRAs accountable for
poor quality ratings or other malfeasance through civil lawsuits.968 The CRAs have successfully
won dismissal of investor lawsuits, claiming that they are in the financial publishing business
and their opinions are protected under the First Amendment.969 In addition, the CRAs have
attempted to avoid any legal liability for their ratings by making disclaimers to investors who
potentially may rely on their opinions. For example, S&P’s disclaimer reads as follows:
“Standard & Poor’s Ratings
Analytic services provided by Standard & Poor’s Ratings Services (“Ratings Services”)
are the result of separate activities designed to preserve the independence and objectivity
of ratings opinions. The credit ratings and observations contained herein are solely
statements of opinion and not statements of fact or recommendations to purchase, hold,
or sell any securities or make any other investment decisions. Accordingly, any user of
the information contained herein should not rely on any credit rating or other opinion
contained herein in making any investment decision. Ratings are based on information
received by Ratings Services. ...”970
RMBS and CDO Ratings. Over the last ten years, Wall Street firms have devised ever
more complex financial instruments for sale to investors, including the RMBS and CDO
securities that played a key role in the financial crisis. Because of the complexity of the
instruments, investors often relied heavily on credit ratings to determine whether they could or
should buy the products. For a fee, Wall Street firms helped design the RMBS and CDO
securities, worked with the credit rating agencies to obtain ratings, and sold the securities to
investors like pension funds, insurance companies, university endowments, municipalities, and
Inc.; and Realpoint LLC. 9/25/2008 “Credit Rating Agencies – NRSROs,” SEC, available at
967 See Sections 15E(c)(2) and 17(a)(1) of the Securities Exchange Act of 1934, as amended by the Credit Rating
Agency Reform Act of 2006, codified at 15 U.S.C § 78o-7(c)(2) and § 78q(a)(1).
968 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San
Diego Law School Legal Studies Research Paper Series (5/2006), at 61.
970 Standard & Poor’s ClassicDirect website, https://www.eclassicdirect.com/NASApp/cotw/CotwLogin.jsp.
“The rating agencies perform a critical role in structured finance – evaluating the credit
quality of the transactions. Such agencies are considered credible because they possess
the expertise to evaluate various underlying asset types, and because they do not have a
financial interest in a security’s cost or yield. Ratings are important because investors
generally accept ratings by the major public rating agencies in lieu of conducting a due
diligence investigation of the underlying assets and the servicer.”
Without investment grade ratings, Wall Street firms would have had a much
more difficult time selling these products to investors, because each investor would have had to
perform its own due diligence review of the financial instrument. Credit ratings simplified the
review and enhanced the sales. Here’s how one federal bank regulatory handbook put it:
In addition to making structured finance products easier to sell to investors, Wall Street
firms used financial engineering to create high risk assets that were given AAA ratings – ratings
which are normally reserved for ultra-safe investments with low rates of return. Firms combined
high risk assets, such as the BBB tranches from subprime mortgage backed securities paying a
relatively high rate of return, in a new financial instrument, such as a CDO, that issued securities
with AAA ratings and were purportedly safe investments. Higher rates of return, combined with
AAA ratings, made subprime RMBS and related CDO securities especially attractive
(2) The Rating Process
Prior to the massive ratings downgrade in mid-2007, the RMBS and CDO rating process
followed a generally well-defined pattern. It began with the firm designing the securitization –
the arranger – sending a detailed proposal to the credit rating agency. The proposal contained
information on the mortgage pools involved and how the security would be structured. The
rating agency examined the proposal and provided comments and suggestions, before ultimately
agreeing to run the securitization through one of its models. The results from the model were
used by a rating committee within the agency to determine a final rating, which was then
Arrangers. For RMBS, the “arranger” – typically an investment bank – initiated the
rating process by sending to the credit rating agency information about a prospective RMBS and
data about the mortgage loans included in the prospective pool. The data typically identified the
characteristics of each mortgage in the pool including: the principal amount, geographic location
of the property, FICO score, loan to value ratio of the property, and type of loan. In the case of a
CDO, the process also included a review of the underlying assets, but was based primarily on the
ratings those assets had already received.
971 See 9/2009 “The Financial Crisis of 2007-2009: Causes and Circumstances,” report prepared by the Task Force
on the Cause of the Financial Crisis, Banking Law Committee, Section of Business Law, American Bar Association
(This report was prepared by a subgroup of the Banking Law Committee and did not represent the official position
of the Committee or the Association).
972 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset
Securitization,” at 11.
In addition to data on the assets, the arranger provided a proposed capital structure for the
financial instrument, identifying, for example, how many tranches would be created, how the
revenues being paid into the RMBS or CDO would be divided up among those tranches, and
how many of the tranches were designed to receive investment grade ratings. The arranger also
identified one or more “credit enhancements” for the pool to create a financial cushion that
would protect the designated investment grade tranches from expected losses.973
Credit Enhancements. Arrangers used a variety of credit enhancements. The most
common was “subordination” in which the arranger “creates a hierarchy of loss absorption
among the tranche securities.”974 To create that hierarchy, the arranger placed the pool’s
tranches in an order, with the lowest tranche required to absorb any losses first, before the next
highest tranche. Losses might occur, for example, if borrowers defaulted on their mortgages and
stopped making mortgage payments into the pool. Lower level tranches most at risk of having to
absorb losses typically received noninvestment grade ratings from the credit rating agencies,
while the higher level tranches that were protected from loss typically received investment grade
ratings. One key task for both the arrangers and the credit rating agencies was to calculate the
amount of “subordination” required to ensure that the higher tranches in a pool were protected
from loss and could be given AAA or other investment grade ratings.
A second common form of credit enhancement was “over-collateralization.” In this
credit enhancement, the arranger ensured that the revenues expected to be produced by the assets
in a pool exceeded the revenues designated to be paid out to each of the tranches. That excess
amount provided a financial cushion for the pool and was used to create an “equity” tranche,
which was the first tranche in the pool to absorb losses if the expected payments into the pool
were reduced. This equity tranche was subordinate to all the other tranches in the pool and did
not receive any credit rating. The larger the excess, the larger the equity tranche, and the larger
the cushion created to absorb losses and protect the more senior tranches in the pool. In some
pools, the equity tranche was also designed to pay a relatively higher rate of return to the party or
parties who held that tranche due to its higher risk.
Still another common form of credit enhancement was the creation of “excess spread,”
which involved designating an amount of revenue to pay the pool’s monthly expenses and other
liabilities, but ensuring that the amount was slightly more than what was likely needed for that
purpose. Any funds not actually spent on expenses would provide an additional financial
cushion to absorb losses, if necessary.
Credit Rating Models. After the arranger submitted the pool information, proposed
capital structure, and proposed credit enhancements to the CRA, a CRA analyst was assigned to
evaluate the proposed financial instrument. The first step that most CRA analysts took was to
use a credit rating model to evaluate the rate of probable defaults or expected losses from the
973 See, e.g., 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit
Rating Agencies,” report prepared by the SEC, at 6-10.
974 Id. at 6.
asset pool. Credit rating models are mathematical constructs that analyze a large number of data
points related to the likelihood of an asset defaulting. RMBS rating models typically use
statistical analyses of past mortgage performance data to calculate expected RMBS default rates
and losses. In contrast, rather than statistics, CDO models use assumptions to build simulations
that can be used to project likely CDO defaults and losses.
The major RMBS credit rating model at Moody’s was called the Mortgage Metrics
Model (M3), while the S&P model was called the Loan Evaluation and Estimate of Loss System
(LEVELS). Both models used large amounts of statistical data related to the performance of
residential mortgages over time to develop criteria to analyze and rate submitted mortgage pools.
CRA analysts relied on these quantitative models to predict expected loss (Moody’s) or the
probability of default (S&P) for a pool of residential loans.
To derive the default or loss rate for an RMBS pool of residential mortgages, the CRA
analyst typically fed a “loan tape” – most commonly a spreadsheet provided by the arranger with
details on each loan – into the credit rating model. The rating model then automatically assessed
the expected credit performance of each loan in the pool and aggregated that information. To
perform this function, the model selected certain data points from the loan tape, such as borrower
credit scores or loan-to-value ratios, and compared that information to past mortgage data using
various assumptions, to determine the likely “frequency of foreclosure” and “loss severity” for
the particular types of mortgages under consideration. It then projected the level of “credit
enhancement,” or cushion needed to protect investment grade tranches from loss.
For riskier loans, the model required a larger cushion to protect investment grade tranches
from losses. For example, the model might project that 30% of the pool’s incoming revenue
would need to be set aside to ensure that the remaining 70% of incoming revenues would be
protected from any losses. Tranches representing the 70% of the incoming revenues could then
receive AAA ratings, while the remaining 30% of incoming revenues could be assigned to
support the payment of expenses, an equity tranche, or one or more of the subordinated tranches.
In addition to using quantitative models, Moody’s analysts also took into account
qualitative factors in their analysis of expected default and loss rates. For example, Moody’s
analysts considered the quality of the originators and servicers of the loans included in a pool.
Originators known for issuing poor quality loans or servicers known for providing poor quality
servicing could decrease the loss levels calculated for a pool by a significant degree, up to a total
of 20%.975 Moody’s only began incorporating that type of analysis into its M3 ratings process in
December 2006, only six months before the mass downgrades began.976
975 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-
0001-16, at 2-3, footnote 5.
In contrast, S&P
976 Id. See also 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select
Credit Rating Agencies,” report prepared by the Securities and Exchange Commission, at 35, n.70.
analysts did not conduct this type of analysis of mortgage originators and servicers during the
time period examined in this Report.977
Credit Analysis. After obtaining the model’s projections for the cushion or
subordination needed to protect the pool’s investment grade tranches from loss, the CRA analyst
compared that projection to the tranches and credit enhancements actually proposed for the
particular pool to evaluate their sufficiency.
In addition to evaluating an RMBS pool’s expected default and loss rates, credit
enhancements, and capital structure, CRA analysts conducted a cash flow analysis of the interest
and principal payments to be made into the proposed pool to determine that the revenue
generated would be sufficient to pay the rates of return projected for each proposed tranche.
CRA analysts also reviewed the proposed legal structure of the financial instrument to
understand how it worked and how revenues and losses would be allocated. Some RMBS and
CDO transactions included complex “waterfalls” that allocated projected revenues and expected
losses among an array of expenses, tranches, and parties. The CRA analyst was expected to
evaluate whether the projected revenues were sufficient for the designated purposes. The CRA
review also included a legal analysis “ensuring that there was no structural risk presented due to
a failure to fulfill minimally necessary legal requirements … and confirming that the deal
documentation accurately and faithfully described the structure modeled by the Quant
The process for assigning credit ratings to cash CDOs followed a similar path. CRA
analysts used CDO rating models to predict the CDO’s expected defaults and losses. However,
unlike RMBS statistical models that used past performance data to predict RMBS default and
loss rates, the CDO models relied primarily on the underlying ratings of the assets as well as on a
set of assumptions, such as asset correlation, and ran multiple simulations to predict how the
CDO pool would perform. The CDO simulation model at Moody’s was called “CDOROM,”
while the S&P CDO model was called the “CDO Evaluator,” which was repeatedly updated,
eventually to “Evaluator 3” or “E3.” Both companies’ CDO models analyzed the likely rates of
loss for assets within a particular CDO, but neither model re-analyzed any underlying RMBS
securities included within a CDO. Instead, both models simply relied on the credit rating already
assigned to those securities.979
977 In November 2008, after the time period examined in this Report, S&P published enhanced criteria
requiring the quality of mortgage originators and their underwriting processes to be factored into its
RMBS rating analyses. 6/24/2010 supplemental letter from S&P to the Subcommittee, Hearing Exhibit
4/23-108, Exhibit W, 11/25/2008 “Standard &Poor’s Enhanced Mortgage Originator and Underwriting
Review Criteria for U.S. RMBS.”
978 Michalek prepared statement, at 4.
979 Synthetic CDOs, on the other hand, involved a different type of credit analysis. Unlike RMBS and cash CDOs,
synthetic CDOs do not contain any cash producing assets, but simply reference them. The revenues paid into
synthetic CDOs do not come from mortgages or other assets, but from counterparties betting that the referenced
assets will lose value or suffer a specified credit event.
After calculating the CDO’s default and loss rates and the cushion or subordination
needed to protect the pool’s investment grade tranches from loss, the CRA analyst examined the
CDO’s capital structure, credit enhancements, cash flow, and legal structure, in the same manner
as for an RMBS pool.
Evidence gathered by the Subcommittee indicates that it was common for a CRA analyst
to speak with the arranger or issuer of an RMBS or CDO to gather additional information and
discuss how a proposed financial instrument would work. Among other tasks, the analyst
worked with the arranger or issuer to evaluate the cash flows, the number and size of the
tranches, the size and nature of the credit enhancements, and the rating each tranche would
receive. Documents obtained by the Subcommittee show that CRA analysts and investment
bankers often negotiated over how specific deal attributes would affect the credit ratings of
Rating Recommendations. After completing analysis of a proposed financial
instrument, the CRA analyst developed a rating recommendation for each proposed RMBS or
CDO tranche that would be used to issue securities, and presented the recommended ratings
internally to a rating committee composed of other analysts and managers within the credit rating
agency. The rating committee reviewed and then voted on the analyst’s recommendations. Once
the committee approved the ratings, a rating committee memorandum was prepared
memorializing the actions taken, and the ratings were provided to the arranger. If the arranger
indicated that the issuer accepted the ratings, the credit rating agency made the ratings available
publicly. If dissatisfied, the arranger could appeal a ratings decision.980 The entire rating
process typically took several weeks, sometimes longer for novel or complex transactions.
RMBS and CDO Groups. Moody’s and S&P had separate groups and analysts
responsible for rating RMBS and CDOs. In 2007, Moody’s RMBS ratings were issued by the
RMBS Group, which had about 25 analysts, while it had about 50 derivatives analysts in its
Derivatives Group, whose responsibilities included rating CDOs.981 Each group responsible for
rating these products was headed by a Team Managing Director who reported to a Group
Managing Director. Both the RMBS Group and the Derivatives Group were housed in the
Structured Finance Group. The setup was similar at S&P. At S&P, RMBS ratings were issued
by the RMBS Group, which had about 90 analysts in 2007, while CDO ratings were issued by
the Global CDO Group, with about 85 analysts.982 Each group was headed by a Managing
Director, and housed in the Structured Finance Ratings Group which was headed by a Senior
During the years reviewed by the Subcommittee, at Moody’s, the CEO and Chairman of
the Board was Raymond W. McDaniel, Jr.; the Senior Managing Director of the Structured
980 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating
Agencies,” report prepared by the Securities and Exchange Commission, at 9.
981 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and
982 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 32-34, and at 43-44.
Finance Group was Brian Clarkson; the head of the RMBS Group was Pramila Gupta; and the
heads of the Derivatives CDO analysts were Gus Harris and Yuri Yoshizawa. At S&P, the
President was Kathleen A. Corbet; the Senior Managing Director of the Structured Finance
Ratings Group was Joanne Rose; the head of the RMBS Group was Frank Raiter and then Susan
Barnes; and the head of the Global CDO Group was Richard Gugliada.
Surveillance. Following an initial credit rating, both Moody’s and S&P conducted
ongoing surveillance of all rated securities to evaluate a product’s ongoing credit risk and to
determine whether its credit rating should be affirmed, upgraded, or downgraded over the life of
the security. Both used automated surveillance tools that, on a monthly basis, flagged securities
whose performance indicated their rating might need to be adjusted to reflect the current risk of
default or loss. Surveillance analysts investigated the flagged securities and presented
recommendations for rating changes to a ratings committee. Within both the RMBS and
Derivatives Groups, in 2007, Moody’s had 15 RMBS surveillance analysts and 24 derivatives
surveillance analysts, respectively.983 S&P maintained a Structured Finance Surveillance Group
that included an RMBS Surveillance Group and a CDO Surveillance Group, with about 20
analysts in each group in 2007.984 Each of these groups was headed by a Managing Director
who reported to the head of the Structured Finance Group. The Managing Director for Moody’s
surveillance analysts was Nicolas Weill. At S&P, the Managing Director of the Structured
Finance Surveillance Group was Peter D’Erchia.
Meaning of Ratings. The purpose of a credit rating, whether stated at first issuance or
after surveillance, is to forecast a security’s probability of default (S&P) or expected loss
(Moody’s). If the security has an extremely low likelihood of default, credit rating agencies
grant it AAA status. For securities with a higher probability of default, they provide lower credit
When asked about the meaning of an AAA rating, Moody’s CEO Raymond McDaniel
explained that it represented the safest type of investment and had the same significance across
various types of financial products.985 While all credit rating agencies leave room for error by
designing procedures to downgrade or upgrade ratings over time, Moody’s and S&P told the
Subcommittee that their ratings are designed to take into account future performance. Prior to
the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were
983 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and
984 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 48-49, and at 56-57.
985 Subcommittee interview of Raymond McDaniel (4/6/2010).
986 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by
(3) Record Revenues
From 2004 to 2007, Moody’s and S&P produced a record number of ratings and a record
amount of revenues in structured finance, primarily because of RMBS and CDO ratings. A 2008
S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued more
than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings.987 The number of
ratings it issued increased each year, going from approximately 700 RMBS ratings in 2002, to
more than 1,600 in 2006. Its mortgage related CDO ratings increased tenfold, going from 34 in
2002, to over 340 in 2006.988 Moody’s experienced similar growth. According to a 2008
Moody’s submission to the SEC, from 2004 to 2007, it issued over 4,000 RMBS ratings and over
870 CDO ratings.989 Moody’s also increased the ratings it issued each year, going from
approximately 540 RMBS and 45 CDO ratings in 2002, to more than 1,200 RMBS and 360 CDO
ratings in 2006.990
Both companies charged substantial fees to rate a product. To obtain an RMBS or CDO
rating during the height of the market, for example, S&P charged issuers generally from $40,000
to $135,000 to rate tranches of an RMBS and from $30,000 to $750,000 to rate the tranches of a
CDO.991 Surveillance fees, which may be imposed at the initial rating or annually, ranged
generally from $5,000 to $50,000 for these mortgage backed securities.992
Revenues increased dramatically over time as well. Moody’s gross revenues from
RMBS and CDO ratings more than tripled in five years, from over $61 million in 2002, to over
$260 million in 2006.993 S&P’s revenue increased even more. In 2002, S&P’s gross revenue for
RMBS and mortgage related CDO ratings was over $64 million and increased to over $265
million in 2006.994 In that same period, revenues from S&P’s structured finance group tripled
from about $184 million in 2002 to over $561 million in 2007.995
987 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent
the RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or
In 2002, structured finance
ratings contributed 36% to S&P’s bottom line; in 2007, it made up 49% of all S&P revenues
989 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for
multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS
CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on
mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director
of Moody’s RMBS Group (10/29/2009).
991 See, e.g., “U.S. Structured Ratings Fee Schedule Residential Mortgage-Backed Financings and Residential
Servicer Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule
Collateralized Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50.
993 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the
transition of Moody’s accounting systems.
994 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19.
995 Id. at 19.
from ratings.996 In addition, from 2000 to 2007, operating margins at the CRAs averaged
53%.997 Altogether, revenues from the three leading credit rating agencies more than doubled
from nearly $3 billion in 2002 to over $6 billion in 2007.998
Both companies also saw their share prices shoot up. The chart below reflects the
significant price increase that Moody’s shares experienced as a result of increased revenues
during the years of explosive growth in the ratings of both RMBS and CDOs.999 Moody’s
percentage gain in share price far outpaced the major investment banks on Wall Street from 2002
996 Id. at 19.
997 “Debt Watchdogs: Tamed or Caught Napping?” New York Times (12/7/2008). The operating margin is a ratio
used to measure a company’s operating efficiency and is calculated by dividing operating income by net sales.
998 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by Subcommittee using data from
thismatter.com/money, Hearing Exhibit 4/23-1g.
999 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San
Diego Law School Legal Studies Research Paper Series (5/2006), at 67.
Standard & Poor’s is a division of The McGraw-Hill Companies (NYSE: MHP), whose share
price also increased significantly during this time period.1000
Top CRA executives received millions of dollars each year in compensation. Moody’s
CEO, Raymond McDaniel, for example, earned more than $8 million in total compensation in
2006.1001 Brian Clarkson, the head of Moody’s structured finance group, received $3.8 million
in total compensation in the same year.1002
1000 See “The McGraw-Hill Companies, Inc.,” Google Finance,
Upper and middle managers also did well. Moody’s
managing directors made between $385,000 to about $460,000 in compensation in 2007, before
1001 3/19/2008 Moody’s 2008 Proxy Statement, “Summary Compensation Table.”
stock options. Including stock options, their total compensation ranged from almost $700,000 to
over $930,000.1003 S&P managers received similar compensation.1004
C. Mass Credit Rating Downgrades
In the years leading up to the financial crisis, Moody’s and S&P together issued
investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial
sums for issuing these ratings. In mid-2007, however, both credit rating agencies suddenly
reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings.
These mass downgrades shocked the financial markets, contributed to the collapse of the
subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment
grade status, and damaged holdings of financial firms worldwide. Perhaps more than any other
single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate
trigger for the financial crisis.
To understand why the credit rating agencies suddenly reversed course and how their
RMBS and CDO ratings downgrades impacted the financial markets, it is useful to review trends
in the housing and mortgage backed security markets in the years leading up to the crisis.
(1) Increasing High Risk Loans and Unaffordable Housing
The years prior to the financial crisis saw increasing numbers of borrowers buying not
only more homes than usual, but higher priced homes, requiring larger and more frequent loans
that were constantly refinanced. By 2005, about 69% of Americans had purchased homes, the
largest percentage in American history.1005 In the five-year period running up to 2006, the
median home price, adjusted for inflation, increased 50 percent.1006 The pace of home price
appreciation was on an unsustainable trajectory, as is illustrated by the chart below.1007
1003 4/27/2007 email from Yuri Yoshizawa to Noel Kirnon, PSI-MOODYS-RFN-000044 (Attachment, PSIMOODYS-
1004 See S&P’s “Global Compensation Guidelines 2007/2008,” S&P-SEC 067708, 067733, 067740, and 067747.
1005 See 3/1/2006 “Housing Vacancies and Homeownership Annual Statistics: 2005,” U.S. Census Bureau.
1006 “Housing Bubble Trouble,” The Weekly Standard (4/10/2006).
1007 1/25/2010, “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart
prepared by Paulson & Co. Inc., Hearing Exhibit 4/23-1j.
Subprime lending fueled the overall growth in housing demand and housing price
increases that began in the late 1990s and ran through mid-2006.1008 “Between 2000 and 2007,
backers of subprime mortgage-backed securities – primarily Wall Street and European
investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities]
business, according to data from trade publication Inside Mortgage Finance.”1009 By 2006,
subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase
from 2001.1010 The graph below reflects the unprecedented growth in subprime mortgages
between 2003 and 2006.1011
1008 See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of
the Foreclosure Crisis,” at 36. See also “A Brief History of Credit Rating Agencies: How Financial Regulation
Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007 – 2008,” Mercatus on Policy (10/2009),at 2.