PART 9

time.874

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.

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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.

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could have triggered additional panic and loss of confidence in the U.S. banking system and

financial markets.

(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.

(a) Countrywide

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.

At

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

879 Id.

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,”

http://www.ots.treas.gov/_files/777014.html.

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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

mortgages.888

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.

887 Id.

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.

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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:

893

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

million.895

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

(b) IndyMac

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

mortgage loans.898

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.

895 Id.

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,”

http://www.ftc.gov/opa/2010/06/countrywide.shtm.

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”).

234

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.

905 Id.

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,

http://media.washingtonpost.com/wpsrv/

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,

http://www.treasury.gov/about/organizational-structure/ig/Documents/sar042009.pdf.

908 Id. at 31.

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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,”

http://www.sec.gov/news/press/2011/2011-43.htm.

911 Id.

912 “The Fall of IndyMac,” CNNMoney.com (7/13/2008).

913 Id.

914 3/31/2010 Office of Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,”

http://www.treasury.gov/about/organizationalstructure/

ig/Documents/March%202010%20SAR%20Final%20%20(04-30-10).pdf.

915 “Crisis Deepens as Big Bank Fails; IndyMac Seized in Largest Bust in Two Decades,” Wall Street Journal

(7/12/2008).

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”).

236

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

processes.”919

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.”

237

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

delinquency rates.

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

(d) Fremont

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.

In June

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),

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atIgi9otRZ3k.

932 3/2006 Fremont General Corporation Form 10-K filed with the SEC.

933 Id.

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).

238

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).

239

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

markets.

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

securities.944

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.

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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

Currency (OCC).945

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

insurance purposes.”

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

of equals.

946

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.

947

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.”).

241

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.

952

(2) Recommendations

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

the OCC.

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.

949 Id.

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.

242

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.

243

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.”

244

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

ratings.

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).

245

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

follows.

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,

would perform.

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”).

246

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.

B. Background

(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).

247

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

has explained:

“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

instrument.

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.

958 Id.

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.”

248

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.

The

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,

249

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

rating models.967

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

http://www.sec.gov/answers/nrsro.htm.

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.

969 Id.

970 Standard & Poor’s ClassicDirect website, https://www.eclassicdirect.com/NASApp/cotw/CotwLogin.jsp.

250

hedge funds.971

“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:

972

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

investments.

(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

published.

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.

251

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.

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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.

253

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

[quantitative analyst].”978

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.

254

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

particular tranches.

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

Managing Director.

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

SEC_OCIE_CRA_011217.

982 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 32-34, and at 43-44.

255

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

ratings.

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

substantially lower.986

983 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and

SEC_OCIE_CRA_011217.

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

Fitch.

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(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

CDO pool.

In 2002, structured finance

ratings contributed 36% to S&P’s bottom line; in 2007, it made up 49% of all S&P revenues

988 Id.

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).

990 Id.

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.

992 Id.

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.

257

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

to 2006.

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.

258

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

http://www.google.com/finance?q=mcgraw+hill.

1001 3/19/2008 Moody’s 2008 Proxy Statement, “Summary Compensation Table.”

1002 Id.

259

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-

RFN-000045).

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.

260

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.