Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


C. Credit Ratings and Structured Finance

Despite the increasing use of high risk loans to support mortgage related securities, mortgage related securities continued to receive AAA and other investment grade ratings from the credit rating agencies, indicating they were judged to be safe investments. Those credit ratings gave a sense of security to investors and enabled investors like pension funds, insurance companies, university endowments, and municipalities, which were often required to hold safe investments, to continue to purchase mortgage related securities.

Credit Ratings Generally. A credit rating is an assessment of the likelihood that a particular financial instrument, such as a corporate bond or mortgage backed security, may default or incur losses. |37| A high credit rating indicates that a debt instrument is expected to be repaid and so qualifies as a safe investment.

Credit ratings are issued by private firms that have been officially designated by the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs). NRSROs are usually referred to as "credit rating agencies." While there are ten registered credit rating agencies in the United States, the market is dominated by just three: Moody's Investors Service, Inc. (Moody's); Standard & Poor's Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch). |38| By some accounts, these firms issue about 98% of the total credit ratings and collect 90% of total credit rating revenue in the United States. |39|

Credit ratings use a scale of letter grades to indicate credit risk, ranging from AAA to D, with AAA ratings designating the safest investments. 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. |40| Financial instruments bearing AAA through BBB- ratings are generally referred to as "investment grade," while those with ratings below BBB- (or Baa3) are referred to as "below investment grade" or sometimes as having "junk" status. Financial instruments that default receive a D rating from Standard & Poor's, but no rating at all from Moody's.

Investors often rely on credit ratings to gauge the safety of a particular investment. Some institutional investors design an investment strategy that calls for acquiring assets with specified credit ratings. State and federal law also restricts the amount of below investment grade bonds that certain investors can hold, such as pension funds and insurance companies. |41| Banks are also limited by law in the amount of noninvestment grade bonds they can hold, and are typically required to post additional capital for investments carrying riskier ratings. Because so many federal and state statutes and regulations required financial institutions to hold securities with investment grade ratings, the credit rating agencies were not only guaranteed a steady business, but were encouraged to issue AAA and other investment grade ratings. Issuers of securities and other financial instruments also worked hard to obtain favorable credit ratings to ensure more investors could buy their products.

Although the SEC has generally overseen the credit rating industry for many years, it had no statutory basis to exercise regulatory authority until enactment of the Credit Rating Agency Reform Act in September 2006. Concerned by the inflated credit ratings that had been issued for bonds from Enron Corporation and other troubled corporations, Congress strengthened the SEC's authority over the credit rating industry. Among other provisions, the law established criteria for the NRSRO designation and authorized the SEC to conduct examinations of credit rating agencies. The law also, however, prohibited the SEC from regulating credit rating criteria or methodologies used in credit rating models. In June 2007, the SEC issued implementing regulations, which were essentially too late to affect the ratings already provided for mortgage related securities. One month later, in July 2007, the credit rating agencies issued the first of several mass downgrades of the ratings earlier issued for mortgage related securities.

Structured Finance. In recent years, Wall Street firms have devised increasingly complex financial instruments for sale to investors. These instruments are often referred to as structured finance. Because structured finance products are so complicated and opaque, investors often place particular reliance on credit ratings to determine whether they should buy them.

Among the oldest types of structured finance products are RMBS securities. To create these securities, issuers – often working with investment banks – bundle large numbers of home loans into a loan pool, and calculate the revenue stream coming into the loan pool from the individual mortgages. They then design a "waterfall" that delivers a stream of revenues in sequential order to specified "tranches." The first tranche is at the top of the waterfall and is typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a bond, linked to that first tranche. That security typically receives a AAA credit rating since its revenue stream is the most secure.

The security created from the next tranche receives the same or a lower credit rating and so on until the waterfall reaches the "equity" tranche at the bottom. The equity tranche typically receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages in the loan pool default. Since virtually every mortgage pool has at least some mortgages that default, equity tranches are intended to provide loss protection for the tranches above it. Because equity tranches are riskier, however, they are often assigned and receive a higher rate of interest and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or more tranches, each of which is used to create a residential mortgage backed security that is rated and then sold to investors.

Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured finance product whose securities receive credit ratings and are sold to investors. CDOs are a more complex financial product that involves the re-securitization of existing income-producing assets. From 2004 through 2007, many CDOs included RMBS securities from multiple mortgage pools. For example, a CDO might contain BBB rated securities from 100 different RMBS securitizations. CDOs can also contain other types of assets, such as commercial mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often called "cash CDOs," because they receive cash revenues from the underlying RMBS bonds and other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it is often called a "static" CDO; if the CDO's assets are allowed to change over time, it is often referred to as a "managed" CDO. Like an RMBS securitization, the CDO arranger calculates the revenue stream coming into the pool of assets, designs a waterfall to divide those incoming revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets have BBB ratings.

Synthetic CDOs. Some investment banks also created "synthetic CDOs" which mimicked cash CDOs, but did not contain actual mortgages or other assets that produced income. Instead, they simply "referenced" existing assets and then allowed investors to use credit default swaps to place bets on the performance of those referenced assets. Investors who bet that the referenced assets would maintain or increase in value bought the CDO's securities and, in exchange, received periodic coupon payments to recoup their principal investment plus interest. Investors who bet that the referenced assets would lose value or incur a specified negative credit event purchased one or more credit default swap contracts referencing the CDO's assets, and paid monthly premiums to the CDO in exchange for obtaining a large lump sum payment if the loss or other negative credit event actually occurred. Investors in synthetic CDOs who bet the referenced assets would maintain or increase in value were said to be on the "long" side, while investors who bet the assets would lose value or fail were said to be on the "short" side. Some investment banks also created "hybrid CDOs" which contained some cash assets as well as credit default swaps referencing other assets. Others created financial instruments called CDO squared or cubed, which contained or referenced tranches from other CDOs.

Like RMBS mortgage pools and cash CDOs, synthetic and hybrid CDOs pooled the payments they received, designed a waterfall assigning portions of the revenues to tranches set up in a certain order, created securities linked to the various tranches, and then sold the CDO securities to investors. Some CDOs employed a "portfolio selection agent" to select the initial assets for the CDO. In addition, some CDOs employed a "collateral manager" to select both the initial and subsequent assets that went into the CDO.

Ratings Used to Market RMBS and CDOs. Wall Street firms helped design RMBS and CDO securities, worked with the credit rating agencies to obtain ratings for the securities, and sold the securities to investors like pension funds, insurance companies, university endowments, municipalities, and hedge funds. Without investment grade ratings, Wall Street firms would have had a more difficult time selling structured finance products to investors, because each investor would have had to perform its own due diligence review of the product. In addition, their sales would have been restricted by federal and state regulations limiting certain institutional investors to the purchase of instruments carrying investment grade credit ratings. Still other regulations conditioned capital reserve requirements on the credit ratings assigned to a bank's investments. Investment grade credit ratings, thus, purported to simplify the investors' due diligence review, ensured some investors could make a purchase, reduced banks' capital calls, and otherwise enhanced the sales of the structured finance products. Here's how one federal bank regulator's handbook put it:

    "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." |42|

The more complex and opaque the structured finance instruments became, the more reliant investors were on high credit ratings for the instruments to be marketable.

In addition to making structured finance products easier to sell to investors, Wall Street firms used financial engineering to combine AAA ratings – normally reserved for ultra-safe investments with low rates of return – with high risk assets, such as the AAA tranche from a subprime RMBS paying a relatively high rate of return. Higher rates of return, combined with AAA ratings, made subprime RMBS and related CDOs especially attractive investments.

Record Ratings and Revenues. From 2004 to 2007, Moody's and S&P produced a record number of ratings and a record amount of revenues for rating structured finance products. 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. |43| According to a 2008 Moody's submission to the SEC, from 2004 to 2007, Moody's issued over 4,000 RMBS ratings and over 870 CDO ratings. |44|

Revenues increased dramatically over the same time period. The credit rating agencies charged substantial fees to rate a product. To obtain a rating during the height of the market, for example, S&P generally charged 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. |45| Surveillance fees generally ranged from $5,000 to $50,000 per year for mortgage backed securities. |46| Over a five-year period, Moody's gross revenues from RMBS and CDO ratings more than tripled, going from over $61 million in 2002, to over $260 million in 2006. |47| S&P's revenue also increased. S&P's gross revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in 2002, to over $265 million in 2006. |48| Altogether, revenues from the three leading credit rating agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007. |49|

Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for the products they sell. Issuers and the investment banks want high ratings, whether to help market their products or ensure they comply with federal regulations. Because credit rating agencies issue ratings to issuers and investment banks who bring them business, they are subject to an inherent conflict of interest that can create pressure on the credit rating agencies to issue favorable ratings to attract business. The issuers and investment banks engage in "ratings shopping," choosing the credit rating agency that offers the highest ratings. Ratings shopping weakens rating standards as the rating agencies who provide the most favorable ratings win more business. In September 2007, Moody's CEO described the problem this way: "What happened in '04 and '05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade." |50| In 2003, the SEC reported that "the potential conflicts of interest faced by credit rating agencies have increased in recent years, particularly given the expansion of large credit rating agencies into ancillary advisory and other businesses, and the continued rise in importance of rating agencies in the U.S. securities markets." |51|

Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are designed to last the lifetime of the securities. Because circumstances can change, however, credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate the rating and determine whether it should be upgraded or downgraded. Prior to the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially lower. |52| Beginning in July 2007, however, Moody's and S&P issued hundreds and then thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history.

From 2004 through the first half of 2007, Moody's and S&P provided AAA ratings to a majority of the RMBS and CDO securities issued in the United States, sometimes providing AAA ratings to as much as 95% of a securitization. |53| By 2010, analysts had determined that over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been downgraded to junk status. |54|

Moody's and S&P began downgrading RMBS and CDO products in late 2006, when residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both S&P and Moody's initiated the first of several mass downgrades that shocked the financial markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an original value of $7.35 billion. Later that day, Moody's downgraded 399 subprime RMBS with an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had placed on credit watch.

In October 2007, Moody's began downgrading CDOs on a daily basis, downgrading more than 270 CDO securities with an original value of $10 billion. In December 2007, Moody's downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch. Moody's calculated that, overall in 2007, "8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded," |55| which means that it downgraded over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing issuance amounts of approximately $270.1 billion and $263.9 billion, respectively. |56|

These downgrades created significant turmoil in the securitization markets, as investors were required by regulations to sell off assets that had lost their investment grade status, holdings at financial firms plummeted in value, and new securitizations were unable to find investors. As a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and financial firms around the world were left holding billions of dollars in suddenly unmarketable RMBS and CDO securities.


37. See 9/3/2009 "Credit Rating Agencies and Their Regulation," prepared by the Congressional Research Service Report No. R40613 (revised report issued 4/9/2010). For more information about the credit rating process and the credit rating agencies, see Chapter V, below. [Back]

38. See 9/25/2008 "Credit Rating Agencies—NRSROs," SEC, http://www.sec.gov/answers/nrsro.htm. [Back]

39.  See 9/3/2009 "Credit Rating Agencies and Their Regulation," prepared by the Congressional Research Service Report No. R40613 (revised report issued 4/9/2010). [Back]

40. 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 the U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEC-PSI 0001945-71, at 51. (See Chapter V below.) See also 1/2007 "Annual 2006 Global Corporate Default Study and Ratings Transitions," S&P. [Back]

41. For more detail on these matters, see Chapter V, below. [Back]

42. 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller's Handbook, "Asset Securitization," at 11. [Back]

43. 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. (See Chapter V below.) [Back]

44. 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). (See Chapter V below.) [Back]

45. "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. (See Chapter V below.) [Back]

46. Id. [Back]

47. 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. (See Chapter V below.) [Back]

48. 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19. (See Chapter V below.) [Back]

49. "Revenue of the Three Credit Rating Agencies: 2002-2007," chart prepared by the Subcommittee using data from http://thismatter.com/money, Hearing Exhibit 4/23-1g. [Back]

50. 9/10/2007 Transcript of Raymond McDaniel at Moody's MD Town Hall Meeting, Hearing Exhibit 4/23-98. [Back]

51. 1/2003 "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets," prepared by the SEC, at 40. The report continued: "[C]oncerns had been expressed that a rating agency might be tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to submit future large issues to the rating agency." Id. at 40 n.109. [Back]

52. See, e.g., "3/26/2010 "Fitch Ratings Global Structured Finance 2009 Transition and Default Study," prepared by Fitch. [Back]

53. See "MBS Ratings and the Mortgage Credit Boom," Federal Reserve Bank of New York Staff Report no. 449, May 2010, at 1. [Back]

54. See, e.g., "Percent of the Original AAA Universe Currently Rated Below Investment Grade," chart prepared by BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 "Understanding the Securitization of Subprime Mortgage Credit," Federal Reserve Bank of New York Staff Report no. 318, at 58 and chart 31 ("92 percent of 1st lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded."). [Back]

55. 2/2008 "Structured Finance Ratings Transitions, 1983-2007," Credit Policy Special Comment prepared by Moody's, at 4. [Back]

56. 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108 (1/30/2008 "S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings," S&P's RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and additional information is needed to evaluate the rating. [Back]

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B. High Risk Mortgage Lending D. Investment Banks

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