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


B. Background

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|

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.

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| The 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 hedge funds. |971| 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:

    "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." |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 .

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.

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 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| In contrast, S&P 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|

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 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|

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| In 2002, structured finance ratings contributed 36% to S&P's bottom line; in 2007, it made up 49% of all S&P revenues 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.

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| Upper and middle managers also did well. Moody's

managing directors made between $385,000 to about $460,000 in compensation in 2007, before 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|


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). [Back]

958. Id. [Back]

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. [Back]

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. [Back]

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. [Back]

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." [Back]

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. [Back]

964. See, e.g., Section 28 (d) and (e) of the Federal Deposit Insurance Act, codified at 12 U.S.C. § 1831e(d)- (e). [Back]

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). [Back]

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, Inc.; and Realpoint LLC. 9/25/2008 "Credit Rating Agencies – NRSROs," SEC, available at http://www.sec.gov/answers/nrsro.htm. [Back]

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). [Back]

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. [Back]

969. Id. [Back]

970. Standard & Poor's ClassicDirect website, https://www.eclassicdirect.com/NASApp/cotw/CotwLogin.jsp. [Back]

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). [Back]

972. 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller's Handbook, "Asset Securitization," at 11. [Back]

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. [Back]

974. Id. at 6. [Back]

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. [Back]

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. [Back]

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." [Back]

978. Michalek prepared statement, at 4. [Back]

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. [Back]

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. [Back]

981. 3/11/2008 compliance letter from Moody's to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and SEC_OCIE_CRA_011217. [Back]

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

983. 3/11/2008 compliance letter from Moody's to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and SEC_OCIE_CRA_011217. [Back]

984. 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218- 59, at 48- 49, and at 56- 57. [Back]

985. Subcommittee interview of Raymond McDaniel (4/6/2010). [Back]

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

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. [Back]

988. Id. [Back]

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). [Back]

990. Id. [Back]

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. [Back]

992. Id. [Back]

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. [Back]

994. 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218- 59, at 18 - 19. [Back]

995. Id. at 19. [Back]

996. Id. at 19. [Back]

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. [Back]

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. [Back]

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. [Back]

1000. See "The McGraw- Hill Companies, Inc.," Google Finance, http://www.google.com/finance?q=mcgraw+hill. [Back]

1001. 3/19/2008 Moody's 2008 Proxy Statement, "Summary Compensation Table." [Back]

1002. Id. [Back]

1003. 4/27/2007 email from Yuri Yoshizawa to Noel Kirnon, PSI- MOODYS- RFN- 000044 (Attachment, PSIMOODYS- RFN- 000045). [Back]

1004. See S&P's "Global Compensation Guidelines 2007/2008," S&P- SEC 067708, 067733, 067740, and 067747. [Back]

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A. Subcommittee Investigation and Findings of Fact C. Mass Credit Rating Downgrades

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