"PRIVILEGED AND CONFIDENTIAL - S&P DISCUSSION PURPOSES ONLY — Wall Street and the Financial Crisis: Anatomy of a Financial Collapse

"PRIVILEGED AND CONFIDENTIAL - S&P DISCUSSION PURPOSES ONLY

Prior to Transition Date (in preparation for final implementation of E3 for cash CDOs): • A large majority of the pre- E3 cash flow CDOs will be run through E3 in batch processes to see how the ratings look within the new model …

Ratings falling more than 3 notches +/- from the current tranche rating in the batch process will be reviewed in detail for any modeling, data, performance or other issues

If any transactions are found to be passing/failing E3 by more than 3 notches due to performance reasons they will be handled through the regular surveillance process to see if the ratings are stable under current criteria (i.e., if they pass E2.4.3 using current cash flow assumptions the ratings will remain unchanged)

If any transactions are found to be passing/failing E3 by more than 3 notches due to a model gap between E2.4.3 and E3, they will be reviewed by a special E3 committee ...."¹¹⁷¹¹¹⁷¹ 5/19/2006 email from Stephen Anderberg to Pat Jordan, David Tesher, and others, PSI-S&P-RFN-000021 [emphasis in original].

¶It is unclear whether this screening actually took place.

¶Questions continued to be raised internally at S&P about the retesting issue. In March 2007, almost a year after the change was made in the CDO model, an S&P senior executive wrote to the Chief Criteria Officer in the structured finance department:

"Why did the criteria change made in mid 2006 not impact any outstanding transactions at the time we changed it, especially given the magnitude of the change we are highlighting in the article? Should we apply the new criteria now, given what we now know? If we did, what would be the impact?"¹¹⁷²¹¹⁷² 3/12/2007 email from Cliff Griep to Tom Gillis, and others, PSI-S&P-RFN-000015.

¶In July 2007, the same senior executive raised the issue again in an email asking the S&P Analytic Policy Board to address the alignment of surveillance methodology and new model changes at a "special meeting."¹¹⁷³¹¹⁷³ 7/15/2007 email from Tom Gillis to Valencia Daniels, "Special APB meeting," Hearing Exhibit 4/23-74. But by then, residential mortgages were already defaulting in record numbers, and the mass downgrades of RMBS and CDO ratings had begun.

303

¶Consequences for Investors. During the April 23 Subcommittee hearing, credit ratings expert, Professor Arturo Cifuentes, explained to the Subcommittee the importance of retesting existing rated deals when there is a model change.

Senator Levin: If a ratings model changes its assumptions or criteria, for instance, if it becomes materially more conservative, how important is it that the credit rating agency use the new assumptions or criteria to re-test or re-evaluate securities that are under surveillance?

Mr. Cifuentes: Well, it is very important for two reasons: Because if you do not do that, you are basically creating two classes of securities, a low class and an upper class, and that creates a discrepancy in the market. At the same time, you are not being fair because you are giving an inflated rating then to a security or you are not communicating to the market that the ratings given before were of a different class.¹¹⁷⁴¹¹⁷⁴ April 23, 2010 Subcommittee Hearing at 35.

¶Moody's and S&P updated their RMBS and CDO models with more conservative criteria in 2006, but then used the revised models to evaluate only new RMBS and CDO transactions, bypassing the existing RMBS and CDO securities that could have benefited from the new credit analysis. Even with respect to the new RMBS and CDOs, investment banks sought to delay use of the revised models that required additional credit enhancements to protect investment grade tranches from loss. For example, in May 2007, Morgan Stanley sent an email to a Moody's Managing Director with the following:

"Thanks again for your help (and Mark's) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already (assets in warehouses, some liabilities placed). We appreciate your willingness to grandfather these transactions [under] Moody's old methodology."¹¹⁷⁵¹¹⁷⁵ 5/2/2007 email from Zach Buchwald (Morgan Stanley Executive Director) to William May (Moody's Managing Director), and others, Hearing Exhibit 4/23-76. See also 4/11/2007 email from Moody's Managing Director to Calyon, PSI-MOODYS-RFN-000040.

¶When asked about the failure of Moody's and S&P to retest existing securities after their model updates in 2006, the global head trader for CDOs from Deutsche Bank told the Subcommittee that he believed the credit rating agencies did not retest them, because to do so would have meant significant downgrades and "they did not want to upset the apple cart."¹¹⁷⁶¹¹⁷⁶ Subcommittee interview of Greg Lippmann, Former Managing Director and Global Head of Trading of CDOs for Deutsche Bank (10/18/2010). Mr. Lippmann said he thought the agencies' decision not to retest existing securities was "ridiculous." Instead, the credit rating agencies waited until 2007, when the high risk mortgages underlying the outstanding RMBS and CDO securities incurred record delinquencies and defaults and then, based upon the actual loan performance, instituted mass ratings downgrades. Those sudden mass downgrades caught many financial institutions and other investors by surprise, leaving them with billions of dollars of suddenly unmarketable securities. The RMBS secondary market collapsed soon after, and the CDO secondary market followed.

304

(5) Inadequate Resources In addition to operating with conflicts of interest, models containing inadequate

¶performance data, subjective and inconsistent rating criteria, and a policy against using improved models to retest outstanding RMBS and CDO securities, and despite the increasing numbers of ratings issued each year and record revenues as a result, neither Moody's nor S&P hired sufficient staff or devoted sufficient resources to ensure that the initial rating process and the subsequent surveillance process produced accurate credit ratings.

¶Instead, both Moody's and S&P forced their staffs to churn out new ratings and conduct required surveillance with limited resources. Over time, the credit rating agencies' profits became increasingly connected to issuing a high volume of ratings. By not devoting sufficient resources to handle the high volume of ratings, the strain on resources negatively impacted the quality of the ratings and their surveillance.

¶High Speed Ratings. From 2000 to 2007, Moody's and S&P issued record numbers of RMBS and CDO ratings. Each year the number of ratings issued by each firm increased. According to SEC examinations of the firms, from 2002 to 2006, "the volume of RMBS deals rated by Moody's increased by 137%, and the number of CDO deals … increased by 700%." 1177 At S&P, the SEC determined that over the same time period, "the volume of RMBS deals rated by S&P increased by 130%, and the number of CDO deals … increased by over 900%." 1178 In addition to the rapid growth in numbers, the transactions themselves grew in complexity, requiring more time and talent to analyze.

¶The former head of the S&P RMBS Group, Frank Raiter, described the tension between profits and resources this way: "Management wanted increased revenues and profit while analysts wanted more staff, data and IT support which increased expenses and obviously reduced profit."¹¹⁷⁹¹¹⁷⁹ Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor's, April 23, 2010 Subcommittee Hearing, at 1-2.

¶Moody's CEO, Ray McDaniel, readily acknowledged during the Subcommittee's April 23 hearing that resources were stressed and that Moody's was short staffed.¹¹⁸⁰¹¹⁸⁰ April 23, 2010 Subcommittee Hearing at 96-97. He testified: "People were working longer hours than we wanted them to, working more days of the week than we wanted them to." He continued: "It was not for lack of having open positions, but with the pace at which the market was growing, it was difficult to fill positions as quickly as we would have liked."¹¹⁸¹¹¹⁸¹ Id. at 97.

305

¶Moody's staff, however, had raised concerns about personnel shortages impacting their work quality as early as 2002. A 2002 survey of the Structured Finance Group staff reported, for example:

"[T]here is some concern about workload and its impact on operating effectiveness. … Most acknowledge that Moody's intends to run lean, but there is some question of whether effectiveness is compromised by the current deployment of staff."¹¹⁸²¹¹⁸² 5/2/2002 "Moody's SFG 2002 Associate Survey: Highlights of Focus Groups and Interviews," Hearing Exhibit 4/23-92a at 6.

¶Similar concerns were expressed three years later in a 2005 employee survey:

"We are over worked. Too many demands are placed on us for admin[istrative] tasks ... and are detracting from primary workflow .... We need better technology to meet the demand of running increasingly sophisticated models."¹¹⁸³¹¹⁸³ 4/7/2006 "Moody's Investor Service, BES-2005: Presentation to Derivatives Team," Hearing Exhibit 4/23-92b.

¶In 2006, Moody's analyst Richard Michalek worried that investment bankers were taking advantage of the fact that analysts did not have the time to understand complex deals. He wrote:

"I am worried that we are not able to give these complicated deals the attention they really deserve, and that they (CS) [Credit Suisse] are taking advantage of the 'light' review and the growing sense of 'precedent'."¹¹⁸⁴¹¹⁸⁴ 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19.

¶Moody's managers and analysts interviewed by the Subcommittee stated that staff shortages impacted how much time could be spent analyzing a transaction. One analyst responsible for rating CDOs told the Subcommittee that, during the height of the boom, Moody's analysts didn't have time to understand the complex deals being rated and had to set priorities on what issues would be examined:

"When I joined the [CDO] Group in 1999 there were seven lawyers and the Group rated something on the order of 40 – 60 transactions annually. In 2006, the Group rated over 600 transactions, using the resources of approximately 12 lawyers. The hyper-growth years from the second half of 2004 through 2006 represented a steady and constant adjustment to the amount of time that could be allotted to any particular deal's analysis, and with that adjustment, a constant re-ordering of the priority assigned to the issues to be raised at rating Committees."¹¹⁸⁵¹¹⁸⁵ Prepared statement of Richard Michalek at 20, April 23, 2010 Subcommittee hearing.

306

¶A Moody's managing director responsible for supervising CDO analysts put it this way in a 2007 email: "Unfortunately, our analysts are o[v]erwhelmed .…"¹¹⁸⁶¹¹⁸⁶ 5/23/2007 email from Eric Kolchinsky to Yvonne Fu and Yuri Yoshizawa, Hearing Exhibit 4/23-91. Moody's CEO testified at the Subcommittee's hearing, "[w]e had stress on our resources in this period, absolutely."¹¹⁸⁷¹¹⁸⁷ April 23, 2010 Subcommittee Hearing at 97. Senator Levin asked him if Moody's was profitable at the time, and he responded, "[w]e were profitable, yes."¹¹⁸⁸¹¹⁸⁸ Id.

¶S&P also experienced significant resource shortages. In 2004, for example, a managing director in the RMBS Group wrote a lengthy email about the resource problems impacting credit analysis:

"I am trying to put my hat on not only for ABS/RMBS but for the department and be helpful but feel that it is necessary to re-iterate that there is a shortage in resources in RMBS. If I did not convey this to each of you I would be doing a disservice to each of you and the department. As an update, December is going to be our busiest month ever in RMBS. I am also concerned that there is a perception that we have been getting all the work done up until now and therefore can continue to do so.

"We ran our Staffing model assuming the analysts are working 60 hours a week and we are short resources. We could talk about the assumptions and make modifications but the results would be similar. The analysts on average are working longer than this and we are burning them out. We have had a couple of resignations and expect more. It has come to my attention in the last couple of days that we have a number of staff members that are experiencing health issues."¹¹⁸⁹¹¹⁸⁹ 12/3/2004 email from Gail McDermott to Abe Losice and Pat Jordan, PSI-S&P-RFN-000034.

¶A May 2006 internal email from an S&P senior manager in the Structured Finance Real Estate Ratings Group expressed similar concerns:

"We spend most of our time keeping each other and our staff calm. Tensions are high. Just too much work, not enough people, pressure from company, quite a bit of turnover and no coordination of the non-deal 'stuff' they want us and our staff to do ...."¹¹⁹⁰¹¹⁹⁰ 5/2/2006 email from Gale Scott to Diane Cory, "RE: Change in scheduling/Coaching sessions/Other stuff," PSI- S&P-RFN-000012.

¶The head of the S&P CDO Ratings Group sent a 2006 email to the head of the Structured Finance Department to make a similar point. She wrote:

"While I realize that our revenues and client service numbers don't indicate any ill [e]ffects from our severe understaffing situation, I am more concerned than ever that we are on a downward spiral of morale, analytical leadership/quality and client service."¹¹⁹¹¹¹⁹¹ 10/31/2006 S&P internal email, "A CDO Director resignation," PSI-S&P-RFN-000001.

307

¶Some of the groups came up with creative ways to address their staffing shortages. For example, the head of the S&P RMBS Ratings Group between 2005 and 2007, Susan Barnes, advised the Subcommittee that her group regularly borrowed staff from the S&P Surveillance Group to assist with new ratings. She said that almost half the surveillance staff provided assistance on issuing new ratings during her tenure, and estimated that each person in the surveillance group might have contributed up to 25% of his or her time to issuing new ratings.¹¹⁹²¹¹⁹² Subcommittee interview of Susan Barnes (3/18/2010).

¶The Subcommittee investigation discovered a cadre of professional RMBS and CDO rating analysts who were rushed, overworked, and demoralized. They were asked to evaluate increasing numbers of increasingly complex financial instruments at high speed, using out-of- date rating models and unclear ratings criteria, while acting under pressure from management to increase market share and revenues and pressure from investment banks to ignore credit risk. These analysts were short staffed even as their employers collected record revenues.

¶Resource-Starved Surveillance. Resource shortages also impacted the ability of the credit rating agencies to conduct surveillance on outstanding rated RMBS and CDO securities to evaluate their credit risk. The credit rating agencies were contractually obligated to monitor the accuracy of the ratings they issued over the life of the rated transactions. CRA surveillance analysts were supposed to evaluate each rating on an ongoing basis to determine whether the rating should be affirmed, upgraded, or downgraded. To support this analysis, both companies collected substantial annual surveillance fees from the issuers of the financial instruments they rated, and set up surveillance groups to review the ratings. In the case of RMBS and CDO securities, the Subcommittee investigation found evidence that these surveillance groups may have lacked the resources to properly monitor the thousands of rated products.

¶At Moody's, for example, a 2007 email disclosed that about 26 surveillance analysts were responsible for tracking over 13,000 rated CDO securities:

"Thanks for sharing the draft of the CDO surveillance piece you're planning to publish later this week. … In the section about your CDO surveillance infrastructure, we were struck by the data point about the 26 professionals who are dedicated to monitoring CDO ratings. While this is, no doubt, a strong team, we wanted to at least raise the question about whether the company's critics could twist that number – e.g., by comparing it to the 13,000+ CDOs you're monitoring – and once again question if you have adequate resources to do your job effectively. Given that potential risk, we thought you might consider removing any specific reference to the number of people on the CDO surveillance team."¹¹⁹³¹¹⁹³ 7/9/2007 email to Yuri Yoshizawa, "FW: CDO Surveillance Note 7_071.doc," PSI-MOODYS-RFN-000022.

¶The evidence of surveillance shortages at S&P was particularly telling. Although during an interview with the Subcommittee, the head of S&P's RMBS Surveillance Group from 2001 to 2008, Ernestine Warner, said she had adequate resources to conduct surveillance of rated RMBS securities during her tenure, her emails indicate otherwise.¹¹⁹⁴¹¹⁹⁴ During an interview, the head of RMBS surveillance advised that she believed she was adequately resourced and prioritized her review of outstanding securities by focusing on 2006 and 2007 vintages that had performance problems. Subcommittee interview of Ernestine Warner (3/11/2010). In emails sent over a two-year period, she repeatedly described and complained about a lack of resources that was impeding her group's ability to complete its work. In the spring of 2006, she emailed her colleague about her growing anxiety:

308

"RMBS has an all time high of 5900 transactions. Each time I consider what my group is faced with, I become more and more anxious. The situation with Lal [a surveillance analyst], being off line or out of the group, is having a huge impact."¹¹⁹⁵¹¹⁹⁵ 4/28/2006 email from Ernestine Warner to Roy Chun, and others, Hearing Exhibit 4/23-82.

¶In June 2006, she wrote that the problems were not getting better:

"It really feels like I am repeating myself when it comes to completing a very simple project and addressing some of the other surveillance needs. … The inability to make a decision about how the project is going to be resourced is causing undue stress. I have talked to you and Peter [D'Erchia, head of global structured finance surveillance,] about each of the issues below and at this point I am not sure what else you need from me. …

¶To rehash the points below:

In addition to the project above that involves some 863 deals, I have a back log of deals that are out of date with regard to ratings. … We recognize that I am still understaffed with these two additional bodies. … [W]e may be falling further behind at the rate the deals are closing. If we do not agree on the actual number, certainly we can agree that I need more recourse if I am ever going to be near compliance."¹¹⁹⁶¹¹⁹⁶ 6/1/2006 emails from Ernestine Warner to Roy Chun, Hearing Exhibit 4/23-83.

¶In December 2006, she wrote:

"In light of the current state of residential mortgage performance, especially sub-prime, I think it would be very beneficial for the RMBS surveillance team to have the work being done by the temps to continue. It is still very important that performance data is loaded on a timely basis as this has an impact on our exception reports. Currently, there are nearly 1,000 deals with data loads aged beyond one month."¹¹⁹⁷¹¹⁹⁷ 12/20/2006 email from Ernestine Warner to Gail Houston, Roy Chun, others, Hearing Exhibit 4/23-84.

¶In February 2007, she expressed concerns about having adequate resources to address potential downgrades in RMBS:

"I talked to Tommy yesterday and he thinks that the [RMBS] ratings are not going to hold through 2007. He asked me to begin discussing taking rating actions earlier on the

309

poor performing deals. I have been thinking about this for much of the night. We do not have the resources to support what we are doing now. A new process, without the right support, would be overwhelming. ... My group is under serious pressure to respond to the burgeoning poor performance of sub-prime deals. … we are really falling behind. … I am seeing evidence that I really need to add staff to keep up with what is going on with sub prime and mortgage performance in general, NOW."¹¹⁹⁸¹¹⁹⁸ 2/3/2007 email from Ernestine Warner to Peter D'Erchia, Hearing Exhibit 4/23-86 [emphasis in original].

¶In April 2007, a managing director at S&P in the Structured Finance Group wrote an email confirming the staffing shortages in the RMBS Surveillance Group:

"We have worked together with Ernestine Warner (EW) to produce a staffing model for RMBS Surveillance (R-Surv). It is intended to measure the staffing needed for detailed surveillance of the 2006 vintage and also everything issued prior to that. This model shows that the R-Surv staff is short by 7 FTE [Full Time Employees] - about 3 Directors,²² See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states); Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches in multiple states). See also "Going Interstate: A New Dawn for U.S. Banking," The Regional Economist, a publication of the Federal Reserve Bank of St. Louis (7/1994). b; 1/2005 "Higher Risk Lending Strategy 'Asset Allocation Initiative,'" submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a. to Paulson"); 12/7/2006 email chain between Daniel Sparks and Tom Montag, "More thorough response," GS MBS-E-010931324 (Goldman had previously handled approximately $9 billion in transactions for Paulson); Subcommittee interview of Michael Swenson (4/16/2010) ("Paulson [hedge fund] was the biggest counterparty on day 1 [of the ABX Index] and throughout 2006").Show full note AD's, and 2 Associates. The model suggests that the current staff may have been right sized if we excluded coverage of the 2006 vintage, but was under titled lacking sufficient seniority, skill, and experience."¹¹⁹⁹¹¹⁹⁹ 4/24/2007 email from Abe Losice to Susan Barnes, "Staffing for RMBS Surveillance," Hearing Exhibit 4/23-88.

¶The global head of the S&P Structured Finance Surveillance Group, Peter D'Erchia, told the Subcommittee that, in late 2006, he expressed concerns to senior management about surveillance resources and the need to downgrade subprime in more significant numbers in light of the deteriorating subprime market.¹²⁰⁰¹²⁰⁰ Subcommittee interview of Peter D'Erchia (4/13/2010). According to Mr. D'Erchia, the executive managing director of the Global Structured Finance Ratings Group, Joanne Rose, disagreed with him about the need to issue significantly more downgrades in subprime RMBS and this disagreement continued into the next year. He also told the Subcommittee that after this disagreement with her, he received a disappointing 2007 performance evaluation. He wrote the following in the employee comment section of his evaluation:

"Even more offensive – and flatly wrong – is the statement that I am not working for a good outcome for S&P. That is all I am working towards and have been for 26 years. It is hard to respond to such comments, which I think reflect Joanne's [Rose] personal feelings arising from our disagreement over subprime debt deterioration, not professional assessment. … Such comments, and others like it, suggest to me that this year-end appraisal, in contrast to the mid-year appraisal, has more to do with our differences over subprime deterioration than an objective assessment of my overall performance." 1201

¶In 2008, Mr. D'Erchia was removed from his surveillance position, where he oversaw more than 314 employees, as part of a reduction in force. He was subsequently rehired as a managing director in U.S. Public Finance at S&P, a position without staff to supervise.

310

¶Similarly, Ernestine Warner, the head of RMBS Surveillance, lost her managerial position and was reassigned to investor relations in the Structured Finance Group.

¶On July 10, 2007, amid record mortgage defaults, S&P abruptly began downgrading its outstanding RMBS and CDO ratings. In July alone, it downgraded the ratings of more than 1,000 RMBS and 100 CDO securities. Both credit rating agencies continued to issue significant downgrades throughout the remainder of 2007. On January 30, 2008, S&P took action on over 8,200 RMBS and CDO ratings – meaning it either downgraded their ratings or placed the securities on credit watch with negative implications. These and other downgrades, matched by equally substantial numbers at Moody's, paint a picture of CRA surveillance teams acting at top speed in overwhelming circumstances to correct thousands of inaccurate RMBS and CDO ratings. When asked to produce contemporaneous decision-making documents indicating how and when the ratings were selected for downgrade, neither S&P nor Moody's produced meaningful documentation. The facts suggest that CRA surveillance analysts with already substantial responsibilities and limited resources were forced to go into overdrive to clean up ratings that could not "hold."

(6) Mortgage Fraud A final factor that contributed to inaccurate credit ratings involves mortgage fraud.

¶Although the credit rating agencies were clearly aware of increased levels of mortgage fraud, they did not factor that credit risk into their quantitative models or adequately factor it into their qualitative analyses. The absence of that credit risk meant that the credit enhancements they required were insufficient, the tranches bearing AAA ratings were too large, and the ratings they issued were too optimistic.

¶Reports of mortgage fraud were frequent and mounted yearly prior to the financial crisis. As noted above, as early as 2004, the FBI began issuing reports on increased mortgage fraud.¹²⁰²¹²⁰² FY 2004 "Financial Institution Fraud and Failure Report," prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats-services/publications/fiff_04. The FBI was also quoted in Congressional testimony and in the popular press about the mortgage fraud problem. CNN reported that "[r]ampant fraud in the mortgage industry has increased so sharply that the FBI warned Friday of an 'epidemic' of financial crimes which, if not curtailed, could become 'the next S&L crisis.'"¹²⁰³¹²⁰³ "FBI warns of mortgage fraud 'epidemic'," CNN.com (9/17/2004), http://articles.cnn.com/2004-09- 17/justice/mortgage.fraud_1_mortgage-fraud-mortgage-industry-s-1-crisis?_s=PM:LAW. In 2006, the FBI reported that the number of Suspicious Activity Reports on mortgage fraud had increased sixfold, from about 6,800 in 2002, to about 36,800 in 2006, while pending mortgage fraud cases nearly doubled from 436 in FY 2003 to 818 in FY 2006.¹²⁰⁴¹²⁰⁴ "Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006," prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats- services/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view. The Mortgage Asset Research Institute, LLC (MARI) also reported increasing mortgage fraud over several years, including a 30% increase in 2006 alone.¹²⁰⁵¹²⁰⁵ 4/2007 "Ninth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association," prepared by Mortgage Asset Research Institute, LLC.

311

¶Published reports, as well as internal emails, demonstrate that analysts within both Moody's and S&P were aware of the serious mortgage fraud problem in the industry.¹²⁰⁶¹²⁰⁶ See, e.g., 9/2/2006 email chain between Richard Koch, Robert Mackey, and Michael Gutierrez, "Nightmare Mortgages," Hearing Exhibit 4/23-46a; 9/5/2006 email chain between Edward Highland, Michael Gutierrez, and Richard Koch, "Nightmare Mortgages," Hearing Exhibit 4/23-46b; and 9/29/2006 email from Michael Gutierrez, Director of S&P, PSI-S&P-RFN-000029. Despite being on notice about the problem and despite assertions about the importance of loan data quality in the ratings process for structured finance securities,¹²⁰⁷¹²⁰⁷ See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23- neither Moody's nor S&P established procedures to account for the possibility of fraud in its ratings process. For example, neither company took any steps to ensure that the loan data provided for specific RMBS loan pools had been reviewed for accuracy.¹²⁰⁸¹²⁰⁸ See, e.g., 2008 SEC Examination Report for Moody's Investor Services Inc., PSI-SEC (Moodys Exam Report)- 14-0001-16, at 7; and 2008 SEC Examination Report for Standard and Poor's Ratings Services, Inc., PSI-SEC (S&P Exam Report)-14-0001-24, at 11 (finding with respect to each credit rating agency that it "did not engage in any due diligence or otherwise seek to verify the accuracy and quality of the loan data underlying the RMBS pools it rated").Show full note The former head of S&P's RMBS Group, Frank Raiter, stated in his prepared testimony for the Subcommittee hearing that the S&P rating process did not include any "due diligence" review of the loan tape or any requirement for the provider of the loan tape to certify its accuracy. He stated: "We were discouraged from even using the term 'due diligence' as it was believed to expose S&P to liability."¹²⁰⁹¹²⁰⁹ Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor's, April 23, 2010 Subcommittee Hearing, at 3. Fraud was also not factored into the RMBS or CDO quantitative models.¹²¹⁰¹²¹⁰ Subcommittee interviews of Susan Barnes (3/18/2010) and Richard Gugliada (10/9/2009).

¶Yet when Moody's and S&P initiated the mass downgrades of RMBS and CDO securities in July 2007, they directed some of the blame for the rating errors on the volume of mortgage fraud. On July 10, 2007, when S&P announced that it was placing 612 U.S. subprime RMBS on negative credit watch, S&P noted the high incidence of fraud reported by MARI, "misrepresentations on credit reports," and that "[d]ata quality concerning some of the borrower and loan characteristics provided during the rating process [had] also come under question."¹²¹¹¹²¹¹ 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108 (7/11/2007 "S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced," S&P's RatingsDirect (correcting the original version issued on 7/10/2007)). In October 2007, the CEO of Fitch Ratings, another ratings firm, said in an interview that "the blame may lie with fraudulent lending practices, not his industry."¹²¹²¹²¹² 10/12/2007 Moody's internal email, PSI-MOODYS-RFN-000035 (citing "Fitch CEO says fraudulent lending practices may have contributed to problems with ratings," Associated Press, and noting: "After S&P, Fitch is now blaming fraud for the impact on RMBS, at least partially."). Moody's made similar observations. In 2008, Moody's CEO Ray McDaniel told a panel at the World Economic Forum:

"In hindsight, it is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models. … [One reason for the failure was that the]

312

'information quality' [given to Moody's,] both the complete[ness] and veracity, was deteriorating."¹²¹³¹²¹³ "Moody's: They Lied to Us," New York Times (1/25/2008), http://norris.blogs.nytimes.com/2008/01/25/moodys-they-lied-to-us/.

¶In 2007, Fitch Ratings decided to conduct a review of some mortgage loan files to evaluate the impact of poor lending standards on loan quality. On November 28, 2007, Fitch issued a report entitled, "The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance." After reviewing a "sample of 45 subprime loans, targeting high CLTV [combined loan to value] [and] stated documentation loans, including many with early missed payments," Fitch reported that it decided to summarize information about the impact of fraud, as well as lax lending standards, on the mortgages. Fitch explained: "[t]he result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file."¹²¹⁴¹²¹⁴ 11/28/2007 "The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance," report prepared by Fitch Ratings, at 4, Hearing Exhibit 4/23-100.

¶To address concerns about fraud and lax underwriting standards generally, S&P considered a potential policy change in November 2007 that would give an evaluation of the quality of services provided by third parties more influence in the ratings process. An S&P managing director wrote:

"We believe our analytical process and rating opinions will be enhanced by an increased focus on the role third parties can play in influencing loan default and loss performance. … [W]e'd like to set up meetings where specific mortgage originators, investment banks and mortgage servicers are discussed. We would like to use these meetings to share ideas with a goal of determining whether loss estimates should be altered based upon your collective input."¹²¹⁵¹²¹⁵ 11/15/2007 email from Thomas Warrack to Michael Gutierrez, and others, Hearing Exhibit 4/23-34.

¶An S&P employee who received this announcement wrote to a colleague: "Should have been doing this all along."¹²¹⁶¹²¹⁶ 11/15/2007 email from Robert Mackey to Michael Gutierrez, and others, Hearing Exhibit 4/23-34.

¶S&P later decided that its analysts would also review specific loan originators that supplied loans for the pool. Loans issued by originators with a reputation for issuing poor quality loans, including loans marked by fraud, would be considered a greater credit risk and ratings for the pool containing the loans would reflect that risk. S&P finalized that policy in November 2008.¹²¹⁷¹²¹⁷ 6/24/2010 supplemental letter from S&P to the Subcommittee, Exhibit W, Hearing Exhibit 4/23-108 (11/25/2008 "Standard & Poor's Enhanced Mortgage Originator and Underwriting Review Criteria for U.S. RMBS," S&P's RatingsDirect). As part of its ratings analysis, S&P now ranks mortgage originators based on the past historical performance of their loans and factors the assessment of the originator into credit enhancement levels for RMBS.¹²¹⁸¹²¹⁸ Id.

313

¶In September 2007, Moody's solicited industry feedback on proposed enhancements to its evaluation of nonprime RMBS securitizations, including the need for third-party due diligence reviews of the loans in a securitization. Moody's wrote: "To improve the accuracy of loan information upon which it relies, Moody's will look for additional oversight by a qualified third party."¹²¹⁹¹²¹⁹ "Moody's Proposes Enhancements to Non-Prime RMBS Securitization," Moody's (9/25/2007). In November 2008, Moody's issued a report detailing its enhanced approach to RMBS originator assessments.¹²²⁰¹²²⁰ "Moody's Enhanced Approach to Originator Assessments for U.S. Residential Mortgage Backed Securities (RMBS)," Moody's, Hearing Exhibit 4/23-106 (originally issued 11/24/2008 but due to minor changes was republished on 10/5/2009).