Fraud - Credit Rating Agencies Competitive Pressures Affecting Ratings

8/9/2019 Fraud - Credit Rating Agencies Competitive Pressures Affecting Ratings

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Excerpts from Documents Related toCredit Rating AgenciesCompetitive Pressures Affecting Ratings

"Analysts and [Managing Directors] are continually 'pitched' by bankers, issuers, investors --aUwith reasonable arguments -- whose views can color credit judgment, sometimes improving it,other times degrading it (we


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"We have spent significant amount of resource on this deal and it will be difficult for us tocontinue with this process if we do not bave an agreement on the fee issue." "We are okay withthe revised fee schedule for this transaction. We are agreeing to this under theassumption that this will not be a precedent for any future deals and that you will work withus further on this transact ion to try to get to some middle ground with respect to the ratings."

-Email exchange between Moody' s and Merrill Lynch, 6112107, Subject., "Re: Rating application forBelden Point COO," PSI-Moodys-OOOO97 , Ex . 23 ."And so wbat happened was, it was a slippery slope. As you see markets that are robust, anexample would be what bappened recently in commercial mortgages, or more importantly whathappened with subordinated tranches in residential mortgages in '04 and '05 with respect tosubordinated tranches is that our competition, Fitch and S&P went nuts. Everything wasinvestment grade. It didn't really matter."

-Moody 's CEO Raymond McDaniel at Moody' s Town Hall Meeting, September 10,2007, Ex. 98.

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010


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Excerpts from Documents Related toCredit Rating AgenciesRatings Methodology

"[N]o body gives a straight answer about anything aro1:ll1d here ... how about we come out withnew [criteria] or a new stress and ac[tuJally have clear cut parameters on what the hell we aresupposed to do."--Instant Message from S&P employee , 510812007 , Ex. 30b."I would like to discuss how we plan on ultimately 'spinning' our revised correlationassumptions [regarding the model]."

--Email from S&P employee, 3/0412005 , Subject: "R: FW: Wachovia Report Cites Questions of S&P'sIntegrity," S&P-SEC-E 401265 , Ex. 25."This deal ended up not weak-linking to [Goldman Sachs]. Chui told me that while the three ofus voted 'no', in writing, that there were 4 other 'yes ' votes. . . . [T]his is a great example of howthe criteria process is NOT supposed to work. Being out-voted is one thing (and a good thing, inmy view), but being out-voted by mystery voters with no 'logic trail' to refer to is another. ...Again, this is exactly the kind ofbackroom decision-making that leads to inconsistent criteria,confused analysts, and pissed-off clients."

--Email fromS&Pemployee.Sll21200S. Subject: "FW: Adirondack COO," S&P-SEC-E 491870, Ex. lOc."Don't even get me started on the language he cites .. . which is one of the reasons I said thecotulterparty criteria is totally messed up. . . . And not only have these trades consumed tons ofmy time, but they have generated an enormous amotult of stress since I'm the one that has tobreak the news that these trades are \\!Tong . . . which makes us look like idiots."

--Email from S&P employee, 412312006, Subject: "RE: ABACUS 2006-12 - Writedowns immediatelyprior to Stated Maturity," S&P-SEC-E 177281, Ex . lOb .


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to create an even bigger monster -- the CDO market. Let's hope we are all wealthy and retired bythe time this house of cards falters."Email from S&P employee, 1211512006, Subject: "RE: Synthetic CDO"2 of ABS (both Cash andSynthetic)," S&P-SEC-E 199613. Ex. 27.

"Can anyooe give me a crash course 00 the 'hidden risks in CDO's ofRMBS'?"-Email fromS&Pemployee, 1/ 17(2007, Subject: "FW: Summary ofConference Call," S&P-SEC-E1319429, Ex . 2g.

"It sounds like Moody's is trying to figure out when to start downgrading, and how muchdamage they 'r e going to cause -- they' re meeting with various investment banks."

-Internal UBS email, 5/0712007, Subject: "ABS Subprime and Moody' s Downgrades," Pursuit Partners,UC v. UBS, AG et 01., Ex. 940"Over time, different chairs have been giving different guidelines at different points of time onhow much over-enhancement we need for a bond to be notched up to Aaa, the numbers varyfrom 10% to 1/3 ofhond size. The main reason I sent Tony to you is to get some generalguidance on the notching practice, so that people can follow without having to run by you everytime the issue comes up."

--Email from Moody's employee, 612g12007, Subject: "RE: Please READ M-I sign of f,"SEC_MOODYS00002g55, Ex. 39."Back in May. the deal had 2 assets default, which caused it to fail. We tried some things, and itnever passed anything I ran. Next thing I know, I' m told that because it had gone effectivealready, it was surveillance's responsibility, and I never heard about it again. Anyway, becauseof that, I never created a new monitor."

--Email from S&P 's employee, g/0712007 , Subject: "RE: Fw: S&P COO Monitor Kodiak COO I: Urgent,"S & P - S E C ~ E 163941, Ex. 96a.

"We might need to change our model as well for this. For now I am asking analysts to do theseasoning benefit themselves outside the model."


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Excerpts from Documents Related toCredit Rating Agencies

Deteriorating Subprime Mortgages"The potential impact of mortgage fraud on fmancial institutions and the stock market is clear. Iffraudulent practices become systemic within the mortgage industry and mortgage fraud isallowed to become unrestrained, it will ultimately place financial institutions at risk and haveadverse effects on the stock market."

~ S t a t e m e n t of Chris Swecker, Assistant Director of the Criminal Investigative Division, Federal Bureau ofInvestigations, 8/0712004 ."Rampant fraud in the mortgage industry has increased so sharply that the FBI warned Friday ofan 'epidemic' of financial crimes which, i f not curtailed, could become 'the next S&L crisis.'"

--"FBI warns of mortgage fraud epidemic," CNN.com, 9/1712004."I have been a mortgage broker for the past 13 years and I have never seen such a lack ofattention to loan risk."

Email from Resource Realty, 7122105 , Subject: "Washington Mutual," psr SP000395 , Ex. 45."'Who Will Be Left HoldinR The Bag?' It 's a question that comes to mind whenever one priceincrease after another- say, for ridiculously expensive homes-leaves each succeeding buyerout on the end of a longer and longer limb: When the limb finally breaks, who's going to gethurt? In the redhot U.S. housing market, that's no longer a theoretical riddle. Investors arestarting to ask which real estate vehicles carry the most risk- a n d i f mortgage defaults surge,who will end up suffering the most."

-S&P economic research paper, 9/ 1212005."I'm not surprised; there has been rampant appraisal and underwriting fraud in the [mortgage]industry for quite some time as pressure has mounted to feed the origination machine."


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"You hit it right on the head - Ernestine [S & P head of surveillance group] told me that brokendown to loan level what she is seeing in losses is as bad as high 40s -low 50s %[.] I'd love to beable to publish'a commentary with this data but maybe too much of a powder keg"--Email from S&P Managing Director, Subject:


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Excerpts from Documents Related toCredit Rating AgenciesGrandfathering

"FYl. Just sat on a panel with Frderie Drevon, my opposite number at Moody's who fielded aquestion on what happens to old transactions when there is a change to rating methodologie. TheofficiaJ Moody's line is that there is no 'grandfathering' and that old transactions are reviewedusing the new criteria. However, 'the nutb is that we do not have the resources to reviewthousands of transactions, so we focus on those that we feel are more at risk.' Interestingly,Olivier Dufour from Fitch said they 'grandfathered' as it would otherwise be 'unfair'."Email from S&P employee, 312112006, Subject: "Moodys ," S&P-SEC-E 355327, Ex. 71."The overarching issue at this point is what to do with currently rated transactions if we dorelease a new version of Evaluator [S&P ratings model]. Some of [U5] believe for both logisticaland market reasons that the existing deals should mainly be 'grand fathered '. Others believe thatwe should run all deals using the new Evaluator. The problem with running all deals using E3 istwofold: we don 't have the model or resource capacity to do so, nor do we all believe that even i fwe did have the capability, it would be the responsible thing to do to the market."

--Ema il from S&P employee, 6flll2oo5, Subject: "RE : new COO criteria," S&P-SEC-E 403320, Ex . 60."[T]he way surveillance is done is different from how a new deal is done. .. . In my opinion,this creates a sense of disco nnect and analysts (new dea1 and surveillance) do not feel a need tomake sure there is a good process and procedwe in place to identify basic global assumptionchanges. . . . The two major reasons why we have taken the approach is (i) lack of sufficientpersonnel resowces and (ii) not having the same models/information available for surveillance torelook at an existing deal with the new assumptions (i.e. no cash flow models for a number ofassets). The third reason is concerns of bow disruptive wholesale rating changes, based on a


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"Simply put - although the RMBS Group does not 'grandfather' existing deals, there is not anabsolute and direct link between changes to our new ratings models and subsequent ratingactions taken by the RMBS Surveillance Group. As a result, there will not be wholesale ratingactions taken in July or shortly thereafter on outstanding RMBS transactions, absent adeterioration in perfonnance and projected credit support on any individual transaction."--Email from S&P employee, 612312006, Subject: "RMBS LEVELS 5.7 and its Impact on OutstandingDeals," S&P-SEC-E 1255416, Ex. 72.

"Thanks again for your help (and Mark's) in getting Morgan Stanley up -lo-speed with your newmethodology. As we discussed last Friday, please find below a list of transactions with whichMorgan Stanley is significantly engaged already (assets in warehouses, some liabilities placed).We appreciate your willingness to grandfather these transactions [with regards to] Moody's oldmethodology."

--Email from Morgan Stanley Executive Director to Moody's, 51212007, Subject: "Upcoming CLOs /grandfathering list," SEC_MOODYSOOOO0345, Ex. 76."Heads-up/note on further question that the FT [Financial Times] (paul Davis) are pursuing:Why don't we reassess all outstanding bonds when we announce to change our modelassumptions for future transaction? He is focussing on US eMBS's recent changes, but thisquestion applies across the board."--Email from Moody's Senior Director in Structured Finance, 5125/2007, Subject: "FW: Financial Timesinquiry on transparency of assumptions," MIS-OCIE-RMBS-0364942."Currently, following a methodology change, Moody's does not re-evaluate every outstanding,affected rating. Instead, it reviews only those obligations that it considers most prone to multinotch rating changes, in light of the revised rating approach. This decision to selectively reviewcertain ratings is made due to resource constraints ."

--Moody's Structured Finance Credit Committee, 3/3112008, MIS-QCIE-RMBS_095, Ex. 80."[E]ach of our current deals is in crisis mode. This is compounded by the fact that we haveintroduced new criteria for ABS CDOs. Our changes are a response to the fact that we are


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Excerpts from Documents Related toCredit Rating AgenciesChronic Resource Shortages

"Thanks for sharing the draft of the COO surveillance piece you're planning to publish later thisweek. In the section about your CDO surveillance infrastructure, we were struck by the datapoint about the 26 professionals who are dedicated to monitoring CDO ratings. While this is, nodoubt, a strong team, we wanted to at least raise the question about whether the company' scritics could twist that nwnber - e.g., by comparing it to the 13 ,000+ CDOs you're monitoringand once again question if you have adequate resources to do your job effectively. Given thatpotential risk, we thought yOll might consider removing any specific reference to the number ofpeople on the CDO surveillance team."

--Email from Moody's employee, 7/0912007, Subject: "FW: COO Surveillance Note 7_07I.doc,"SEC_MOODYS00000545 .

"While I realize that our revenues and client service numbers don't indicate any il l [e]ffects fromour severe understaffing situation, I am more concerned than ever that we are on a downwardspiral of morale, analyticalleadershipl quality and client service."

-Email from S&P employee, 10/31 12006 , Subject: "A COO Director resignation," S&P-SEC-E 354159."There is some concern about workload and its impact on operating effectiveness. . .. Mostacknowledge that Moody's intends to run lean, but there is some question of whethereffectiveness is compromised by the current deployment of staff."

--Moody's SFG [Structured Finance Group12002 Associate Survey, Ex . 92a."We are over worked. Too many demands are placed on us for administrative tasks ... and aredetracting from primary workflow .... We need better teclmology to meet the demand ofrunning increasingly sophisticated models."

-Moody ' s BES Employee Survey 2005, Ex. 92b.


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"We spend most of our time keeping each other and our staff calm. Tensions are high. Just toomuch work, not enough people, pressure from company, quite a bit of turnover and nocoordination of the non-deal 'stuff' they want us and our staff to do."--Email from S&P employee, 51212006 , Subject: "RE: Change in scheduling/Coaching sessions/Otherstuff," S&P-SEC-E 1152365.

"RMBS has an all time high of 5900 transactions. Each time I consider what my group is facedwith, 1 become more and more anxious. The situation with La!, being offline or out of thegroup, is having a huge impact."--Email S&P Head of Global Surveillance Ernestine Warner, 412812006, S&P-SEC-E 1197409, Ex. 83 .

"In light of the current state of residential mortgage perfonnance, especially sub-prime, 1think itwould be very beneficial for the RlvlBS surveillance team to have the work being done by thetemps to continue. It is still very important that perfonnance data is loaded on a timely basis asthis has an impact on our exception reports. Currently, there are nearly 1,000 deals with dataloads aged beyond one month."--Email from S&P Head of Global Surveillance Ernestine Warner, 1212012006, Subject: "Please continuetemps," S&P-SEC-E 1223053, Ex. 84.

"I talked. to Tommy yesterday and he thinks that the ratings are not going to hold through 2007.He asked me to begin discussing taking rating actions earlier on the poor performing deals. 1have been thinking about this for much of the night. We do not have the resources to supportwhat we are doing now. A new process, without the right support, would be overwhelming . ..really need to add to s taff to keep up with what is going on with sub prime and mortgageperfonnance in general, NOW ."--Email from S&P Head ofGlobal Surveillance Ernestine Warner to Peter O'Erchia, 2/0312007, Subject:"RE: Headcount for RMBS Surveillance?I," S&P-SEC-E 1201718, Ex. 86.

"We really need help. Sub prime is going down hill. The 20% not covered in our system is alsoof great concern. 1am going ahead with interviewing for the open positions."

--Email from S&P Head of Global Surveillance Ernestine Warner to Peter D'Erchia, 2/1312007, Subject:


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Revenue of the Three Credit Rating Agencies: 2002-2007$7 ,000$6,000$5,000

.. $4,000.2-'E $3,000$2 ,000$1000


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1:1'"t' l -33- a"- l g"" g... -- -;.

2006 Originations and RMBS Issuance Mortgage Originations $2.5 Trillion

- Subprime Originations - S600 Billion(70-75% of which is securitized and rated)

RMBS Issuance $1.9 Trillion- Non-Agency (Rated) Market - Sl.2 Trillion

Subprime Issuance - $435 Billion or 36%- Agency (Freddie. Fannie and GNMA) Market -SO.7 TrillionOther Non-Securitized Outstandings - SO.6 Trillion

Held on balance sheet or in portfolio by financialinstitutions and privately financed generallythrough a base of retail deposits

Agency28%

NOllAgenty....,,,%

Billion RMBS Issuance3,0002 . . .2,0001.5001.000

5000

2003 2004 AgencySource : Inside MBS & ABS

2005 ,.06o Non-Agency

2006 Issuance Rated by Transaction Type.-------..

AII..A,,%

Subprlme..,.

HELOCand CES7%

Source: Standard & Poor's Rating Services. u.s. Residential Mortgage Subprime Market. March 29. 2007.


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Percent orthe Original AAA Universe Currently Rated Below Investment Grade

Vintage Prime Prime Alt-A Alt-A Option Subprime. " Fixed ARM Fixed ARM ARM , - , . . --_. - _.. -- ---- 2004 3% 9% 10% 17% 50% 11%-"l c 2005 39% 58% 73% 81% 76% 53%a 2006 81% 90% 96% 98% 97% 93%-.., 0.. 0 2007 92% 90% 98% 96% 97% 91%.. ; '-.


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ESTIMATION OF HOUSING BUBBLE: Comparison of Recent Appreciation vs. Historical Trends, ' , ; . ~ ~ ; ; - ; : . i : : : t " " ' : ' ' l . " " ' - " - i ~ ' : " ~ ' : - _ ' - L _ ' ~ ' : ~ ~ . J ' .c;. I ' :_. i ...... .. ~ . ; . .. ' ......... -3 ~ , ~ ; . , ~ . ~ , _ " ' - . . : : .: ...,. _,fr:o t-',

3M;; '=== g... 3

>-l'I t g... -

I . ~ .

Real Home Price Index (1975 =100)200 .-- -- -180

160

140

120 ..

1001975

.----,,---,1980

I'lousing Bubble

irer.G lilt l i 7 S - 2 0 0 ~

\,- - - - -_ . ,._.-_. -- .-

1985 1990 1995 2000 June 20061.4% 7.6% --I GAGR

Source: Office of Federal Housing Enterprise Oversight, Bureau of Economic Analysisr,\U I..'iU.' -

.10 I' ll.,", U ",,,.. , l.tl i. U''''I"I",I r",,,, .."'''('5 w l " " ' ~ , 1 ." t", , d , ~ bUl ~ " - " ' , K ) " nnnOl be G I I ; U ; o n l ~ ~ ~ 1 . Th is 1


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Table 3: Biggest Clients of the Credit Rating AgenciesThis table shows the amount of business each CDO originator did with the three main CRAs.

Ranks are based on the total par amount ofCDO tranches rated by the agency: the higher rankscorrespond to more business. The total amount rated by the agency is shown in parentheses underthe rank. The results are sorted by average ranking.Average Moody's Fitch Rank S&PRankOriginator Rank Rank (Smm) (Smm)(Smml

Merrill Lynch 1 1 t 1(S76,908) (S31,269) (S77,275)Citigroup 2 2 6 2(S28,497) (S2,9721 (S29,1061UBS 3 6 2 4(SI7124) (S6,962) (520,396)Wachovia 4 4 7 5(S20,328) (52,527) (520,337)Calyon 5 7 3 7(516,877) (54,656) ($16,8481Goldman Sachs 6 3 14 3(522,477) ($0,7981 ($22617)Deutsche Bank 7 10 5 8(SI2,2511 ($3,3901 (5144711Various Small Banks 8 5 13 6(SI8,742) (50,947) (SI8,689)Credit Suisse 9 8 8 9

(S13,3301 (51,8931 ($14,088)RBS 10 12 9 12($10,686) (SI,673) ($117041


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