Senate Hearing, 110TH Congress - Subprime Mortgage Market Turmoil: Examining The Role of Securitization

S. HRG.
110913
SUBPRIME MORTGAGE MARKET TURMOIL:

EXAMINING THE ROLE OF SECURITIZATION
HEARING
BEFORE THE
SUBCOMMITTEE ON
SECURITIES AND INSURANCE AND INVESTMENT
OF THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
ON HOW SUBPRIME MORTGAGES ARE SECURITIZED; THE EFFECT OF
RECENT INCREASES IN DEFAULTS AND DELINQUENCIES ON THE
SUBPRIME SECURITIZATION MARKET FOR BOTH BORROWERS AND INVESTORS; AND HOW CREDIT RISK FOR MORTGAGE-BACKED SECURITIES IS DETERMINED AND HOW THE ASSIGNED RATINGS ARE MONITORED
TUESDAY, APRIL 17, 2007

Printed for the use of the Committee on Banking, Housing, and Urban Affairs
(
Available at: http: //www.access.gpo.gov /congress /senate /senate05sh.html
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota
RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island
ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York
WAYNE ALLARD, Colorado
EVAN BAYH, Indiana
MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware
CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey
JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii
MIKE CRAPO, Idaho
SHERROD BROWN, Ohio
JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania
ELIZABETH DOLE, North Carolina
JON TESTER, Montana
MEL MARTINEZ, Florida
SHAWN MAHER, Staff Director
WILLIAM D. DUHNKE, Republican Staff Director and Counsel
JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator
GEORGE WHITTLE, Editor
SECURITIES
AND
INSURANCE
AND
INVESTMENT
JACK REED, Rhode Island, Chairman

WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey
MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire
CHARLES E. SCHUMER, New York
ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana
CHUCK HAGEL, Nebraska
ROBERT P. CASEY, Pennsylvania
JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii
MIKE CRAPO, Idaho
JON TESTER, Montana
DIDEM NISANCI, Staff Director

TEWANA WILKERSON, Republican Staff Director
(II)
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C O N T E N T S
Page
Opening statement of Chairman Reed ...................................................................

Opening statements, comments, or prepared statements of:
Senator Allard ...................................................................................................
Senator Menendez ............................................................................................
Senator Crapo ...................................................................................................
Senator Casey ...................................................................................................
Senator Schumer ..............................................................................................
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WITNESSES
Gyan Sinha, Senior Managing Director and Head of ABS and CDO Research,
Bear Stearns & Company, Inc. ...........................................................................
Prepared statement ..........................................................................................
David Sherr, Managing Director and Global Head of Securitized Products,
Lehman Brothers, Inc. .........................................................................................
Response to written questions of:
Senator Reed ..............................................................................................
Senator Schumer .......................................................................................
Susan Barnes, Managing Director, Standard & Poors Ratings Services ...........
Warren Kornfeld, Managing Director, Residential Mortgage-Backed Securities
Rating Group, Moodys Investors Service ..........................................................
Response to written questions of:
Senator Reed ..............................................................................................
Senator Schumer .......................................................................................
Kurt Eggert, Professor of Law, Chapman University School of Law ..................
Christopher L. Peterson, Associate Professor of Law, University of Florida ......
(III)
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SUBPRIME MORTGAGE MARKET TURMOIL:

EXAMINING THE ROLE OF SECURITIZATION
U.S. SENATE,
SECURITIES, INSURANCE, AND
INVESTMENT,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The subcommittee met at 3 p.m., in room SD538, Dirksen Senate Office Building, Senator Jack Reed (Chairman of the Subcommittee) presiding.
SUBCOMMITTEE
ON
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman REED. I call the hearing of the Subcommittee to order,

and I want to thank Senator Allard, the Ranking Member, for joining me. I want to thank our witnesses for being here today. Senator Menendez has joined us, too.
Our hearing this afternoon builds on the record begun last fall
by Senators Allard and Bunning when the Subcommittee on Housing and Transportation and the Subcommittee on Economic Policy
first began to look to these issues.
In recent months, there has been a dramatic increase in home
loan delinquencies and foreclosures, the closure or sale of over 40
subprime lenders, and an increase in buybacks of delinquent loans.
While the subprime market has experienced most of the turbulence, there are now signs of weakness in the Alt-A market.
This is a complicated issue. Chairman Dodd and Senator Shelby
have held a number of hearings where we have heard from brokers, originators, regulators, and borrowers regarding the causes
and consequences of the current mortgage market turmoil. However, we are here today to look at the financial engine which helps
drive this market: the securitization process.
Clearly, there are many benefits from securitization.
Securitization creates liquidity, enables lenders to originate a
greater volume of loans by drawing on a wide source of available
capital, spreads risk, and allows investors to select their risk level
of pattern of returns. When securitization works well, it bridges the
gap between borrowers and investors and makes homeownership
more affordable.
However, what happens when it does not work as well as it
should? Does the complex structure of mortgage-backed securities
and the servicers duty to act on behalf of different investors limit
the servicers ability to provide loan workout options for the borrower? Also, is it possible that securitization can create perverse in(1)
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2
centives, such as an erosion of underwriting standards or the development of exotic loan products that do more harm than good?
Lewis Ranieri, the pioneer of mortgage-backed securities, recently stated that he believes standards are largely set by the risk
appetites of thousands of hedge fund, pension fund, and other
money managers around the world. Emboldened by good return on
mortgage investments, they have encouraged lenders to experiment
with a profusion of loans. As many credit-stressed borrowers still
face resets on some of these experimental loan products, the Center
for Responsible Lending has estimated that one in five subprime
loans originated during the prior 2 years will end in foreclosure,
costing homeowners $164 billion, mostly in lost equity.
Last, there is some cause for concern on the investor front.
Again, Lewis Ranieri stated last year, When you start divorcing
the creator of the risk from the ultimate holder of the risk, it becomes an issue of, Does the ultimate holder truly understand the
nature of the risk that you have redistributed? By cutting it up in
so many ways and complicating it by so many levels, do you still
have clarity on the nature of the underlying risk? It is not clear
that we have not gone in some ways too far, that we have not gone
beyond the ability to have true transparency. That is a fair question that many of us in the business and people in the regulatory
regime are wrestling with.
A related issue on this front is the steadily increased loss expectations for pools of subprime loans. According to a recent Moodys
report, loss expectations have risen by about 30 percent over the
last 3 years. Loss expectations ranged from an average of 4 to 4.5
percent in 2003 to an average of 5.5 to 6 percent today.
I am also concerned about possible downgrades of these securities that could affect pension plans and other large institutional investors and whether there could be a systemic effect down the
road. As such, the purpose of our hearing this afternoon is twofold:
First, we want to examine how subprime mortgages are
securitized, how credit risk for mortgage-backed securities is determined and monitored, and what effect the recent increase in defaults and foreclosures has had on the subprime securitization market.
Second, we want to learn what role, if any, the securitization
process has played in the current subprime market turmoil and
what issues Wall Street and Congress should consider as we move
forward.
We will hear from one panel of witnesses, but before I introduce
them, I want to recognize Senator Allard and other Members of the
Committee who are with us today for their statements. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator ALLARD. First, I would like to congratulate my friend

from Rhode Island on his first hearing as Chairman of the Subcommittee on Securities, Insurance, and Investment.
Over the years, I have had the privilege of working with Senator
Reed in a number of different capacities, always valued our partnership and our ability to work together. We worked together on
the Strategic Subcommittee on Armed Services at the time I was
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Chairman, and then over here on Housing and Transportation we
worked together, and now I have an opportunity to continue to
work with him on Securities. And I am looking forward to continuing our working relationship. He has always had a thoughtful
approach, and I have enjoyed working with him in that regard.
Today we are here, well aware of the difficulties in the mortgage
markets. The effects have been dramatic and widespread. Individual families, neighborhoods, and entire communities suffer when
foreclosure rates rise. That is the unfortunate reality for far too
many.
Last year, Senator Reed and I had an opportunity to examine the
matter from several different angles, including examining the role
of nontraditional mortgage products. Under the leadership of Senator Dodd and Senator Shelby, the full Committee has also provided opportunities to delve into the mortgage markets.
Lately, we have even seen the uncertainties in the mortgage
markets spill over into the broader financial markets, and this is
concerning and certainly worthy, I think, of careful review. Yet in
taking account of the mortgage and financial markets, there is still
one significant component that we have not yet examined, and that
is the secondary market.
As we transition from the Housing Subcommittee to the Securities Subcommittee, Chairman Reed has chosen an especially appropriate topic: the role of securitization in the subprime mortgage
market. Todays hearing will allow us to build on our previous
record in a new area of jurisdiction. I will be interested in hearing
about how securitization has expanded homeownership opportunities, but also the accompanying policy concerns. As noted by FDIC
Chairman Sheila Blair, there is no doubt that securitization has
had an impact on looser underwriting standards as we have seen
by lenders. I will be interested in hearing about the other ways in
which the dispersion of risk has affected the subprime mortgage
markets.
Once again I would like to thank Chairman Reed for convening
this important hearing. We have an excellent line-up of witnesses,
and I am confident that they will help us understand the role of
securitization in the subprime mortgage markets, which will give
us a much fuller and richer understanding of the markets. I look
forward to your testimony.
Chairman REED. Thank you very much, Senator Allard.
Senator Menendez, do you have an opening remark?
STATEMENT OF SENATOR ROBERT MENENDEZ
Senator MENENDEZ. Thank you, Mr. Chairman. I, too, want to

commend you on having this as your first hearing on an incredibly
important issue, and also I appreciate Senator Allard and his work.
As we proceed with the hearing, I think it is important to remember what this is ultimately all about, and that is, the American dream of owning a home. In the last full Banking Committee
hearing, we heard from individuals who became victims to deceptive predatory lenders, and I told of a story, one of many in my own
State in New Jersey, of a woman who could not make the payments on her home after the teaser rate expired, and she is still
facing foreclosure action today.
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It seems to me that in the face of the tsunami of foreclosures we
are facing, we must not lose sight of our objective and work toward
a solution that protects the homeowners. I do not think anyone can
argue against the notion that we are in an increasing subprime crisis. Over 40 subprime lenders have halted operations or filed for
bankruptcy. We now have the highest delinquency rate in 4 years.
As many as one in five recent subprime mortgages will end in foreclosure, and 2.2 million subprime borrowers have had their homes
foreclosed or are facing foreclosure. That to me is simply unacceptable.
So as we move forward today on one of the different dimensions
of this issue, Mr. Chairman, I hope we remember this is not just
numbers. They are a single mother struggling to make ends meet,
an elderly couple facing the depletion of their life savings, or a minority family crushed with the reality that they may lose their first
home. It is a financial nightmare for families across America, and
I fear it is only going to get worse.
Last, I think it is time for all parties to take responsibility, to
change behavior in order to prevent particularly in the context of
predatory loans. In the Banking hearing last month, after some of
my questions, regulators were forced to stand up and say that they
did too little too late. And today I hope we will hear from those who
are involved in the overall chain of this process to take some responsibility for their part in how we move forward and how we can
improve the securitization process. As long as it appears that there
is an overzealous secondary market for these loans, they will continue to flourish without checks and balances. And so we certainly
want to see the secondary market continue to exist, but we also,
I believe, need to make sure that there are some appropriate
checks and balances at the end of the day in order to ensure that
we do not have the animal instincts of the marketplace take over,
as it seems to have today.
So I look forward to the testimony and to working with you, Mr.
Chairman.
Chairman REED. Thank you, Senator Menendez.
Senator Crapo, do you have a statement?
OPENING STATEMENT OF SENATOR MIKE CRAPO
Senator CRAPO. Yes, just very briefly, Mr. Chairman. I also applaud you for holding this hearing. I think it incumbent on all of
us to understand much better the role of securitization in the mortgage market, not just the subprime market. But as this moves forward, we are going to be facing the question of whether there
should be a regulatory governmental response and, if so, whether
that response should come from the agencies who now have authority, or whether it requires further legislative authorization in terms
of statutory changes, or whether the market discipline that is already being seen is adequate.
I agree with Senator Menendez. The ultimate question here is
about protecting homeowners and making sure that that part of
the American dream which is homeownership is something that we
assure is available to the maximum number of people in America
who want to have that part of their dream. There are two sides to
that.
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We are now seeing the very harmful side of the collapse or the
crisis that we are seeing in the subprime market, and the stories
that we are seeing about the impact that has on people.
The other side of it is that there are lot of people who will not
be able to get a home if there is not adequate credit available to
them. And it is that balance that we have to strike.
I am going to be very interested, as we go through this hearing
and other hearings, to get answers to the basic question of what
type of market discipline needs to be in place, what type is in
place, what is happening today, why didnt it happen in a better
way, why did we face this crisis, what was not in place that should
have been, and is that going to lead us to require more regulatory
oversight or more statutory authorities for such oversight.
I would note that if you look at the market itself right now and
the adjustments that are occurring, we have noticed that stock
prices of major subprime specialists have already plummeted.
Firms which could not support their representations and warrants
for loans that were sold into the secondary market when asked to
buy back poorly unwritten loans are closing their doors as equity
is exhausted. Credit spreads on lower-rated tranches of subprime
securities have widened appreciably as investors already demand
greater returns on these investments. Various segments of the
subprime market have already raised credit standards on their
own. Federal regulators in March have issued for comment a proposed statement on subprime mortgage lending.
So things are happening in the market itself and among the regulators and here in Congress as we are evaluating in hearings such
as this.
But, again, Mr. Chairman, and to the witnesses and others, I
really think our focus needs to be on finding that balance. You
know, the proverbial pendulum needs to be adjusted, probably. The
question is: Will we adjust it too far and stop people who should
have some sort of credit from being able to get that credit and
being able to get a hand on that rung and start down the process
of homeownership? Or will we not move it far enough and leave
people exposed to credit practices that will deny them that dream
and cause them economic and financial hardship that will deprive
them of the dream longer than it should have happened?
So it is that balance that I hope that we are able to strike here
as we proceed, Mr. Chairman. Thank you.
Chairman REED. Thank you very much, Senator Crapo.
Senator Casey, do you have opening remarks?
OPENING STATEMENT OF SENATOR ROBERT P. CASEY
Senator CASEY. Just very briefly. Thank you, Mr. Chairman, for
calling this hearing and for the witnesses who will testify and everyone else who is here. I will, with your permission, submit a
written statement for the record, but just by way of reiteration of
what we have heard, this is a complex and technical area. But like
a lot of things that happen in this town, it gets back to real people
and real families and their lives. And one thing that we are going
to be listening carefully to are the areas of testimony and the areas
of questioning which involve incentives. What kinds of incentives
do brokers have and firms have that create problems for real peo-
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ple and real families who have real-live budgets? And sometimes
they are left out in the cold on their own because of the way some
of these deals go down.
So I am going to be listening carefully to that, but I do want to
commend the Chairman for calling this hearing, and we want to
get to the statements.
Thank you very much.
Chairman REED. Thank you.
Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator SCHUMER. Thank you, Mr. Chairman, and I appreciate

the opportunity to be here. I have a whole bunch of questions, but
I have to be gone by 4, so I do not think we will get up to them.
So I want to maybe ask a few of them in my opening statement
and ask the witnesses to submit them in writing eventually, if that
is OK.
But, first, let me just say I agree with my colleague from Idaho
that we have to set a balance here, but I think we have to be cognizant of a few things as we do.
First, an amazing statistic which has not gotten enough attention. You know, you read some of particularly the more conservative publications, and they say, well, listen, this is great because
all this subprime lending is allowing people to buy homes for the
first time.
Well, that has some degree of truth, but only some. Eleven percent of the subprime mortgages issued were to first-time homebuyers. That is all11 percent. The remainder were to two groups:
one, people who had bought one home and were moving to another;
but a large number are people refinancing. And at least in my experienceand this is mainly based on just people I have talked to
in the field. There is no statistical basis that I have. A lot of the
people who refinanced their homes were called up on the phone,
they said, Hey, do you want $50,000? I will do it for you. And
their home is refinanced.
I bring up the case of a fellow I met from Ozone Park named
Frank Ruggiero. He had a $350,000 mortgage. He has diabetes. He
needed extra money. Some guy called him on the phone regularly
and said, I can get you $50,000, and the mortgage will be $1,500,
which Ruggiero knew he could pay. He lived in Ozone Park. Of the
$50,000 increase in the mortgage, he got $5,700. The mortgage
broker got about $20,000 because they liked the spread on the loan
between his old loan and his new loan. And the others picked up
the rest. Worse, his interest rate went from $1,500 to $3,800 in a
short time, and he is about to lose his home, and he did not get
the help he needed to pay for his diabetes condition.
Well, something is wrong when that happens, and to just say,
well, we are creating new markets for people, yes, we said that in
the 1890s and maybe the 1920s, but not in the 21st century. So
we have got to figure out what to do.
Just a couple of other quick points. The market itself has pretty
severe discipline. Any company that has gotten involved in buying
a lot of these loans, they are paying a price nowlots of them. And
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that discipline, sometimes even the pendulum swings a little too
far. But that is how markets work.
The people who are left holding the bag are the Mr. Ruggieros,
and then people who initially sold them the mortgages are gone.
You know, the guy who sold Frank Ruggiero his mortgage got
$20,000, and he is off into the sunset, and there is virtually no regulation over people like that. And we ought to have it, and I intend
to fight for it. That is very, very important, particularly if the mortgage broker did not come from a bank. That is not to condemn all
mortgage brokers. Some do a very fine and necessary job in society.
And the questions that I have relate to how we help the future
Mr. Ruggieros. We all know in 2007, 2008, and maybe 2009, there
are going to be more of these loans because the most extreme of
the liar loans, of the ARMs that just jumped, were issued in 2005,
2006. So the chickens will come home to roost a year, 2 years, 3
years later, when the rate goes way up.
What can we do to assist them? I have called for aiding some
nonprofits, for the Federal Government to actually shell out some
money to the nonprofits who help people refinance the loans. We
have found that a foreclosure can on average cost stakeholders up
to $80,000. Foreclosure prevention may only cost $3,300.
And my questions are: If we give money to these nonprofits and
others, they could bebut they are people whose job is to help the
next Mr. Ruggiero refinance. My questions that I would ask the
holders, particularly Mr. Sinha and Mr. Sherr, is: How much leverage do these nonprofits have in getting some of the existing stakeholders to get back in the game when it is in their interest to do
so? What percentage of the securitized subprimes have clauses that
prohibit or significantly limit loan modifications? I would ask the
panel again, in writing, to discuss those. Is there anything the
holder of the loan can do to ease the servicers ability to prevent
foreclosures by modifying the loans? And since it would be in both
the servicers and loan holders best economic interest to prevent
foreclosure, shouldnt loan servicers put a time-out on foreclosures
until they can work out loan modifications consistent with what the
loan holders need?
So those are some of the questions that I would like to ask, practical questions. I would ask that you folks all submit something to
the Committee in writing so we can take a look, but these are
aimed at preventing large numbers of foreclosures.
One final fact, Mr. Chairman. Sorry to go on a little bit here.
This is not just going to affect the people who have the loans, the
mortgagor side or mortgagee side, no matter how far up the chain.
It is estimated that for every foreclosure within one-eighth of a
mile of your home the property falls by 0.9 percent. That is an average, obviously. But in some neighborhoods, some communities,
our Joint Economic Committee issued statistics that one out of
every 21 homes in Detroit had foreclosure; one in 23 in Atlanta. It
is going to hurt property values significantly.
So having a diminution of future foreclosures, which will get
worse if we do nothing, makes sense for everybody. And I would
ask all of your help in figuring out how we do that.
Thank you, Mr. Chairman.
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Chairman REED. Thank you very much, Senator Schumer. And
if your staff prepares those questions, we will forward them to the
witnesses.
Senator SCHUMER. Thank you.
Chairman REED. Thank you very much.
We are very fortunate to have a knowledgeable and very accomplished panel. Let me introduce them, and then I will recognize Mr.
Sinha to make his presentation.
We are joined by Gyan Sinha. He is the Senior Managing Director and Head of the Asset-Backed Research Group at Bear Stearns.
He has been consistently one of the top-ranked analysts in Institutional Investors All-American Fixed Income Research Survey for
his work in asset-backed securities, notably in prepayments, ARMs,
and CDOs. Prior to joining Bear Stearns, he was a Vice President
at CS First Boston in the mortgage research area, an assistant professor in the Faculty of Commerce at the University of British Columbia from 1991 to 1993.
Next to Mr. Sinha is Mr. David Sherr. Mr. Sherr is currently
serving as a Managing Director and Head of the Global
Securitization Products business at Lehman Brothers. Mr. Sherr
first joined Lehman Brothers in 1986 and has previously served as
head of mortgage trading. Additionally, he is a member of the
Fixed Income Division Operating Committee.
Next to Mr. Sherr is Ms. Susan Barnes. Ms. Barnes is the Managing Director and Practice Leader of the U.S. Residential Mortgage Group, with responsibility for managing all Standard & Poors
U.S. RMBS activities, products, and analysis. Previously, as the
senior analytical manager of the Residential Mortgage Group, Ms.
Barnes was responsible for the development and implementation of
criteria for all residential mortgage products. Prior to joining
Standard & Poors in 1993 from Citicorp Securities Markets, she
worked with primary mortgage companies as well as secondary
market participants.
Next to Ms. Barnes is Mr. Warren Kornfeld. Mr. Kornfeld coheads Moodys Residential Mortgage-Backed Securities Group,
which is responsible for rating residential mortgage securitizations,
including subprime, jumbo, Alt-A, HELOC, FHA, VA, and closed
and seconds. In addition, Mr. Kornfeld is in charge of Moodys
RMBS and ABS Service Ratings Group. Mr. Kornfeld has more
than 20 years of experience in the securitization market. Prior to
joining Moodys in 2001, Mr. Kornfeld headed up the Securitization
Group at William Blair and Company. Before joining William Blair,
Mr. Kornfeld was previously with the Industrial Bank of Japan,
Bickford & Partners, Inc., and Trepp & Company.
Next to Mr. Kornfeld is Mr. Kurt Eggert. Mr. Eggert is a professor of law and Director of Clinical Legal Education at Chapman
University Law School. He has written extensively on
securitization and predatory lending issues, and previously testified
before Congress on predatory lending issues. Professor Eggert is a
member of the Federal Reserve Boards Consumer Advisory Council, where he chairs the Subcommittee on Consumer Credit. From
1990 until 1999, he was a senior attorney at Bet Tzedek Legal
Services in Los Angeles, where he specialized in complex litigation
including consumer fraud and home equity fraud.
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Finally, Mr. Chris Peterson is an assistant professor of law at
the University of Florida, Levin College of Law, where he teaches
commercial and consumer law courses. Professor Peterson served
as the judicial clerk for the United States Court of Appeals for the
Tenth Circuit. He has also served as a consumer attorney responsible for consumer finance issues on behalf of the United States
Public Interest Research Group. His book on the economics, history, and law governing high-cost consumer debt received the
American College of Consumer Financial Services Attorneys Outstanding Book of the Year prize for 2004.
We look forward to all of your testimony, ladies and gentlemen.
Let me just say that all your statements will be in the record. Try
to hold to 5 minutes. You can assume everything that you have
written will be read by all of usat least by all the staffand that
we will eagerly await your improvised comments and your insights
into this very difficult problem. I must commend my colleagues for
very thoughtful opening statements.
Mr. Sinha.
STATEMENT OF GYAN SINHA, SENIOR MANAGING DIRECTOR

AND HEAD OF ABS AND CDO RESEARCH, BEAR STEARNS &
COMPANY, INC.
Mr. SINHA. Good afternoon, Chairman Reed, Ranking Member

Allard, and members of the Senate Subcommittee on Securities, Insurance, and Investment. My name is Gyan Sinha. I am a Senior
Managing Director at Bear Stearns and head the division responsible for market research regarding asset-backed securities and
collateralized debt obligations. In that capacity, I analyze mortgage
loans and securities in the private-label market. The nonprime sector constitutes a portion of the private-label market.
I have been invited today to present testimony regarding four
matters related to the mortgage securitization process and recent
developments in the marketplace. I will address each of these
issues in turn, beginning with an overview of the mechanics of
nonprime mortgage securitization.
Nonprime borrowers maintain loans through mortgage brokers or
retail lending establishments. Once a suitably large number of
loans have been originated, the loans are often packaged as a portfolio and moved into securitization vehicles owned by a third party.
The securitization vehicle then issues mortgage-backed securities,
often referred to as MBS. The MBS generate revenues which finance the purchase of loans by the securitization vehicle.
The decision to buy loans from originating lenders for purposes
of securitization is based on a determination of whether the lossadjusted yield that can be generated from the purchase of the
asset, after paying for financing expenses in the MBS market, is
commensurate with the risk of the loans. If the securitization sponsor elects to move forward with a purchase after making this determination, it will also conduct due diligence before acquiring the assets. The cashflows from the loans are then divided among debt
classes. These debt classes are divided into senior, mezzanine, and
subordinate, with ratings ranging from AAA to BB. Typically, any
losses in the maligned loans are allocated to the lowest-rated bonds
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initially and then moved up the rating scale as the face amount of
each class is eroded due to higher and higher losses.
The amount of MBS that can be issued is determined based on
criteria established by the rating agencies. Typically, the amount
of MBS that are issued is less than the par amount of the mortgage
loans. This difference is referred to as overcollateralization. The
claim of equity holders in the securitization is comprised of two
components: the overcollateralization amount and the difference between the coupon net of servicing expenses and the weighted average cost of debt. The equity holders cash-flow entitlement is net of
any current period losses.
MBS are purchased by a wide variety of investors. For senior
debt borrowers, MBS have provided a preferred alternative to other
credit-risky instruments, such as corporate bonds. As a result, institutions with low funding costs, such as banks, view them with
favor and have purchased many of them. In recent years, the
lower-rated tranches have been bought primarily by collateralized
debt obligations. CDOs in turn issue debt to finance the purchase
of these bonds. There has been significant foreign investment in
CDOs that further spreads market risk.
Finally, at the lower end of the capital structure, hedge funds to
purchase the speculative grade and unrated equity portion of the
MBS. In making purchase determinations, hedge funds tend to employ the same risk-adjusted calculus as used by the original buyer
of the loans.
You have also asked about the effect of increases in defaults and
delinquencies. Without doubt, the rise in defaults and delinquencies has had a significant impact recently in the nonprime
securitization market. At this juncture we are witnessing a significant correction in the MBS market of nonprime loans. A number
of originators have exited the industry. The risk profile of the loans
being considered in the nonprime market today has generally improved as loan originators have moved to change loan-to-value limits, requiring multiple appraisals on collateral and enhanced
verification of borrower income. Valuations appear to have stabilized at this juncture, albeit at lower levels, since the beginning
of the year.
For those that remain in the market, significant challenges will
persist. Managing the credit risk of a nonprime portfolio in an environment of stagnant or even declining real estate prices will require a different strategy than that used in the last 5 years. From
an economic value perspective, it is in the interest of all parties in
a securitization vehicle that the value of the maligned loans in the
securitization is maximized. Accordingly, services will have strong
incentives to offer loss mitigation options to borrowers that have a
reasonable chance of succeeding. This is particularly true given
that the alternative will be to foreclose upon and ultimately attempt to sell the property in an unfavorable housing market.
The Subcommittee has asked me to discuss impediments in the
securitization process that would make it more difficult to mitigate
potential foreclosures. Loan modifications present one of the most
viable vehicles for mitigating foreclosures under appropriate circumstances. However, it is important to note that there is considerable variation based on tax law and contractual requirements
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across transactions with respect to the scope of permissible modifications.
Despite these various limitations, services are indicating various
loss mitigation steps within the flexibility that they have under existing securitization agreements.
I think my time is up.
Chairman REED. If you have a minute more, you may finish.
Mr. SINHA. OK. Thank you.
The Subcommittee has also asked, finally, about credit risk assessment. I think there are two members on the panel that are better equipped from the rating agencies to deal with that. I will skip
that in the interest of time.
In closing, I would like to emphasize that while the issues surrounding the recent events in the nonprime market warrant serious attention, the securitization process that has occurred for over
25 years has resulted in considerable benefits to borrowers in the
broader economy. This market has allowed American homebuyers
to tap into a rising global pool of savings through increased credit
availability, raising overall homeownership rates in the United
States. At the same time, securitization has also allowed this increase in mortgage lending to be achieved without an excessive
concentration of risk. This has permitted any shocks to the system,
such as the current one, to be absorbed without major disruption
to the broader economy. Thus, it is important in evaluating any potential responses to the current concerns to ensure that the availability of mortgage credit is not unduly restricted and the historic
benefits provided by the securitization process are not eroded.
I would be happy to answer any questions that you may have.
Thank you.
Chairman REED. Thank you very much, Mr. Sinha.
Mr. Sherr, and if you could bring that microphone up close so everyone can hear.
STATEMENT OF DAVID SHERR, MANAGING DIRECTOR AND

GLOBAL HEAD OF SECURITIZED PRODUCTS, LEHMAN
BROTHERS, INC.
Mr. SHERR. Chairman Reed, Ranking Member Allard, and Members of the Subcommittee. I am David Sherr, Managing Director
and Global Head of Securitized Products at Lehman Brothers. I appreciate the opportunity to appear before the Subcommittee today
on behalf of Lehman Brothers. Lehman, an innovator in global finance, serves the financial needs of corporations, governments, and
municipalities, institutional clients, and high-net-worth individuals
worldwide. Lehman is pleased to share with the Subcommittee its
experience in the subprime mortgage securitization process.
The subprime mortgage securitization market is a subset of the
broader mortgage securitization market. Mortgage securitization
was developed approximately 30 years ago. Since then, the mortgage-backed securities market has grown to become the largest
fixed-income segment of the Nations capital markets, with approximately $6.5 trillion of securitized mortgage debt outstanding as of
the end of 2006.
While the Subcommittee is focused on very recent instances of
foreclosure, please remember that for three decades mortgage-
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backed securities have provided and continue to provide great benefits to the average American. Because of mortgage securitization,
loans for home purchases have become more widely available for all
borrowers, including those considered subprime. If not for the innovation of the mortgage securitization, the United States would not
have become the Nation of homeowners that it is today, with homeownership close to its highest level in our history, almost 70 percent.
Before securitization became widespread, banks had relatively
limited capital available to make loans to prospective homeowners.
Their lending activities were constrained because they had no effective means to convert their existing loan portfolios to cash that
could be used to make additional loans. There was no liquid market for mortgage loans.
With the advent of securitization, banks and other financial institutions have been able to monetize their existing loan portfolios
and to transfer the risks associated with those loans to sophisticated investors. As a result, more money is available to borrowers
who wish to buy their own homes or to refinance their existing
mortgage loans on more attractive terms.
Securitization represents a new way to fund Americas demand
for home mortgages by accessing the significant liquidity of the
capital markets. Borrowers continue to take out loans with local
banks and State-regulated mortgage companies, just as they always have. Those lenders determine if they want to retain mortgage loans or transfer them into the secondary market, either in
whole loan form or through securitization. If a lender elects
securitization, the loans are assembled into pools by sponsors, such
as Lehman.
The lenders continue to stand behind their decision to make a
loan by making representations about the loan quality. After the
rating agencies have completed their review of the pool, the loans
are conveyed into a securitization trust and interests in the loans
are sold to investors in the form of securities. From then on, payments made by borrowers on their mortgage loans flow through to
make payments on these securities.
It should be noted that sponsors of mortgage-backed
securitizations such as Lehman are careful about choosing the
lenders with whom they do business. All the lenders selling loans
to Lehman are either federally chartered banks or State-regulated
originators. Prior to establishing a business relationship with a
particular lender, Lehman spends time learning about that lender,
its past conduct and its lending practices and standards. Further,
Lehman, like other securitization sponsors, performs a quality
check on the mortgage loans before purchase them. These reviews
include sample testing to confirm that loans were underwritten in
accordance with designated guidelines and complied with applicable law.
The Subcommittee has asked about the incentives of the participants in the subprime mortgage securitization process. Consumers
benefit because they are able to obtain loans with a greater variety
of payment structures. This is especially true for borrowers considered to be subprime, many of whom who did not have access to
mortgage loans and so could not purchase their own homes prior
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to the creation of the securitization market. Lenders benefit because they are able to free up capital to make additional loans, and
investors benefit because mortgage-backed securities present a diverse range of investment options, with investors able to choose the
type of product and the risk-reward profile appropriate for their
needs.
It cannot be emphasized enough that no participant in the
securitization process has any incentive to encourage the origination of loans that are expected to become delinquent. No financial
institutions would knowingly want to make or securitize a loan
that it expected would go into default; rather, the success of mortgage-backed securities as an investment vehicle depends upon the
expectation that homeowners generally will make their monthly
payments since those payments form the basis for the cashflow to
bondholders.
As it relates to the impact of recent increasing defaults on the
market, the market currently is adapting to changes in the performance of subprime loans, just as it adapts to other changes that
significantly affect participants in the mortgage securitization process. Importantly, the interest of all market participants, from the
borrower to the investor, are generally aligned with regard to reducing the number of defaults and delinquency. Everybody loses
when the only viable option for managing loans is foreclosure.
Given the general alignment of interest, it is not surprising that
the market is adjusting rapidly to minimize foreclosures and improve the performance of securitized loans.
For example, mortgage loans to subprime borrowers are now
being underwritten according to stricter guidelines to reflect current market conditions. At the same time, the volume of
securitizations has been reduced, as has the range of mortgage
products being offered to consumers. Further, financial intermediaries are pushing forward new practices, including contacting
borrowers early when their loans appear to be at risk for default.
All these adjustments in the market are being driven by the fact
that nobody benefits from the underwriting of loans that do not ultimately perform. We must be careful, however, not to overreact to
the increased number of delinquencies and defaults which could
lead to an undue tightening of credit availability to prospective
homeowners.
At the same time that we consider how the market has changed,
we should also keep in mind how it has stayed the same. The vast
majority of subprime borrowers remain current in their loan obligations, and the mortgage securitization process continues to provide
unprecedented access to the capital markets so that others can purchase their own homes.
So how do we mitigate potential foreclosures? Mortgage
securitization structures do provide flexibility to avoid foreclosure.
Much of that flexibility rests in the hands of the financial institutions that service mortgage pools. Servicers collect principal and interest payments from borrowers and also make decisions on the administration of the pooled home loans. They have flexibility to work
with borrowers so that loan payments will be made while exercising the right to foreclosure only as a last resort.
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Notably, many of the largest servicers are commercial banks,
which also hold substantial mortgage loans in their own portfolios.
Regardless of whether these banks are managing their own portfolios or servicing loans in a securitized pool, we expect they generally will follow the same prudent home retention practices in an
effort to avoid foreclosure.
The title of this hearing speaks to the role of securitization in the
subprime mortgage market turmoil. Because none of the participants in the securitization process benefits from foreclosure, the
market has evolved and will continue to evolve so as to minimize
the number of foreclosures. Servicers are ramping up their home
retention teams, both with respect to early intervention for at-risk
borrowers and loan modification programs for borrowers that are in
financial distress. To the extent that the servicer currently lacks
any necessary powers to reduce the number of foreclosures in a
prudent mannerand Lehman does not believe that such powers
are materially lackingthe market will adjust by enhancing the
servicers flexibility in future contracts. In short, we expect that the
subprime mortgage securitization process will continue to create
opportunities for a long-ignored segment of the population to join
and remain in the ranks of American homeowners.
Thank you again for the opportunity to be here today, and I also
welcome any questions you might have.
Ms. Barnes, and if you could bring the microphone close to you.
STATEMENT OF SUSAN BARNES, MANAGING DIRECTOR,

STANDARD & POORS RATINGS SERVICES
Ms. BARNES. Thank you, Mr. Chairman, Members of the Subcommittee. Good afternoon. I am Susan Barnes, Managing Director
of the U.S. Residential Mortgage-Backed Securities Group for
Standard & Poors. S&P recognizes the hardship the current
subprime situation is placing on certain homeowners. However, as
requested by this Subcommittee, my testimony is focused on the effects the subprime market has had on the financial sector.
Today I will discuss our ratings analysis for these transactions,
including the factors we consider when evaluating mortgage securities backed by subprime mortgage loans and the impact the current
mortgage loan delinquencies and defaults on the performance of
RMBS transactions based by subprime mortgage loans. As described more fully in my written testimony, S&Ps rating process
for these transactions includes a loan-level collateral analysis, a review of the cash-flow within the transaction, a review of the originator and servicer operational procedures, and a review of the
transactional documents for legal and structural provisions.
First, S&P performs a loan-level collateral analysis on these
transactions. Specifically, we evaluate the loan characteristics,
quantify multiple risk factors, and assess the default probability
associated with each factor. This helps us determine how much
credit enhancement is, the amount of additional assets or funds
needed to support the rated bonds and cover losses.
In 2006, using this analysis we identified the deteriorating credit
quality of the mortgage loans and consequently increased the credit
enhancement requirements necessary to maintain a given rating on
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a mortgage-backed security. Next, we assessed the cash flow availability generated by mortgage loans through a proprietary model
which assumed certain stresses related to the timing of payments
and prepayments on the mortgage loans and uses the S&P mortgage default and loss assumptions to simulate the cash-flow of an
RMBS transactions underlying loans under these stresses.
We then evaluate the availability and impact of various credit
enhancement mechanisms on the transaction. We also perform a
review of the practices and policies of the originators and servicers
to gain comfort with the ongoing performance of the transaction.
Included within this review is an evaluation of the monthly
servicer report.
Additionally, we review legal documents and opinions of thirdparty counsel to assess whether the transaction will pay interest as
promised and whether the bondholders will receive the promised
principal payments before the stated maturity of the bonds.
Now to the current market. The poor performance of subprime
mortgages originated in 2006 dampened investor appetite for such
mortgages, causing the interest rate sought by investors to increase
as compared to mortgage-backed bonds issued in prior years.
Therefore, the securitization of subprime loans has become less economical, resulting in fewer subprime mortgage loan originations in
2007.
While delinquencies for the 2006 vintage are much higher than
what the market has experienced in recent years, they are not
atypical with past long-term performance of the RMBS market,
such as the delinquencies reported for the 2000 vintage after similar seasoning.
Regardless, subprime loans and transactions rated in 2006 have
been performing worse than previous recent vintages. This performance may be attributed to a variety of factors, such as lenders
underwriting guidelines that stretch too far, this falling of home
price appreciation rates, and ARM loans that in rising interest rate
environments create a heightened risk of delinquencies.
Due to minor home price declines in 2007, we expect losses and
negative rating actions to keep increasing in the near term relative
to previous years. However, as long as interest rates and unemployment remain at historical lows and income growth continues to
be positive, we believe there is sufficient protection for the majority
of investment grade bonds. As of April 12, 2007, only 0.3 percent
of the outstanding subprime ratings issued in 2006 have been
downgraded or placed on Creditwatch.
S&P views loss mitigation efforts, such as forbearance and loan
restructuring, as an important part of servicing securitized mortgage loans. Generally, servicers have the ability to mitigate losses
by a variety of techniques so long as they act in the best interest
of investors and in accordance with the standard servicing industry
practices. So long as these standards are met, S&P believes that
the current ratings on the RMBS securities will not be negatively
affected.
We do need to be sensitive, however, to the balance between the
negative effect of the potential reductions in prepayments received
from borrowers and available to pay investors, with the positive
impact of fewer borrower defaults.
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Let me conclude by stating S&P does not anticipate pervasive
negative rating actions on financial institutions due to rising credit
stresses in the subprime mortgage sector since the majority of
rated financial institutions have diversified assets and mortgage
lending and servicing operations aligned with strong interest rate
and credit risk management oversight. Specialty finance companies
that focus solely on the subprime market, however, do not enjoy
the same protection and have felt the effects of the current
subprime credit stresses.
We thank you again for the opportunity to participate in these
hearings and are happy to answer any questions you may have.
Chairman REED. Thank you, Ms. Barnes.
Mr. Kornfeld.
STATEMENT OF WARREN KORNFELD, MANAGING DIRECTOR,

RESIDENTIAL MORTGAGE-BACKED SECURITIES RATING
GROUP, MOODYS INVESTORS SERVICE
Mr. KORNFELD. Thank you. Good afternoon, Chairman Reed and

Members of the Subcommittee. I appreciate the opportunity to be
here on behalf of my colleagues at Moodys Investors Service.
By way of background, Moodys publishes rating opinions that
speak only to one aspect of the subprime securitization market,
which is the credit risk associated with the bonds that are issued
by the securitization structures.
The use of securitization has grown rapidly both in the U.S. and
abroad since its inception approximately 30 years ago. Today it is
an important source of funding for financial institutions and corporations. Securitization is essentially the packaging of a collection
of assets, which can include loans, into a security that can be sold
to bond investors. Securitization transactions vary in complexity
depending on specific structural and legal considerations, as well as
in the type of asset that is being securitized.
Through securitization, mortgages of many different kinds can be
packaged into bonds, commonly referred to as mortgage-backed securities, which are then sold into the market like any other bond.
The total mortgage loan origination volume in 2006 was approximately $2.5 trillion, and of this, approximately $1.9 trillion was
securitized. Furthermore, we estimate that roughly 25 percent of
the total mortgage securitizations were backed by subprime mortgages. Securitizations use various features to protect bondholders
from losses. These include overcollateralization, subordination, and
excess spread. The more loss protection or credit enhancement a
bond has, the higher the likelihood that the investors holding that
bond will receive the interest and principal promised to them.
When Moodys is asked to rate a subprime mortgage-backed
securitization, we first estimate the amount of cumulative losses
that the underlying pool of subprime mortgage loans will experience over the lifetime of the loans. Moodys considers both quantitative as well as qualitative factors to arrive at the cumulative
loss estimate. We then analyze the structure of the transaction and
the level of loss protection allocated to each tranche of bonds.
Finally, based on all of this information, a Moodys rating Committee determines the rating of each tranche. Moodys regularly
monitors its rating on securitization tranches through a number of
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steps. We receive updated loan performance statistics, generally
monthly. A Moodys surveillance analyst will further investigate
the status of any outlier transactions and consider whether a rating committee should be convened to consider a rating change.
The majority of the subprime mortgages contained in the bonds
that Moodys has rated and that originated between 2002 and 2005
have been performing better than historical experience might have
suggested. In contrast, the mortgages that originated in 2006 are
not performing as well. It should be noted, however, that the 2006
loans are, on average, performing similarly to loans originated and
securitized in 2002 and 2001.
Pools of securitized mortgages from 2006 have experienced rising
delinquencies and loans in foreclosure, but due to the typically long
time to foreclose and liquidate the underlying property, actual
losses are only beginning to be realized. Among several factors, we
believe that the magnitude and extent of negative home price
trends will have the biggest impact on future losses in subprime
pools. Economic factors, such as interest rates and unemployment,
will also play a significant role.
From 2003 to 2006, as has already been noted, Moodys cumulative loss expectations of subprime securitization steadily increased by approximately 30 percent in response to the increasing
risk characteristics of the mortgage loans being securitized, as well
as changes in our market outlook. As Moodys loss expectations
have steadily increased over the past few years, the amount of loss
protection in bonds we have rated has also increased. We believe
that performance of these mortgages will need to deteriorate significantly for the vast majority of the bonds we have rated singleA or higher to be at risk of loss.
Finally, I want to give Moodys view on loan modifications by
servicers in the event of a borrowers delinquency. Loan modifications are typically aimed at providing borrowers an opportunity to
make good on the loan obligations. Some RMBS transactions, however, do have limits on the percentage of loans in any one
securitization pool that the servicer may modify. Moodys believes
that restrictions in securitizations which limit a servicers flexibility to modify distressed loans are generally not beneficial to the
holder of the bonds. We believe loan modifications can typically
have positive credit implications for securities backed by subprime
mortgage loans.
With that, I thank you, and I would be pleased to answer any
questions.
Chairman REED. Thank you very much, Mr. Kornfeld.
Professor Eggert.
STATEMENT OF KURT EGGERT, PROFESSOR OF LAW,

CHAPMAN UNIVERSITY SCHOOL OF LAW
Mr. EGGERT. Thank you, Chairman Reed and Ranking Member

Allard and other Members of the Committee. I would like to talk
about how securitization has changed the mortgage industry as we
know it, and some of those changes have not been beneficial to borrowers.
Securitization has put subprime lending largely in the hands of
thinly capitalized and lightly regulated lenders and mortgage bro-
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kers. Many of the companies doing subprime loans are non-banks
regulated by State agencies, and without the underwriting standards imposed by regulators of, say, depository institutions.
Securitization is designed to divert value away from the originator. That is the whole point of securitization: it allows banks to
originate loan, quickly sell it to the secondary market and to investors, and that way the lender does not have to hold the mortgage.
And to a large extent, it reduces its own risk if the loan goes bad.
It also allows lenders to easily go belly up. We have seen even
large subprime lenders go belly up recently, and because they are
not holding all the loans that they have made for the last 5, 10,
15 years, it is much easier for them to go out of business.
If you look at the history of the subprime market, you see sort
of waves of lenders going out of business and then coming back into
business and going out of business. So many borrowers who took
out loans find that their lender, when they go to discuss fraud, is
no longer there for them to argue with.
The secondary market is protected in large part from risk of default and from risk of fraud. It is protected in part because of the
risk abatement aspects that the secondary market imposes in
securitization so they ask for credit enhancements of various types
to protect them against default. And it is also protected by something called the holder in due course doctrine, which provides that
if a loan is purchased by a bona fide purchaser, many of the defenses that the originator has to thethat the borrower has to the
originator are cut off, and so the borrower may be able to sue the
lender but cannot sue the secondary market or the current holder
for some aspects of fraud. And if the lender has gone belly up, that
leaves the borrower kind of with its defenses cut off completely.
Another thing that securitization has done is made the regulation of the subprime market a de facto regulation, really is by the
securitizers. The rating agencies and the investment houses that
assemble the pools by and large determine the underwriting criteria, by and large determine what kinds of products are being offered, and so they are the true regulators of the subprime industry,
much more so than the State regulators that may supervise the
non-bank entities. However, rating agencies and the securitizers
are not monitored in the same way that a formal agency might be
monitored. There is no congressional oversight of them, and so
there are concerns aboutI have greater concerns about turning
over regulation to essentially private parties.
Securitization also puts impediments in loan modifications. We
have heard of some of those impediments already. Servicers may
have limited flexibilitythey may have flexibility, but it may be
limited by the terms of the servicing agreements. These terms may
be vaguely written so that the service area is not even sure how
far it can go in making modifications. The pooling agreements may
limit the number of loans that may be modified, and so loan pools
that turn out to have a much higher risk of default may leave some
borrowers unable to get their loans modified because so many other
borrowers had the same problems.
Servicers might be overwhelmed by an increasing number of defaults, and I would be interested to see how many servicers are
going to add new staff that they will need to do loan modification.
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Loan modification is much more time-intensive than merely collecting payments. Are servicers going to hire the new people that
they need to do this kind of in-depth counseling?
Another problem is that if you take a unitary interest in a loan
and split it up among all the different tranches in a securitization,
it makes it harder for the servicer to modify the loan. Servicers act
in the best interests of investors, but investors may benefit differently by different loan modifications. Different tranches of the
securitization may be helped or may be hurt by loan modifications.
And so you might have a servicer engaging in what I call tranche
warfare as they decide which tranche will benefit and which will
be harmed. That kind of discretion may be difficult for servicers to
use, concerned as they are about protecting all investors.
Securitization also loosens underwriting. It has transformed underwriting from a very specific thing designed to protect a depository institution to a very automated process that can be objectively
monitored, but also that can be altered depending on the market
needs. If the market needs looser underwriting, we have looser underwriting. If a market needs tighter underwriting, we have tighter
underwriting. But that kind of inconsistent underwriting can be
very harmful to borrowers.
And so I think we need to see the secondary market become more
accountable and more responsible for what it has done to loans,
and there are two ways to do that, and then I will be done. I am
almost done.
First is assignee liability. Have the current holders of market be
liable where there has been fraud against the borrowers. And the
other thing is I think we need to have regulatory oversight over the
securitizers and the rating agencies who are actually regulating the
subprime industry.
Thank you.
Chairman REED. Thank you very much, Mr. Eggert.
Mr. Peterson.
STATEMENT OF CHRISTOPHER L. PETERSON, ASSOCIATE

PROFESSOR OF LAW, UNIVERSITY OF FLORIDA
Mr. PETERSON. Mr. Chairman and Ranking Member Allard,

thanks to the Committee for holding these hearings. It is a tremendous honor and a privilege to be here to speak with you today and
share a few thoughts. And I would also like to, before I begin, express some empathy for the folks at Virginia Tech. It is a terrible
tragedy.
I would like to make three points in my 5 minutes: first, I would
like to talk about maybe a very short historical overview of how I
see the forces in the marketplace, in the mortgage marketplace
working; second, the current state of what I think the law is; and,
third, what I think the law has to become at some point if we want
to prevent the kinds of problems that we have seen in the past
year.
An overview of the market. I think that in my view you can picture the American mortgage market in three periods. First was an
era of two-party mortgage finance, and this was from the founding
of the Republic probably up until the Great Depression was the
predominant mode, where there was a lender and a borrower, two
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people, they worked things out. The mortgagee gives a mortgage in
exchange for borrowing money. And in that market the incentive
isthe dominant incentive is the lender polices the underwriting
because they want to get paid back. They receive their money out
of the monthly payments on the loan.
After the Great Depression, when that system broke down, we
had to find some way to restart the economy, and so Congress,
under the leadership of the administration, passed a variety of
statutes that created programs that created what I think of as a
three-party model of mortgage finance, which had a lender, an
originator, a borrower, and also the Government acted in virtually
all of the middle-class mortgage loans in some direct underwriting
capability, in some way guaranteeing it or insuring it, some direct,
active involvement of the Federal Government or an agency affiliated with the Federal Government.
Although the lender did not get paid out of the proceeds of
monthly payments, instead they gotthere was still some force
there that was policing the marketplace, and that was the sort of
public institutional, public policy forces of the Government. So that
substituted for the profit motive to some degree of the lenders.
Since 1977, when the first private-label mortgage securitization
took place, I think there has been a third era of mortgage finance,
and I think of that as the private-label securitization markets. And
in that era, whichthe first was in 1997or, excuse me, 1977, but
it really did not take off, you know, get large until the 1990s after,
you know, the tax hurdles and some accounting hurdles were sort
of cleared out of the way. And the problem, as I see it, is that the
two core mechanisms of policing loan origination have broken down
to some degree. The people that make the loans do not get paid out
of the proceeds of the monthly payments on those loans. Instead,
they get paid out of the fees and from selling the loan to somebody
else. So there is less short-term, immediate incentive to make sure
that the loan gets paid back on time.
And the second thing that has broken down is that those folks
there is no Government involvement, there is no stable bureaucratic hand which is notyou know, a non-risk-seeking hand that
is trying to act in the benefit of the public that is overseeing this
process anymore. Those are the two forces, and to a large extent,
they have beenthey are gone.
So what is left to try and make sure that things do not fall apart
and get out of hand? Well, there is only one thing that is really left,
and that is the rule of law. That is what I want to talk about next.
So what is the current state of the law? And I do not want to
be disrespectful or anything, but my sense is that, after having
studied it for most of my adult life, it is really in shambles, particularly the Federal law is. It does not do much. You read through it
all, and at the end of the day you find out, well, the Federal law
does not really apply. And what has happened, I think, is that the
market has evolved past the law. All of the statutes that we have
passed, which were good statutes, good compromises from both
sides of the aislethe Truth in Lending Act, the Fair Debt Collection Practices Act, less by the Homeownership and Equity Protection Act. The vast majority of them were all basically conceived in
an era that predated securitization by 10, 20 years. So their basic
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scope and definitions and structure has notdoes not even conceive of the type of lending that we are seeing now.
Just to give an example, what is the most important definition
in the entire Consumer Credit Protection Act? Well, that would be
the definition of a creditor. What is a creditor? It is the person to
whom a loan is initially payable. But the person to whom a loan
is initially payable neither holds the loan nor does that person in
todays market actually ever talk to the person that is actually
going to take out the money.
The Truth in Lending Act, the statute was supposed to promote
fair and efficient comparison and shopping, does not even apply to
the mortgage brokers that actually talk to the borrower. That is a
pretty serious breakdown in the law. And there are half a dozen
other examples. You know, the Fair Debt Collection Practices Act
does not even apply to debt collectorsor it only applies to debt
collectors, which in most cases will not apply in the servicing marketthe servicing for mortgage loans.
I see I am already out of time.
So the last bit is what should we do to try and fix that. In my
view, I think that, you know, we could talk about all these trends
that we can sort of do to try and fix things a little bit here and
there, but I think honestly we need to have comprehensive reform
of the Nations consumer credit law. We need to go back to the
drawing board and re-updateupdate everything, and that is going
to include comprehensive reform of the Truth in Lending Act and
RESPA, trying to integrate those into a more coherent disclosure
process. The Fair Debt Collection Practices Act needs to be revisited. I think that we need to figure out what we want to do finally
about usury law and the Marquette Doctrine, which I think is a big
problem, in my opinion.
Finally, we need to reconsider how it is that various participants
and middlemen in this market are going to be held liable for, I
think, in some instances aiding and abetting the process of making
predatory loans.
If you want my opinionyou called me up herewe need to fix
the whole legal system, or this is just going to happen again. So
that is what I think.
Chairman REED. Thank you very much, Mr. Peterson.
What I propose to do is have 6-minute rounds, at least two
rounds, I think, so if you do not get a chance to ask a question in
the first round, my colleagues, stick around because we will go
again.
Let me open up a line of questioning for Mr. Sinha and Mr.
Sherr. William Dallas, who is the CEO of Ownit, which was one
of the mortgage companies that went out of business through bankruptcy, said, The market is paying me to do a no-incomeverification loan more than it is paying me to do the full-documentation loan. He said, What would you do? rhetorically. And,
in fact, we have looked at some of the publicly filed documents and
some of these subprime originators, and there is language very
similar to the following in all of them: We seek to increase our
premiums on whole loan sales by closely monitoring requirements
of institutional purchases and focusing on originating and pur-
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chasing the types of loans for which institutional purchases tend to
pay higher premiums.
It raises the question, you know: Who is designing these products? Where are the incentives coming for some of these exotics?
Is it coming from the Ownits, the creative originators? Or is it coming from Wall Street and the securitization process by saying this
is what we want to buy and we are paying more for it?
Your thoughts, Mr. Sinha.
Mr. SINHA. Generally speaking, I think in the securitization markets, the securitization markets will effectively make a decision
about whether to buy something or not to buy something and at
what spread or price to buy it. So secondary market investors generally will not dictate what types of loans are effectively being
made. The process effectively starts with the loans being presented
to the rating agencies. The rating agencies will then take their own
opinion about the risk of the pool which these loans effectively constitute and then will assign the enhancement levels appropriately
at levels that they think are commensurate with the models that
they run. And then that transaction is brought to the market, and
the market then decides I will buy this at this spread.
So, generally speaking, I think, you know, the pools are presented to the market.
Chairman REED. So you see the role as very passive, the
securitizationthese originators come with apples and oranges and
pears, and you look around and, you know, you pick
Mr. SINHA. I think in general, as I look at these marketsand
people do refer to these markets as effectively markets where you
have risk-based pricing. Risk-based pricing is being done at the
loan level itself. The loan is viewed as a mix of risks that have to
be priced, and that is how the markets are pricing it, and that is
how they are bringing it to the rating agencies. And then the markets areultimately, the capital markets are providing the final
pricing level of which that risk would clear.
Chairman REED. Mr. Sherr, your thoughts.
Mr. SHERR. I think to a large degree these mortgage originators
are relatively sophisticated, and they are clearly monitoring the
capital markets to get a sense of what the value of the product they
are originating is. And so there are loansthey are a running business. There are clearly loans that are probably more profitable for
them to make, and there are clearly loans that cost them money
to make. And I think part of their diligence is making sure they
are originating loans that, one, they think they can transfer, and
making sure they are not originating loans that ultimately, if their
system breaks down, if they are losing money on every loan they
originate.
Chairman REED. The question here all throughout, because it is
a very complicated process, is who is ultimately watching over to
make sure that that loan that is made to the borrower is within
the competence of that borrower to pay for. And the impression I
got from, you know, the quote from this individual was that he was
not looking much at the borrowers capacity, he was looking at the
highest premium he could get, the types of loans. Also, I think
whatI do not want to put words in your mouth, but you are also
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saying, you know, we are not looking either, I mean, because he
is bring us this paper. Is that
Mr. SHERR. No, that is not what I am saying. Ultimately, at the
end of the day, if he is going to run a business and continue to
think he has access to the capital markets, his loans have to perform as expected. And the market turns, as you are seeingyou
talk about loan repurchase. The market turn very quickly when
loans start to underperform and cuts off his capital and his ability
to run his business.
So I think there are lot of market-policing mechanisms across the
board that prevent those abuses and make sure loans are originated to guidelines.
I want to turn now to Ms. Barnes and Mr. Kornfeld about the
rating agencies, and you gave very detailed testimony about the
process. You indicated clearly you have been downgrading some of
the paper that you previously had rated.
There was a comment made by Jeanette Tavakoli of Tavakoli
Structured Finance pointing out that AA-rated tranches of CDOs
backed by subprime mortgage paper now yield far more than AArated debt backed by other assets, which is suggesting that maybe
these ratings are not asthey are not being believed by the marketplace.
Is there a problem with the model right now? You do not have
enough historic data or these new products came on so quickly? Or
are you looking carefully and reviewing your models to make sure
they are accurate? Ms. Barnes.
Ms. BARNES. As with any mortgage product or any product within structured finance, as new products come to the marketyou
know, mortgages are not new. The characteristics are new. And
what is new in the paradigm here is this combination of characteristics. It is this low-doc, high LTV, the piggy-back loans to a
subprime borrower. That is really what is the new paradigm that
we are seeing here. So while all those characteristics are not new
to us, it was that combination.
So what we typically do, in developing our default probabilities
and ultimate losses, is look back on historical performance and
then gauge what would happen in the future. As we cited, what we
saw was the performance was actually deteriorating earlier than
we had expected. And that is why back in 2006, when we saw this
high-risk characteristics coming in with higher early payment defaultsthat is really what is different here. It is not the delinquencies themselves. It is the amount of loans that are defaulting
within the first few months of the loans.
We actually increased our enhancement levels and default probabilities to protect the bond holders because of that likelihood.
But to answer your question specifically about the CDO buyers,
the CDO buyers are going to base their determination on the
spreads and what is available in the marketplace. So I would not
say it is a fundamental disbelief but it is that concern in the marketplace with the higher yields that people are asking for. It is no
longer economical for people to keep putting their money into mortgages and they are just shifting it to the next product.
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Chairman REED. Mr. Kornfeld quickly, because my time has expired.
Mr. KORNFELD. Our focus once again is credit, which is only one
part of what goes into spreads. There are a lot of different things
as far as in spreads.
We do take, however, we have a lot of discussions, a lot of participants out in the marketplace. And we look at spreads as far as
what investors are saying in regards to whether it is a tactical,
whether it is a fundamental credit evaluation that those spreads
are indicating.
Senator Allard.
Senator ALLARD. Thank you, Mr. Chairman.
I think we understand that when you have a primary lender
dealing with somebody who wants to borrow money, and then he
goes ahead and securitizes it out, there is a spreading of the risk.
So ultimately, where does the accountability rise? I think that is
does somebody maybe want to respond to that? Mr. Kornfeld,
maybe?
Mr. KORNFELD. From our standpoint, once again, I am not sure
if that is really a question for a rating agency for a policy, almost
in a way somebody would have a policy standpoint.
Our role is a specific role. We have been rating credit, assessing
credit worthiness in regards to a likelihood of a bond, as to whether
a bond is going to pay or not. We do not look at ourselves in regard
to that from that sort of type of role.
What we have to do, though, is our reputation is obviously very,
very important. We continually publish how we are going and performing in regards to the ratings. We want a single-A rating to perform like a single-A rating. We do not want it to perform like a
AAA. We do not want it to perform like something lower.
Senator ALLARD. Now, will certain investors say that we want a
certain particular type of loan coming to us? And does this drive
subprime mortgage instruments that perhaps are of questionable
value as far as the borrower is concerned?
Mr. KORNFELD. There is a discipline. The investors generally
would not specify specifically of a typical loan type. But there is a
balance in the marketplace that sometimes as far as the marketplace will view as we are too conservative. Frequently, actually, we
are viewed in the mortgage market as the most conservative rating
agency. Many market participants view us, in general, as being
conservative. But that is not our goal. Our goal is, once again, from
a credit standpoint, to be relatively accurate.
So sometimes, yes, investors are going to believe that we are
right on a risk and other times they are going to believe that we
are either over and under. And they will price it accordingly in regards to spreads as part of their overall investment decision.
Senator ALLARD. I wonder who would buy a BB rating security
rating today. Does anybody want to answer that question? Mr. Peterson?
Mr. PETERSON. If I were a servicer and if I bought that, it would
help me get the servicing rights. And then I have a lot of opportunities to tap fees out of the borrowers and make my money out of
those fees instead of the BBB bond. And I would want to do it.
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Senator ALLARD. But the people that are buying the security,
who would buy that kind of security?
Mr. PETERSON. The servicer.
Senator ALLARD. The servicer would?
Mr. PETERSON. Right.
Senator ALLARD. Well then, is thatdo you think, is that a limited market today? How would that compare to a AA rating, as a
BB rating?
Mr. PETERSON. I am sure that the folks on that side of the table
would be better able to answer that than me.
Senator ALLARD. I can understand the fees driving that. Who
would buy a BB, I guess, when you look at it as an investment vehicle? I mean, they are on the market. Somebody is buying them?
Mr. SHERR. There are a fair amount of sophisticated investors
who participate in this space, and it all gets down to price. Am I
being compensated for the risk that I am taking in buying that security?
Certain securities rating BB trade at different prices. The market for a certain vintage of mortgage loans is repriced to reflect the
additional risk that the investor is taking. And investors to the
marketthe market and investors find that appropriate
Senator ALLARD. So they are rather sophisticated investors
Mr. SHERR. By and large
Senator ALLARD [continuing]. That understand the risk. And so
if things go bad, they understand the risks?
Mr. SHERR. By and large, the lower rate mortgage investors, I
would say, are a relatively sophisticated group of investors.
Senator ALLARD. Now those that buy the AAA or the AA, those
are probably thewould you describe them as less sophisticated
type of investor?
Mr. SHERR. I do not know if it is less sophisticated, because certainly very sophisticated investors participate in investment grade
and high rated bonds. I would say the risk those investors are taking is significantly less, and therefore they are getting paid significantly less on that security to take that risk.
Senator ALLARD. I am going to yield back the balance of my time.
I will let the rest of the committee ask questions.
Chairman REED. Senator Menendez.
Senator MENENDEZ. Thank you, Mr. Chairman.
A quick question, a yes or no would do, to Mr. Sinha and Mr.
Sherr. Any responsibility from the securitizers for what has happened in the secondary market in the defaults and foreclosures?
Mr. SHERR. I do not think thereI mean, I think we spent, at
Lehman, a tremendous amount of time trying to diligence the
counterparties that we deal with. And we have done a tremendous
amount of work, both on the investor side and the originator side,
making sure we are dealing with reputable counterparties and
doing everything within our means to make sure that the loans
that we are buying and the transactions that we are doing in the
marketplace conform to the guidelines as represented when we
went into the transaction.
Senator MENENDEZ. Meaning?
Mr. SHERR. Meaning no.
Senator MENENDEZ. Thank you.
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Mr. Sinha, can you be more succinct? Yes or no?
Mr. SINHA. No.
Senator MENENDEZ. No, thank you.
Ms. Barnes, Mr. Kornfeld, any responsibility from the credit rating agencies? Yes or no?
Ms. BARNES. No.
Senator MENENDEZ. No? Mr. Kornfeld?
Mr. KORNFELD. For a simple yes or no, no. It is a difficult question, though, in terms of simple yes or no.
What the rating agency does is to express our opinion. What we
are trying to do is do our best opinion
Senator MENENDEZ. Your opinion matters in the terms of investors and what it means in terms of them willing to make commitments and then fuel the secondary market, does it not?
Mr. KORNFELD. But rating is not a pass/fail. A rating is trying
to do what the probability of the potential losses to a bond holder.
Senator MENENDEZ. So the answer is no for you, as well?
Mr. KORNFELD. Yes.
Senator MENENDEZ. Now no one has any responsibility at the
table.
Let me ask this: Mr. Sherr, what is an acceptable percentage of
default rates and foreclosures in the market, as far as from a market perspective?
Mr. SHERR. Different loans carry different loan level characteristics and different loans have different frequencies of default. So it
is hard to say that there is an acceptable standard for delinquencies.
Senator MENENDEZ. Is 20 percent acceptable?
Mr. SHERR. No, it is not acceptable.
Senator MENENDEZ. That is what we have right now going.
I asked you that question because, as I listened to your testimony, it sounds that you are as chagrined about defaults and you
suggest that for securitizers that is clearly not a good thing. But
it certainly seems to me that the securitizers have looked the other
way, fueling a market that has very little discipline over itself, and
therefore not so concerned about the rate of default looking at it
in a mass way, well, X percent is fine and we will take that as part
of the risk in an equation of investing.
Is that a fair statement?
Mr. SHERR. I do not think so. I think the marketthink about
the recourse. You mentioned pretty much every independent
subprime originator who has been forced out of business. So clearly
there are ramifications for running a business the wrong way.
Senator MENENDEZ. Well, those are the originators. I am talking
about the securitizers. Isnt there a good part of what happens to
the securitizer is that if the loan defaults the originator has to buy
it back? Isnt that a good part of what happens?
Mr. SHERR. I do not know if it is a good part. No one wants to
see loans go down.
Senator MENENDEZ. No, I say a good part meaning isnt it a significant part of what happens in the marketplace, that the originator, as part of the agreement with the securitizer, has to buy it
back?
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Mr. SHERR. The originator makes representations around his
loan and he typically reps that the loan will not default on their
first payment.
Senator MENENDEZ. So what I am saying is the securitizer has
a much more limited liability here at the end of the day. Between
that and the credit rating agencies, it seems to me that while you
say you are chagrined about defaults, you actually fuel the marketplace in a way that has no controls, largely speaking, over it as defined by the two professors here. And ultimately, when you talked
in response to the Chairmans questions and you said market
mechanisms are in place. But they are in place only when we are
at the default stage. Isnt that a little late for market mechanisms
to take place?
Mr. SINHA. Senator, if I can just add to this, I think at the end
of the day ex poste, every loan that defaults is effectively something that is not the favorable outcome for the people that effectively advance the funds for that. The real question is in a market
where there is greater risk if credit is going to be advanced to those
borrowers, what is the right level of pricing or spread that has to
be charged to make it worthwhile for capital to be advanced into
that sector?
And I think the big attempt over the 10 years has been to get
capital into markets that were otherwise perceived as risky, that
conventional lending would not go to but where the introduction of
a balance between risks and spread has allowed funding to go to.
So at the end of the day, I think the people that are funding
these loans have a tremendous amount at stake because they are
responsible. They have their own fiduciary duties to their investors.
And if they make a loan and that loan does not perform, they are
just as much hurt by that loan going bad.
So the real challenge, I think, is for us to figure outand there
is no perfect situations in the world and there are no perfect solutions. But the question is, on balance, the fact that we are able to
make loans to people that were perceived as risky, and risky
enough 10 years ago that they were delegated to the outer reaches
of the finance markets and have become much more mainstream,
is that benefit sufficient to alter the fact that yes, there have been
some issues in terms of the fact that an above larger number of
borrowers are going into foreclosure than was otherwise expected?
I think that is part of the reason why you are seeing the kind
of correction that you are seeing in the markets, in terms of people
re-evaluating the types of risks they were taking on.
But I think that is the mechanism for ensuring that mid-course
corrections are made, is when people do not get their money back
or their bonds get downgraded. That has real consequences for
those folks that are have. We are also accountable.
Senator MENENDEZ. When you have lost your home, a mid-course
correction is a little late.
Mr. Chairman, I have plenty of other questions. I will wait for
the second round.
Senator Crapo.
Senator CRAPO. Thank you very much, Mr. Chairman.
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I think this question is probably for Mr. Sinha and Mr. Sherr
and Mr. Eggert and Mr. Peterson, on different sides of the question.
That is what are the benefits and drawbacks of requiring borrowers to be qualified at the fully indexed rate, which is suggested
in the proposed interagency subprime mortgage lending statement?
Mr. SINHA. Senator Crapo, I think the benefit would be that to
the extent that there are dangers put on or risks put on borrowers
from a payment shock perspective by allowing them to qualify, or
effectively qualifying them at the fully indexed fully amortizing
rate, youve clearly removed that risk from the table.
The drawback would be that there may be some borrowers that
are truly able to handle the payment shock that would not then be
able to afford that mortgage anymore because the bar has been
raised.
So I think, as I said earlier, there are never any perfect solutions. I think what the right balance is in terms of the right
amount of time that you need to provide to that borrower such that
there would be a reasonable expectation that he or she would be
able to handle the payment shock if that comes. That probably is
the right solution. I do not know what the answer to that question
is.
And I think it is specific to every borrower in terms of their own
financial and individual circumstances.
Senator CRAPO. Mr. Sherr, did you want to add to that?
Mr. SHERR. No, I would agree. I think that clearly, by qualifying
potential borrowers to the fully index rate, you create a pool of
loans that arguably perform better. On the other hand, you are
going to restrict credit potentially. And typically there are
mitigants that would allow an underwriter to make a loan that otherwise may not qualify at a fully indexed rate. But we run the risk
of not providing credit to that group of potential borrowers.
Senator CRAPO. So it would shrink credit and, if I understand
you right, in your opinion it would probably shrink it more than
we would need to to solve the problem we are dealing with here?
Mr. SHERR. I would agree with that.
Senator CRAPO. Thank you.
Mr. Eggert or Mr. Peterson, do either of you want to respond?
Mr. EGGERT. I think one of the advantages of forcing you to underwrite to the full rate is some of what we are seeing are borrowers who do not realize how high the rates on their loans are
going to go or could go. And when they are being sold these loans,
they are being sold them based on the teaser rate.
If you look at the ads for a lot of the subprime loans, it is reduce
your loan payments by $500 and all they are advertising is the
teaser rate. When they sit down with the mortgage broker, the
mortgage broker talks about the teaser rate.
Many of the borrowers do not see the full rates at all until closing, and may not understand it at that point.
Senator CRAPO. And this proposal would solve that?
Mr. EGGERT. It would mitigate it because while it would not
solve the problem completely, at least you would get borrowers into
loans that they could afford when they are fully indexed.
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Mr. Peterson.
Mr. PETERSON. I think it is a reasonable, decent idea. But I think
it is a Band-aid. I mean, if you do that, then it will help tighten
up credit a little bit. There will be a few less really dangerous poorly underwritten loans. But my sense is that you could probably
start to think of ways to make the same sort of things happen with
different contract mechanisms and contract around that rule.
So ultimately, I do not know that it would necessary prevent the
types of things we have seen.
And with the couple of minutes I have left, I will come back to
Mr. Sinha and Mr. Sherr. What would be the impact on the secondary market if Congress or thewell, if Congress, imposed assignee liability standards similar to the Georgia or New Jersey
State laws? What has been your experience with these laws? And
what do you think would happen?
Mr. SINHA. Senator, we actually have had an experience with assignee liability in two states, Georgia and New Jersey, and in the
State of New Jersey, in the high cost market. From the investors
perspective, and that is predominantly the client base that I serve,
if you think about the securitization process, anything that makes
the process inherently unpredictable in terms of how you adhere to
a particular standard or what the particular sort of consequential
losses might be as a result of any piece of legislation makes the
rating process fundamentally not possible.
So as a result of that, when we have seen this type of risk come
into the market, what we have seen are investors effectively saying
that we do not have the ability anymore to understand the type of
risk that we are buying.
I do not want to necessarily speak for the rating agencies, but
I think that has been that same argument that has been applied,
as well.
So it comes back down to if it is a risk that is quantifiable and
that one can sort of rate around or structure around. Markets can
price it. But if it is completely up in the air and it is completely
indeterminate, and there is no real way of objective standard of determining whether you are in compliance with it or not, then it becomes very hard for the capital markets to deal with.
Senator CRAPO. Quickly, Mr. Sherr.
Mr. SHERR. I would say why not get at the problem more directly? If the goal is to cut out predatory lending, which I think
every responsible lender would support, why not define clearly
what is a predatory loan and create a national standard that would
regulate those loans being made? As opposed to trying to transfer
that risk to second and third order investors who may not be close
enough to the transaction to fully understand what risk he is taking. And therefore, I do think you will find that it may have significant impacts on the capital available for borrowers.
Chairman REED. Thank you very much, Senator Crapo.
Senator Casey.
Senator CASEY. Mr. Chairman, thank you very much, and I want
to thank the witnesses for your testimony.
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I want to focus on where do we go from here? What are solutions
or proposed solutions?
I am going to start with both Professors Eggert and Peterson.
Professor Eggert, I was looking at your testimony and, in particular, I know sometimes when you have limited time you do not
have the ability to go through all of it. These are pretty significant
pieces of work here.
But I wanted to reiterate and have you reiterate, if you have covered a lot of this already, but especially if you have not, some of
the conclusory statements that you make. I am looking at page 29.
I was struck by one of the last sentences in your testimony. It
said, and I quote from page 29, To be effective, any regulation that
protects consumers from inappropriate loans, must affect the actions of the Wall Street players that direct the securitization of
subprime loans. A regulatory regime that purports to limit the
harmful effects of predatory loans or loans unsuited to borrowers
must include not only the lenders that originate the loans, but also
the rating agencies and investment houses that create the loan
products, determine the underwriting standards and it goes on
from there.
I just wanted to have you comment on that, in terms of specific
focus of reform, based upon not just your testimony but your experience.
Mr. PETERSON. I think the reason I say that is if you look at how
this process works, I think we have had a presentation as the secondary market are mere passive purchasers of loans and oh, they
may select a loan but it is really the lenders who decide loans.
But if you talk to people on the origination side, they will tell you
the complete opposite. They will say our underwriting criteria are
set by the secondary market. They tell us what kinds of loans they
want to buy. They tell us what underwriting criteria they want us
to use. And that is what we do because we are selling to them.
So the securitizers and the rating agencies really are the de facto
regulators. If you are going to fix the problem so that we do not
have the high levels of default we have seen, I think you have to
involve the de facto regulators. There are, I think, two ways to do
that.
One, I think, is assignee liability. Rating agencies and the investment houses are really looking out for the investors. They are not
looking out for the borrowers. If you want to make them decrease
the amount of inappropriate lending, the way to do that is to make
inappropriate lending hurt the investors. If investors are on the
hook when somebody is defrauded, then the securitizers are going
to make sure fewer people are defrauded and that fewer defrauded
peoples loans get securitized. Assignee liability is the way to make
the secondary market do real monitoring of the originators.
And also, I think the other thing is that there should be more
regulatory purview over the rating agencies and the investment
houses. I have not quiteI have come to this conclusion recently
and I cannot sit here and tell you exactly how that should work.
But we are used to having our national mortgage market regulated. I think we all want it to be regulated.
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But at the current moment, it is not really regulated other than
by these private de facto regulators, as far as the subprime industry.
And so we need to figure out a way to pull back the subprime
market under real regulation. Exactly how that will work, I think
will take some thinking. But I think that should be something that
should be on the agenda.
Senator CASEY. Thank you. If we have more time later, I will ask
your colleagues at the witness table to respond.
But I do want to ask Professor Peterson, in terms of, as you say
in your testimony, not believing in a wait and see attitude but having specific steps. Can you outline, you have got about four or five
specific recommendations. Can you summarize those for us?
Mr. PETERSON. Sure.
Senator CASEY. Or highlight one.
Mr. PETERSON. Yes. I can fill up a little booklet of things that
I think that need to probably be fixed with the Federal consumer
lending regulations.
But specifically related to this problem, if I could just pick two
things that I would focus on, the first is that at a minimum, the
bare minimum that we need to do is apply the Federal Trade Commissions Holder in Due Course Notice Rule that is applied to say
car lending ever since the 1970s. That should apply to all home
mortgages. The markets have been able to do that. That provides
some assignee liability, but it is a cap level of assignee liability
that I think that the rating agencies and the investment banks can
live with. That is the first thing.
The second thing is that I think it would be great if the Federal
Government would step up and articulate some sort of standard of
imputed liability for investment banks that package mortgage
loans. Because remember, if you have assignee liability, that is just
going to get the investors on the hook. But a lot of those investors
are innocent parties and nobody wants to have uncapped liability
for these innocent parties.
But if you really want to have some deterrent mechanism, then
you need to have some uncapped liability for the truly bad actors,
the real predators that are out there. You have to have punitive
damages or you will not ever be able to deter them.
And the way that you need to do that is I think there has to be
imputed liability for the investment banks that are facilitating it.
If the investment banks know or should have known that there is
predatory loans or unsuitable loans being packaged in those securities, those investment banks should be liable.
Senator CASEY. I know I am out of time. Thank you.
Chairman REED. Thank you very much, Senator Casey.
Let me begin the second round and address follow-on questions
to Mr. Sinha and Mr. Sherr.
Both Bear Stearns and Lehman Brothers not only are
securitized, they also originate. You have got vertical integration.
I am wondering, in your origination, were you involved in low-doc
and no-doc loans and some of the more exotic products?
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Mr. SINHA. Senator, yes. I should point out, though, that I am
head of research. And what I know about Bears operations are
what are publicly available to everybody.
I think lim-doc loans were a commonplace aspect of the markets
over the last couple of years. So to that extent, yes.
Chairman REED. It goes back to my original question. What
made it attractive to Bear Stearns? Was it the origination fees or
the securitization fees? It goes back, I think, to who was driving
the train here, my initial question? Do you have any notion about
that?
Mr. SINHA. Again, I cannot speak specifically about the decisions
at Bear. But I think generally speaking the market throws out a
menu of alternatives into the marketplace. At any given point in
time you will see a variety of mortgages being offered out. And it
is really sort ofyou know, the demand in terms of the borrower
base that will determine any one particular type of instrument that
does decide to come in.
What we have seen is overall broader market participants is that
the increasing levels of home price appreciation over the last couple
of years did, in and of themselves, create sort of a feedback mechanism in terms of what people refer to as affordability products. And
so I think the last couple of years of very high home price appreciation rates are also responsible, to some extent, in terms of broadening the menu of offerings that get thrown out there.
Chairman REED. Mr. Sherr, the same question. Since your company dos originations as well as securitizations, what was driving
these low-doc loans?
Mr. SHERR. You know, I think we tried to identify an underserved market. And if you think about the entire Alt-A market, for
example, that is a documentation market, for the most part. We
found there were a number of borrowers who were deniedwho
could not access credit for whatever reason, they were self-employed. There were a number of reasons why they could not provide
the full documentation or chose not to provide the full documentation that a traditional bank may have wanted. And we found a
market segment that we thought made sense from a risk-adjusted
basis and provided capital to borrowers who otherwise could not
get it.
Chairman REED. You know, one of the points that were made
when we looked at this, so many of these no-doc or low-doc loans
did not routinely escrow taxes or insurance, which suggests to me,
you know, this is a segment of the economy who probably would
be well advised to save some money for taxes. And yet, with that
characteristic, would that not suggest to you that this loan could
be bad? Or that there would be other demands on the salaries of
these individuals?
Mr. Sherr.
Mr. SHERR. I think all of those characteristics were taken into account when you underwrite the loan. I think it is important to understand that when you make the loan it is in everyones interest
that the borrower can afford to pay that loan back.
Chairman REED. Let me just go back to the rating agencies. You
have already begun to downgrade some of this paper. You suggest,
though, I think you are confident. Do notlet me have you reaf-
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firm that that issue go forward, unless there is a tremendous deceleration in wages or economic activity, that it is not going to have
serious systemic repercussions. Is that fair?
Ms. BARNES. We believe that there is sufficient credit enhancement, given the current economic stresses, for the vast majority of
the investment grade tranches. The speculative grade tranches obviously would experience a higher downgrade ratio. That is what
they are designed for.
Chairman REED. So to the extent of the non-investment grade
tranches, who is holding those? That would be hedge funds, principally?
Ms. BARNES. Typically, yes. Those were those people you were
addressing earlier.
Chairman REED. Have you, either through some analysis or
through a gut check about what is the impact if these investment
grade or non-investment grade securities go down, is there going
to be an impact? For example, pension funds are invested in hedge
funds. Is there a domino effect?
Ms. BARNES. Pension funds are typically investors in the higher
rated tranches, the teachers retirement fund and others. Those are
your AAA investors, so fairly insulated from this.
A domino effect, the speculative grade investors do expect and
are paid for the higher yields, so do have a higher downgrade ratio
or default probability. And it is baked into their overall return expectations.
Chairman REED. Quick comment, Mr. Kornfeld?
Mr. KORNFELD. No.
Chairman REED. Let me ask another question which goes to
something Senator Schumer raised initially. And that is at this
point there is a recognition by everyone on this panel, everyone in
the room, everyone across the country, that foreclosure is bad. It
is bad for people who lose their homes. It is probably bad for the
financial institutions that do not come out whole after the transaction.
And yet, there seems to be some inhibitions because of the
securitization process and how flexible the servicer or whoever is
holding the paper can be in terms of working outProfessor Eggert
pointed out, where are these people that go into the field and start
talking one-on-one with the homeowners to work this out?
So I just want to get a sense. Mr. Sinha, you suggest in some
of your comments that there are different REMIC rules, which are
tax rules. There are accounting rules such as FAS 140. There are
covenants within all these documentations with respect to how
much leeway they have.
Given all of this cross-cutting restrictions realistically, if someone
did have a pool of $1 billion, like some financial institutions are
proposing, how effectively could they deploy that money to help individuals? What are the transaction costs? Do you have aI am
going to ask everyone. Do you have a notion of that?
Mr. SINHA. Sure. I mean, not to downplay the significance of
some of those restrictions, but I do not think they are insurmountable. And certainly, in some instances, they are a lot easier. In others they may be more difficult.
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But I think the issue that would be faced by everybody in the
market is that there is a cohort of borrowers that are going to be
facing stagnant housing markets and potentially a reset coming up.
And not dealing with them in a sensible way, considering the fact
that the markets risk profile has changed, would be shooting oneself in the foot fundamentally.
So I think my perception, this is my opinion, is that I think when
people are faced with the gravity of the situation, to some extent,
I think it should be easier to arrive at a consensus in terms of the
right thing to do. I mean, the right thing for investors and borrowers is that borrowers stay in their homes and keep making
their payments. And the more of that we can generate, the better
off everybody is.
So I think from that perspective, in my opinion, I am more optimistic about that aspect.
Chairman REED. Mr. Sherr.
Mr. SHERR. Although, I would agree there are rules and guidelines for how securitization should be serviced, I would agree with
Mr. Sinha that at the end of the day the servicer has a tremendous
amount of flexibility to do what is in the best interest of that
securitization.
I think, again, it is very important to understand that in this environment the interests of the borrower and the interests of the
lender are very much aligned. The interests of the securitization
and the interests of the lender are very much aligned. No one wins
in a foreclosure.
Mr. Schumer represented the disparity between loss, between
putting someone on forbearance or loan modification plan and actually trying to sell that home in a down market. It is in everyones
best interest to accommodate that borrower and keep him in his
loan for as long as possible.
Chairman REED. Ms. Barnes, Mr. Kornfeld, comments from your
perspective?
Ms. BARNES. I agree with the comments. It is in everyones best
interest to have the loans repay. But in applying the forbearance
process, the servicers will first need to determine is it even feasible
for the people to even repay these terms. Because there is no point
in setting a new interest rate if they are going to default again. So
that is one aspect.
And then two, as far as applying widespread loss mitigation efforts, it does put a sense of uncertainty in the repayment of bonds.
Because as servicers had the ability then to change interest rates,
change terms, it is then something that needs to be factored into
the ultimate return profile for the investors on the individual
bonds.
Chairman REED. You earlier, limits in terms of the modification
is based upon your credit evaluation?
Ms. BARNES. No. Some documents do require or limit the percentage. But that is not a Standard & Poors requirement or limitation.
Chairman REED. But some credit rating agencies would have
that?
Ms. BARNES. I do not know who is driving it. It is in some of the
documents.
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Mr. KORNFELD. It is not, as far as in terms of a requirement that
we have put. We do not advocate having the caps, as I mentioned
in my initial remarks, in terms of anything that would reduce the
servicers flexibility we do not think is a benefit to bond holders.
Nor do we think it is obviously a benefit to borrowers.
Do concur that we do not think that this is insurmountable. We
do think that if all the various groups get together, we think there
is some communication, we think there is some education.
Chairman REED. Mr. Eggert and Mr. Peterson. Everyone gets a
chance.
Mr. EGGERT. First, I would like to react to a statement we have
heard a couple of times, that the interests of the investors and the
interests of the borrowers are congruent and so the people taking
care of the investors will take care of borrowers.
I do not think that is true. They diverge in one significant way.
Both sides do not want higher defaults but investors are willing to
accept higher defaults as long as they also obtain higher interest
rates in return. The more the risk, the more return they want. In
other words, they are willing to accept one bad thing for borrowers,
which is higher defaults, as long as the borrowers get the double
whammy of also getting higher interest rates.
So the interests are not congruent. And what we have seen recently is that the investors, faced with these higher default rates,
have said we need higher returns and so we need subprime loans
to cost borrowers more, which I think also makes them more likely
to be defaulted.
As far as the difficulty in giving servicers flexibility, I think one
study found that the terms, that about 30 percent of bond deals
had the kinds of terms saying you cannot have more than X number of loan modifications.
But the real question, I think, is who is going to be giving
servicers their marching orders? Who is going to be telling them
how to deal with these loan modifications? If these were loans held
by national banks, we would be looking to Federal regulators to
give the banks an idea of how to respond to increased default rates.
Here we do not have that. We do not have the kind of regulation
that I think could help us respond to this kind of problem.
Chairman REED. Professor Peterson, finally.
Mr. PETERSON. The thing I want to respond to is I am not so
sure that I agree with the statement that it is in everybodys best
interests to avoid foreclosure. I am not sure that that is true. It is
certainly in the investors interest, by and large, and in the investment banks interest, by and large. But if you are the servicer, it
may be in your best interest to foreclose, in some cases. For example, if there is a divergence in the incentives of the investors and
you, if you look at the contract and there is the potential for you
to get a lot of feesif you have a fee generating opportunity at a
foreclosure, it may be more profitable for you to foreclose than not
foreclose.
So the question that I would want to know is whether or not the
insistence on foreclosure is because of a lack of flexibility because
of conflicts with tranches in the pooling servicing agreement or if
it is because the servicer is reluctant to give up the windfall of fees
from foreclosing in exchange for the hard process of helping a bor-
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rower reformulate the loan or repattern the loan and work it out.
Because that is going to be a difficult, time consuming thing. Do
you take the fees or do you help them work it out? It may be possibly in the interests of the servicer not to work it out, and instead
take the fees.
And I would have to look at some hard numbers to know which
that is. And it may be different in different cases. But I have not
seenI have never seen anything that convinced me that the
servicers do not have an incentive to foreclose.
Chairman REED. Well, thank you. This is very revealing to me.
Again, I think there is the issue of the congruence of the incentives
to foreclose, not foreclose, forbear, not forbear. But then there is
also the issue of the capacity to communicate and get it done and
who is going to take the lead to get it done, if in fact there is either
a pool of private money or public money or any other mechanism
to help these people.
So I think that we have explored and exposed a very significant
issue.
Senator Crapo, do you have additional questions?
Senator CRAPO. No.
Chairman REED. Senator Menendez.
Senator MENENDEZ. Thank you, Mr. Chairman.
Let me ask you, Mr. Sinha and Mr. Sherr, do you know if your
companies have purchased tranches of mortgages from New Jersey?
Mr. SHERR. From who?
Senator MENENDEZ. New Jersey. Mortgages that originated in
New Jersey, properties in New Jersey?
Mr. SINHA. Frankly, I would refer theI do not know. It is possible that we do have New Jersey loans.
Senator MENENDEZ. Would you know, Mr. Sherr?
Mr. SHERR. I believe we have.
Senator MENENDEZ. And the reason I ask that question, because
in response to Senator Crapos question about assignee liability,
you gave a negative response of view of assignee liability. Yet, New
Jersey has assignee liability under its law and it is the 13th State,
in terms of Senator Schumers joint economic study, in the number
of defaults that have taken place across the country. So obviously,
there is a lot of people buying those mortgages, notwithstanding assignee liability.
So I think it is fair to say that notwithstanding assignee liability,
there is still clearly a marketplace to buy those mortgages. Yet, it
creates some recourse to the borrower at the end of the day.
Let me ask you this: in the purchases of these tranches of mortgages, you never had any sense that there was any predatory lending loans within them?
Mr. SHERR. If we purchased a loan, it was our opinion there were
no predatory loans in that tranche or in that pool. And we do that
via diligence and compliance checks.
Senator MENENDEZ. Mr. Sinha.
Mr. SINHA. I mean, I would generally, again, agree with that
statement. I think nobody knowingly would want to purchase a
predatory loan.
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Senator MENENDEZ. But with the number or percentages of loans
that are falling within that categoryand I agree with you, Mr.
Sherr. You said lets have a national law that defines predatory
lending and lets have a consequence. I agree with you.
And I do not believe every subprime loan is a bad thing, either.
But I also do not buy the general statement that if we do anything
we are going to find ourselves with limiting access to capital to all
of these people who might not otherwise have the wherewithal.
Well, getting that access and then having your home foreclosed
not only has a direct consequence on your life, but it also has a direct consequence on your credit for a long period of time. So striking a balance here is, I think, what is important.
What I do not hear the industry as coming forthother than saying we have no responsibility, we have done what we need to do
I do not hear the industry coming forth and being proactive in this.
And I think that is a mistake on behalf of the industrys part.
But is it not true that market investors are really in the best
at least under the existing systemthey are in the best position
not only to keep bad players and products out of the market in the
first place by not funding them? And also in a better position to
make originating offenders accountable.
It seems to me that you have a responsibility with your underwriting standards that would work a long way, both for your investors as well as for the marketplace and for the people who are losing their homes. Dont you think that you, in fact, have by virtue
of the powerI mean, you know, if you cannot securitize it, it will
not sell.
Mr. SINHA. That is correct, Senator. I think, if you couch the
issue, I think, in terms of better disclosure to borrowers, better
education for borrowers, better up front education about the types
of products and the types of risks the borrowers are taking, better
enforcement of existing practices, marketing practices, et cetera, I
think they would go
Senator MENENDEZ. I agree with you all of those things. Those
are the downstream things.
I am asking you, from your perspective, isnt there a role for you
to have a stronger, moreI do not want to use the word stringent
because that can go overboardbut a stronger standard that understands that some of these products that are being purchased are
products that ultimately are leading to the number of foreclosures
that we have?
Because if you would not securitize them, they would not be able
to be out there loaning it.
Mr. SINHA. That is correct, Senator, but I think traditionally
there is a certain expectation that loans that have certain sets of
characteristics behave in a certain way. That is where the disconnect comes about. It is not that everybody sort of knowingly
knows thatunderstands that that is a bad loan. It is just at the
end of the day, in hindsight, the loan does not turn out to be as
it was supposed to be.
Senator MENENDEZ. Let me just turn to the rating agencies for
a moment. As I understand it, 97.9 percent of all subprime deals
over the last 3 years has been rated by S&P and jointly, often a
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second rating, as well. So really, your respective agencies have
been out there doing all this rating.
I asked you a question earlier and, of course, you gave me the
answer that you really do not see any responsibility. With all the
information that has been coming to light in these hearings, can
you explain to me how you could have possibly given and continue
to give strong ratings to these inherently flowed investment vehicles? Didnt you have some earlier signs that this market segment
was writing checks that you simply could not cash?
And dont you think that you have any responsibility in this regard?
Ms. BARNES. Well, to address your first couple of points, in looking at those loan characteristics, we did identify them as being
riskier and, in doing so, increased our enhancement levels by 50
percent in 2006. So in essence, making those loans more costly to
be originated because we do believe that the default rate was higher. And we went out publicly with that in the middle of last year.
Senator MENENDEZ. Mr. Kornfeld.
Mr. KORNFELD. Obviously, in terms of the magnitude of the situation is very, very serious. But to a certain extent we want to
frame somewhat of the issue. It is not all subprime loans. It is
mostly confined to 2006. And it is also not all of 2006s originations.
There are a significant portion of 2006 originations that are performing.
But once again I do not want to, by any means, it is a very good
question, it is a very proper question to be asking.
Part of the areas are certain specific areas. It is the areas as far
asit is not even completely the stated documentation loans. It is
the loans to wage earners. And the significant growth over the last
year or two have been to salaried borrowers. And that is where, in
terms of from a risk standpoint, things have performed somewhat
worse than expectation.
It is also, it is very much in where you combine those risk characteristics all together where you take a no equity loan, you take
it as maybe stated documentation and maybe it is a stated wager
earner. And then you combine it with a borrower with either a
first-time borrower or a borrower with limited mortgage history.
And you bring all of those together and, as far as the overall risk,
it is not complete.
From our standpoint, once again, what the market judges us on
that if we are incorrect in regards to consistently whether we
under or basically over, in regards to the risk estimation, then as
far as the market is going to no longer be utilizing and relying on
our ratings.
Ms. BARNES. I am sorry, Senator. I just wanted to answer your
question about how we could give high ratings to these poorer quality loans. I just wanted to make sure that it is understood that we
do not make the loans, we do not give the approval of these loans.
We simply assess the risk of these loans, and in doing so those individual tranches.
And when I mentioned that our enhancement levels were increased by 50 percent, the ratings are asked of us from the issuer.
So if they say they want to issue a BBB bond, we reply based on
our credit assessment what enhancement level of protection to
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cover losses would be to achieve that BBB. So in essence, we can
give the same rating but it will become much more costly because
that enhancement level or the amount of protection increased by 50
percent over that period.
Senator MENENDEZ. And you believe that the ratings that you
gave, at the end of the day, covered more than sufficiently the risk
in the marketplace?
Ms. BARNES. For the majority of the investment grade bonds,
yes.
Senator MENENDEZ. Mr. Chairman, if I may, one last question?
Let me turn to the two professors. If it was moot court and you
heard all of this testimony, can you give me a verdict on no responsibility by the securitizers or the credit rating agencies?
Mr. PETERSON. I think that there is some responsibility, obviously. And I do not mean to be rude or disrespectful, but I do.
And if I could encapsulate it, the sentence that was said earlier
was that no one would want to purchase a predatory loan. I think
that that is false. Sure you would. If you could purchase it and
then, especially if you could purchase it through a shell company
that did not have your fingerprints all over it, and then you sold
it to some sucker at a profit, then you would want to do it; right?
And you would pretend that you did not know that it was a predatory loan.
Or you would actually not know that it was a predatory loan because you did not check. That is the situation when you would
want to buy a predatory loan. And I think that is what has been
happening.
As far as the yes or no question that you asked earlier, responsibility? I would give, for the rating agencies, maybe they did not do
as good a job as they could. But ultimately I do not, in the end,
see them as the primary culprit. They are trying to sell a product,
accurate ratings. And maybe I will regret this statement later, but
I would probably give them more or less a pass.
But I do think that the investment banks are very much responsible for this. I think that a lot of them knew or should have known
that this sort of thing could happen and they were profiting from
the transaction fees in packaging and selling these loans.
If they find out that it is a predatory loan or that it does not suit
the borrowers needs, that just means they cannot go through with
the deal and they are going to lose all the revenue they would have
made in going through with the deal.
If the loan does not pay out, well, it is bad for the investors. But
ultimately that does not come out of the investment banks pocket.
So I think they are very much responsible.
Mr. EGGERT. I think there are sort of two levels of responsibility,
since if I were in moot court there would have to be two of everything.
The first level of responsibility is what has been done with the
loans the last year or two? And I think we do see responsibility.
I think there could have been a lot more done to look at the individual loans. I think there has beenwhat securitization does is it
values quantity over quality. And as long as there were a lot of
loans going through and they could push the risk off in various
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ways, then it did not matter if many of these loans, objectively
looking at them, were bad loans.
But I think the other aspect of responsibility is in designing the
market. If you look at predatory lending laws, you see that the rating agencies have, to some extent, fought against good assignee liability, have essentially told the States if you have assignee liability that we do not like, we are not going to rate in your State, and
have to some extent attempted to act as a super legislator deciding
what our assignee liability laws should be.
As a result, I think in some places we have had less strong predatory lending laws than we might have had.
Securitizers and that industry can do better than borrowers and
should bear the responsibility for predatory loans. They have better
access to information about who the bad lenders are, about what
the bad scams are. They are better able to determine if a loan is
above market interest, which many loansthe essence of a predatory loan often is that it is way too expensive. And the secondary
market can see which loans are way too expensive and want to buy
loans that are too expensive because they are more profitable. Not
that they want to seek out predatory loans, but if they have abovemarket loans, that is good.
And so I think we need to put the onus on them to stop the problem because they are better able to do it, certainly than the borrowers are.
Mr. KORNFELD. Mr. Chairman, could I just respond to the one
statement in regards to the rating agencies?
Chairman REED. Absolutely, Mr. Kornfeld. Yes, you may.
Mr. KORNFELD. Thank you.
Chairman REED. This is not a debate, but please.
Mr. KORNFELD. I understand it is not a debate.
The rating agencies do not opine whether law is good, whether
law is bad, whether this predatory lending law is a good thing or
a bad thing.
What we are looking for, in terms of on the predatory, and we
have both published in terms of on this, is can the risk be quantified? As long as the risk can be quantified, we are able to rate
the other securities.
I am not, off the top of my head, I am not the expert in terms
of within Moodys on New Jerseys law. But for instance, New Jersey does have a law which has been clearly defined and has, as
Senator Menendez has pointed out, has still allowed for lending to
be done within the State.
Chairman REED. Ms. Barnes, yes.
Ms. BARNES. I would echo a lot of the comments that Warren has
just stated. Standard & Poors would just like to go on record that
we support all of the predatory lending laws that arein fact, as
long as the damages are quantifiable and that the terms are clear,
meaning people can definitively determine whether they are adhering to the law or breaking the law. So terms like net tangible benefit are the ones that put into question that cause the secondary
markets concern.
Chairman REED. Thank you very much. I want to thank my colleagues. This has been a very serious and a very thoughtful discussion about a problem that is affecting many, many Americans
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across the country. And I think it has given us all an opportunity

to reflect, and also to think of ways in which we might be helpful.
And I think the first response, and the best response, will come
from the industry. So I would hope in this case these discussions
might prompt some serious thought about continued efforts by the
industry, all segments in the industry, to respond. And perhaps we
can be helpful in that regard, too.
But thank you all for your very fine testimony, and thank my
colleagues.
I would just say that some of my colleagues will have written
questions, additional written questions. I will ask them to get them
into the committee by April 26th, and within 10 days after that if
you could respond, I would appreciate it.
Thank you very much.
The hearing is adjourned.
[Whereupon, at 5:10 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions for the
record follow:]
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139
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED

FROM DAVID SHERR
Q.1. We are aware that there are various parties involved in

securitization structures, and it has been said that at times the interests of one party might vary from the interests of others. Are
there situations where the best interest of the borrower (remaining
in their home) might be in conflict with the interest of another participant? Can you explain a situation where that might be the case?
What are some ways in which we can ensure that parties work toward a common solution that benefits both the borrower and the
investor?
A.1. The interests of all participants in the mortgage securitization
process are generally aligned. Everyone wants homeowners to be
able to make the monthly payments on their mortgage loans. Nobody wins when the only viable option for managing a loan is foreclosure, not borrowers who could lose their home, nor bondholders
who rely upon loan payments as the basis for returns on their investments.
Typically interests remain aligned even when a loan is in distress. Because foreclosure hurts everyone, the interested parties already are motivated to do exactly what your questions askwork
toward a common solution that benefits both the borrower and the
investor. For example, loan servicers currently are engaging in
early intervention for at risk borrowers, and are modifying loan
terms when possible so as to increase the likelihood that borrowers
will be able to make their monthly payments.
Notwithstanding all the efforts to avoid foreclosures, there unfortunately are situations where no reasonable modification of a loan
can be made that would increase the likelihood of borrower repayment, and foreclosure becomes the only practical option. At that
point, the interests of borrowers may diverge from the interests of
other participants in the securitization process who depend upon
some payment flow from borrowers. But that divergence is reached
only after a long road on which everybody works together to keep
borrowers in their homes.
Q.2. What do you view as the major impediments towards you
being able to work out flexible arrangements with troubled borrowers whose loans reside in securitization structures? For example, some have referred to the REMIC rules, others have mentioned
accounting rules, while others have pointed to limitations in the
deal documents. Can you provide further clarity on this subject?
A.2. Certain impediments to loan modifications already have been
removed. For example, the securitization industry was concerned
about the accounting treatment of loan modifications under Financial Accounting Standard 140, but guidance issued by the Securities and Exchange Commission this past July has eliminated that
concern. Other factors that have been pointed to as potentially creating impediments do not in practice hinder loan modifications.
The REMIC rules permit modification as long as a loan is in default or reasonably likely to go into default. Similarly, most deal
documents do not impede modifications, as they provide servicers
with ample flexibility to work with borrowers. To the extent that
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servicers have lacked any significant powers to modify, market
forces will lead to enhanced flexibility in future contracts.
As for ways that the government could increase flexibility to
modify loans, it has been suggested that tax treatment should be
modified to provide that forgiveness of principal is not taxable to
borrowers.
Q.3. There has been considerable discussion in the financial press
about loan putbacks due to early payment default. Please provide
a definition of an early payment default putback. Why would investors who are being paid to assume the risk in these securitization
structures be allowed to put these loans back to another party?
Can you give us some idea as to how many loans were put back
during 2006 because of early payment default? In your view, what
does an increase in early payment default putbacks tell us about
the underwriting standards used in making these loans? Also, what
percentage of loan purchase agreements is made with recourse?
How many loans were put back during 2006 because of recourse
agreements?
A.3. Contractual provisions for early payment default putbacks
vary, so there is no single definition. In general, such provisions require the seller of a loan to repurchase it from the purchaser when
the purchaser does not timely receive the first and/or second
monthly payment on that loan following the sale. A rationale for
such provisions is that an early payment default could be an indication of fraud in the lending process, and that responsibility for
detecting and avoiding such fraud should lie with the seller of the
loan. In addition to the possibility of fraud, an increase in early
payment defaults could reflect a deteriorating economy, a declining
housing market, or insufficiently rigorous underwriting standards.
With respect to loans acquired or otherwise owned by Lehman
during 2006, Lehman estimates that approximately 2.0% of such
loans have been subject to repurchase claims as a result of
breaches of representations or warranties made in connection with
the origination or sale of such mortgage loans. Most of such repurchase claims would be the result of early payment defaults.
Substantially all of the mortgage loans that are purchased by
Lehman are purchased subject to recourse agreements pursuant to
which the seller makes certain representations and warranties regarding the mortgage loans. The pool of residential loans purchased by Lehman during 2006, without recourse to representations and warranties, would be de minimis.
Q.4. An examination of Pooling and Servicing agreements outlining the contractual duties of mortgage servicers for securitized
loans reveals, for example, a 510% cap on loan mediation generally based on the total number of loans in the pool as of the closing date. Please explain the rationale behind these caps. Are you
aware of any specific loan pools where these caps were maxed out
and whether rating agency permission would have been necessary
to exceed the caps? When caps are maximized, what is the process
and likelihood for obtaining permission to exceed the caps?
A.4. Lehman typically does not use caps for loan modifications on
its residential mortgage deals. Nor is it aware of any other deals
where a cap on modifications has been exceeded.
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Q.5. When mortgage originations and securitization are done by
vertically integrated firms, where are the checks and balances to
prevent inappropriate actions that could harm borrowers and investors?
A.5. Vertical integration in the mortgage securitization business
benefits both consumers and investors. When a financial institution, such as Lehman, sells mortgage-backed securities to sophisticated investors, its success depends largely upon the quality and
ultimate performance of the loans underlying those investments.
By participating in the origination process through vertical integration, financial institutions are situated to implement origination
controls that result in loans that are likely to perform over the long
term. Moreover, financial institutions such as Lehman derive great
value from maintaining their reputation in the business community. This reputational concern creates yet another incentive for
such institutions to originate quality loan products.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM DAVID SHERR
FORECLOSURE PREVENTION STRATEGIES
Q.1. Last week, the Joint Economic Committee of Congress issued

a report called Sheltering Neighborhoods from the Subprime Foreclosure Storm that found that foreclosure prevention is much less
costly than actual foreclosures, for all parties involved. We found
that one foreclosure can cost all stakeholders up to $80,000, while
foreclosure prevention services by a non-profit can cost as little as
$3,300 on average. In your testimonies today, we have learned that
because half of these loans have been securitized, loan modifications of securitized sub-primes could be much more difficult, and
perhaps even more costly. I have two questions that hope to get at
the heart of this difficulty and figure out how we can better align
incentives toward loan modifications that keep vulnerable families
in their homes.
Q.2. My follow-up question is to Mr. Sherr from Lehman Brothers:
Mr. Sherr, you mentioned in your testimony that you expect the
banks, as many of the largest sub-prime loan servicers and holders
of mortgage loans, to engage in home retention practices in an effort to avoid foreclosures.
Given the large percentage of exploding ARMs that were underwritten to borrowers that can not afford them at their fully-indexed
rates, will these home retention practices include some form of
debt forgiveness for borrowers that were proven victims of predatory lenders? In other words, when a loan modification results in
a conclusion that the home owner was deceived into a loan that
was mathematically designed to fail them after the teaser rate
resets, is home retention even possible without forgiving the portion of the debt that the homeowner would have never qualified for
under acceptable underwriting standards?
A.1. & 2. Your question focuses specifically on loans originated
fraudulently and without regard for the borrowers ability to make
payments after the initial interest rate resets to a higher rate. A
borrower who was defrauded into entering into a loan could pursue
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various legal remedies against the perpetrator of the fraud. Moreover, the borrower might be able to retain his or her home by exploring workout options. Where feasible, servicers could modify a
loan that resets at a high interest rate, so as to increase the likelihood that the borrower could make reasonable monthly payments.
Lehman is working with the servicing community to increase the
number of borrowers who may be appropriate candidates for some
form of loan modification. As a separate matter, financial institutions, such as Lehman, are helping to deter unscrupulous lending
practices before they begin, through enhanced diligence of mortgage originators.
Q.3. Finally, Mr. Sherr you spoke about the industry using home
retention practices to avoid foreclosures. Can you and your colleague Mr. Sinha talk to us in more detail about particulars of
what your firms are doing on the home retention front?
Have you all discussed the need for a private market rescue
fund?
A.3. Lehman has implemented an extensive set of home retention practices that emphasize early intervention and flexible options. For example, Lehman sends notification letters to borrowers
in advance of a substantial increase in their interest rate. In those
letters, Lehman encourages the borrowers to call Lehmans Home
Retention Department before the reset if they believe that they will
not be able to make the increased payments. The Department also
unilaterally reaches out to borrowers in delinquency to discuss
workout options. In order to make sure that distressed borrowers
get the help they need, Lehman recently has expanded the Home
Retention Departments hours of operation and is increasing staff
to enhance counseling availability.
As warranted by the circumstances, Lehman makes various
strategies available to distressed borrowers. Forbearance plans
allow delinquent borrowers to reinstate their accounts over several
months by paying more than the monthly contractual payment.
Special forbearance plans suspend or reduce contractual payments
to allow borrowers to solidify arrangements to reinstate past due
amounts. Loan modifications provide adjustments to note terms,
such as reductions in interest rates and extension of maturity
dates. These are but a few of the types of strategies offered to distressed borrowers by Lehman.
As a separate matter, Lehman has committed to contribute $1.25
million to the National Community Reinvestment Coalition during
the next three years. NCRC will use this money to help distressed
borrowers restructure their loans and to educate prospective borrowers about mortgages.
REGULATION
Q.4. As you all know on the panel, federal banking regulators published guidance on alternative mortgage as well as sub-prime hybrid adjustable mortgage products last year and more recently have
issued a new statement on these products for comment. Does the
guidance apply to your firms in each of its capacitieslender, issuer, and underwriter of sub-prime and alternative mortgage products?
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Given your status as a Consolidated Supervised Entity (a brokerdealer that meets certain minimum standards can apply for this
status. It gives them the ability to use alternative methods of computing net capital), do you think the SEC should be involved in the
process of developing future guidance on these mortgage products
in order to ensure that securities companies that are non-bank regulated entities are covered?
A.4. Lehman appreciates the leadership exercised by the federal financial regulatory agencies through their guidance on nontraditional mortgage products. That guidance applies to Lehman when
it makes or purchases loans. Lehman also notes that, because
much of its origination activities occur through Lehman Brothers
Bank, those activities are subject to review by the Office of Thrift
Supervision.
Lehman believes that the agencies that issued the guidance,
rather than the SEC, should continue to take the lead in regulating
mortgage products. The SEC nonetheless has an important role
with respect to the mortgage securitization processprotecting investors in mortgage-backed securities. And the SEC has been active in that area, especially through its adoption in 2005 of Regulation AB, which codified decades of guidance and practice in the regulation of publicly registered asset-backed securities.
Q.5. What level of due diligence do purchasers of sub-prime loans
conduct to ensure the products they are buying meet underwriting
requirements and or state/federal laws?
Follow up:
Given the level of due diligence that is conducted, would the purchaser not be in a good position to guard against bad loans entering into investment pools from the very beginning?
A.5. Purchasers of sub-prime loans, such as Lehman, start their
diligence by examining the lenders themselves. Before Lehman enters into a relationship with a lender, it spends time learning about
that lender, its past conduct and its lending practices. After that
review is completed, Lehmans diligence turns to the specific loans
that are offered for sale, often relying on third party due diligence
providers who have expertise in reviewing loan files. The percentage of a loan pool that gets tested is greater when Lehman first
enters into a relationship with a lender than when Lehman has a
longstanding relationship with a lender who has demonstrated
good practices. The sample testing focuses on, among other things,
whether the loans were underwritten in accordance with designated guidelines and complied with applicable laws. When loans
fail the review, they generally are removed from the loan pool.
All this diligence helps to detect poor lending practices. But the
key to guarding against fraudulent or unduly aggressive loans lies
with regulation of the interaction between loan originators and borrowers. Loan purchasers do not participate in those interactions.
Because it is the originator, not the purchaser, who interacts directly with the borrower, it is that interaction that should be the
focus of efforts to reduce unscrupulous practices.
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CREDIT QUALITY
Q.6. As we all know, the sub-prime industry is an important one

sub-prime mortgage credit market has expanded access to credit for
many Americans. Today, we have seen many Wall Street firms
move from not only providing capital for sub-prime loans, but also
to owning sub-prime lending companies outright. My question to
the investment banks on the panel is do you believe this shift to
ownership is improving credit quality and performance of subprime loans? What more can the industry do to improve credit
quality and the performance of sub-prime loans?
A.6. As discussed in response to Senator Reeds question about
vertical integration, Lehman believes that ownership of subprime
loan originators by financial institutions increases the integrity of
mortgage loan products, thereby benefiting borrowers and investors
alike. That said, since the original hearing on this matter, there
have been significant changes in the mortgage industry, particularly in the subprime segment. The volume of new subprime loans
has decreased substantially. In connection with that pullback in
the market, Lehman has closed the operations of its subprime
originator, BNC Mortgage. Nonetheless, as an industry observer,
Lehman believes that credit quality in the subprime area has been
improving due to the tightening of underwriting criteria.
LIABILITY
Q.7. There has been a significant amount of discussion about the

role Wall Street has in the sub-prime market. There has also been
a great deal said about the imposition of assignee liability to purchasers of loans. Do you feel assignee liability would play a significant role in guarding against bad loans being made by lenders
and ultimately ending up in investor pools? If so, what level of assignee liability do you feel is appropriate?
A.7. Imposition of assignee liability would lead to an undesirable
tightening of credit for prospective homeowners. The State of Georgias experience with its assignee liability law illustrates this point.
Soon after that law was passed, a major rating agency announced
that it would no longer rate mortgage-backed securities subject to
Georgia law. The rating agency reasoned that the assignee liability
law created unquantifiable risk for anybody who touched the loans,
including issuers and investors. Without sufficiently high ratings,
mortgage-backed securities would not be purchased by investors,
many of whom, such as pension funds, can only purchase investment grade securities. In light of the prospect that credit availability would be severely reduced for its citizens, Georgia amended
its law to delete assignee liability.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED

FROM WARREN KORNFELD
Q.1. How do the credit risk profiles of recent subprime borrowers
differ from past borrowers?
A.1. As we discussed in our written testimony, the risk profiles of
recent subprime borrowers differ from those in the past. Through
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2005 and 2006, in an effort to maintain or increase loan volume,
many lenders made it easier for borrowers to obtain loans. For example, borrowers could:
obtain a mortgage with little or no money down;
choose to provide little or no documented proof of income or assets on their loan application;
obtain loans with low initial teaser interest rates that would
reset to new, higher rates after two or three years;
opt to pay only interest and no principal on their loans for several years, which lowered their monthly payments but prevented the build-up of equity in the property; or
take out loans with longer terms, for example of 40 years or
more, which have lower monthly payments that are spread out
over a longer period of time and result in slower build-up of
equity in the property.
Often a loan was made with a combination of these characteristics, which is also known as risk layering. The weaker performance of 2006 subprime mortgage loans in part has been due to the
increasing risk characteristics of those mortgages.
Q.2. Do rating agencies have adequate data to assess credit and
market risk posed by recent subprime borrowers and some of these
exotic or experimental products? If so, what new types of data are
you using? Do you examine from what entities the loans are originated?
A.2. Moodys cannot represent what types of data other rating
agencies attain in analyzing subprime mortgage securitizations.
For Moodys part, it is important to note that, in the course of
rating a transaction, we do not see loan files or data identifying
borrowers or specific properties. Rather, we rely on the information
provided by the originators or the intermediaries, who in the underlying deal documents provide representations and warranties on
numerous items including various aspects of the loans, the fact
that they were originated in compliance with applicable law, and
the accuracy of certain information about those loans. The originators of the loans issue representations and warranties in every
transaction. While these reps and warranties will vary somewhat
from transaction to transaction, they typically stipulate that, prior
to the closing date, all requirements of federal, state or local laws
regarding the origination of the loans have been satisfied, including
those requirements relating to: usury, truth in lending, real estate
settlement procedures, predatory and abusive lending, consumer
credit protection, equal credit opportunity, and fair housing or disclosure.
Moodys would not rate a security unless the originator or intermediary had made reps and warranties such as those discussed
above. In rating a subprime mortgage backed securitization,
Moodys estimates the amount of cumulative losses that the underlying pool of subprime mortgage loans are expected to incur over
the lifetime of the loans (that is, until all the loans in the pool are
either paid off or default). Because each pool of loans is different,
Moodys cumulative loss estimate, or expected loss, will differ
from pool to pool.
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In arriving at the cumulative loss estimate, Moodys considers

both quantitative and qualitative factors. First, we analyze many
characteristics of the loans in a pool,1 which help us project the future performance of the loans under a large number of different
projected future economic scenarios.
The quality and depth of the loan-level data provided by prospective mortgage securitizers are important elements of Moodys rating process. For each new transaction, a data tape providing key
information for each loan is processed through our proprietary rating model, Moodys Mortgage Metrics.
As new products are introduced in the market and as originators
capture more data, Moodys periodically expands the loan level
data that we review to increase the granularity of our analysis; the
most recent expansion was April 2007.2 Generally, in the absence
of key information, assumptions are utilized.
The key fields currently used in our standard analysis are listed
below in the Appendix. The fields are divided into three groups:
primary, highly desirable or desirable based on their overall
risk weights. For instance, FICO is a primary field, while pay
history grade, if provided, would be used to supplement our understanding of a borrowers risk profile. Other highly desirable fields
such as cash reserves or escrow help us in further assessing the
risk of a loan especially when we try to determine where a loan
falls along the Alt-A to subprime continuum.
Another example of a set of highly desirable fields, are the characteristics of the corresponding first lien when analyzing a second
lien loan. The characteristics of the first lien have a strong impact
on the credit risk and performance of the second lien loan. Moodys
expects a closed-end second lien loan behind a fixed-rate first lien
loan to have a lower probability of default than a second lien loan
behind a first lien Option ARM loan. Again, absent such information about the respective underlying first lien mortgage, conservative assumptions would be utilized to size for the unknown risks.
Next, we consider the more qualitative factors of the asset pool
such as the underwriting standards that the lender used when deciding whether to extend a mortgage loan, past performance of
similar loans made by that lender, and how good the servicer has
been at collection, billing, record-keeping and dealing with delinquent loans. We then analyze the structure of the transaction and
the level of loss protection allocated to each tranche of bonds. Finally, based on all of this information, a Moodys rating committee
determines the rating of each tranche.
Q.3. Have you analyzed the impact loan modifications would have
on mortgage backed securities and the threshold needed to stabilize
the portfolios into performing loans?
A.3. To date, the level of modified loans in securitizations that we
have rated has been low. We however expect this to change as interest rates on many hybrid adjustable rate loans originated during
1 As noted earlier, we do not receive any personal information that identifies the borrower or
the property.
2 Please see, Moodys Revised US Mortgage Loan-by-Loan Data Fields, Special Report, April
3, 2007.
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the past few years approach their reset dates.3 Furthermore, in an

environment with fewer refinancing opportunities for borrowers
and a slowing housing market, loan modifications are likely to become more prevalent.
A servicers flexibility in modifying loans that have been
securitized is determined by each securitizations legal documentation and by accounting and tax rules. Most securitization governing
documents give servicers a degree of flexibility to modify loans if
the loan is in default or default is reasonably foreseeable, but the
exact provisions differ from one transaction to another. Moodys recently reviewed the governing documents for the subprime
securitizations that it rated in 2006. The vast majority of transactions permit the use of modificationsonly approximately 5% of
the securitizations contain specific language that does not permit
the servicer to modify loans. For transactions where the servicer is
allowed to modify loans, approximately 30% to 35% specify that
modifications may not exceed 5% of the original pool loan balance
or, alternatively, of the cumulative number of loans in the transaction. The balance of the transactions that permitted modifications contained no such cumulative restrictions. Moodys believes
that restrictions that limit a servicers flexibility to modify loans
are generally not beneficial to bondholders.
Moreover, in deciding whether to modify the terms of a loan, a
servicer will assess whether the loss expected from modifying a
loan will be lower than the loss expected from other loss mitigation
options or from foreclosure. If so, then a loan modification would
lead to higher cash flows for the securitization as a whole and
therefore the judicious use of modifications should lead to lower cumulative losses on loan pools backing securitizations. Therefore,
the threshold needed to stabilize the portfolios is necessarily a
case-by-case determination.
Since the purpose of a loan modification is to reduce the loss expected to be incurred on a loan that could potentially go into foreclosure, loan modifications should improve the credit profile of a
securitization as a whole. The credit impact of loan modifications
on any given class of bonds within a securitization, however, will
vary and depend not only on the level of losses that is incurred by
the pool, but also by the timing of those losses, by the bonds position in the securitizations capital structure and by the impact of
loan modifications on any performance triggers that may exist in
the securitization.
Q.4. Could loan modifications help stabilize the housing market
generally?
A.4. Moodys does not have the expertise to opine on the impact of
loan modifications on the overall housing market.
Q.5. Would you agree that the poorly underwritten exploding
ARMs in the Mortgage-Backed Securities make default reasonably
foreseeable? If not, why not? What analysis has been done to identify what characteristics more specifically define loans with high
probabilities of default?
3 For a more detailed discussion, please see Loan Modifications in U.S. RMBS: Frequently
Asked Questions, Special Report, June 6, 2007.
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A.5. We assume that this question is referring to the probability
of default for the individual ARM mortgages rather than the securities that are issued by a structured finance product where the underlying assets are such mortgages. As discussed earlier, when
riskier loan characteristics are combined or layered the credit
risk associated with that loan can increase. (In May 2005, we published on the significant increase in risk posed by the increasing
difference between the fully indexed rate and the original rate or
the amount of teasing of newly originated loans.4) However, the
analysis of the default probability of a particular loan is in large
part based on historical data with respect to similar types of loans.
Importantly, the default probability of such loans will depend not
only on the loan characteristics but on the macro-economic environment and the overall state of the housing market. Consequently,
MIS believes that while exploding ARMs may have riskier characteristics, that fact alone does not determine whether the borrower will default on his mortgage.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR
SCHUMER FROM WARREN KORNFELD
Q.1. As you all know on the panel, federal banking regulators published guidance on alternative mortgage as well as sub-prime hybrid adjustable mortgage products last year and more recently have
issued a new statement on these products for comment. Does the
guidance apply to your firms in each of its capacitieslender,
issuer, and underwriter of sub-prime and alternative mortgage
products?
Given your status as a Consolidated Supervised Entity (a brokerdealer that meets certain minimum standards can apply for this
status. It gives them the ability to use alternative methods of computing net capital), do you think the SEC should be involved in the
process of developing future guidance on these mortgage products
in order to ensure that securities companies that are non-bank regulated entities are covered?
A.1. These series of questions are not applicable to rating agencies.
Q.2. What level of due diligence do purchasers of sub prime loans
conduct to ensure the products they are buying meet underwriting
requirements and/or state/federal laws?
A.2. While this question is for the most part outside our area of
credit expertise, as a general matter, we believe that purchasers of
whole loans have an ability to conduct a certain level of due diligence on the loans and the loan files that they are purchasing. In
contrast, investors in the mortgage backed securities do not have
the appropriate level of expertise or resources to verify whether
loans in a particular pool have satisfied underwriting requirements
and or state/federal laws.
Whole-loan purchasers may conduct due diligence on and re-underwrite anywhere from a small portion to 100% of the loans that
they are purchasing, and may either use their own staff or a third
4 Please see, An Update to Moodys Analysis of Payment Shock Risk in Sub-Prime Hybrid
ARM Products, Rating Methodology, May 16, 2005.
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party to review loan files. However, they typically do not verify information directly with the borrower. Therefore, the whole-loan
purchaser will not know whether any documents have been altered
or are missing; and, will not know about the verbal communications between the originator, the broker and the borrower.
Mortgage backed securities investors typically rely on the originators and/or securitization sellers representations and warranties
that the loans are in compliance with all regulations and all laws.
However, it is our understanding that more and more mortgage
backed securities investors are receiving some non-identifying loan
level information and that the larger investors meet periodically
with the management of the originators and may conduct on site
visits (perhaps annually).
Q.3. Additional Follow-up questions: Given the level of due diligence that is conducted, would the purchaser not be in a good position to guard against bad loans entering into investment pools from
the very beginning?
A.3. Moodys does not have sufficient information or expertise to
adequately respond to this question.
Q.4. Liability: There has been a significant amount of discussion
about the role Wall Street has in the subprime market. There has
also been a great deal said about the imposition of assignee liability to purchasers of loans. Do you feel assignee liability would play
a significant role in guarding against bad loans being made by
lenders and ultimately ending up in investor pools? If so, what
level of assignee liability do you feel is appropriate?
A.4. Moodys role in the market is to provide independent opinions
on the creditworthiness of structures or securities. It is not Moodys
position or expertise to opine on the appropriateness of legislative
action. Our role in the capital markets leads our residential mortgage backed securities (RMBS) team to take a narrow focus on
legislationnamely, can the impact of the legislation be quantified.
With respect to assignee liability laws, in certain circumstances
such laws create unlimited assignee liability exposure or vague
definitions which, in turn, make analyzing the credit risk associated with a pool of such loans difficult if not impossible. As we
have said on previous occasions, laws that provide clear and objective standards and that define the thresholds for exposure are ones
that can more readily be dimensioned and analyzed.
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Senate Hearing, 110TH Congress - Subprime Mortgage Market Turmoil: Examining The Role of Securitization

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SUBPRIME MORTGAGE MARKET TURMOIL:

TUESDAY, APRIL 17, 2007

U.S. GOVERNMENT PRINTING OFFICE

smartinez on DSKH9S0YB1PROD with HEARING

For sale by the Superintendent of Documents, U.S. Government Printing Office

VerDate Nov 24 2008

05:10 Dec 12, 2009

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

JACK REED, Rhode Island, Chairman

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DIDEM NISANCI, Staff Director

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Opening statement of Chairman Reed ...................................................................

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SUBPRIME MORTGAGE MARKET TURMOIL:

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OPENING STATEMENT OF CHAIRMAN JACK REED

Chairman REED. I call the hearing of the Subcommittee to order,

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STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. First, I would like to congratulate my friend

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STATEMENT OF SENATOR ROBERT MENENDEZ

Senator MENENDEZ. Thank you, Mr. Chairman. I, too, want to

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OPENING STATEMENT OF SENATOR MIKE CRAPO

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OPENING STATEMENT OF SENATOR ROBERT P. CASEY

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STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman, and I appreciate

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STATEMENT OF GYAN SINHA, SENIOR MANAGING DIRECTOR