[Senate Hearing 110-913]
[From the U.S. Government Publishing Office]
S. Hrg. 110-913
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
C O N T E N T S
----------
TUESDAY, APRIL 17, 2007
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Allard............................................... 2
Senator Menendez............................................. 3
Senator Crapo................................................ 4
Senator Casey................................................ 5
Senator Schumer.............................................. 6
WITNESSES
Gyan Sinha, Senior Managing Director and Head of ABS and CDO
Research, Bear Stearns & Company, Inc.......................... 9
Prepared statement........................................... 42
David Sherr, Managing Director and Global Head of Securitized
Products, Lehman Brothers, Inc................................. 11
Prepared statement........................................... 49
Response to written questions of:
Senator Reed............................................. 139
Senator Schumer.......................................... 141
Susan Barnes, Managing Director, Standard & Poor's Ratings
Services....................................................... 14
Prepared statement........................................... 55
Warren Kornfeld, Managing Director, Residential Mortgage-Backed
Securities Rating Group, Moody's Investors Service............. 16
Prepared statement........................................... 74
Response to written questions of:
Senator Reed............................................. 144
Senator Schumer.......................................... 148
Kurt Eggert, Professor of Law, Chapman University School of Law.. 17
Prepared statement........................................... 90
Christopher L. Peterson, Associate Professor of Law, University
of Florida..................................................... 19
Prepared statement........................................... 118
SUBPRIME MORTGAGE MARKET TURMOIL: EXAMINING THE ROLE OF SECURITIZATION
----------
TUESDAY, APRIL 17, 2007
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The subcommittee met at 3 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
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 servicer's duty to act on behalf of
different investors limit the servicer's ability to provide
loan workout options for the borrower? Also, is it possible
that securitization can create perverse incentives, 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 Moody's 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 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. Today's 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.
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.
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
didn't 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
people 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 all--11 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 experience--and 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 1890's and maybe the 1920's, 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 now--
lots of them. And 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 be--but 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 servicer's ability to prevent foreclosures by
modifying the loans? And since it would be in both the
servicer's and loan holder's best economic interest to prevent
foreclosure, shouldn't 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.
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 &
Poor's 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 & Poor's 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 co-
heads Moody's 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 Moody's RMBS and ABS Service Ratings Group. Mr.
Kornfeld has more than 20 years of experience in the
securitization market. Prior to joining Moody's 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 Board's
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.
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 us--at least by
all the staff--and 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 loss-adjusted 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
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 holder's 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 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 Nation's 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-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 America's
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 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.
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 manner--and
Lehman does not believe that such powers are materially
lacking--the market will adjust by enhancing the servicer's
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.
Chairman Reed. Thank you.
Ms. Barnes, and if you could bring the microphone close to
you.
STATEMENT OF SUSAN BARNES, MANAGING DIRECTOR, STANDARD & POOR'S
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 & Poor's. 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&P's
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 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 transaction's 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
third-party 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.
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, MOODY'S 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 Moody's Investors Service.
By way of background, Moody's 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 Moody's 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. Moody's 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 Moody's rating
Committee determines the rating of each tranche. Moody's
regularly monitors its rating on securitization tranches
through a number of steps. We receive updated loan performance
statistics, generally monthly. A Moody's 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 Moody's 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, Moody's
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
Moody's 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 single-A or higher to be at
risk of loss.
Finally, I want to give Moody's view on loan modifications
by servicers in the event of a borrower's 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. Moody's believes that restrictions in securitizations
which limit a servicer's 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 brokers. 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
the--that 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
about--I 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 flexibility--they 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. 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 people, they worked things out. The mortgagee
gives a mortgage in exchange for borrowing money. And in that
market the incentive is--the 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 got--there 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, which--the first was
in 1997--or, excuse me, 1977, but it really did not take off,
you know, get large until the 1990's 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 not--you 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 been--they 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 aisle--the
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 scope
and definitions and structure has not--does 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 today's 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
collectors--or it only applies to debt collectors, which in
most cases will not apply in the servicing market--the
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 Nation's consumer credit law. We
need to go back to the drawing board and re-update--update
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 opinion--you called me up here--we 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-income-
verification 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
purchasing 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
securitization--these 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 markets--
and 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 are--ultimately, 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
loans--they 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 borrower's capacity, he
was looking at the highest premium he could get, the types of
loans. Also, I think what--I do not want to put words in your
mouth, but you are also 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 seeing--you 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.
Chairman Reed. Thank you.
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 AA-
rated debt backed by other assets, which is suggesting that
maybe these ratings are not as--they 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 market--
you 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 defaults--that 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.
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.
Chairman Reed. Thank you.
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.
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 that--do 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 market--the 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 the--would 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 there--I 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.
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 market--think
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. Isn't there a good part of what
happens to the securitizer is that if the loan defaults the
originator has to buy it back? Isn't 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 isn't 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?
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
Chairman's questions and you said market mechanisms are in
place. But they are in place only when we are at the default
stage. Isn't 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 out--
and 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.
Chairman Reed. Thank you.
Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
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, you've 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.
Senator Crapo. Thank you.
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.
Senator Crapo. Thank you.
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 the--well, 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
investor's 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.
Senator Crapo. Thank you.
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.
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 people's 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 quite--I 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.
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 Commission's Holder in Due Course Notice Rule
that is applied to say car lending ever since the 1970's. 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?
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 of--you 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
denied--who 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
everyone's 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 not--let me have
you reaffirm 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 out--Professor
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 a--I 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.
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 market's 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
everyone's 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 everyone's
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 & Poor's 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.
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 servicer's 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 everybody's
best interests to avoid foreclosure. I am not sure that that is
true. It is certainly in the investor's interest, by and large,
and in the investment bank's 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
fees--if 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 borrower 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 seen--I 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 the--I 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 Crapo's 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 Schumer's 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.
Senator Menendez. But with the number or percentages of
loans that are falling within that category--and I agree with
you, Mr. Sherr. You said let's have a national law that defines
predatory lending and let's 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 forth--other 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
industry's part.
But is it not true that market investors are really in the
best--at least under the existing system--they 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. Don't you think that you, in
fact, have by virtue of the power--I 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, isn't there a role
for you to have a stronger, more--I do not want to use the word
stringent because that can go overboard--but 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 that--understands 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 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? Didn't you have some earlier signs
that this market segment was writing checks that you simply
could not cash?
And don't 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
2006's 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 as--it 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 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 borrower's 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 bank's 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 been--what
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 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
loans--the 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 above-market 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 Moody's on New Jersey's 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 & Poor's would just like to go on
record that we support all of the predatory lending laws that
are--in 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 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:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
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
ask--work 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 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 5-10% 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.
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.
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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 borrower's
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 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 Lehman's 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
Department's 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 capacities--
lender, issuer, and underwriter of sub-prime and alternative
mortgage products?
Given your status as a Consolidated Supervised Entity (a
broker-dealer 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
process--protecting 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, Lehman's 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.
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 sub-prime 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 Reed's 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 Georgia's 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.
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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 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. Moody's cannot represent what types of data other rating
agencies attain in analyzing subprime mortgage securitizations.
For Moody's 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.
Moody's 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, Moody's 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, Moody's
cumulative loss estimate, or ``expected loss,'' will differ
from pool to pool.
In arriving at the cumulative loss estimate, Moody's
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
Moody's rating process. For each new transaction, a data tape
providing key information for each loan is processed through
our proprietary rating model, Moody's Mortgage Metrics.
As new products are introduced in the market and as
originators capture more data, Moody's 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 borrower's
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. Moody's 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 Moody's rating committee determines the
rating of each tranche.
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\1\ As noted earlier, we do not receive any personal information
that identifies the borrower or the property.
\2\ Please see, ``Moody's Revised US Mortgage Loan-by-Loan Data
Fields,'' Special Report, April 3, 2007.
Q.3. Have you analyzed the impact loan modifications would have
on mortgage backed securities and the threshold needed to
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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 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.
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\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 servicer's flexibility in modifying loans that have been
securitized is determined by each securitization's 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. Moody's recently
reviewed the governing documents for the subprime
securitizations that it rated in 2006. The vast majority of
transactions permit the use of modifications--only
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. Moody's believes
that restrictions that limit a servicer's 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 bond's position in the
securitization's 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. Moody's 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?
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.
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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 capacities--
lender, issuer, and underwriter of sub-prime and alternative
mortgage products?
Given your status as a Consolidated Supervised Entity (a
broker-dealer 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.
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\4\ Please see, ``An Update to Moody's Analysis of Payment Shock
Risk in Sub-Prime Hybrid ARM Products,'' Rating Methodology, May 16,
2005.
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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 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
originator's and/or securitization seller's 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. Moody's 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. Moody's role in the market is to provide independent
opinions on the creditworthiness of structures or securities.
It is not Moody's 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 legislation--namely,
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.