We finally came full circle relative to subprime, mortgage blues, and the subsequent recession. What we could not see in 2006 are new laws enacted today. Under sweeping financial overhauls that have now passed the House and Senate, home buyers won’t be able to get a mortgage without producing pay stubs or other evidence they can make their monthly payments.

A new consumer watchdog will police lenders who offer impossible-to-resist subprime mortgages and then jack up the interest rates to impossible-to-pay levels.

The bills, which still have to be blended into one that could reach the president’s desk this summer, also shine more light on complex but hidden financial instruments, the “derivatives” that made long-odds bets on whether Americans could make payments on mortgages they never should have qualified for.

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WASHINGTON – The government says the number of troubled banks kept growing last quarter even as the industry as a whole had its best quarter in two years.

The Federal Deposit Insurance Corp. says the number of banks on its confidential “problem” list leaped to 775 from 702 in the January-March period. But banks overall posted net income of $18 billion. That was up from $5.6 billion in the same quarter a year earlier. (reference)

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continuing to react to the mortgage crisis be creating new laws, one more law is on the books. Earlier Thursday, senators dealt a blow to the nation’s largest credit-rating agencies, approving tough new rules for the industry and voting to remove the government’s formal endorsement of a handful of firms.

Sen. Al Franken (D-Minn.) had taken aim at what he called “staggering conflicts of interest” in the current structure, in which issuers of financial products can shop for the most favorable ratings. Because issuers also pay the ratings agencies for their services, Franken said, the agencies have an incentive to give securities a higher rating than warranted.

“This conflict of interest has cost American investors and pensioners billions and billions of dollars,” Franken said, “because supposedly risk-free investments have failed or been downgraded to junk status.”

Franken’s measure seeks to end the practice of shopping for ratings by creating a clearinghouse regulated by the Securities and Exchange Commission. Financial companies seeking to have a new security rated would be assigned a rating agency by the clearinghouse. Firms could then seek out subsequent ratings on their own, but any discrepancies between the ratings would be made public.

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The New York attorney general has begun an investigation into eight banks to determine whether they provided misleading information to agencies that rate mortgage securities, The New York Times reported on Thursday.

New York Attorney General Andrew Cuomo’s office issued subpoenas late on Wednesday notifying the banks of his investigation, the Times reported on its Web site, citing two people with knowledge of the probe.

According to the report, the probe’s targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Credit Agricole and Merrill Lynch, now owned by Bank of America.

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WASHINGTON, May 12 (Reuters) – The U.S. Senate on Wednesday voted to end mortgage kickbacks and so-called “liar loans,” two lending practices that played a role in the meltdown of the subprime mortgage market.

By a 63-36 vote, the Senate adopted a measure that would prohibit mortgage lenders from offering incentives to brokers who steer customers into more-expensive loans.

The amendment, which was added to a sweeping rewrite of financial regulations, also would end “liar loans” by requiring lenders to verify that borrowers have enough income to repay their mortgages.

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In a pay-to-play game ratings agencies were trusted by Americans until problems becmae obvious in 2007. An SEC investigation of ratings agencies could turn up some interesting facts. While the Dow Jones Industrial Average rose almost 4 percent Monday, share prices for Moody’s Corp. tumbled 7.19 percent as investors digested confirmation of a Securities and Exchange Commission investigation into the credit-rating agency.

The fall in Moody’s share value to $21.68 dragged down its chief competitor, Standard & Poor’s , part of McGraw-Hill Companies, which fell almost 4 percent.

Most Americans look forward to the truth and welcome the SEC investigation.

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A Democratic official familiar with Senate banking negotiations says a provision that would force banks to spin off their derivatives operations will be incorporated into sweeping regulatory legislation despite Obama administration misgivings.

The provision would cost the nation’s largest banks billions of dollars in business. In an agreement struck Sunday, Banking Committee Chairman Christopher Dodd agreed to replace his proposed restrictions on derivatives with those of the Senate Agriculture Committee.

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Here’s the written testimony of Eric Kolchinsky before the Senate Permanent Subcommittee on Investigations last week who, during the majority of 2007, was the Managing Director in charge of the business line which rated sub-prime backed CDOs at Moody’s Investors Service.

He was suspended by Moody’s after warning the compliance group regarding what he believed to be a violation of securities laws within the rating agency.

Here’s the statement, now a matter of public record:

‘My name is Eric Kolchinsky, and during the majority of 2007, I was the Managing Director in charge of the business line which rated sub-prime backed CDOs at Moody’s Investors Service. More recently, I was suspended by Moody’s after warning the compliance group regarding what I believed to be a violation of securities laws within the rating agency.

In my opinion the cause of the financial crisis lies primarily with the mis-aligned incentives in the financial system. Individuals across the financial food chain, from the mortgage broker to the CDO banker were compensated based on quantity rather than quality. The situation was no different at the rating agencies.

It is my firm belief that the vast majority of the analysts at Moody’s are honest individuals who try hard to do their jobs. However, the incentives in the market for rating agency services favored, and still favor, short term profits over credit quality and quantity vs. quality.

At Moody’s, the source of this conflict was the quest for market share. Managers of rating groups were expected by their supervisors and ultimately the Board of Directors of Moody’s to build, or at least maintain, market share. It was an unspoken understanding that loss of market share would cause a manager to lose his or her job.

Prior to the crisis, it may have been reasonable to believe that the pursuit of market share could be unrelated to credit quality. People would say, “we are credit specialists – it is our job to be able to analyze anything we are asked to.” After the crisis, it became clear that the drive for market share was the main cause of the deterioration in credit standards in the ratings of structured finance.

As a former head of compliance testified, Moody’s had an unofficial policy of never committing controversial items to paper or email. Instead, people were encouraged to walk over and have a conversation or to have a conference call. However, because of its importance, market share information was an exception.

Senior management would periodically distribute emails detailing their departments’ market share. These emails were limited to Managing Directors only. Even if the market share dropped by a few percentage points, managers would be expected to justify “missing” the deals which were not rated. Colleagues have described enormous pressure from their superiors when their market share dipped.

While, to my knowledge, senior management never explicitly forced the lowering of credit standards, it was one easy way for a managing director to regain market share. I do not believe that this was done in a deliberate manner. Instead, during the bubble years, it was quite easy to rationalize changes in methodology since the nominal performance of the collateral was often quite exceptional. Easier still was avoiding the questioning whether the collateral provided by the bankers was really of the same quality assumed by the model, whether the collateral standards declined or whether some of the parties had ulterior motives in closing the transaction.

I began to receive these emails when I was promoted to Managing Director. They would list all the deals in the market for the relevant period and the amounts rated by Moody’s, S&P and Fitch. At the bottom of the spreadsheet, the market share for each agency was calculated.

I believe that my 2007 dismissal from the rating agency was a consequence of placing credit quality above market share. I was a Managing Director in the Derivatives group, which was responsible for rating CDOs. CDOs were an extremely lucrative area for Moody’s – in the first two quarters of 2007, the group generated over $200 million of revenue. This amount accounted for approximately one-fifth of the total revenue of the entire rating agency for that period.

However, trouble for the securitization was already brewing. In early 2007, New Century, a major sub-prime lender, imploded. During the course of the year, the prices of synthetic subprime bonds precipitously declined. The end of this initial phase of the crisis was heralded by the fall of two Bear Stearns hedge funds which heavily invested in CDOs in July of 2007. The resulting price dislocation sent bankers hurrying to finish CDOs already in progress and to clean up their balance sheets.

As Managing Director, I ignored the market share priority as much as I could. I refused to rate a complex CDO that I believed we did not have the tools to model appropriately. I continued to upset bankers, and my own management, by insisting on following long established rules and procedures which became inconvenient as the market began to fall apart.

However, the incident which I believe caused me to lose my role at the rating agency occurred in September of 2007. During the course of the year, the group which rated and monitored subprime bonds did not react to the deterioration in their performance statistics. That changed by the late summer of 2007. In early September, I was told that the ratings on the 2006 vintage of subprime bonds were about to be downgraded severely. While the understaffed group needed time to determine the new ratings, I left the meeting with the knowledge that the then current ratings were wrong and no longer reflected the best opinion of the rating agency.

This information was critical for the few CDOs in my pipeline, which were being hyper- aggressively pushed by the bankers. Our rating methodology for these transactions used the ratings which were about to be downgraded as a basis for our ratings. If the underlying ratings were wrong, the ratings on these CDOs would be wrong too. I believed that to assign new ratings based on assumptions which I knew to be wrong would constitute securities fraud. I immediately notified my manager and proposed a solution to this problem.

My manager declined to do anything about the potential fraud, so I raised the issue to a more senior manager. As a result of my intervention, a procedure for lowering subprime bond ratings going into CDOs was announced on September 21, 2007. I believe that this action saved Moody’s from committing securities fraud. Because of the culture, I knew what I did would possibly jeopardize my role at Moody’s.

Just about a month later, in mid-October, another periodic market share email was sent to the Managing Directors in my group. Along with the email, our business manager noted that our market share dropped from 98% plus to 94% in the third quarter. My manager immediately replied to the email and demanded an accounting of the missing deals.

This was the most disturbing email I had ever received in my professional career. A few days before, Moody’s had downgraded over $33 billion in subprime bonds. At the time, this was the largest ever single downgrade at Moody’s. However, as a direct result of the October 07 and additional downgrades, over $570 billion of ABS CDOs would be downgraded through the end of 2008.

Despite the massive manifest errors in the ratings assigned to structured finance securities and the market implosion we were witnessing, it appeared to me that my manager was more concerned about losing a few points of market share than about violating the law.

In late October, less than a month after that email and less than two months after I intervened, my manager asked me to leave the group. I was given a smaller position with less responsibility and less pay in another group. I believe that this demotion was in retaliation for my earlier actions in September.

While Moody’s has acknowledged that the rating situation in September 2007 constituted a “problem”, they failed to act to prevent a nearly identical situation in January of 2009 in connection with a transaction called Nine Grade Funding II. Instead of following some common-sense steps to prevent a violation of the law, Moody’s management chose to suspend me after pointing out the breach.

Recent rating activity indicates that market participants still prefer the most aggressive ratings. Rating firms which have taken conservative positions have seen their market share tumble. We will no doubt see the results of this lesson when the regulatory spotlight is turned off. Credit standards will once again plunge as rating agencies race to build their market share.

The only way to prevent this from occurring is to recognize that the function which the rating agencies perform is a quasi-regulatory one, much like accountants. A single set of public standards needs to be implemented, to be used for regulatory purposes only. This will allow rating agencies to compete for clients without being forced to lower credit standards’.

Source – Senate Permanent Subcommittee on Investigations

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One of our most popular articles discusses repeal of Glass Steagall. Robert Reich is Professor of Public Policy at the University of California at Berkeley. He has served in three national administrations. He also explains why our article was so popular:

If any three people are most responsible for the failure of financial regulation, they are Greenspan, Larry Summers, and my former colleague, Bob Rubin. In 1999, they advised Congress to repeal the Glass-Steagall Act, which since 1933 had separated commercial from investment banking.

By 1999, Wall Street was salivating over such a repeal because it wanted to create financial supermarkets that could use commercial deposits to place bets in the financial casino. That would yield the Street trillions.

At the same time, Greenspan, Summers, and Rubin also quashed the efforts of the Commodity Futures Trading Corporation to regulate derivatives when its director began to worry that derivative trading already was getting out of control.

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Senate aides inched closer Friday to combining separate bills that would establish oversight of the vast market for derivatives, an effort central to the ongoing push to revamp the nation’s financial regulations.

The Senate banking and agricultural committees, which share jurisdiction over parts of the derivatives market, recently passed different versions of legislation with a common goal — bringing transparency and supervision to a market that has remained largely devoid of regulation.

Legislation seeks to ban big Wall Street banks from trading in derivatives. It also requires nearly all derivative contracts to be traded on public exchanges and approved by a separate body called a clearinghouse.

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