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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Confirming what most analysts knew, both before and after 2007, a Senate panel investigating the causes of the nation’s financial crisis on Thursday unveiled evidence that credit-ratings agencies knowingly gave inflated ratings to complex deals backed by shaky U.S. mortgages in exchange for lucrative fees.

The Senate Permanent Subcommittee on Investigations will hold a detailed hearing on Friday, where its chairman, Sen. Carl Levin , D- Mich. , will introduce e-mail records in which executives from Standard & Poor’s and Moody’s Investors Service acknowledge compromising the integrity of ratings to win business from big Wall Street firms.

“They did it for the big fees they got,” Levin told reporters on Thursday after outlining the broad strokes of what he’d pursue Friday when he puts current and former ratings agency officials on the hot seat.

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The federal government and states are girding themselves for the next foreclosure crisis in the country’s housing downturn: payment option adjustable rate mortgages that are beginning to reset.

“Payment option ARMs are about to explode,” Iowa Attorney General Tom Miller said after a Thursday meeting with members of President Barack Obama’s administration to discuss ways to combat mortgage scams.

“That’s the next round of potential foreclosures in our country,” he said.

Option-ARMs are now considered among the riskiest offered during the recent housing boom and have left many borrowers owing more than their homes are worth. These “underwater” mortgages have been a driving force behind rising defaults and mounting foreclosures.

In Arizona, 128,000 of those mortgages will reset over the the next year and many have started to adjust this month, the state’s attorney general, Terry Goddard, told Reuters after the meeting.

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In an article titled “They Gave Your Mortgage To A Less-Qualified Minority” we see the effect of Clinton-era changes. Did these changes set the stage for the subprime crisis? You be the judge, but the system was abused, and went well beyond minorities. “Under Clinton, the entire federal government put massive pressure on banks to grant more mortgages to the poor and minorities. Clinton’s secretary of Housing and Urban Development, Andrew Cuomo, investigated Fannie Mae for racial discrimination and proposed that 50 percent of Fannie Mae’s and Freddie Mac’s portfolio be made up of loans to low- to moderate-income borrowers by the year 2001.

Instead of looking at “outdated criteria,” such as the mortgage applicant’s credit history and ability to make a down payment, banks were encouraged to consider nontraditional measures of credit-worthiness, such as having a good jump shot or having a missing child named “Caylee.”

Threatening lawsuits, Clinton’s Federal Reserve demanded that banks treat welfare payments and unemployment benefits as valid income sources to qualify for a mortgage. That isn’t a joke — it’s a fact. ” (see full article)

By 2005 brokers encouraged people to claim they were 1 percent Native American, and in one facinating case, actually gave a $480,000 mortgage to an illegal alien from Mexico. By 2007 it was not uncommon to encourage people to borrow money, boosting their checking account balance before closing, but before the loan was seen on a credit report. The borrower had to lie about the source of the funds.

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Just when we thought subprime could not get uglier, one of the world’s largest banks has found a way to usurp U.S. government regulations. High-Rate, High-Fee Loans HOEPA/Section 32 Mortgages and how to get around the regulation seems to be the newest and latest marketing ploy.

“As a current employee I am appauled to see Beneficial and HFC’s latest trick which seems to be avoiding federal caps on interest rates. As of May 5th they rolled out their new pricing sheets with rates set above the maximum Sect 32 rates set by the goverment. How can they do this? Simple, force customers to take “advantage” of their Pay Right Rewards system that lowers your interest rate by a whole .25% every year that you pay on time. This allows them to magically show you a much lower APR than the true rate you will be paying.

The APR they show you assumes you will be keeping the loan for the full 30yrs and getting all 12 of the rate reductions. However, in reality most customers only have to suffer on the books with us for an average of 36 months before they wise up and find another lender or get foreclosed on.

I’m currently searching for a new job and will hopefully not have to live my life ashamed of what I do for a living for much longer. In the almost 10yrs I have worked for this company I have unfortunetly seen examples of almost every other upset employee’s post on this site and have had enough.”

We thank this employee for the informaiton. To see more about High-Rate, High-Fee Loans (HOEPA/Section 32 Mortgages) see the FTC guidelines.

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This time it’s an investment bank with problems. Swiss-based UBS announced a $10 billion writedown this week on subprime exposures. An injection of capital from investors in Singapore and the Middle East was also announced. UBS has also slammed on the brakes at its investment bank, where the problems originated. UBS has been the biggest casualty so far among major European banks of the meltdown in U.S. subprime mortgages. Some analysts continue to characterize subprime as loans made to people with poor credit histories. Others say lack of regualtory action and oversight transformed predatory lending into acceptable lending standards.

A recent article by Andrew Hurst has more details about problems at UBS.

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While Treasury Secretary Henry Paulson was speaking, a federal appeals court shut the door to state enforcement of federally charted banks. Now Paulson wants help from the states. What in the world is going on? Didn’t the court render the states powerless to seek documents and enforce predatory lending laws, while Paulson is asking stes for help after the fact? First we blame poor people, then we take no action at the federal level, and now this? American’s are not that stupid and gullible!

Paulson proposed state and local governments should temporarily be allowed to issue tax-exempt bonds to include money for mortgage refinancings. “Given the local nature of housing markets, state and local solutions can be particularly effective,” the secretary said.

A federal appeals court on Tuesday upheld a lower courts 2005 decision that barred the New York attorney generals office from subpoenaing documents and instituting enforcement actions against national banks as part of an investigation into lending practices. In an order Tuesday, the 2nd Circuit Court of Appeals affirmed a decision that the New York attorney generals office had infringed on the Office of the Comptroller of the Currencys role in supervising national banks under the National Bank Act with a probe into possible racially discriminatory practices in residential lending.

The OCC filed a lawsuit against the attorney generals office in June 2005, saying the investigation infringed on its regulatory role. In the lawsuit, the OCC said the attorney generals office had sought public and nonpublic information about the mortgage lending business of four national banks that operate in New York. The banks included units of HSBC Holding PLC, JPMorgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. From 2005 until today the OCC took little regulatory action, if any. The OCC needs to take partial responsibility for letting the subprime crisis spiral out of control.

We are filing this little bit of irony in our “Quotable Quotes” section for the time being.

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As lawmakers, Treasury Secretary Henry Paulson, Housing and Urban Development Secretary Alphonso Jackson, a slew of presidential hopefuls, and many others weigh in on a solution to the subprime mess it is clear that President Bush is in a jam. While some realists say the recession of 2001 never ended, others claim the manufactured wealth needed for U.S. economic growth was sure to fall apart. That it did, but during the build-up President Bush protected businesses, predatory lenders, banks, and investors with new legislation such as the 2005 revision of bankruptcy laws.

Now many pro-consumer ideas are on the table. Admissions that this is not a ’subprime’ problem takes the focus off of people with less than stellar credit. But where is the focus now? Like a child’s game of dodgeball or musical chairs the music may stop playing on 6 December. For once Bush may not be able to protect those who got us into this problem to begin with. The Bush administration expects to make an announcement Dec. 6th. Paulson said “I am optimistic that we are going to have something to announce by the end of the week.’

When the announcement is made investors are sure to scream. Contracts are in place, and the delicate job of balancing future U.S. growth against legal issues will be interesting. Without a solution U.S. growth is sure to stall. I am writing this on the evening of December 3rd, but I guarantee if history is correct the Bush administration will throw money at the problem. That is money we do not have.

The fact that Bush is in a jam between business interests and real people – like consumers and home owners – reminds some of post-Katrina. Some alleged that Bush did not like black people. Others said Bush didn’t like poor people. Now that the mortgage industry has imploded, we can look back at financial legislation since hurricane Katrina to see that, given a choice between business and real people, Bush just doesn’t like people.

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Some say the U.K. is a warning to the U.S. but the news sounds about the same. One third of all U.K. homeowners will face big increases in their house payments. A report released yesterday said approximately 5.5 million people in the U.K. would be effected. Many fell into the subprime trap because of divorce, employment issues, or other unforeseen financial issues. While the U.K. classifies adults as ‘non-standard’ the United States also faces many subprime and ALT-A problems as adjustable rate mortgages reset. The United States classifies the problem as ’subprime’ but analysts say the analogy no longer holds up to examination. Here is why:

“Subprime suggests people with less than stellar credit caused the credit crunch around the world. Such a classification, and total volume of of subprime losses suggest a much bigger problem” said Household – HSBC Watch.

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The housing recession will drive down property values by $1.2 trillion next year and slash tax revenue by more than $6.6 billion, according to a report issued today by the U.S. Conference of Mayors. The 361 largest U.S. cities will experience a combined loss of $166 billion in economic growth, led by $10.4 billion in the New York-Northern New Jersey area, according to the study.

The effect of sliding home prices has a direct impact on lenders. About 56 percent of HSBC’s subprime U.S. home loans will slip into so-called negative equity if home prices fall ten percent, whereby a borrower’s outstanding loan is greater than the value of their property, the analysts estimated.

Negative equity is more probable when loans have high closing costs, are high loan to value, contain single premium PMI, have an attached second mortgage or HELOC, or if early payoff penalties must be added to refinance the loan.

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