American Enterprise Institute

November 15, 2007

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Panelists:	J. Kyle Bass, Hayman Capital Partners
		Joseph R. Mason, Drexel University
		Alex J. Pollock, AEI
		Frank Raiter, Luminent Mortgage Capital and Clayton Holdings
		Glenn Reynolds, CreditSights
	Moderator:	R. Christopher Whalen, Institutional Risk Analytics
4:00	Adjournment

Proceedings:

R. Christopher Whalen:  Good afternoon, ladies and gentlemen, thank you for coming today.  My name is Christopher Whalen and on behalf American Enterprise Institute and Professional Risk Managers’ International Association who are cosponsoring this event today, I want to thank you for giving us your attention.

I serve as Regional Director of PRMIA’s Washington Chapter and I’m also chair of the Speakers’ Committee, which gets me involved in events all over the world and it is a lot of fun.  For those of you who do not know PRMIA, we are one of the larger risk management associations in the world.  We have about 45,000 members.  The largest growth component is in Asia, interestingly enough, which should not surprise anybody.  But for me, it is nice because we focus on education and we focus on the individual.  We have members running the association.  The only professional staff we have is the people who help us put on events and do sponsorship activities.  So it has really been a wonderful thing for us to work with AEI and with Alex Pollock and some of the other scholars in this organization, and we look forward to doing so in the future.

 We have actually done three events in the past year or so, I think on subprime debt.  This is the first event on the ratings agencies.  Of interest, when we were organizing this event, I think we have to let you all know that we did invite S&P, Moody’s and Fitch to be with us today and they all declined respectfully.  We also invited the Attorney General --

 Male Voice:  Or perhaps, not so respectfully.

 R. Christopher Whalen:  Yeah, that is true but I’m trying to be nice.

 We did invite the Attorney General of the state of Ohio, who initially showed interest but then begged off.  I think the bottom line is that this situation that we have today in the ratings space is so relevant and so pressing that it has become a matter of general interest for Americans, really, of all different backgrounds.  I have beat reporters from U.S.A. Today and people who covered general news calling me up and asking for tutorials on structured finance.  That tells you how important this issue is. 

I have had a couple of very politic conversations with people in the rating agencies who say, “Well, Chris you are being unfair.  You are being very critical.  We see you on TV and in your writing, taking us to task.”  And I said, “Well, would you like to spend some quality time with the members of my association?”

 We host meetings for chief risk officers in New York every other month.  And I got to tell you, when we close those doors and let everybody talk over their sandwiches, it is pretty amazing, some of the things that are being said.  You can understand why they are upset because they have lost tens of millions, hundreds of million, in some cases billions of dollars.  They have had colleagues immolated and fired. 

Just look at the casualty list on Wall Street.  Warren Spector, Chuck Prince, you know the list goes on and on, these are people I have worked for in the past and who are really smart people.  I do not think there is anyone at Bear Stearns who thought Warren Spector would be forced out of that firm; they were expecting him to be the next CEO.

 So I think, the context for today’s discussion, I think a really excellent discussion, given the panel we have been able attract, is that the obscure and often unnoticed process of rating the default probability or the expected loss of a given security has become general interest in the United States.  It is probably bad news for the rating agencies but it is good news to those of us who work in finance and like to focus our time and attention on these subjects.

 Ground rules for today’s discussion - I have asked all of our panelists to answer two questions:  What is the problem?  And how do we solve it?  If there is a problem, of course, I do not want pre-judge.

 I have asked each one of our colleagues to speak for about 12-15 minutes and then open it up to Q&A, which is always the interesting part of the event.  And we are going to go in alphabetical order starting with Mr. Kyle Bass.  You can stay at your seat, by the way, if you like.  And with that, let me let you begin.

 J. Kyle Bass:  Thank you.  I appreciate the invitation to talk about this and I’m upset that they would not come here to debate us again.  It was fun in Congress.

 We all know, I guess, why we are here.  I will gloss over a little bit, what I believe to be the problem.  How the problem is definitely going to get worse and what we think is the best solution to the ratings agencies issues.  So I will start now.

 The credit crisis, I believe, was inevitable.  The disintermediation of risk on an epic scale has contributed to the colossal credit problems that exist in the market place today.  The lenders pass the risks to the Wall Street firms.  The Wall Street firms, in collusion with the ratings agencies, pass the proverbial hot potato onto unwary investors.  Now, as the gross negligence is unveiled, all parties are pointing the finger at one another.  You know, a securitization is basically a big off balance sheet bank.  There is a sliver of equity and a lot of leverage.  No policemen are there to keep the players honest.  Securitization is basically a mediocre idea, in my opinion.

 As my friend David Einhorn recently stated, “Re-securitization of already securitized assets into a CDO is a bad idea.  Re-securitization of CDOs into CDO-squared is a really bad idea.”  The mezzanine CDO is the single instrument that is at the crux of the complete loss of the rating’s agencies credibility, and the associated problems of severe AAA impairments. 

For those of you that do not really follow this, a mezzanine CDO is basically, you have a regular securitization; the bottom of the securitization is just above the equity piece as the first-loss piece.  Those first-loss pieces are considered to be mezzanine pieces but they are just above investment grade pieces.  Well a mezzanine CDO is a collection of just those pieces across many deals repackaged, and magically 80 percent of that package is now rated AAA.

 So in my opinion, that is where the ratings agencies will see severe and sometimes complete AAA impairments, and that is why, I believe, we are sitting here today.  Now, that is the beginning of the problem.  The problem will get worse from there. 

But basically, people blindly lent these opaque structures, full of loans; they have no idea how to reevaluate.  So today, the gold standard is not the gold standard anymore.  AAA is not AAA anymore.  The fact that the probability of default in credit loss differs across asset classes and the ratings agencies models should be cause for concern by many regulatory bodies.

 In the last 10 years, Moody’s has said, “No matter what types of instruments the rating is applied to, no matter where the issuer resides and no matter where the currency or market in which the security is issued, Moody’s ratings are intended to have the same relative meanings in terms of expected credit loss.”  Funny thing about this statement is that sometime between then and now, they have changed their tune.  They expected default rates differ by up to 300 percent between identically rated municipal bonds, corporate bonds, and CDOs.  After default, municipal bonds expected recovery rates are 90 percent compared to 50 percent for corporates and CDOs.

 Somewhere in between, the ratings agencies abandoned this practice and now use a different rating scale with so-called idealized default rates for each rating.  These idealized default rates differ materially between muni bonds and CDOs.  Is it proper to have the same ratings mean different things and different classes of assets?  In my opinion, the answer is no.

 I think we all agree that the ratings agencies model is now broken.  In my opinion, the ratings agencies are not properly positioned to police themselves.  Even if they wanted to, the conflict of interest is too high.  This July, Moody’s publicly complained that by tightening its ratings standards, it had lost share in commercial mortgage-backed securities transactions.  The entities that enable structured finance send so much business to the ratings agencies that they cannot possibly risk alienating them.

 The ratings agencies have lost the ability to impose discipline on the balance sheets of the broker dealers and monoline guarantors they rate.  They have lost the ability to essentially regulate the off balance sheet banking business.  Investors are now suspect of the stated ratings as well as they should be.  Their aggressive and wanton application of AAA ratings to drip BBB pools of assets should be further investigated by more than the SEC.

 The solution that I think is interesting is, I think, we should eliminate the “issuer-pays” system.  Basically, I think, having the ratings agencies bestow ratings on their paymasters is clearly not working.  Egan Jones which I’m sure is here in the room somewhere is actually selling credit analysis on the model of public disclosure ratings and selling a more detailed research piece to subscribers.  You would ask, “How this is funded?”  I would suggest that those of you who are familiar with equity transactions in the market place - on every equity transaction, there is a small SEC fee - that is the way the SEC generates revenues for its policing powers.  I suggest that in every fixed income transaction, we could set aside a nominal fee that would aggregate enough capital to have a self-policing organization.

 Clearly, more strict regulatory oversight from the SEC is needed, and the days of for-profit regulation with 50 percent gross margins are probably a thing in the past.  I look forward to Q&A with the room here.  Thank you.

 R. Christopher Whalen:  Thank you, Kyle.  Joe?

 Joseph R. Mason:  Thank you for having me here today.  I’m going to take a slightly different tack than Kyle.  I’m going to be a little more basic because I think before we start getting into specifics we still have a lot of basics to be covered in the ratings industry as solutions before the specifics can even make much of a difference.

 As I have maintained in the press since February, the key problem facing markets today is information.  Structured finance products are inherently complex and difficult to value.  Hence, the marketplace is inherently opaque.  Without adequate information, investors will not invest on either primary or secondary markets.  In primary markets, that reluctance results in decreased lending.  In secondary markets, that reluctance results in a steep lemons discount, arising because investors do not know the value of assets but are otherwise able to transact.  That is not the same as liquidity crunch where investors know the value of investments but are nonetheless unable to transact.  That is a very important distinction today because information problems in those concomitant steep lemons discounts are the root of most every financial crisis known to history. 

The simple dynamics are then investors know there has been a shock to underlying asset values, but they do not know the incidence of that shock.  When investors do not know the incidence of the shock, they cannot accurately target their divestment and therefore rationally decrease their exposure to the sector as a whole.  In the face of these information problems, typical economic stimuli, i.e. the Fed funds rate will have little effect.

Hence, while the effect will not generally cause recession, investors who doubt the credibility of asset values, will be reluctant to contribute capital to a restoring economic growth, making any recession that does occur both longer and deeper than would otherwise be the case.

Resolving financial crisis, therefore, requires certification of asset values and/or holdings.  Consider the case of the Great Depression.  Bank depositors did not respond to continued assistance programs nor assurances of bank solvency and so the federal government closed the entire banking sector and required banks to be certified by examiners before being allowed to reopen.  Only then did depositors regained sufficient confidence to redeposit funds in the banking sector.  Still, however, banks remained reluctant to lend through the rest of the decade, making a steep recession into a Great Depression.  These information problems have worsened since February considerably.  We have seen the failure of New Century, other subprime lenders, residential mortgage-backed securities, and investors began to learn that mortgages were not just mortgages anymore.

Mortgages differed significantly according to the amount of documentation, the loans to value ratio and size in addition of FICO score.  Then, investors learned about CDOs.  Then, they had learned about things like asset-backed commercial paper and structured investment vehicles.  Now, investors are certainly confused and do not know what they know.

In the face of this, regulators have done little to address the fundamental information problems that perpetuate the crisis.  The Fed has done nothing over the summer beyond merely cut the Fed funds rate, which I have already said does not work with information problems.  The SEC remains reluctant to expand NRSRO membership or monitor ratings agencies.  FASB remains on the sidelines, so far, untouched by a crisis arising from the fictions of FAS 140 and “Mark to Model” fallacies that will be further encouraged by FAS 156.  Congress remains out of reach as yet even considering revisions to RESPA and the mortgage interest tax deduction that started the whole subprime lending mess to begin with.

As a result, the problems remain as before, albeit of increased importance as we approach now the first anniversary of the crisis, with as yet, no end in sight and no promise of meaningful reform.

Solutions - well, the first solution is to have timely ratings actions.  We have decreased the focus on ratings agencies lately ostensibly because they seem to be re-rating the securities as is needed.  They are still far, far too late.  Ratings agencies waited to re-rate these securities because they somehow thought that the credit problems would abate; the problem will just go away.  But when we are dealing in structured finance, we are dealing in static pools of underlying assets.  And once you have an accumulated loss level in that pool, that loss level does not go away; the problem does not abate.  And these securities will not post excess returns later on that will make up for past losses.

The direct cause of this has been that ratings agencies maintain, in hearings and elsewhere, that the initial rating exercise is prospective, yet the subsequent re-rating exercise is retrospective based only upon exhibited past behavior that cannot be denied with any doubt.  Essentially, this is driving using the rearview mirror.  And the effect of this is that investors are still trying to catch up with losses that they know are already in the pools.  Again, they know there has been a shock to value but they do not even know the holdings that they have and where their exposures are.

Going forward, we need a clear, systematic surveillance review and re-rating program that occurs in a regular, periodic basis for structured finance instruments because these instruments are fundamentally different from old corporates.

Second, we need to resolve the problem that ratings still mean different things for different products.  What we have learned is that an AAA is not an AAA is not an AAA depending on the product that you are looking at.  As Kyle noted in some comparative statistics that have been generated through this crisis, have indicated that there is a 250 times difference magnitude of risk when going from a municipal obligation to a collateralized debt obligation.  That is a huge amount of difference in risk for a given rating.  So a rating can mean a lot of different things depending on what it is applied to.

Given this difference in ratings and given the shift in the difference in the meanings of ratings over time, it is not surprising that investors underestimated risk so badly leading up to the current crisis.  But this still needs to be fundamentally resolved.

Third, and perhaps, most importantly, there has been no resolution of the fundamental conflicts of interest in the ratings business.  Ratings agencies claim and they just make this claim ad hoc, that the “issuer-pays” model has been adequately insulated from inherent conflicts of interest.  Yet, it is impossible to tell whether the investors will favor the “investors-pays” model until “investor-pays” agencies can compete on a level playing field with existing NRSROs.  When the SEC allows an “investor-pays” model to have the NRSRO status, we will be able to answer the question of whether there is fundamental business viability to that model.

Second, in terms of conflicts of interest, notwithstanding who pays, credit ratings are still considered opinions.  And credit rating agencies take no liability whatsoever for those opinions.  Audit results are also opinions and yet auditors have some liability to perform a reasonable task and many other businesses have similar standards of conducts.  That needs to be changed.

Third and what we have seen lately coming out in the market and in the press is that we found that businesses that steer a lot of revenue to the ratings agencies are systematically treated more favorably than others.  In other words, they are rated more highly notwithstanding the risks.  We see this from the standpoint of municipalities who are extremely safe, but they are not very sophisticated players in financial markets, and therefore are penalized with more stringent rating scale than that even applied to corporates.  At the other end of the spectrum, are bond insurers that steer much more business than even structured finance towards the ratings agencies, which are now widely believed to be at the very least, close to insolvency and yet, still maintain AAA rating.

 So in summary, the problem is that investors know there has been a shock to asset values but they do not know the incidence of that shock.  We have seen that now spill through markets in terms of hedge fund investors to begin with.  We deal with bank earnings announcements and forecast now almost everyday in the news, and now as of yesterday and now today, we have seen holding reports come from municipalities and state funds that were heavily invested in very risky structured finance obligations that were of course, rated AAA, but are now junk.

 Yesterday, Bernanke promised more transparency.  But he promised central bank transparency toward monetary policy.  I would argue he is getting the solution wrong.  The transparency we need is financial market transparency; transparency of information and holdings regarding a specific stress asset class.  And only once the investors receive that information will any Fed funds cuts mean anything at all.  Thank you.

 R. Christopher Whalen:  Thank you, Joe.  Alex?

 Alex J. Pollock:  On behalf of AEI, I want to express our appreciation for the good work we do with Chris Whalen’s Professional Risk Managers’ Association in together putting on these sessions on current topics in financial issues.

And turning to the credit rating agencies, in that wonderful 1940 book on investing called, Where are the Customers’ Yachts?, Fred Schwed pointedly and so rightly observed that what everybody in financial markets wants to know is the one thing that nobody can know; of course, the future.  So Wall Street invents lots of ways to give opinions about the future, which will make people feel confident enough to buy or sell something. 

For the fixed income markets, the most important types of such opinions are those of the credit rating agencies on the probability that obligors will be able to pay as called for in the debt instruments.  Indeed, the rating agencies, as has been discussed, described themselves as being in the business of publishing opinions on credit. 

Now, unlike the tendency of my first two colleagues on the panel, in this I think they are right.  I actually have a good deal of sympathy with the thought that in the course of financial events, some such opinions will inevitably prove to be mistakes, even disastrous mistakes.  Of course, sources of opinions which are too often mistaken will have little value to investors, except as they may have regulatory, as opposed to predictive value and of this, more in a moment.

When credit opinions turn out to have been wrong and many people have lost a lot of money, let us say tens of billions of dollars, naturally there is a search for the guilty.  In the midst of the current subprime bust, the credit rating agencies find themselves uncomfortably in the glare of accusation.  I cannot help feeling a sneaking sympathy for them because they are being attacked from so many sides at once. 

But the U.S. Congress has held hearings, in which some of our distinguish on the panel have raised thoughtful, well-informed and important criticisms of the dominant rating agencies’ structures and practices with respect to structured securitizations of subprime mortgages.  The President of the United States has asked the Secretary of the Treasury to examine the role of rating agencies through the President’s Working Group on Financial Markets.  The SEC is investigating whether they were unduly influenced by issuers of the securities they rated.  The Attorney-General of Ohio, which has especially high foreclosures from subprime loans and also investment losses in the State Pension Fund, has said he is going to sue them.

 On the international basis, the Chancellor of Germany, the President of France, and members of the British Parliament have singled out the rating agencies for criticism.  And the President of the European Central Bank has said he thinks that he probably needs to take regulatory action.

Meanwhile, the stocks of Moody’s and McGraw-Hill, S&P’s parent company, are off over 40 percent and over 30 percent respectively since June.  So beset and besieged, no wonder all of major credit rating agencies declined our invitation to participate in this conference.

“Investors across the globe have lost confidence in ratings,” the Wall Street Journal has opined and we just heard some good reasons of why that is probably the case.  This loss of confidence in what does AAA or any other rating mean is certainly part of the very large uncertainty premium now affecting the prices or the lack of any clear prices of structured mortgage securities.  In my view, once should be skeptical of all opinions of all the future even when they are formed with thought, care, the analysis of massive amounts of data, complex models, and good intentions. 

Complex risk models themselves risk becoming outmoded as financial market behavior changes to take account of the fact that the models are used.  In other words, the recursive nature of financial markets will cause the models ultimately to fail.  This obviously happened in the case of the subprime mortgage boom and bust.  How ironic that the banking world is moving to the Basel II capital standards, heavily reliant on credit ratings and models just as credit ratings and models have been so embarrassed by the subprime disaster.

Of special interest in the ratings models is the role of House Price Appreciation or HPA because the mortgage boom reflected and fed remarkable house price inflation.  Now, a reliable factor of mortgage credit behavior is that rapid increases in house prices keep defaults and losses low.  If you get into trouble, you sell the house at its new, higher price.  If you are short of cash, you refinance and withdraw the new equity.  But going in the other direction, falling house prices increase defaults.  Why keep paying when you owe more than the house is worth?  And falling house prices increase the loss-given-default of lenders selling foreclosed properties. 

As has been pointed out, as recently as last year, it was common to say that although there could be regional declines in house prices, U.S. house prices could not fall on a national basis -- well, they had not since the 1930s.  But in the first years of the 21st century we had unprecedented house price inflation, so there now follows the inevitable correction.  House prices are falling on a national basis and by some forecast will fall 15 percent or more.  So HPA has become HPD - House Price Depreciation. 

So let us ask what would happen if all the structured mortgage securities outstanding today were re-rated with the current reasonable assumptions of HPD, of falling house prices?  I think we can be assured it would not be pretty.  How should the original ratings have taken account of the possibility of future falling house prices?  When should possible HPD become a factor? 

Since all opinions are liable to error, and opinions based on models are liable to systemic error of vast proportions, as we can now see, here is a question:  Why would the U.S. government want to enshrine certain opinions as having preferred preferential, indeed, mandatory status?  It should not want to, but it did, under the SEC’s regime in previous years of the so-called NRS

By requiring all regulated investors - banks, insurance companies, pension funds, thrifts, mutual funds, so the vast majority of institutional investors - to use NRSRO credit ratings, government regulation created a mandated demand for these favored ratings.  Whether or not they had any predictive or informational value, i.e. competitive market value, they had great regulatory value.

 And while mandating demand, regulation also restricted supply.  So what do you think happened to prices?  Obviously, they became very rich.  The combination of mandated demand and restricted supply powered the remarkable earnings, operating margins, return on investment, and until lately, stock prices of the dominant rating agencies.

 A central objective of the Credit Rating Agency Reformed Act of 2006 was to increase competition in the credit rating agency sector.  This Act took away the discretion of the SEC staff, which had exercised to designate NRSROs based on never articulated criteria and replaced it with a registration regime opening the market for credit ratings in the regulated sector to competitors who are willing to meet the registration requirements. 

Now, this experiment is still in early days and we have to see how it goes.  But greater competition remains a key objective.  When it comes to opinions about the future, in my opinion, the more the merrier.  Having more competitors increases the chance that new insights in the credit risks and how to conceptualize, analyze and measure them will be discovered and made available to investors, advisors and other actors in the debt markets.  It will also reduce the economic rents or monopoly profits granted to the old government- sponsored cartel and paid for by everybody else.

 Now, a particularly desirable form of increased competition, as has been mentioned, would be from rating agencies paid by investors as opposed to those paid by the issuers of securities.  It needs no argument to see that the alignment of incentives in an investor-paid case is superior to that in the dominant issuer-paid model. 

The major rating agencies received much criticism, some of it a few minutes ago, for the potential conflict of interest represented by being employed by those who obviously want the highest possible ratings and the lowest possible subordination in structured securitizations.  Now, my idea is not to restrict the issuer-paid model, but to induce a meaningful competition between the two payment models and to let investors and other users of ratings make the choice of which they prefer. 

It has been suggested that ratings should include a disclosure of whether they were paid for by issuers or investors.  That seems to me a reasonable idea.  Congress might require all the regulatory bodies whose regulations supported the government sponsored credit ratings cartel to study how they might instead promote the competitive objective of the 2006 Act and to consider facilitating investor-paid models.  Certainly, the SEC should get more investor-paid rating agencies registered under the new NRSRO definition of the 2006 Act.

 Let us ask, is there a way that a more robust presence of a new investor-paid ratings model could be created?  One way to achieve this is not to have the SEC have heavier regulation of rating agencies.  But why could not a group of major institutional investors set up their own credit rating agency, capitalized by and paid for by the investors, working from their point of view and supplied with top talent and technology? 

I think it likely the market would reflect the preference for ratings from such an agency.

 A number of good proposals for improving the rating agency system have been made, many by members of this panel.  These include distinguishing the ratings of corporate debt from ratings of structured securitization, as has been discussed they are quite different, perhaps using a different range of symbols accompany ratings of structured debt with calculated probabilities of default and losses-given-default as well as by making the clear the key assumptions used.  Having much more emphasis on monitoring and updating ratings over the life of securitized asset pools.  And when new values for key parameters of ratings are adopted, for example, when HPA has become HPD, have existing structured securities re-rated using the new revised parameter values.  And finally, have ratings reflect the risk that increased complexity and opacity in and of itself creates.

Now, if major investors took up the suggestion to set up their own rating agency, they could instruct it to carry out all these ideas, which would make its ratings more useful and competitively robust.  This would certainly be a more direct and controllable process than trying to get the Congress of the United States to redesign rating agency practices.

Well, we were treated once again in this morning’s papers to discussions of multi-billion dollar write-offs resulting from the subprime mortgage bust.  With the rating agencies so tangled up with the troubles of subprime securitizations, making those of us with a certain kind of education think of Laocoön and his sons intertwined by the serpents, we can say with assurance that these issues and debates about credit rating agencies are not going away anytime soon.

R. Christopher Whalen:  Thank you, Alex.  Frank?

Frank Raiter:  Good afternoon and thank you for joining us.  I have a Dick and Jane slideshow without the entertainment of the colored slides that is in your little package, if you want to follow along with the dancing ball.

You ask whether the rating agencies are fine or broken.  I would submit that they are severely disconnected.  But unlike the other panelists so far, I’m not going to lay the whole blame although, about 80 percent is on the rating agencies.  The current debacle in the subprime, Alt-A and even the prime market has to be shared with issues in investors that were pretty complacent over the last six to eight years.

From a rating agency sign, I need the disconnects fall into five distinct categories.  One is philosophical, the other is the profit motive versus the analytical methodology, the third is the initial ratings versus the surveillance -- which has been mentioned by the other panelist -- and the third and fourth are underwriting reviews and servicer reviews, which are unique to the subprime, particularly the subprime but across most of the RMBS arena.

Philosophically, I will be the fourth in line to say the mantra that the rating agencies have been repeating and most recently in their testimony at Congress that all AAAs are the same.  It is apparent now and actually has been apparent for a number of years that this is not necessarily so.  I just compare corporates and residential mortgages. 

In the corporate side, it is pretty straightforward fundamental analysis.  It is just standard ratio analysis, going concern considerations, manager reviews and when they have a committee vote on the corporate side, you have a half a dozen analysts that are familiar with the industry and with sub-industries that have an impact on that company, and they actually take a vote.

On the RMBS side and all of the structured side, it is a collateral analysis.  It is the frequency of foreclosure times the loss severity equals the credit enhancement, which is the way the ratings get tranched up, completely mathematical.  Instead of a going concern, management review, you have a structure.  It has to meet the legal requirements of the bankruptcy remote structure and it is a basic Betty Crocker cook book.  You meet the legal requirements, surpasses the hurdles, then you have an appropriately structured transaction.

The committee process on the structured side is a QC process.  I would submit that there is not a human being alive regardless of how many years of experience they have in the mortgage industry that can sit at a table and tell you the AAA coverage requirement within 10 basis points on a pool with 2500 mortgages in it.  There is just nothing they can bring to bear if you have got good analytics.

The next area is AAA performance, which has been glanced on several times already this afternoon.  You have to distinguish when we are talking structure between default and downgrades.  The AAA default experience in the structured arena, and I’m leaving out CDOs because they are as they have pointed out, squared and cubed and the risk becomes quite difficult to begin to engineer exactly where it came from. 

But in the residential market, there have been literally no, at least to my knowledge at this time, AAA bond that has defaulted.  That means the AAA bond took a loss while it was AAA.  What you do have and what we are living with right now are the probabilities of the downgrades.  Since downgrades from one rating to another have a significant impact not only on who can hold them but what the price becomes we have a lot of irrational locked up pricing that no one knows where value is because they do not know where the ratings are going.

So the rating agencies typically compare in order to convince you that the AAAs are the same, they will compute [sounds like] false statistics.  But it is really the downgrade side of the transaction that gets important and if you read what has been in the news and in the testimony, both agencies that testified in front of Congress a month or so ago -- all of them harped on the fact that they began issuing warnings in 2005 that the five and six in the 2005 book was not looking very good on the subprime side.  But they did not start downgrading in 2007. 

The question of why is quite simple.  They hang their hats on AAA being the same by tracking default experience and then tracking with transition studies for AAA to AA.  If they started downgrading the transactions at the time that they saw the warnings, it would add a lot of volatility to the underlying ratings and they all perceived that this would not help their reputation.  So rather than necessarily take the correct analytical approach, they decided to just ride it out for a while.

The next area where there is a really big disconnect is in analytics versus profit margin.  And in the RMBS ratings process, it is the collateral.  The economic models or econometric models drive the calculation forward frequency of foreclosure.  Very rigorous historical analysis determines what loss severity maybe under different scenarios for the different types of collateral, the different types of borrower.  Stressed scenarios would then provide you with a range before credit enhancement or tranching of the underlying deal would come out.

As Alex pointed out, the models or most models do incorporate a housing price index, which can either be going up as appreciation or going down for depreciating.  And they use this at the time of issuance to make LTV checks to see if the housing prices in the LTVs are reasonable in the market.  The tapes that you are running on these transactions, they can have anywhere from 2500 to 25,000 loans on them, each with the tape between 60 and 80 data points depending in whose model you are running.  It is a tremendous amount of data.  Data runs the whole operation.

The disconnect in my opinion is, that this is very expensive.  The models that were introduced by S&P were very good models at the time that they were first introduced.  The first model was run on about 500,000 loans for five-year, six-year performance history.  The second version came out and had close to a million loans for six years and seven years of performance history.  And in 2004, there was a third model in the box that was run on 10 million loans with 10 years of performance information covering the spectrum of what were then the issued products.  This is 2007 and that model has yet to be implemented, and it is because it costs a lot of money.  And rather than spend the money, all the rating agencies have determined that extra bit of perfection does not get rewarded in the market place and they can just slide for a while.

Next area of real issue, and Alex also touched on this, is the initial ratings versus surveillance.  And surveillance has traditionally been a stepchild at the rating agencies.  It has been looking in the rearview mirror.  Typically, it is at the pool level and not the loan level.  And typically, up to this point, they would just look at the existing loss levels and the delinquency rates as they were today, apply a multiple to the delinquencies and calculate a new expected severity on the pool.  If it was inside the parameters, it would not get downgraded; if it falls outside of it, it could go on watch.  It is a very, very archaic looking back system.

And the disconnect again, in my opinion and as Alex has pointed out, the models that were run at the time, the transactions rated are very good models, if they were maintained and kept update.  There is no reason why the rating agencies should not run the same model on a monthly basis and determine what is happening in that pool at the loan level and use that for surveillance.  The reason it was not done -- while I was at S&P -- was for the reason that they thought it would add too much volatility to the ratings and that would interfere with their transition studies. 

But as a former investor, it was always my opinion that I would rather see that.  Even if you did not downgrade it, if the information was made available, as an investor, I could make an intelligent determination to whether I wanted to keep that particular security in my portfolio.  So this information, this dearth of information is also plaguing all sides of the market.

In the residential arena, particularly in the subprime area, underwriting reviews are conducted by the rating agencies and they are intended to determine what are the guidelines that they use in originating the loans by product line.  Is it a Prime, Alt-A, Subprime, HELOC?  Each would have its own review.  They check the appropriateness of the guidelines against the products across the different issuers.  They make an estimation on the quality of underwriting and management, and they try to make some estimation on the strength of the firm to absorb the reps and warranties that are entered into in every structured transaction that gets rated.

The disconnect here though, is that their review at the time they go in to make sure the issuer meets their standards is not rechecked against the actual application of those underwriting guidelines at the time the transaction comes in for rating.  And because they have also had a disconnect in just what the product is, everyone here is familiar with the mortgage industry, if Alt-A was a product that indicated it had the same credit perspective as an agency eligible mortgage loan except the balance was too big, or it was a foreign buyer, or it was second home, it had some nuance that made it the illegal for Freddie or Fannie to buy it.  So it was a small balance loan that otherwise should have been acceptable to the agencies, to the two GSEs, but because of this little box they checked, it was not.

By mid-2004, we saw deterioration in the quality of the Alt-A market.  All the transactions set Alt-A on the cover, but some of them are actually B minus and C quality loans.  So there was no real standard either among the rating agencies or among the issuers.  They just called it Alt-A because it was small balance, and they tried to keep it above that was considered slightly better quality than subprime.  They started mixing all the eggs in the same basket.  If you have a good model, your credit enhancement in tranching should have adjusted for it.  If you had any kind of pool specific analysis based on the issuer and the name of the product that could all get lost in the shuffle.  So you would under enhance that transaction.

They also perform servicer reviews because you cannot have a structured transaction without somebody that is going to collect the money for that trust and pass it through to make sure that the investors get the money that has been collected on the underlying collateral and assets.  Again, it is product specific, and there were a lot of gray areas.  It is more of a quality review.  You would look to see if that servicer had the same standards and the level of experience, management and strength as someone else.  They started charging for these and they grade A it so you could get a superior or an above-average average.  Originally, you could not have a rated transaction if you did not at least get the pass/fail at the average level.  And it became a for-profit product as well.  So they started charging more and more for this service.

The disconnect though that is really interesting and this is where a lot of transactions are running into some trouble today is you were not allowed to score the performance of the servicer.  So even if you can get your hands on the tapes and there are providers in the private sector that do private surveillance that can tell their clients, their subscribers-investors how good the servicer is, the rating agencies were not allowed to publish rankings or write a score on them that could be incorporated in the next deal in the wire on the tape to say, “Well, this is good quality loans, but are really a marginal servicer; and therefore, we expect their performance to be worst.”  They were not allowed to do it and they allowed themselves not to be allowed to do it.

They also did not come up with the way to adequately measure financial strength and determine exactly what the rep and warranty liability coverage was for a particular issuer or the banker that acted as a conduit that got in the middle.  This we are going to see in the ensuing months, a lot of the loans that are going into default are definitely going to have rep and warranty searches to find out if there was anything wrong with the initial tape or the information provided so that they can try and stick somebody else with that loss.

But the rating agencies did not come up with a system of financially ranking these people, they just went with the “too big to fail” and as long as you had a big player, then they thought that was fine, but we can see big players can lose.

On the issuer side, issuers had some disconnects.  They took advantage of the naming confusion.  They call it an Alt-A pool when it was clearly, really a subprime pool.  If they could get away with it, they trade it differently in the market.  In the subprime arena, in Alt-A arena, they had to have due diligence performed on the loans under the ‘33 Act for Disclosure and they hired third party firms to do it.  It is another disconnect.

Those third party firms provided reports to show just what the complexion of the loans were that were reviewed.  In their sample, highlighted the number of exceptions were the loan did not meet the guidelines.  None of this was ever disclosed.  It was not required and the issuers and the conduits did not want to disclose it.  It was just another level of exposure they had for what was going into the transactions.  They were on the hook for the veracity of the data. 

On this tape with 60 to 80 fields depending on the model you are running, if it said there was a 75 LTV and it was 95, it got rated as a 75.  That loan goes belly up, there is going to be a rep and warranty issue if they can ferret it out.  Trust me that there are people being hired now to try and ferret each one of those out.  Finally on the rep and warranty side, they just never really looked at what their exposure was.  Everybody was having too good a time in making too much money.

That brings us to the investors.  Frankly, they have not exercised a whole lot of purchase discipline since 1995 when the subprime market really took off.  Excluding the little Russian debacle, which was another liquidity crisis, they were chasing loans.  They were chasing transactions and securities so much that even the lower quality transactions were being sold on a TBA basis because they had money and they needed to spend it.  No one was doing any real fundamental analysis of what they were buying.

I’m not sure the majority of the investors that I dealt with really understood what the surveillance activity was at the rating agency.  All they could see though during this period, particularly the late 90s and the early 21st century, they were seeing a lot more upgrades.  Well, that is a structural certainty involved in some of the -- particularly the higher quality transactions that had super senior bonds with very short average lives.  As they got paid off, everybody below them got to move up, so suddenly it looked like everything was doing quite rosy.

They also suffered from, and we see this in every crisis, they all thought they were smart enough to be the first one out the door.  Frankly, the door shut before any of them even figured out they are in a jam.  And we have a basic liquidity crunch that is now exacerbated on the credit side because no one knows exactly what intrinsic value is in the prices out there.  In some of the senior RMBS arena, transactions that are backed by prime jumbo product are trading at completely irrational prices.  And it is only going to get worse as more products get dumped on the street.

So what would I suggest?  I suggest that there be better and more adequate disclosure.  The information on the due diligence on what the tape looked like that was going into the file.  What the exceptions were should be incorporated, so that investors can actually make a comparison between two deals even by the same issuer.  The fact that it is the same issuer does not mean that they did not throw a bunch of loans that were leftover from some other problem area into this pool.

We ought to have underwriting performance scores to show just whose underwriting actually lives up to the standards.  We should look at the credit risk management function.  These are the independent third-party surveillance firms that are collecting information on the quality of the servicer, the quality of the original underwriting and how good the appraisals were.  They are performing scoring on that.  That should be incorporated in the original ratings. 

I’m talking to some of the rating agencies just within the past couple of weeks.  We have been told that they really do not know what to do with the information.  They do not see that the investors would be interested in it, so they are just not too interested in even collecting it.  So again, the investors are going to have to start exercising a little bit of discipline and vote with their dollars.

On the rating agency side, I think they should be required.  If there is any surveillance going on by the SEC, I’m just not aware of what the heck that is.  Their last foray in after Enron was a very cursory inspection and review.  But on the rating agency side, if you are running a model, you should be required to update it annually at a minimum with the latest data that is available across the product line you are engaged in and there are databases out there with 10 and 12 and 13 million loans, and it costs a lot of money.  So I do not care who pays for the rating, just changing the structure for payment of the rating is not going to improve the quality - not overnight - unless somebody tells them that they are going to have to spend the money to get it up. 

They should all use loan level data, pool - approach your static pools, which is not the way to do it in this modern time.  They should be required to use the same model for rating and for surveillance, so there is not a disconnect where they suddenly look at A and say 30 years on I think it is going to perform like this.  A year later, it looks like it is not performing like that but they do not have to do anything about it.

And they should be required to publish their surveillance criteria because right now if you go to their websites, you cannot find out exactly what they are doing to decide that a particular RMBS should be downgraded or not.  And issuers and servicers should be required to provide loan level performance data to the public domain, so investors and rating agencies and anybody that has got a vested interest in what is going on should be able to pull it down and do their own analysis as they see fit.  Right now you cannot do that on agency paper.  So it ought to go across the board for everybody because there is a wealth of information on what Freddie and Fannie have collected. 

And investors should start using their investment dollars to vote for purchasing those securities that have appropriate disclosure and surveillance and not buy the ones or at least run the price down so low for the ones that do not; it is not worth issuing them.  Because everybody is in it together and just pointing fingers, it is not going to solve that problem today.  So everybody, I think, needs to step up for the plate and try and do it better going forward.  Thank you.

R. Christopher Whalen:  Thank you, Frank.  Glenn, you have been very patient.

Glenn Reynolds:  Okay, I guess in terms of the portfolio mix up on the panel, I’m the investor-pay model.  So thank you for extolling the virtues of that business model.

Just to make a few things clear, CreditSights is -- we are about 110 employees.  We are a credit research operation that sells directly to investors.  We also sell directly to intermediaries, banks and brokers.  Technically, we are registered investment advisers, so we are regulated by the SEC.  We do not manage any assets but we fill up the paperwork and make sure we are on the sides and never wake up one day “to cease [sounds like] and desist.” 

In the U.K., we are regulated by the FSA, so I just want to make a point that none of our employees have died in seven years from regulation.  So if that becomes a concern with the rating agencies, we can reassure them.  In fact, all of our people came from backgrounds in regulated industries in the buy-side and sell-side and somehow they get by.  In fact, I do not think I have ever met a regulator until I got involved with this rating agency process.  So it is really not about burdensome regulations; it is about competition and quality.

The reform process has been ebbing and flowing for the last however many years, really since Enron was shining some light on this and have to [indiscernible] mandate to look at the agencies.  The main thing was not about regulation; it was really about deregulation, but the agencies kept coming back with their Jedi mindset to [indiscernible] say it was about regulation.  It was about competition.  And more to the point, it was about artificial barriers that have been put in place for years.

Just to put some numbers to it, some reference have been made to it earlier, I know the word “cartel” was used and my testimony is in there.  I made the unfortunate quote that I’m on record for saying the rating agencies are at the highest margins this side of Colombian agri-business sector.  I think that is a fair statement. 

To put some numbers, Moody’s year-to-date, 52 percent operating margins.  I do also have a little bit of sympathy for them, but my cut off on sympathy is 25 percent margins.  Take a look at McGraw-Hill, 47 percent.  That is just their financial services segment, and when people talk about margins at McGraw-Hill, that is their whole business because everything else is very low margin.  Frame that against poor-old Microsoft pulling up a distant third at 37 percent in the last fiscal year and Cisco, not a company without some throw weight, 25 percent.  Exxon, that price-gouging evil empire of oil is 16 percent.  So they have to get off the stick and get those margins up and gouge a little better.  Wal-Mart at 5 percent, they are taking over the retail food chain.  So basically, Moody’s has 10 times their margin. 

Usually, after I took Econ 101, I assume it is going to be some market entrance at that point.  But the fact that you did not have any says something is very wrong here, and that is why it took four years to do.  So when people talk about reform and upgrading - where we are today - I think it is gong to be a major challenge because it took four years to do the incredibly obvious, how long will it take to do the much more daunting?  And regulatory-based initiative, that is going to be even harder, so I tend to be a little bit more pessimistic about how much real change would be put in place.  So you have to shoot low and achieve a little lower; it is basically what it seems, although I am not the policy expert.  The people in this room are.

Really, if you think back to what it was, it was also about quality.  Did the agencies do a bad job on Enron?  Well, that is pretty obvious.  They did a decidedly bad job on Enron.  It happens.  They had some decent alibis.  They were dealing with basically with a pack of thieves - fair enough.  Okay.

But since you had control, you had them absolutely hanging by a thread of the rating.  I have never seen anyone who had so much market clout over such an aggressive, really arrogant company as that company was, and they did not use it.  And they also tended to gloss over the fact that even though they were lied to on the way in, their conduct after it was out of the bag in the 3Q ‘01 earnings report is really where you had to step up and protect the investors.  So basically, their legitimate gripe is that they were lied to, but they changed actually the questions to get the right answer.

And so moving on to the conflicts - did the rating agency have conflicts of interest?  I tend to be less hardcore about this than some of the panelists and some of the people in the room.  Yes, they do big time.  However, is it narrowly tied to the issuer-pay model?  I really do not see it that way; in some areas and others, I do. 

Construction and finance - absolutely unequivocally conflicted.  There is no issue without them.  They are the de facto regulator, closet underwriter.  They are the turnstile.  They do not have to worry about the train derailing, but they collect a big fee at the gate.

On corporate issuers - not necessarily.  I tend to be a little more philosophical about that because the issues are going to have to tell you whether you are column single A or a double B because what it cost you to finance in the market is a bigger penalty than paying the rating.  So, in a twisted way, it is economically efficient.  But at the same time, no one is giving them an option.  If there is enough investor-pay options out there, they can say no.  Just say no.  [Indiscernible] some years back, right?  Well they can do that with the issuer-pay model when the competition comes.  That is going to take years.

Did the SEC take too long to take action?  Yes, they obviously did and that is why the Congress stepped in and won the D.C. turf battle.  I’m watching it from the outside, I’m going, “Oh, this is going to be ugly.”  But they finally did get it done, and now we are back up to seven agencies.  Three are located outside the United States -- I’m sure Moody’s and S&P are happy with that -- two Japanese and a Canadian, and a long-standing insurance specialist. 

So we are back to seven, and the last time we were at seven, I had black hair and no glasses, so you can kind of see the extraordinary progress we have made coming out of Enron.  But 2990 did do a lot.  It actually did lower the various entry.  It takes time.  You have to measure the evolution of an industry like this more in rings in the redwood not in quarter-to-quarter attention spans.  So it will get there, but it is going to take time.

So, this conquest has absolutely nothing to do with legislation; it has everything to do with the old framework.  I remember watching the debate in the house, and somebody stood up and said, “Well, if you let more in, you will have something as bad as the thrift crisis.”  Well, frankly, with the old regime, you now have something worse than the old thrift crisis.  So, I would say the competition would get you there eventually.  That is going to take a while. 

The Senate did water it down quite a bit, and that is a testament to the fact that it got highly partisan.  I do not know how a geeky issue like this could get highly partisan, but somehow it managed to be.  I think it is because you had two Pennsylvania guys squaring off and butting heads.  But at the end of the day, this should have been a lay-up.  It just took a while.

Again, competition is a slow process.  So where do we go from here?  I tend to be a disclosure freak partly out of the fact that I was one of those geeks you met so many years and still am.  More disclosure creates more ability to analyze from the outside and it ties back into the competition aspect.  It is still a burdensome disclosure.  This is very expensive.  The cost-benefit analysis is all wrong. 

If you believe this is an expensive process to update and post this data, I have some AAA mezzanine I would like to sell you because frankly it is not costly.  It is very informative and it will promote competition, although it does trigger the “oh-word” -- regulation.  I know some people pass out and fall off the chair if you say regulation.  But frankly, what it is, it is an upgrade in quality and it might require less regulation later, because this subprime issue is a lot different than Enron.

The stocks of McGraw-Hill and Moody’s pushed right through that smile and just kept on going.  Legislation has passed - kept on smiling and kept right on going.  Now, though, they are plunging because this is systemic; this is real; and this gets into the end of their business.  It was not only very profitable, but also increases their contingent liability risk.  So change can be made and I think they have less weight to throw around this time because Moody’s and S&P are enormously powerful.

Investors do not want to stick their heads up because their claims-paying ability, their funds, their treasury, funding costs that are largely dictated by the agencies.  God knows what else they rate around the county.  I mean they have a lot of political clout.  They are not just some bunch of happy-go-lucky journalists.  These guys are borderline monolithic in terms of their clout in the marketplace.  They also have been moving into the fabric of the market.  Every single loan has a pricing grade tied to Moody’s and S&P.  That is a natural commercial barrier to entry that just cannot be beat, and that is why you have to bring value and bring a good idea if you want to compete against them.

But this is the warm-up.  Subprime has now obviously had some issues around what is going on with the monolines, but between 2010 and 2012 is the next big bump, all these CDOs and CLOs that were done, these waves of maturities and re-financing risk on covenant life products.  So the time to get more people in the game with an outside view that is independent.  It is here now.

So, these are interesting times.  And one thing I would like to highlight is a commercial for anybody who wants to get in the industrial-pay side.  There is a lot of dislocation of intellectual capital going on - on Wall Street and in the industry base.  Some call those mass layoffs.  I call it migration of it like [sounds like] for capital.

So that means, for someone who wants to set up shop, you can actually find the people.  There is also a tremendous amount of financial capital looking at this place.  I get speed dialed once a week by some associate private equity knucklehead who says he knows me -- [indiscernible] they want to get investing the space.  The point is, the money is there, and strategic players, they look at those 52 percent margins.  A lot of these guys have 10, 15, and 20 percent margins.  Even they can do the math.  It may be something to do here.

So, you will see a lot of people in the financial media space.  Hearst invested on a pass basis in Fitch [phonetic].  There is a great opportunity in the next five years, but the regulator better encourage it and get started now.

R. Christopher Whalen:  Thank you all very much, and I especially appreciate you adhering to the time guidelines that we discussed over lunch, so we have more than enough time for some interesting questions.  Let me start off with a couple of my own and then we will get the audience involved.

Kyle, I think I wanted to touch on the issue of pricing.  I have been, as a former bank regulator, astounded at the progress of liberalization of U.S. law regarding activities of banks are allowed to engage in.  Do you really think you can rate something that you cannot price?

We have this new level three discipline coming on line today in fact where banks are going to have to segregate assets based on the visibility of pricing information.  But if you cannot rate a price-structured asset, do you think somebody ought to rate it?

J. Kyle Bass:  Well, let me rephrase your question for you on the issue of whether you can price.  You can price everything everyday - we do.  We get prices from every counterparty we have.  We have 12 counterparties with every big name out there.

The people that are moving assets, the banks, investment banks from level I to level II to level III assets, this is the don’t-ask-don’t-tell pricing policy.  They can price these things better than the investing public can.  When they do not like the price, they move it to level III.  When they like the price, they leave it at level I, and it gives them too much wiggle room.

I read all these articles.  I’m actually quoted in an Absolute Return article that is six pages long on pricing this month.  We price our portfolio everyday.  It is not that hard.  Everything trades everyday.  Now whether the intrinsic value as was spoken here is above or below the price is somewhat less relevant.  What is relevant is things price.  Things price everyday and things trade everyday.  You can trade AAA’s on anything everyday.  There is a price for it.  There is a lot of money out there.

Whether you like the price or not is completely another question, so I do not see how anyone can say -- if you heard the Goldman Sachs Conference Call last quarter, Goldman CFO says, “We price everything everyday.”  Therefore, the people saying they cannot, just do not like the prices.  These funds like Ellington and Carrington and the players in the marketplace that have frozen redemptions are hoping prices get better.

I’m telling you that since they froze prices, pricings probably got 15 percent worse, and these guys are 10 times levered.  I mean we can all do math, right?  It is going to be a big issue, and this level III pricing issue is ridiculous.  Realistically, there are prices out there for all of them.

R. Christopher Whalen:  Joe, let’s go back to the comment you made about the strictures put on auditors coming out of Sarbanes-Oxley.  What kind of responsibilities would you impose on rating agencies that would be similar to the duties and responsibilities of an auditor in the context of a public company attestation?

Joseph R. Mason:  I think that the mere potential for liability for a rating decision or the timeliness of a re-rating would have a tremendous disciplinary effect, on the industry right now.

We have seen ratings adjustments on re-ratings of up to 14 notches.  It is hard to argue that the agency was remiss or hard not to argue that the agency was remiss in some way in somehow not catching this before a 14-notch downgrade was necessary in order to really look at transition studies as were discussed earlier.  You would want to monitor the smoothness of the transitions, and if the job is being done properly, you should have a relatively smooth transition from a higher rating to a lower rating unless, of course, there was some type of fraud or other unmeasurable elements involved.  But everything else held constant.  That smoothness may evoke volatility, but if volatility is there, it should not be avoided.

Another point that I think needs to be made about why these re-ratings are avoided is largely the fact that the re-ratings are all going to be path-dependent over time with a structured finance investment.  That is, they generally are all going to be down over time.  Or they are all going to be up over time.  When you have a static pool due to seasoning, over time the performances are always going to follow previous performance.  Either you have a good pool where all the borrowers are repaying, or you have a bad pool where too many borrowers are not repaying?  And behavior follows behavior, you are locked in.  You have no way out of that path.

So, that is the sense in which it is absolutely crucial therefore for re-rating to happen on a consistent, regular and active basis especially early in the life of a deal when seasoning is forming.

R. Christopher Whalen:  It is interesting, in your observation, the chief risk officer of Ambac got up at a meeting we held in September and said exactly that.  It was a rather striking comment from the floor of a seminar like this because it was Bob Salvaggio [phonetic] in fact, and he is an extremely well respected member of the risk management community and just tore the agency’s new orifice in front of 150 of their colleagues.  And indeed, the next morning, both Moody’s and S&P announced that they were going to start notching CDOs on a regular basis.  You know, it is an obvious idea, but one that has not caught on.

Alex J. Pollock:  If I can just add one thought, that it is important to recognize that in the past 30 years for Moody’s, there had been 1,350 downgrades in the residential mortgage-backed securities area.  In October alone, there were almost 3,000.  Something has definitely changed here.

R. Christopher Whalen:  Alex, in your comments, you talked about the Street possibly setting up its own rating agency.  We have actually heard that suggestion in our C-suite lunch in PRMIA, a gentleman from Morgan Stanley in fact.

How would that work?  Will this become a GSE?  I noticed our good friend Bob Feinberg [phonetic] is in the back, and he believes the GSE is the new preferred business model in America.  Is that what we are headed for here?

Alex J. Pollock:  As a matter of fact, to begin with, I will quote Feinberg’s law, “Everybody deserves his own GSE.”  But that is not my view.

I meant if I could just indulge in some verses on the point about the ratings all go one way and then they all go the other way -- I wonder if you know these lines.  A trend is a trend is your friend, but the question is, will it bend?  Will it suddenly change course from some unthought-of force, and bring your fine trend to an end.

R. Christopher Whalen:  Thank you, Alex.

Alex J. Pollock:  My notion is not that it would be the Street, that is to say the sell side.  I’m talking about the buy side.  I’m talking about investors and owners of assets be willing to capitalize and fund their own first class rating agency; therefore, by definition, are paid for by investors and setting it up so that it does all of these great things that we all agree ought to be done.  That is to say intensive monitoring and re-running the analysis at loan level and so on.  I think it would be a good investment to make and it would most definitely not be a GSE.

R. Christopher Whalen:  Frank, to that point, is the issuer paid model flaw?  In other words, is it possible to rebalance the equation so that the representative of a Moody’s or an S&P, when presented with a rating opportunity, has the ability to say no?

I mean you actually worked in one of the agencies.  What do you think culturally has to happen to get these people to the point where they will look at an opportunity, decide whether they like it or not, and maybe even serve as an advocate for the investors that they serve?

Frank Raiter:  Well, actually, it has occurred.  Only the investor does not get to see it because if somebody comes in and you just do not like the smell, you just make their security so expensive, the rating is so onerous that they do not go for it.

But, by and large, you have to make a big distinction between corporate, structured, and public finance in sovereign ratings because in structured, typically, if you do not get a rating, you are not going to sell the deal.  I mean if you can go from a mortgage pool to some royalties on rock star songs, and there have a lot of interesting transactions because as soon as you talk about bankruptcy remote, it is a matter of how do you value the collateral cash flows coming off whatever that thing is that you are going to put in the trust.

So you do not see the deals that do not get rated, but you cannot sell one if it does not have a rating.  And so, on the structured side, really, the rating agencies now distribute their models in the residential arena.  You know, the big three distribute their models for CDOs, so you run your collateral or your transaction through the model, and you get the answers, and you come in and say, “I have done it the way you told me to do it, and now I want to get the rating.”  And, it is very, very quantitative and very model driven.

So, you are not performing a quality control function at the rating agency, but whether issuer-pay or investor-pay is going to have an impact on the services delivered, I’m skeptical that it will make anything change.  They have had the capability for years to do a better job than they have done, and they have opted not to do a better job.  They decided that what they have done is adequate for the needs of the clientele, and that extra yard they could have gone would have eaten into their margins or their profits, so just charging investors now for the privilege of getting the same mediocre information is not going to help the situation.

But the investors on the other hand, if they were to set up their own shop, just having been an investor and run some funds, I have a little problem with that because otherwise we would all be the same and we would not need all the fund managers because if everybody had exactly the same information-

R. Christopher Whalen:  Right.

Frank Raiter:  -- you are getting the same sell order at the same time.  There would not be any benefit to us.  So, I’m not so sure that an investor-sponsored rating agency is going to work.

The other thing you have to remember about the NRSRO, if you get the designation, there is a requirement that you give everybody the answer at the same time.  So if you change your rating, it goes out on the wire.  If you set up a third party private subscription service, you do not have that requirement.   So you can, in fact, be able to do superior analytics in the data that you have collected, provide information that helps your clients perform at a down market or an up market, find the value, and move one way or the other before your competition or their competition.

So there are a variety of ways to just improve the quality without necessarily expanding the NRSRO because as Glenn has pointed out, even if you were to designate five tomorrow, if you are an investor on the institutional side and your investment committee guidelines say you have to have two NRSROs, you are not going to give up Moody’s and S&P to jump onto this new boat.  You are going to want to have a track record in it.  It takes several years to build that track record; unless, you have got a specialty like an insurance rater, and all you are doing is looking at their ratings on your insurance preferred or portfolio.

So, just handing out the designations is not going to necessarily make them fairly acceptable or change the distribution of ratings’ fees around the table.

Joseph R. Mason [??]:  How about a specialist in residential mortgage-backed securities?

Frank Raiter:  Pardon?

Joseph R. Mason [??]:  How about a specialist --

Frank Raiter:  Well, there are several of them [cross talking]

Joseph R. Mason [??]:  -- residential mortgage-backed securities.

Frank Raiter:  -- the data and models and have opted not to start selling the scores because they are trying to sell the information in other ways.  So that decision you just become to apply for an NRSRO.

There is a business model that suggests you might be able to make more privately if you can really do a better job and/or basically the lack of interest or the sort of mediocre analysis from the rating agencies and sell to your clients one-month or two-month preview of where the ratings might be going under whatever new criteria they publish.

R. Christopher Whalen:  Exactly.  Last question - Glenn, my good friend, and your competitor Sean Egan [phonetic] has told [audio glitch] I think he agrees with Frank that you cannot change the issue of rating agencies.  They are just beyond that.

But as a banker and a journalist, I have always been really puzzled by an entity that on the one hand embraces the First Amendment privilege, but at the same time has access to nonpublic information is allowed to communicate with the managers of public companies without disclosure about those communications under Reg FD.

Is there an argument to be made that anybody who is paid by an issuer should be regulated like an investment banker, to be made to come under NAST regulation, be given arbitration protection, instead of being exposed to civil litigation, but really regulated as someone who works with issuers, and then people like yourself on the other hand who are simply working for investors and with public data have that journalistic exemption?

Glenn Reynolds:  There are a couple of questions in there.  One about their Reg FD exemption, they would not even tell you when they use the Reg FD exemption so you can be lead at times where there is a false sense of security.  We saw that with Enron.  They would not even tell you what they asked because that is confidential, but you do not even know if they are asking the right questions.

That gets back to the other issue, to the extension of the issuer versus investor pay.  Whether you are being paid with an issuer pay or an investor pay, if you do not bring quality to the table and cost-effective quality, then you are not going to have a business anyway.  The difference between an investor pay and an issuer pay right now is if you are an investor pay, and you are no good, you are getting a revenue.  If you are an issuer pay and you are no good, you get a monopoly.  So, you have got a quality problem in the market that you cannot legislate or reform away.

But to your question, I think they would just say, “We do not really want to have regulatory exemption.  They actually threw that out there with the support of the securities industry lobby that was against Reg FD in the first place just to make sure that their issuer was very comfortable while they were billing them I think.

But to your point, my view on agencies is a quality issue.  I do not think they really know how to handle public information as well as they should -- let alone Reg FD exempt.  It is one of the reasons why I noticed some people have mentioned the idea of more Reg FD exemptions for more people.  A lot of people do not want to get conflicted because then you cannot be aggressive and have a strong view in the market for your constituency.

So on the sell side, you got tainted.  We would go way out of our way to make sure no guy got tainted, because then you cannot write.  Maybe that was a little bit lax in the 80s, but it got pretty tight in the new millennium where if you get conflicted, you are shut down.  Then you are not a very useful analyst.

R. Christopher Whalen:  I agree with you.  As I always remind my friends on Wall Street, if you are a member of the NAST, you have no First Amendment rights.  You cannot use unnamed sources.  You cannot write anything or research report that does not come from anchor [sounds like] basically or from the company press release.

With that, let’s have some questions for the audience, if you could wait for Karen to bring the microphone over to you please, and identify yourself.  And of course, Bert Healey [phonetic] had his hand up first.

Bert Healey:  My name is not Helen Thomas; although, I was accused that the other day.

But first of all, I want to pose a question and I will acknowledge right out front that my tongue is deeply in my cheek.  I want to express some concern for underwriters and investment banking firms particularly as it deals with structured products.

If the rating agencies are not being paid by investors and not by the issuing firms and therefore are not being paid to advise on how to structure these complicated transactions, what is Wall Street going to do?  Where will they look for guidance as to how to structure a deal to get a rating of single A or AAA or whatever they want if they do not have Moody’s and S&P and Fitch leading them along the way.  I think there is a real serious concern here.  What is Wall Street going to do without that kind of help?  How will they know how to structure these complicated transactions or may they not end up with such complicated structures?

R. Christopher Whalen:  Who wants to take a shot at that?  Go ahead, Joe.

Joseph R. Mason:  Really, Bert, that is the way out - less complicated structures.

The structuring exercise in deciding the number of tranches is very much like the classic example of price discrimination that we cover in microeconomics.  We are a theater that sells multiples classes of tickets for viewing at different times of day.  Just like the movie theaters, the more different classes of tickets you sell, the more revenue you can capture.

So what we have here is the industry that has essentially turned their treasuries into profit centers.  Extracting the last possible basis points out of every deal by maximizing the different tranches, the different levels of perceived risk, they can sell from the deal.

At the end of the day, however, in any structured finance transaction, your ability to slice and dice risk ever more finally through a greater number of tranches is limited by your ability to accurately predict underlying collateral performance.

What happened in subprime is that there were too many tranches to be supported by relatively inaccurate predictions of collateral performance.  Subprime loans are really more like subprime mortgage loans -- someone made reference to naming difficulties -- are mortgages in name only.  And the name is the only thing that they share with the traditional fixed rate 30-year mortgage.

In function, they are much more like a credit card loan.  Traditional 30-year fixed rate mortgage-backed securities contained about 50 tranches and IO/PO strips and back bonds and all kinds of other crazy stuff that can be supported by reasonably accurate predictions of collateral performance.

Credit card securitizations?  The most complex credit card securitizations contain about four waterfall tranches, and that is all.  No IO/PO strips, no back bonds, none of that stuff because of the fundamental difficulty of predicting the underlying collateral performance.

So I argue that one of the out of the current difficulties with subprime mortgages is to simplify the structures, but that will require leaving basis points on the table.  As Kyle mentioned, there are prices there.  There are ways to make deals move by leaving some basis points on the table or accepting a price that you do not like.

And that is what I made reference to earlier in my comments when I said this is not a liquidity crisis.  There is money there willing to trade.  It is just a matter that those who are looking to sell do not like the prices they would get.  That is a fundamentally different market than a liquidity crisis.  That is a lemons market.  You need to clean up the information.  One way to do that is to move your tranches.

Alex J. Pollock:  I’ll make a comment there, Joe.

Another way to say or to expand what Joe just said is the structured financing and especially the moving from subprime mortgage-backed securities to CDOs to CDO squared and so on is that you had the structures, which were highly leveraged in the first place to the accuracy of a prediction of credit behavior, which was subject to great uncertainty.  And then the more structure you got, in effect you got hyper-leveraged and then hyper-squared leveraged structures around a highly uncertain credit performance prediction then of course we find out it is hard to find buyers at a price you like.

I was at a conference about two weeks ago, and somebody said in a deep and profound voice, “Well what crisis has taught us is the importance of liquidity risk?”  I said, “That’s what every crisis teaches us.”

J. Kyle Bass:  I like that one anecdote - a piece of data here that you will find interesting.

I was at the wedding with the head of structured products marketing for one of the biggest securities firms in the world a few months ago, and he knew how we had positioned ourselves in the market.  And I asked him how he could possibly gather up these mezzanine tranches and market them as a AAA-rated CDO.  First of all, they could not sell those to real money accounts.  The insurance companies stopped buying the bottom of the cap structure in 2003.

So he said, “We had to put it together in a structure that was so opaque that we could just export the risk to Asia and Europe.”  And he said it with the straightest face you have ever seen as my jaw hit the ground because this firm is one of the three biggest firms in the world and this guy runs structured products marketing.  I mean, it is clear that there was actual intent there as opposed to, “We were just stupid.”  Either we were stupid or there is criminal intent, right?  I mean that is what it boils down to.  Realistically, it is probably some of both.

R. Christopher Whalen:  A good friend of mine, Don van Deventer [phonetic] from Kamakura Corp. wrote a couple of months ago, the only reason you bring a CDO is because you know the rating is wrong - if you think about it.

The other point I would make is that an earlier session, Alex and I had on subprime debt back in May, one of the things I touched on was if you look at your traditional 30-year mortgage series, it pretty much tracked the economy.  When you get into subprime, the portfolios become entirely idiosyncratic.  In other words, they are really a function of the choices made by the lender in terms of picking their customers because the default rates are so high, that they have no correlation to the economy at all.  Look at GE Money Bank for example.  It is a great example, if you just look at their default experience over the last five years; it is all over the place.  There were some quarters when GE wrote 10 percent of their portfolio off and the other lenders in that sector were showing pretty much normal behavior, whatever normal for subprime is.

Another question?  Jillian, you want to wait for a microphone -- where is Karen [indiscernible]?

Jillian Garcia [phonetic]:  Hi.  Jillian Garcia, I’m an international financial consultant.  I have got a question.  I got a clear idea I think from the panel, of very many things that are wrong, basically asymmetric information.  My question is, what do you guys think it is going to take to fix it and how long is it going to take before we see the benefits of your recommended fixes?

Frank Raiter:  Well, I think that depends on where the fix is start taking place.  In my opinion, if we were to start providing loan level data to the domain, there will be people entrepreneurs, there could be money that would flow into it.  If they can accumulate it, they can start analyzing it, and publishing and using it.  And the more information you get out there on exactly how particular transactions are expected to behave, the more opportunity you have for opening up some of these deadlock. 

And in fact, there is money out there, but in the people that we have been talking to from our side, they do not know what to buy because it is just like the housing business.  If you buy the house now and it goes down two months from now, and they are waiting for the CDO shoot-ahead because as soon these defaults, these downgrades start getting run through the CDO models then it becomes almost a vicious circle.  Because the CDOs are going to start getting downgraded and so many bids in there, which have already disappeared. 

So even if you are looking at a AAA LIBOR floater off a prime jumbo pool trading at 80, one you would think in a good liquidity environment, if you had a 250-basis point haircut that would be overly conservative.  People still are not stepping up to the plate to buy it.  Somebody needs to start providing information to suggest that, you know if you have got the money, and you got this kind of a horizon, if you buy this at 80, in 18 to 24 months it is going to be back at 99 and you will make a windfall.  Until that information is available, they are not going to take the words of the rating agencies.  But somebody has to start providing it.  I think that is one way it will start turning it around but it will take time.

Jillian Garcia:  Then how are you going to get the information out there?

Glenn Reynolds:  Well, I’ll put on my two cents on that.  The 2010, 2012, to put a number on it, a date, that is when you are going to have a real storm coming because that is the backend of all of this hyper origination of covenant light tight spread loans.  And right now, this thing I was talking over bridges [sounds like] over the summer but away from the mortgage business, this is just a warm up.  It is like a tornado is rolling through, so there is another round coming then.  So that is really when the winners and losers are going to get sorted out, in terms of the quality of products they offer.

So this is a long solution.  So we are looking out past 2012 before you start to see some real meaningful competition and upgrade of quality of information.  But the regulators need to act now to get the clock going so people can invest, grow of staff; because it is coming and people knew this was coming but they just did not want to believe it.  Now they are probably overly bearish, but at the same time when you have eight, nine times levered loans with minimal asset protection being slapped into structures under the same framework we are seeing here, maybe not quite anywhere near as bad as the CDO square’s, but that means you are not going to have a solution until after that because then you have sorted out who has the game and who does not.

J. Kyle Bass:  I would like to add one quick thing to that.  We are talking about cause and effect here and the thing that people have to realize is that, $2 trillion worth of loans were made to people that probably should not have had a loan in the first place.  So regardless of how we structure things, how we get loan level data out to people, these were terrible loans in the first place.  You have a trillion dollars of subprime, a trillion dollars of Alt-A sitting out there, and Alt-A is acting worse than subprime because it is really just subprime in drag. 

So you have a situation where getting loan level data out there today is irrelevant.  I mean, whatever your model tells you, is whatever the inputs that you give it are.  I mean we like to say that, we saw this coming two years ago.  It is not that hard to model these securities.  All you have to do are assumptions and an Excel program, right?  We get loan level data, too, but again it is less relevant.  What is more relevant is there are $2 trillion of bad loans out there.  There are going to be $400 billion plus in write-offs and who takes them?  I do not know where we are we up to now, $60, $70 billion dollars?  We are just getting started. 

So this has to flush itself through and I know AAA’s had not been impaired because they downgrade them before they are going to be impaired.  But realistically, the AAAs that were AAAs once, they are going to see massive impairments.  And that is going to be a structural problem in the ratings agencies’ business for the next five years.  There is no way to fix it quickly.  This is kind of a Darwinian exercise in my opinion.

R. Christopher Whalen:  Kyle, let me ask you a follow-up question to that.  I have been speculating that people like yourself on the buy-side are going to start buying in these deals and taking them apart, the deals that actually have collateral as opposed to these pure derivative deals.  Do you see any of that yourself?  Do you think that is going to start happening?  Because if the default rates on the collateral is not that high yet, it is the expectations that are driving all these prices.

J. Kyle Bass:  Yes, first of all, you have to [audio glitch] in pooled transactions that we are talking about, it is not a traditional distressed investment.  Meaning if you buy into one of these pieces of the pool and your assumptions are off by just a little bit, these pieces are so thin that it is binary.  You lose everything.  If you buy into a distressed investment that is typical on a corporate side, you say I'm going to pay four times [indiscernible] for it and it trades down at two and a half percent, well you still have the comfort that you know what the valuation of the company is, okay? 

So being a distressed investor in the mortgage market is precarious and I would say albeit, if you are only investing in AAAs it is a different story.  But anywhere else in the cap structure, the risk rewards are not there.  So the answer is no, and you cannot buy a mortgage bond and grab the collateral. 

The only way that this process works with these securitizations is foreclosures will happen.  Foreclosures happen, they will blow out the assets.  We are launching a funding Q1 that buys these assets.  I mean, there is plenty of money out there to buy hard assets at depreciated values, but the mortgage securities market is a complete different market than corporate securities and understanding the chapter 13 -- [cross-talking]

R. Christopher Whalen:  To that point, you just made me think of something funny, I think we are going to write about next week because it goes back to what Joe was saying which is that the mortgage market really flips the Mertin model on its head, does it not?

J. Kyle Bass:  It does.

R. Christopher Whalen:  Wall Street is geared on the premise that you have limited downside and unlimited upside.  That is what all the co-ops models in Wall Street are about.  But in the mortgage market, you have limited upside but unlimited downside.

J. Kyle Bass:  That is exactly right. 

R. Christopher Whalen:  Well where is the next question?  John, do you want to ask questions?  Identify yourself.

John Macon:  John Macon, AEI.  The rating agencies have taken some tough licks today, probably deservedly, but it seems to me is not the franchise of the rating agencies being severely undercut.  You can see that from the prices of their securities and they have been counterproductive.  Let’s say they have actively distributed bad information.  So let’s say that, the value of their franchise goes to zero.  I do not know why it has any value now, maybe some of you could speculate on that. 

Let’s say the value of their franchise goes to zero.  Do we need that middleman?  And why don’t -- I guess I was thinking, you know, there is this new movie, Frank Lucas cuts out the middleman in the drug business and goes and gets all that heroin in Vietnam and sells it at lower price in the Mafia.  I mean, why do we need rating agencies?  Banks have lots of people sitting around, scratching their butts with nothing to do.  Why cannot they do the due diligence the rating agencies do? 

And especially that the rating agencies apparently as you say, as you clearly have indicated, if you are a lender, they are working against you.  They are in collusion with the borrower.  And they get paid to misrepresent what you are buying.  Now that we know that, why will they not just disappear and why will lenders, large institutions like banks, not put together own rating agencies internally and accurately price securities?

R. Christopher Whalen:  Go ahead Joe.

Joseph R. Mason:  It comes down the regulatory responsibilities.  I think you are right, if rates were sold in a competitive market and were thought to be an information product; I think they were used as an information product for these structured finance products that are sold.  They would have no market value right now, and I think they would be on the brink of insolvency.  But, every one of these products requires a rating to meet investment guidelines beginning with ERISA and ending some hundreds of statutes and literally, thousands of regulatory references later.  And right now, that is one of the chief impediments to changing this broken NRSRO system. 

The Fed, for months now, has been reviewing its own regulations and noting instances that reference NRSRO ratings and reliance upon those ratings, and finding just an incredible web of reliance on ratings for regulatory purposes.  The SEC has undertaken a similar exercise.  So, relying upon something else will affect literally thousands of regulations and statutes in perhaps unintended ways.  That, however, I would argue, should not be a reason to not change the current system that is not -- or rather, another way to put it is [audio glitch] is an explanation for the delay.  It is not an excuse. 

That just means that, the exercise will be difficult and going forward, we should not make this mistake again of outsourcing regulation.  That is, maintain control of either, assigning your job responsibilities or assessing your competency in those responsibilities.  But if we give you both, the right to determine what you do for your job and the right to assess your job performance every year, you are going to do a great job every year and your job will merely be collecting your paycheck.

Alex J. Pollock:  John, that was why I was trying to say.  I said, even if the rating - even if, which I do not maintain, but even if it had no predictive value, it still has enormous regulatory value because in the entire domain, as Joe says, of regulated investors, they cannot buy these things without a rating from a designated NRSRO.

John Macon:  Just a quick follow-up.  So it is a legislative constraint.  Then who can franchise as the rating agencies by designating them as a necessary supplier of a rating?

J. Kyle Bass:  Everyone.  I mean let’s start with the Fed.

John Macon:  So it legislative or is it SEC?  Is it --

Glenn Reynolds:  It is both regulatory.  It is primarily a regulatory, but both regulatory and legislative.

Male Voice:  Like I said earlier the [cross-talking] single bank document so it is to the banks’ as well.  The intermediaries have also anointed them.

Joseph R. Mason:  But let me go to where this started, which is something nobody has talked about yet.  Department of Labor, that is where ERISA comes from and that is what started it all.  Everybody else piled on.

R. Christopher Whalen:  This one, this gentleman here?

John Petersen:  I was going to make a comment.  In a lot of contracts, like additional bonds test and so forth, you will have specification as to Moody’s, and Standard and Poor’s, straight there.  Rating triggers in various kinds of loan agreements, it is just rampant throughout the entire industry. I'm John Petersen, George Mason University.

R. Christopher Whalen:  Thank you, John.  Who else?  This lady back here and then, the gentleman next to her.

Kay Acevedo [phonetic]:  I'm Kay Acevedo at Stanford Group.  Alex, I had a question on a point that you made about all the different players are kind of attacking the credit rating agencies, the President’s Working Group, Congress, even a legal argument that is coming in.  So I guess I would like to know your opinion and anyone else on the panel on who is actually -- you know, what is the most significant attack and where is this going to play out?

Alex J. Pollock:  Well, I do not know which the most significant attack is.  I suppose you are always worried if Congress is after you, much more than say if the AEI and their professional risk managers are after you.

You would have to think, thinking of the legal attacks or if they really are coming and it looks like they are coming, serious lawsuits against rating agencies, from investors who have suffered losses and will claim there was a kind of a misrepresentation or so