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F FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT
choices that lowered the estimated correlation of default, which would improve the
ratings for these securities. Using these methods, Moody’s estimated that two mort-
gage-backed securities would be less closely correlated than two securities backed by
other consumer credit assets, such as credit card or auto loans.
The other major rating agencies followed a similar approach. Academics, in-
cluding some who worked at regulatory agencies, cautioned investors that assump-
tion-heavy CDO credit ratings could be dangerous. “The complexity of structured
finance transactions may lead to situations where investors tend to rely more heavily
on ratings than for other types of rated securities. On this basis, the transformation of
risk involved in structured finance gives rise to a number of questions with important
potential implications. One such question is whether tranched instruments might re-
sult in unanticipated concentrations of risk in institutions’ portfolios,” a report from
the Bank for International Settlements, an international financial organization spon-
sored by the world’s regulators and central banks, warned in June .
CDO managers and underwriters relied on the ratings to promote the bonds. For
each new CDO, they created marketing material, including a pitch book that in-
vestors used to decide whether to subscribe to a new CDO. Each book described the
types of assets that would make up the portfolio without providing details. With-
out exception, every pitch book examined by the FCIC staff cited an analysis from ei-
ther Moody’s or S&P that contrasted the historical “stability” of these new products’
ratings with the stability of corporate bonds. Statistics that made this case included
the fact that between and , of these new products did not experience
any rating changes over a twelve-month period while only of corporate bonds
maintained their ratings. Over a longer time period, however, structured finance rat-
ings were not so stable. Between and , only of triple-A-rated struc-
tured finance securities retained their original rating after five years. Underwriters
continued to sell CDOs using these statistics in their pitch books during and
, after mortgage defaults had started to rise but before the rating agencies had
downgraded large numbers of mortgage-backed securities. Of course, each pitch
book did include the disclaimer that “past performance is not a guarantee of future
performance” and encouraged investors to perform their own due diligence.
As Kyle Bass of Dallas-based Hayman Capital Advisors testified before the House
Financial Services Committee, CDOs that purchased lower-rated tranches of mort-
gage-backed securities “are arcane structured finance products that were designed
specifically to make dangerous, lowly rated tranches of subprime debt deceptively at-
tractive to investors. This was achieved through some alchemy and some negligence
in adapting unrealistic correlation assumptions on behalf of the ratings agencies.
They convinced investors that of a collection of toxic subprime tranches were
the ratings equivalent of U.S. Government bonds.”
When housing prices started to fall nationwide and defaults increased, it turned
out that the mortgage-backed securities were in fact much more highly correlated
than the rating agencies had estimated—that is, they stopped performing at roughly
the same time. These losses led to massive downgrades in the ratings of the CDOs.
In , of U.S. CDO securities would be downgraded. In , would. 
