Warren Buffett Testifies at FCIC Hearing

Angelides called the current model of ratings agencies the "worst of many worlds: the issuer pay model…pressure to produce ratings…the duopoly with enormous pricing power…and First Amendment protection." Buffett agreed in the sense that: "I hate issuer pay," but it's "difficult to think of alternatives where the user pays–I'm not going to pay," for ratings.

Buffett said that "excess leverage" played a large role in the "size and pop of bubble" including "some off balance sheet" leverage. He was surprised, for instance, "when Citigroup turned out to have SIVs [special investment vehicles that some banks used to hide assets off their books]…many billions," of dollars. And, he asserted, there were "no flashing signs."

Buffett said that in September 2008, the U.S. financial system could have fallen apart "if the Fed had not acted to support commercial paper and money markets, and everyone would have been touched." At that time he was approached by a number of Wall Street firms, including Goldman Sachs, in which he ultimately invested $5 billion. He said he had more faith in that firm's "risk management" than some of the others, and so once Goldman Sachs had offered terms Buffett was comfortable with, he thought it would be "a good use of our $5 billion."

The last session started off with Mark Froeba, Moody's former senior vice president of U.S. derivatives, strongly asserting that there was a "cultural revolution" at Moody's coincident with the firm going public and the housing bubble, and that the company's former president and COO, Brian M. Clarkson (scheduled to testify but was hospitalized), and other executives were more concerned with market share relative to Standard & Poor's than the quality of ratings.

The most interesting exchange came when former Senator Robert Graham asked Gary Witt, Moody's former team managing director of U.S. derivatives, how Moody's took "stacks of mediocre mortgages," and managed to "convert them into 80% being Triple-A?"

Witt answered that it was by using a binomial mathematical model that takes a "large number of assets," and represents them "as only one mortgage, because you think they'll all behave the same way–95% of the time they'll all pay off; 5% of the time they'll all default." It's as if they took blocks of geographically diverse mortgages from a total of 100, "10 from Florida, 10 from New York, 10 from California," and so on, so that you had blocks of assets you wouldn't expect to behave the same way. They'd be "highly correlated to themselves but not all default at once." They were able in this way to rate what would normally be BBB rated assets as AAA mezzanine CDOs. But the default rate on those ended up at "90%." So the theory didn't do well in practice.

Moody's models were based on rising real estate markets, so once the market corrected even slightly, the model was way off; at a 4% downturn in real estate, Moody's had to downgrade billions of dollars in mortgage-backed securities.

And so ended a day of somber testimony from current and former Moody's executives, analysts, and Warren Buffett. The FCIC report is expected to be finalized on December 15.

Comments? Please send them to [email protected]. Kate McBride is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard. She is a shareholder of Berkshire Hathaway.