[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
REFORMING CREDIT RATING AGENCIES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 30, 2009
__________
Printed for the use of the Committee on Financial Services
Serial No. 111-82
U.S. GOVERNMENT PRINTING OFFICE
54-873 PDF WASHINGTON : 2010
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina RON PAUL, Texas
GARY L. ACKERMAN, New York DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California WALTER B. JONES, Jr., North
GREGORY W. MEEKS, New York Carolina
DENNIS MOORE, Kansas JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts GARY G. MILLER, California
RUBEN HINOJOSA, Texas SHELLEY MOORE CAPITO, West
WM. LACY CLAY, Missouri Virginia
CAROLYN McCARTHY, New York JEB HENSARLING, Texas
JOE BACA, California SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia RANDY NEUGEBAUER, Texas
AL GREEN, Texas TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois JOHN CAMPBELL, California
GWEN MOORE, Wisconsin ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota KENNY MARCHANT, Texas
RON KLEIN, Florida THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio KEVIN McCARTHY, California
ED PERLMUTTER, Colorado BILL POSEY, Florida
JOE DONNELLY, Indiana LYNN JENKINS, Kansas
BILL FOSTER, Illinois CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana ERIK PAULSEN, Minnesota
JACKIE SPEIER, California LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York
Jeanne M. Roslanowick, Staff Director and Chief Counsel
Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises
PAUL E. KANJORSKI, Pennsylvania, Chairman
GARY L. ACKERMAN, New York SCOTT GARRETT, New Jersey
BRAD SHERMAN, California TOM PRICE, Georgia
MICHAEL E. CAPUANO, Massachusetts MICHAEL N. CASTLE, Delaware
RUBEN HINOJOSA, Texas PETER T. KING, New York
CAROLYN McCARTHY, New York FRANK D. LUCAS, Oklahoma
JOE BACA, California DONALD A. MANZULLO, Illinois
STEPHEN F. LYNCH, Massachusetts EDWARD R. ROYCE, California
BRAD MILLER, North Carolina JUDY BIGGERT, Illinois
DAVID SCOTT, Georgia SHELLEY MOORE CAPITO, West
NYDIA M. VELAZQUEZ, New York Virginia
CAROLYN B. MALONEY, New York JEB HENSARLING, Texas
MELISSA L. BEAN, Illinois ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin J. GRESHAM BARRETT, South Carolina
PAUL W. HODES, New Hampshire JIM GERLACH, Pennsylvania
RON KLEIN, Florida JOHN CAMPBELL, California
ED PERLMUTTER, Colorado MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana THADDEUS G. McCOTTER, Michigan
ANDRE CARSON, Indiana RANDY NEUGEBAUER, Texas
JACKIE SPEIER, California KEVIN McCARTHY, California
TRAVIS CHILDERS, Mississippi BILL POSEY, Florida
CHARLES A. WILSON, Ohio LYNN JENKINS, Kansas
BILL FOSTER, Illinois
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
C O N T E N T S
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Page
Hearing held on:
September 30, 2009........................................... 1
Appendix:
September 30, 2009........................................... 45
WITNESSES
Wednesday, September 30, 2009
Dobilas, Robert G., President and CEO, Realpoint LLC............. 19
Gallagher, Daniel M., Co-Acting Director, Division of Trading and
Markets, U.S. Securities and Exchange Commission............... 12
Gellert, James H., Chairman and CEO, Rapid Ratings International,
Inc............................................................ 21
Joynt, Stephen W., President and CEO, Fitch, Inc................. 17
McDaniel, Raymond W., Chairman and CEO, Moody's Corporation...... 14
Schacht, Kurt N., Managing Director, CFA Institute Centre for
Financial Market Integrity..................................... 23
Sharma, Deven, President, Standard & Poor's...................... 16
APPENDIX
Prepared statements:
Bachus, Hon. Spencer......................................... 46
Dobilas, Robert G............................................ 48
Gallagher, Daniel M.......................................... 60
Gellert, James H............................................. 76
Joynt, Stephen W............................................. 88
McDaniel, Raymond W.......................................... 109
Schacht, Kurt N.............................................. 124
Sharma, Deven................................................ 129
Additional Material Submitted for the Record
Kanjorski, Hon. Paul E.:
Written statement of Dominic Frederico, Chief Executive
Officer, Assured Guaranty Limited.......................... 155
Letter from Egan-Jones Ratings Company, dated September 29,
2009....................................................... 158
Written statement of John A. Courson, President and CEO,
Mortgage Bankers Association............................... 160
Foster, Hon. Bill:
Responses to questions submitted to Stephen W. Joynt......... 165
Responses to questions submitted to Kurt Schacht............. 168
Responses to questions submitted to Deven Sharma............. 169
Garrett, Hon. Scott:
Written statement of the Commercial Mortgage Securities
Association................................................ 174
REFORMING CREDIT RATING AGENCIES
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Wednesday, September 30, 2009
U.S. House of Representatives,
Subcommittee on Capital Markets,
Insurance, and Government
Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 2:10 p.m., in
room 2128, Rayburn House Office Building, Hon. Paul E.
Kanjorski [chairman of the subcommittee] presiding.
Members present: Representatives Kanjorski, Sherman, Scott,
Perlmutter, Donnelly, Carson, Speier, Foster, Kilroy, Kosmas;
Garrett, Castle, Manzullo, Royce, Hensarling, Posey, and
Jenkins.
Ex officio present: Representative Bachus.
Also present: Representative Green.
Chairman Kanjorski. This hearing of the Subcommittee on
Capital Markets, Insurance, and Government Sponsored
Enterprises will come to order pursuant to agreement with the
ranking member. Opening statements today will be limited to 15
minutes on each side. Without objection, all members' opening
statements will be made a part of the record.
Today we meet to discuss one of the most important issues
Congress will address as part of our overhaul of financial
regulations: The reform of credit rating agencies. This issue
has already generated much debate.
Credit rating agencies play an integral part in our
markets. Even though they operate as independent firms, they
hold quasi regulatory powers. Investors around the world also
heed their words, or the letters, as the case may be.
These entities also greatly contributed to our current
economic problems by inappropriately issuing triple A ratings
for mortgage-backed securities and other complex financial
instruments that later failed spectacularly. These agencies
further used the same faulty assumptions as so many others that
real estate prices would never go down. They were wrong.
Perhaps most troubling, these agencies failed to learn more
about the quality of the products they rated. Investors have
come to rely on the judgment of credit rating agencies, and it
now appears that rating agencies with their, ``Ask me no
questions, I will tell you no lies'' approach betrayed not only
that trust, but also the special status under our laws.
To correct these problems, I have worked to draft
legislation that achieves a balance between improving the
regulatory oversight of credit rating agencies, while also
creating incentives for investors to recognize that ``caveat
emptor'' is still the ultimate rule for any financial
transaction. Today's hearing is therefore on a discussion draft
that aims to reform and regulate these gatekeepers to our
markets using these two principles as guides.
This summer, the Administration released a promising
proposal to reform rating agency regulation. I have
incorporated many useful provisions from that document into my
discussion draft, including reforms aimed at enhancing the
oversight of the rating agencies by the Securities and Exchange
Commission and requiring new disclosures about how issuers pay
rating agencies.
Under the reforms, rating agencies will remain independent.
The Commission will not opine on the methods used for
determining ratings, but it will ensure that rating agencies
follow their internal procedures. The changes additionally
require new duties for compliance officers at each rating
agency to monitor and manage the many conflicts of interest
inherent in this industry.
We must however go further. My draft therefore includes the
sensible proposals to promote accountability through liability
as first suggested by my friend, Senator Jack Reed.
One of the most repeated complaints I heard in my district
is that no one has been held accountable for the credit crisis.
While the Justice Department belatedly works to take legal
action against wrongdoers who caused this economic meltdown,
going forward I believe that all responsibility parties,
including the rating agencies, should be held accountable for
their actions, good or bad.
We can promote accountability in credit ratings through the
threat of liability. While these legal reforms are an important
change from current law, I want to assure everyone that I am
committed to working to refine them as we move through the
legislative process.
To get at the tremendous conflicts of interest created by
the issuer pay model, I have also proposed a new idea: making
the rating agencies responsible for each others' ratings
through collective liability. This reform will hopefully incent
participants in this oligopoly to police one another and
release reliable high-quality ratings. This reform, however, is
not the only way to fix this problem, and I am open to other
ways to achieve this objective.
My discussion draft further includes many other new
reforms, like a duty for supervisors to manage the work of
their subordinates, and the establishment of boards with
independent directors. Many of us also share the policy goal of
diminishing the reliance on credit ratings. I wish we could
just snap our fingers and take away the countless references to
credit ratings in laws and regulations. While I have proposed
in this discussion draft the elimination in Federal statutes of
all credit rating agency references, I have serious concerns
about the unintended consequences of this plan.
In sum, this is the start of a process. I want to thank my
cosponsors, Representatives Cleaver, Kilroy, and Kosmas, for
joining me in producing this bill. Going forward, I optimistic
that many more Members--from both sides of the aisle--will join
me as we find the best ways to reform the regulation of these
gatekeepers to our markets.
I now recognize the gentleman from New Jersey, Ranking
Member Garrett, for 5 minutes for his opening statement.
Mr. Garrett. I thank the chairman and the members of the
subcommittee for holding this important hearing today. I also
thank the chairman for all of his hard work and that of his
staff as well that they put into this discussion draft. I must
begin by saying I am a little disappointed, as I am sure the
chairman is, that we couldn't find 100 percent complete
bipartisan consensus on all portions of this proposed release,
but I do sit here today and pledge to continue to work with the
chairman moving forward in hopes that we can eventually reach a
place where we both are able to support the eventual final
legislation.
One of the provisions, as the chairman just indicated, he
has some concerns with deals with the national recognized
statistical rating organizations, the NRSROs and removal of
them from the statute. I approached this debate on the credit
rating agencies reform with the belief that the two most
fundamental problems with our rating system are overreliance on
ratings and a lack of investors' due diligence. Investors have
become increasingly all too often solely reliant on the use of
these ratings in determining the safety and soundness of any
investment. In literally hundreds of Federal and State
government statutes and regulations, there are specific
requirements mandating certain grades from the approved
agencies is this formal requirement that provides an implicit
stamp of approval to investors. So when an investor sees that
the government is requiring a specific grade to make a safe
investment, it reenforces the belief that any investment
obtaining such a grade is basically safe. I know that the SEC
has a similar concern as I do. So 2 weeks ago, the SEC
announced it is removing references to the NRSROs in several of
the regulations and studying other areas to determine where
else they can be removed.
And so I applaud the SEC for their actions and I urge them
to continue their work. I believe that Congress should follow
suit and reexamine all the areas where statute mandates the
ratings of NRSROs. Credit ratings are only one piece of the
puzzle in determining creditworthiness. Investors must be
encouraged to do proper due diligence as well in evaluating
issuer credit quality.
Another way in which I believe we can help increase
investor due diligence that this bill does touch on but does
not go far enough is to increase disclosure through information
by the issuer. When dealing with equity securities, investors
have all the public information about the company because of
the annual and quarterly filing requirements. So I believe that
we should require the similar situation with debt securities.
The issuer of debt securities should disclose the information
contained in the offering more broadly so that investors have
the ability themselves to delve in deeper into the submitted
transaction.
While there may be other things included in the proposal
that I do support, like increased disclosure and better
oversight, there are a couple of provisions that I have a
little concern with. The provisions that I am most troubled by
center around the question of liability. Unlike many of my
friends across the aisle, I do not believe that the solution to
some of these problems is more lawsuits. In the discussion
draft, there is a provision to institute a collective liability
among the NRSROs. And I must say, I am concerned about the
practicality of this provision, not to mention the
constitutionality as well. I don't see what positive can be
obtained by holding all the NRSROs accountable for the actions
of just one.
The main thrust of the 2006 Reform Act was to increase
competition between credit rating agencies. Now, I know that
the chairman voted for final passage of that Act in 2006, not
withstanding his previously stated belief that there might be a
natural oligopoly as he indicated within the credit rating
industry. If we institute a sharing of financial legal
liability however between all the NRSROs, I cannot think of any
bigger impediment to new entries into the marketplace. The
second area of concern regarding legal liability is the
language in Section 4 to lower the pleading standards for
lawsuits against the rating agencies. By making the rating
agencies subject to suits whenever they are ``unreasonable,''
you are essentially lowering the bar from fraud to negligence.
The practical effect of lowering the pleading standard will be
a dramatic increase in cases being filed and eventually going
to court.
So I don't believe that having more lawsuits brought
against rating agencies is a really constructive way to improve
the rating process. As Chairman Frank so often noted during the
Bush Administration, that he did not realize that he was here
to defend President Bush and his policies whenever there is an
argument on the Floor of the House with regard to them,
likewise, I must say I did not realize it would fall upon me to
defend President Obama's efforts in this context as well,
because the Obama Administration has submitted an extensive
credit rating agency reform proposal and increasing legal
liability and was nowhere to be found in his proposal.
Also, a recent ruling by a Federal court judge debunks the
myth that it is impossible to get the credit rating agencies
into the courtroom. So we should see how that case plays out
before we overreact in committee. I have another concern as
well, basically the increased liability. And so while I support
the SEC providing better oversight of the NRSROs, I am worried
that too much SEC involvement with ratings further implies a
government sign-off on the ratings themselves. At what point
during the SEC examination process to review whether rating
agencies are following their methodologies does the SEC start
prescribing specific methodologies for the NRSROs to follow? In
my opinion, this would only further the belief that government
is doing the rating themselves.
Also, the requirement for differentiation of ratings from
structured products is a concern. All structured products are
not the same. And giving them the same connotation implies that
they are. The SEC has already once considered this idea and
they frankly dismissed it after an overwhelming number of
investors voiced their concerns. So in conclusion, I think we
all agree that significant reforms for the credit rating
agencies are much needed. And I, quite frankly, do
wholeheartedly applaud the chairman for his hard work and again
of his staff. And I do look forward to working closely with him
and the members of his staff and other members from both sides
of the aisle as we move forward on this extremely important
issue. With that, I yield back.
Chairman Kanjorski. Thank you very much, Mr. Garrett. We
now recognize the gentleman from California, Mr. Sherman, for 3
minutes.
Mr. Sherman. Thank you. Nothing is more responsible for the
fact that we are in this situation than the credit rating
agencies giving AAA to Alt-A and otherwise giving outrageously
high ratings to very bad mortgage-backed securities. Smart
people in these credit rating agencies discovered that if they
could devise a model based on the idea that home prices would
never go down, then they could please the issuer, get the big
fee, and avoid a liability. And so just sticking to your own
model is insufficient since devising an issuer pleasing model
is the key to get more business. We either have to remove the
incentive the credit rating agencies have to please the issuer,
or we have to counterbalance that incentive with the fear of
liability.
The best way to defend the status quo, to defend a system
of pleasing the issuer, and getting the big fee and avoiding
liability is to just tell people, don't rely on the credit
rating agencies, let them do whatever they want, and we will
put a little cigarette warning on the bottom of the rating
agency. This is a clever way to defend the status quo. Blame
the investor for relying on the rating. How is my mother
supposed to know which corporate bond to invest in if she wants
a super safe bond? She either has to rely on the agency or hire
a team of financial analysts to work for her. Which is a better
system? And then we are told, well, invest in mutual funds. How
are you supposed to determine which of two funds is safer if
you want to invest in the corporate bond fund? The one that
averages a AA rating or the one that averages an AAA rating or
is my mother going to have to hire a team of financial experts
to tell her which mutual fund is necessary?
Rates are necessary. That is why people rely upon them. No
matter what we say, people will continue to rely on them, so we
have to make them reliable. One way to do that--as the chairman
points out--is to counterbalance the risk that they will give
to liberal--and a rating with the threat of liability. Another
is to remove the incentive to give too liberal an A rating by
eliminating the program where the issuer picks the credit
rating agency. That is like having the home team pick the
umpire and that is why I will have a legislative proposal.
I look forward to working with the chairman on it, perhaps
including it in his bill. I will have the work on it done next
week to say that we should select the credit rating agency for
the issuer at random from among the qualified umpires. That is
how the American League does it. That is how the National
League does it. Where would Major League Baseball be if the
home team picked the umpire? The other way to do it is to have
instant replay and make the umpire liable if he is calling too
many balls that were really strikes. That might be effective as
well. But the current system has failed. I yield back.
Chairman Kanjorski. Thank you very much, Mr. Sherman. We
will now recognize the gentleman from New Jersey, Mr. Garrett.
Mr. Garrett. Just for unanimous consent to issue a
statement from the Commercial Mortgage Security Association on
this--regarding this hearing on reforming credit rating
agencies.
Chairman Kanjorski. Are there any objections? Without
objection, it is so ordered. Next, we will hear from the
gentleman from Delaware, Mr. Castle, for 2\1/2\ minutes.
Mr. Castle. Thank you, Mr. Chairman. Credit rating agencies
are meant to provide a valued service to investors by giving
them an informed judgment on the risk of certain bonds. As we
know, subprime and other mortgages were fragmented into pieces
and bundled into mortgage-backed securities and then rated.
Investors relied heavily on the rating agency models to assess
the risk of these investments before making a purchase
decision. Yet when AAA mortgage-backed securities began to
fail, it became evident there was a problem with the system. As
the housing bubble burst, I grew increasingly concerned with
this issue, as did my colleague, Mr. Ackerman from New York. In
July 2008, again, this Congress in the form of H.R. 1181,
introduced legislation that directs the SEC to establish a
process by which asset-backed instruments can be deemed
eligible for nationally recognized statistical rating
organizations, NRSRO ratings. Under this bill, eligible
investments must consist of securities whose future
performances can be recently predicted, such as those with
established track records or homogenous structures. The SEC
would have the authority to strip nationally recognized
statistical rating organizations of their NRSRO designation if
the rating agency fails to comply with provisions set forth in
the legislation. I am pleased that we are continuing debate on
credit rating agency reform.
Although I believe it is clear that action must be taken, I
believe we must do more to set guidance on the eligibility for
investment for NRSRO designation to avoid falling into the same
problems we currently face. I look forward to working with my
colleagues to ensure adequate reform moving forward. Just one
further comment beyond my talking points here, and that is the
question I will have of the methodology of paying for your
services. That was raised a little bit by Mr. Sherman, I think.
And I think it is a matter of legitimate concern, that if the
entities are asking you to rate a product or paying you, does
that influence all the way this comes out or not and are
investors shortchanged for some reason or another? I don't have
a solution to that. I am just interested in your comments on
that as we go forward. I yield back the balance of my time.
Mr. Sherman. Will the gentleman yield? My concern is not
who pays the umpire, but who selects the umpire.
Mr. Castle. If the wrong team pays the umpire, regardless
of who selects him, that could be an issue too. So maybe we
have to combine the two concerns. I understand where you are
coming from. I would be happy to try to work with you on it. I
yield back.
Chairman Kanjorski. Thank you very much, Mr. Castle. We
will now hear from the gentleman from Indiana, Mr. Carson, for
2 minutes.
Mr. Carson. Thank you, Mr. Chairman, for holding this
important hearing today. We all agree that reform is necessary
in the credit rating industry. This has become all too evident
in the ongoing financial crisis. However, I believe that as we
work to make the industry more independent and objective, we
cannot ignore the industry's relation to systemic risk. Credit
rating agencies can increase systemic risk through
unanticipated and abrupt downgrades. Such rating crises can
lead to large market losses, fire sales and liquidity
shortages. In this financial crisis, we have seen many recent
examples of this. Defaults of subprime loans have led to abrupt
and unanticipated rating downgrades of a number of rated
securities, insurers, and bond insurers. These downgrades in
turn led to larger market losses for investors. Although
conflicts of interest and informational issues are key to
understanding why such rating crises occur, it is critical to
identify the different facets of risks in the ratings market
and how it can lead to systemic crises and how to measure and
manage them. We need to better assess the nature and extent of
the use of credit ratings in financial markets as well as their
potential impact on our long-term financial stability.
It is clear that such an assessment will require a global
approach that includes both micro and macro level analysis and
includes all market participants. I look forward to this
opportunity to discuss these issues with the distinguished
panel, and I yield back my time.
Chairman Kanjorski. Thank you very much, Mr. Carson. We
will now hear from the gentleman from California, Mr. Royce,
for 3 minutes.
Mr. Royce. Thank you, Mr. Chairman. As we dissect the
proliferation of the exotic mortgages throughout our financial
sector, it is hard to overlook the role played by the ratings
issued by the various rating agencies. Certainly there were
flaws in the actual ratings. In January of 2008, there were 12
AAA rated companies in the world. At that time, there were also
64,000 structured finance instruments like collateralized debt
obligations holding that AAA rating.
Further, many of those products were based on nothing more
than junk mortgages. Of the $3.2 trillion of subprime mortgage
securities issued, 75 percent were awarded AAA ratings. But the
rating agencies missing the mark when assessing the potential
risk associated with these products was not the core problem. I
believe the major failure over the years was the blind reliance
on the rating agencies by investors, financial institutions,
and by the Federal Government. In many respects, the government
has institutionalized these failed ratings. Looking back, this
overreliance was as misguided as the ratings being issued by
the NRSROs.
Going forward, nothing will replace due diligence by
investors and institutions and regulators. Alternative risk
indicators must supplant what was previously an oligopoly by
the NRSROs. I think a more competitive market with alternatives
to the NRSROs ratings is the most effective alternative. And,
for instance, I would raise the issue that many economists for
some time have advocated for mandating large institutions to
issue subordinated debt. Credit default swap spreads have also
been used as an alternative to agency ratings. I look forward
to discussing the draft legislation issued by the chairman as
well as other potential reforms with my colleagues here today
and hearing from these witnesses and I thank you, Mr. Chairman.
And I think in retrospect, Mr. Chairman, had we never codified
under law some of the references to rating agencies that
essentially put government behind the rating agencies there
might have been more due diligence. Going forward, I hope we
learn from that. Thank you, Mr. Chairman. I yield back the
balance of my time.
Chairman Kanjorski. We will now hear from the gentleman
from Illinois, Mr. Foster, for 2 minutes.
Mr. Foster. Thank you. And I would like to thank Chairman
Kanjorski for convening this hearing today to discuss the
important topic of how best to reform the credit rating
agencies. While I applaud the general thrust of this bill, and
I think it signals advanced improvement over today's regulatory
environment, there are at least two major areas where I think
the bill could be improved. The first major problem that we are
wrestling with is the conflicts of interest inherent in the
issuer pays business model for the rating agencies. I believe
that the best model for going forward is to mimic the way that
we handle similar conflicts and oversight of accounting and
maybe modeled on the public company accounting oversight board,
PCAOB.
An oversight board like the PCAOB would be constituted
largely or dominantly by users of credit ratings and would have
teeth. Specifically, it would have powers to set standards and
mandate disclosures, conduct spot checks and investigations,
impose civil fines, ban firms and individuals from the credit
rating industry. I believe that the PCAOB has been a necessary
and sufficient entity to restore the credibility of the
accounting industry in the post-Enron area. So the question I
will be asking is what, if anything, might be the downside of
instituting a similar oversight board for the credit rating
industry. The second major problem that I see is the
nonuniformity and nonquantitative nature of the language in
which the ratings are reported by the CRAs. While the draft
bill mandates the CRAs use generally recognized models when
arriving at their ratings, I believe that greater detail under
various well-defined market conditions would be very beneficial
to investors.
Specifically, I would emphasize the desirability of, first,
standardization of ratings terminology so that all firms report
ratings using identical terms. Second, industrywide
standardization of stress conditions under which the ratings
are evaluated. Thirdly, unambiguous quantitative correspondence
between the ratings and the default probabilities under
standardized conditions of economic stress. And fourth,
standardization of terminology across asset classes so that,
for example, a given rating applied to a municipal bond and a
corporate bond will have the identical default probability
under identical market stress conditions. One specific proposal
that I would like to see investigated are what might be called
ABZ ratings at a glance in which the three digits of a rating,
instead of just being things that are made up, correspond to
default probabilities under three different, well-defined
levels of market stress.
So the first digit, for example, could represent the
default probability under normal market stress, the second
digit under severe market stress and the third digit represents
the default probability under extreme market stress. A 50
percent asset price drop, 10 percent increase in unemployment
and so on. So a rating, if this style of ratings had been
applied, then the ratings that would be assigned to an
intermediary tranche of a mortgage pool, for example, might
hold up well under normal market conditions and then collapse
at times of stress would be ABZ.
And had this sort of language been applied to the ratings
of mortgage-backed securities, then the right questions would
have been asked and there would have been no way that AAA
ratings would have been so freely disbursed. I thank the
chairman for convening this hearing and I look forward to
working with him to strengthen this critical legislation. I
yield back.
Chairman Kanjorski. Thank you very much, Mr. Foster. And
now we will hear from the gentleman from Texas, Mr. Hensarling,
for 3 minutes.
Mr. Hensarling. Thank you, Mr. Chairman. Clearly, there
were a number of causes of our Nation's economic turmoil, and
most had their genesis in flawed public policy. Particularly
with respect to the affordable housing mission of the
government-sponsored enterprises, Fannie Mae and Freddie Mac, a
story we know all too well. Now to state the obvious, the three
major credit rating agencies badly missed the national housing
bubble. That does not necessarily make them duplicitous, and it
doesn't necessarily make them incompetent. It just makes them
wrong--very, very wrong. It is also a painful and expensive
reminder that there is no substitute for some modicum of
investor due diligence and personal responsibility.
Now there is a sincere bipartisan desire for credit rating
agency reform in this committee. Unfortunately, I believe the
draft that is before us now falls short. There are a number of
good provisions in the draft, in Chairman Kanjorski's draft,
including essentially removing the NRSRO designation from
current statute in regulation. Unfortunately, the bill also
includes provisions that will allow new liability exposure,
including joint liability for the rating agencies. I feel that
these sections will actually increase barriers to entry into
the rating market and make it more difficult to have
competition. An increase in lawsuits will become, I believe, an
insurmountable barrier to competition. The joint liability
provision especially troubles me. To make every rating agency
potentially liable for the ratings of other agencies, I don't
see the parallel anywhere else in our body of law. I heard
someone say that is a little like making Ford liable for a
defective car manufactured by GM and then not giving Ford a
chance to defend themselves.
No nation can sue its way into economic recovery and
financial stability. Increasing the agencies' liability does
not get at the root of the problem, which is the de facto
government stamp of approval behind the rating agency's work
product. That is indeed where we need to go. People assume
wrongly that the government stamp of approval meant accurate
ratings. Congress took a good step with the Credit Rating
Agency Reform Act, but it was too little too late. Again, there
is a vitally important lesson we have all learned about implied
government backing. And so I want to compliment the chairman
and the ranking member for having a bill before us that would
essentially terminate the NRSRO designation. But unless we
eliminate all barriers to entry, I am fearful that it is all
for naught. And with that, Mr. Chairman, I yield back the
balance of my time.
Chairman Kanjorski. Thank you very much, Mr. Hensarling.
Now, we will hear from the gentlelady from Ohio, Ms. Kilroy,
for 2 minutes.
Ms. Kilroy. Thank you, Mr. Chairman. Thank you for your
leadership on this issue and for the opportunity to work with
you and the task force on this very important issue. Credit
rating agencies occupy a unique and powerful position within
the global markets and reforming this industry is a critical
part of strengthening our financial regulatory system. Like
many of my House colleagues, I have firsthand experience with
the role credit rating agencies play as gatekeepers to the
financial markets. Before coming to this House, I served for 8
years as a Franklin County commissioner and also for 8 years on
the Columbus board of education representing constituents of
central Ohio and as a county commissioner, worked very hard to
make our county fiscally responsible and to maintain our
double, AAA rating.
It is a rating that we worked hard to keep because we
thought it had meaning and value, that it represented a seal of
approval and that it would save our taxpayers their hard-earned
money. Of course, as you know, the rise of credit rating
agencies as financial gatekeepers began when the Securities and
Exchange Commission in 1975 in what probably seemed like a
benign move tied broker/dealer capital requirements to credit
ratings issued by the nationally recognized statistical rating
organization, a designation created and determined by the SEC.
Since then, the credit rating agencies have experienced
unprecedented growth. Even when the credit rating agencies
seemed to get it all wrong, they did amazingly well, posting
record profits at about the same time they were downgrading
billions of dollars worth of subprime offerings. And it is not
just that the rating agencies seemed to miss big. But now an
infamous instant message exchange has been made public, instant
messaging between two Standard & Poor's officials about a
mortgage-backed security deal dated April 5, 2007, which seems
to suggest that credit rating agencies can make billions of
dollars to provide an opinion on just about anything with
little fear of penalty or recourse and that exchange one
analyst stated over a colleague's objections, ``We rate every
deal. If it is structured by cows then we would rate it.'' And
as recently as September 23, 2009, The Wall Street Journal
reported that Moody's is still assigning inflated ratings to
complicated debt securities that they still do not fully
understand. I am a sponsor of this very important piece of
legislation, because it is this cavalier culture made worse by
a broken system that cost millions of hard-working Americans
their live savings and set our Nation into the worst economic
crisis since the Great Depression.
Addressing the overreliance on NRSRO ratings and Federal
statutes and regulations is a good place to start. Rating
agencies should be a part of the equation when making
investment decisions, not the equation. That is not to say that
credit rating agencies do not provide value. For thousands of
small investors, rating each and every security individually
would be an impossible task. The proposal directs the SEC to
adopt rating symbols to help the small investor distinguish
between a municipal bond issue and a collateralized debt
compromised of subprime mortgages that have been sliced and
diced and repackaged into looking like a safe investment.
Finally, the proposal seeks to deal with credit rating
agencies that act with malfeasance. Credit rating agencies that
knowingly or recklessly failed to conduct a reasonable
investigation into the very ratings they were paid to provide
an assessment on should not be allowed unfetterred
constitutional protection. Thank you again, Mr. Chairman, for
the opportunity, and I yield back.
Chairman Kanjorski. Thank you very much, Ms. Kilroy. We
will now hear from the gentleman from Georgia for 1 minute, Mr.
Scott.
Mr. Scott. Thank you, Mr. Chairman. As we continue to
monitor the current economic climate we are in and look towards
some solutions and improvements that can be made, this hearing
is quite timely as the credit rating agencies played a
considerable role in what transpired and what will also impact
in the future. Once a financial institution achieves the
desired quality grade on a product, it pays the agency for the
rating. This process is rife with conflict as I believe the
agencies are acting as the market regulators, investment
bankers, and as a sales force all the while claiming to be
providing independent opinions.
As these organizations are extremely important to the
financial world, we should realize they did have a significant
role to play in where we are now. And I also want to more
intently focus on finding some consensus on how to move
forward. These organizations determine corporate and government
lending risk and are an integral part of our financial services
sector. And as such, I want to ensure that we take all issues
into account, including conflicts of interest, as well as the
international financial world in reforming how we rate
financial products.
I am very interested to hear each of your thoughts and
opinions on the recently introduced draft legislation by our
chairman addressing rating agency reforms. And the requirement
of disclosure revenue serving the Securities and Exchange
Commission. Thank you very much, Mr. Chairman, for the time.
And I look forward to this panel's discussion.
Chairman Kanjorski. Thank you very much, Mr. Scott. And now
for our last presenter, Mr. Donnelly of Indiana, for 1 minute.
Mr. Donnelly. Thank you, Mr. Chairman. Some of the things
we are going to be determining include whether it makes any
sense for the very people who are trying to sell the product to
be paying for the rating on it, whether we need a blind pool
similar to how they do it with judges throughout this country
in many places or as Mr. James Simon, whom we heard from,
talked about a quasi-public utility. Whether a few pennies from
each trade should go in to try to get an independent rating
agencies. The fact is that this caused extraordinary damage and
harm to our country and to Main Street America. In my very
hometown, of South Bend, Indiana, Moody's, in fact, closed
their office there. And it was done because of economic
hardship, allegedly, a very, very, very profitable company, and
that hardship was supposedly caused by the meltdown we had that
was caused, in part, by the credit rating agencies.
So Main Street America has been extraordinarily damaged by
this. And it is our job to make sure it does not happen again.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you very much, Mr. Donnelly. We
have a little bit of a dilemma. We have four votes, I
understand. And of course, we have 7 panelists of 5 minutes
each for a presentation. Rather than break up the presentations
of the panel, I suggest we will take our recess now, go over
and vote, come back, and then hear the entire panel strung
together so we have a better consensus. That means you are
going to have to stay. We are sorry. Okay. With no other
comments, the committee stands in recess.
[recess]
Chairman Kanjorski. The committee will reconvene. The Chair
recognizes the gentleman from Alabama.
Mr. Bachus. Thank you, Mr. Chairman. I have a written
statement for the record. So I would just like to submit it for
the record.
Chairman Kanjorski. Without objection, it is so ordered.
We are at the point now where we have to welcome the panel.
Thank you for accepting the delay. That is not uncommon around
here. Many of you know that because of your prior experience.
First and foremost, let me say that without objection, your
written statements will be made a part of the record. You will
each be recognized for a 5-minute summary of your testimony.
First, we have Mr. Daniel M. Gallagher, Co-Acting Director
of the Division of Trading and Markets at the United States
Securities and Exchange Commission. Mr. Gallagher.
STATEMENT OF DANIEL M. GALLAGHER, CO-ACTING DIRECTOR, DIVISION
OF TRADING AND MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION
Mr. Gallagher. Chairman Kanjorski, Ranking Member Garrett,
and members of the subcommittee, my name is Dan Gallagher, and
I am a Co-Acting Director at the Division of Trading and
Markets at the Securities and Exchange Commission. Thank you
for the opportunity to testify today regarding the oversight of
credit rating agencies. I note at the outset that my written
testimony today was approved by the Commission, but any remarks
I make today, in particular on the draft bill, will be my own
and may not reflect the views of the Commission.
The poor performance of highly-rated securities over the
last few years has resulted in substantial investor losses and
increased market turmoil. As we work to restore the health of
the markets, it is vital that we take further steps to improve
the integrity and the transparency of the ratings process to
promote competition among rating agencies and give investors
the appropriate context for evaluating ratings. The proposed
legislation Chairman Kanjorski recently released for discussion
contains a number of measures that could enhance the
Commission's oversight program, including provisions designed
to address conflicts of interest, a lack of transparency and
limited accountability in the credit rating industry.
I would note that over the last few years, the Commission
has been addressing a number of these issues and we welcome the
opportunity to discuss these efforts. As you know, Congress
provided the Commission with authority to register and oversee
nationally recognized statistical rating organizations, NRSROs,
in the Credit Rate Agency Reform Act of 2006.
In the summer of 2007, using our new oversight authority
and in response to gradually worsening marketing conditions,
the Commission staff began examination of the three largest
NRSROs--Fitch, Moody's, and Standard & Poor's--to look into
their policies and practices relating to ratings of structured
finance products linked to aggressively underwritten mortgages.
To put it bluntly, the examinations revealed a number of
serious problems. In particular, the examinations raised
serious questions about the NRSROs' management of conflicts of
interest, internal audit processes, and due diligence
activities. Findings from these initial examinations informed a
second round of rule amendments which the Commission proposed
in June of 2008 and adopted in February of 2009. Earlier this
month, on September 17th, the Commission embarked on further
rulemaking designed to promote greater accountability, foster
competition, decrease the level of undue reliance on NRSROs,
and empower investors to make more informed decisions.
The Commission adopted rule amendments designed to create a
mechanism for NRSROs not hired to rate structured finance
products to nonetheless determine and monitor credit ratings
for these instruments. The goal of this rule is to make it
possible for nonhired NRSROs to provide unsolicited ratings in
the structured finance market just like they can in the
corporate debt market. The Commission also adopted a
requirement that NRSROs must disclose ratings history
information for all outstanding ratings initially determined on
or after June 26, 2007. This new disclosure requirement is
designed to promote greater transparency of ratings, quality
and increased accountability among NRSROs. The Commission also
published for comment three sets of new requirements for
NRSROs. The first proposal would increase accountability by
requiring NRSROs to furnish the Commission with an annual
compliance report describing actions taken to ensure compliance
with the securities laws.
The goal of this proposal is to increase accountability by
strengthening the compliance function at the NRSROs and to
alert the Commission to issues that may need to be examined.
The second and third proposals would increase the information
NRSROs must disclose to the public about the conflict of being
paid for determining credit ratings and other services. These
disclosures which would include a consolidated annual report
are designed to provide investors with additional information
on the source and magnitude of revenue, including revenues from
non-rating services that an NRSRO receives from its clients.
Notably, in its recent rulemaking, the Commission also proposed
rating disclosure requirements for issuers of securities. For
example, the Commission proposed amendments that would require
certain detailed disclosures regarding credit ratings and
registration statements.
The Commission also proposed requiring the disclosure of
preliminary ratings, as well as final ratings not used by an
issuer so that investors would be informed when an issuer may
have engaged in rating shopping. The Commission also took
action to eliminate references to NRSRO credit ratings in
certain of its rules and forms. This is designed to address
concerns that references to NRSRO ratings and Commission rules
may have contributed to an undue reliance on those ratings by
market participants and the Commission found that the removal
of references either improved the rules or had no effect on
them.
Finally, the Commission issued a concept release seeking
comment on whether it should propose rescinding a rule that
exempts NRSROs from expert liability under Section 11 of the
Securities Act. Rescinding Rule 436(g), coupled with the
proposal to require disclosure of credit ratings in a
registration statement if a rating is used in connection with a
registered offering, could cause NRSROs to be included in the
liability scheme for experts set forth in Section 11. The
Commission appreciates Congress' interest in this issue, and we
stand ready to provide any assistance the subcommittee might
need in its consideration of measures to reform the financial
markets. I would be happy to answer any questions you may have.
Thank you.
[The prepared statement of Mr. Gallagher can be found on
page 60 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Gallagher. And
now we will hear from Mr. Raymond McDaniel, chairman and chief
executive officer of Moody's Corporation. Mr. McDaniel.
STATEMENT OF RAYMOND W. McDANIEL, CHAIRMAN AND CEO, MOODY'S
CORPORATION
Mr. McDaniel. Thank you. Good afternoon, Chairman
Kanjorski, and members of the subcommittee. I am Ray McDaniel,
chairman and CEO of Moody's Corporation, the parent of Moody's
Investor Service. I welcome the opportunity to contribute
Moody's views to the discussion today on legislative proposals
of the credit rating industry. As this subcommittee knows well,
the economic downturn has exposed numerous vulnerabilities in
the infrastructure of the financial system. It has also
provided important lessons for credit rating agencies and other
market participants.
In light of these lessons, during the past 18 months,
Moody's has adopted a number of measures to enhance the
quality, independence, and transparency of our credit ratings.
While these steps are detailed more thoroughly in my written
statement, they include changes in the following five key
areas: Strengthening the analytical quality of our ratings;
enhancing consistency across rating groups; bolstering measures
to manage conflicts of interest; improving transparency of
ratings and the ratings process; and increasing resources in
key areas. We believe we have made important progress but we
welcome continued efforts that would reenforce high quality
ratings and improve market transparency without intruding on
the independence of rating opinion content.
To that end, I would like to provide Moody's initial views
on the discussion draft circulated by the committee last week.
These views are based on a preliminary review of the draft and
we will be happy to provide the committee with more detailed
comments in the near future. Moody's supports the proposal to
increase the transparency of ratings performance and
methodologies. We believe such transparency will allow
comparisons that can drive improvements in ratings quality
across the industry. We also support enhancing regulatory
oversight of the industry. Creating a dedicated SEC office for
example, staffed by individuals with the necessary expertise,
could increase the focus of regulatory oversight and help
protect the interests of all market participants.
We also welcome efforts to limit the use of ratings and
regulation. Moody's has long believed that using ratings as a
regulatory tool for oversight of regulated entities can
adversely affect market behavior. It encourages overreliance on
ratings as well as rating shopping and it can reduce incentives
for rating agencies to compete based on the quality of ratings.
While we strongly support the goal of the discussion draft to
remove references to credit ratings and regulation, we also
recognize the wisdom of pursuing this goal judiciously so as to
not create unintended market disruptions. Moody's also supports
ratings oversight by an independent board of directors. Eight
of the nine directors on Moody's board are independent and, we
believe, effective governance is well served by having the
board provide oversight with respect to procedures and policies
for the rating agencies. If, however, their role extends beyond
oversight to the content of methodology, we believe the content
of methodologies would suffer. This would replace the judgment
of our current large body of analysts and credit policy
professionals with a small body of board members who are at
best part time experts in credit analysis. One provision in the
discussion draft that Moody's does not support is imposing a
collective liability regime on all NRSROs. Credit rating
agencies currently have the same liability as any other market
participant if, for example, they knowingly make false
statements or issue opinions that they don't genuinely hold. We
do not believe the market would be well served by changing the
standard of liability in a way that would increase the ability
of market participants to pursue litigation because they are
unhappy with our ratings.
We believe the effect on the credit rating industries would
be to wash diversity of opinion, reduce competition, negatively
impact market transparency, and make rate opinions more
volatile.
Finally, we strongly support efforts to address rating
shopping, which is a serious concern. We believe, however, that
to deter rating shopping, issuers must be required to disclose
more detailed information to the market. Issuers in the
structured finance market are not currently required to
disclose publicly sufficient information for investors to
engage in reliable analysis of the underlying assets of a
securitization. We urge this subcommittee and the Congress to
consider requiring that issuers in the structured finance
market make disclosures similar to those required in the
corporate market. Moody's strongly supports constructive
reforms that can enhance confidence in the credit ratings
industry and the Nation's credit markets. And we are committed
to working with you to achieve that goal. I am happy to respond
to any questions.
[The prepared statement of Mr. McDaniel can be found on
page 109 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. McDaniel.
And now we will hear from Mr. Deven Sharma, president of
Standard & Poor's. Mr. Sharma.
STATEMENT OF DEVEN SHARMA, PRESIDENT, STANDARD & POOR'S
Mr. Sharma. Chairman Kanjorski, Ranking Member Garrett, and
members of the subcommittee, good afternoon. My name is Deven
Sharma. I am the president of Standard & Poor's, and I am
pleased to appear before you today.
Let me start by saying that at S&P, we appreciate your goal
to reinvigorate the economy and job growth through stability
and innovation. This is an important point in history as a
regulatory reform is being considered that will shape the
future of capital markets and economic growth for many years to
come. Since our founding more than a century ago, we have tried
to learn from experience to improve and strengthen our
analytics and criteria and to review processes when
appropriate. Thus in 2008, we announced a series of initiatives
aimed at improving checks and balances in our organization.
These measures are designed to promote the integrity of the
rating process and enhance analytical quality, provide greater
transparency to investors, and more effectively educate
investors about ratings.
Let me assure you that these improvements are substantive
and will go a long way to restoring confidence in our ratings.
Another way to restore confidence in ratings is to pursue
effective regulation of credit rating agencies. Although we are
already subject to a broad and robust regulatory scheme, S&P
shares the view that further regulation appropriately crafted
can serve the goal of restoring and maintaining investor
confidence. Indeed, we support many recent proposals for
greater regulatory oversight and enhanced internal processes to
promote integrity in the ratings process. These include
increased accountability through SEC authority to oversee NRSRO
and impose steep fines and other sanctions for noncompliance
with SEC rules or NRSRO rules, internal procedures and to
require disclosure around issues such as data quality. There
are other proposed measures that would seriously disrupt the
capital markets by encouraging less diversity of opinions,
providing strong disincentives for analytical innovation and
creating global inconsistency. One such proposal would seek to
lower the threshold, legal requirements for bringing a
securities fraud claim against NRSROs.
Such a measure, if enacted, would cause some NRSROs to rate
only those entities and securities that are the least likely to
default or be downgraded. As a result, issuers who are
relatively new to the debt markets may have a difficult time
getting rated and therefore greater difficulty accessing
capital and contributing to economic recovery. Since small and
medium enterprises as well as new technology companies, for
example, green companies or broadband providers, represent
critical and emerging elements in our national production and
employment basis, this result could have detrimental effects on
economic growth. Another proposal would subject each NRSRO to
collective liability for legal judgments against any NRSRO. No
NRSRO should be required to act as an insurer for its
competitors. We are also concerned about a proposal providing
that rating opinions shall not be deemed forward looking
statements under the Federal securities laws.
This proposal ignores that the very essence of a rating is
forward looking; that is, ratings speak to the likelihood that
an obligor will pay back principal and interest in the future.
At S&P, we have heard consistently from investors that ratings
must be forward looking in order to have value. Another
proposal would dictate that ratings could only measure
likelihood of default. At S&P, our analysis includes additional
important factors such as credit stability, which addresses
whether an issuer or security would have a likelihood of
experiencing large declines in credit quality in certain
stressful situations. These are analytical considerations that
investors have told us repeatedly that they want. Any
government mandate that would dictate how NRSROs form their
rating opinions and which factors they may or may not consider
would deprive investors of the full breadth and diversity of
NRSROs' opinions. It could also lead to undue investor reliance
on rating opinions based on the perception that the government
has endorsed NRSROs' methodologies and their written opinions,
a result counter to the goal of recent proposals that would
remove the NRSRO designation from existing laws and rules.
In sum, we agree completely with the goal of improving the
integrity, quality, and transparency of credit rating analysis
to better inform investors in their decisionmaking. However, we
urge caution in the crafting of proposals that will result in
less comprehensive and informative ratings to the detriment of
investors, business enterprises large and small and the capital
markets as a whole. I thank you for the opportunity to
participate in this hearing and would be happy to answer any
questions you may have.
[The prepared statement of Mr. Sharma can be found on page
129 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Sharma.
Next we will hear from Mr. Stephen W. Joynt, president and
chief operating officer at Fitch, Incorporated. Mr. Joynt.
STATEMENT OF STEPHEN W. JOYNT, PRESIDENT AND CEO, FITCH, INC.
Mr. Joynt. Thank you, Chairman Kanjorski, and members of
the subcommittee. I am pleased to appear before you on behalf
of Fitch Ratings. Today's hearing marks the third time this
year I have appeared before congressional panels on the topic
of regulation of credit rating agencies. I have attached my
written statement from August to the end of my statement.
However, I would like to highlight a few brief important points
in light of selected recent events.
I believe in the last several years, Fitch generated and we
continue to produce a significant amount of balanced and
insightful fundamental credit analysis across many asset
classes and capital markets. Having said that, I have also
previously acknowledged that too many of our rating opinions,
particularly in some of the most impacted structured finance
asset classes, did not perform as expected with too many
downgrades of too many notches. I am aware that this negative
result is the key factor in our discussions here today.
Improving our performance drives many of the changes that
we continue to make at Fitch. Having said that, all credit
rating agencies are not the same. When it comes to the issues
of credit culture and intent, I would like Fitch to be judged
on its own merits. Over the last several years, media coverage
of the credit rating agencies and related regulatory inquiries
tend to characterize the industry as being dominated by the Big
3 agencies. Many market participants and commentators then
extend the point by asserting and implying that there is no
difference among the Big 3.
In the SEC's 2008 report on the rating agencies, the source
document for many negative e-mails often quoted in the media,
none of the negative e-mails referenced were from Fitch. That
same report concluded that our internal processes were robust
and that our staffing levels were appropriate and kept pace
with the growth in our business. In the early stages of the
credit crisis in November 2007, Fitch decided we needed to
conduct a wholesale review of our CDO methodology. As a result,
we imposed a moratorium on rating any new CDOs while we
conducted this review. We subsequently adopted a revamped and
more conservative criteria for corporate CDOs on April 30,
2008.
Since that time, we have assigned very few ratings to any
corporate or other CDOs. Fitch was also early in highlighting
the increasing credit risk of the financial guarantors,
lowering AAA ratings, which resulted in direct public attacks
against us from these monolines, followed by requests to
withdraw our ratings and termination of all commercial
relationships.
Fitch culture and credit practices consistently emphasize
the importance of the timeliness, transparency, and integrity
of our ratings and credit opinions over any revenue
implications. Turning to recent regulatory developments in the
United States, the SEC has introduced some final rules and
proposed a series of new ones, while much progress has been
made, we are disappointed that one key area has yet to be
addressed: enhanced public disclosure broadly and structured
for finance securities. Fitch has repeatedly suggested that the
information made available to the rating agencies as parts of
the rating process for securitization should be made available
to all investors and the responsibility for disclosing that
information should rest with issuers.
To date, the SEC continues to focus narrowly on the sharing
of information only among NRSROs. Regarding the committee's
recent draft of the bill, Fitch shares the general objectives
of greater reliability, transparency, and accountability
embodied in many of the provisions for credit rating agencies.
A number of the provisions are very reasonable and consistent.
We will provide comments in more detail to the members and
staff in the coming days. I would like to highlight several
issues that have also already been mentioned. The goal of
reducing the market's reliance on ratings through reference in
Federal regulation, the proposed bill removes all such
references. Fitch has previously noted that ratings have been
used effectively in regulations in many places as independent
benchmarks, a position that has been supported by many market
participants. We continue to suggest that an in-depth, case-by-
case review of any removals to determine whether such course of
action is appropriate.
The question of what would replace ratings also remains
unanswered, or at least without a thorough understanding of the
specific pros and cons or unintended consequences of the
removals. Also, a bill that mandates the removal of all
references to NRSROs and all Federal statutes while
significantly enhancing the Federal regulatory requirements and
burden on NRSROs seems contradictory to us. I believe it would
affect the increasing competition that the committee was hoping
for, for the industry. We have previously commented on the
concept of the mandatory registration for credit rating
agencies. I noted in my testimony before the Senate Banking
Committee in August that Fitch, along with the other NRSROs, is
already registered and subject to explicit SEC regulatory
oversight. We believe the mandatory registration concept is
unnecessary. Fitch has previously stated that it supports the
concept of enhanced accountability for what we do, but we
continue to disagree with the notion that far greater liability
or specific liability is the right way to achieve that.
Ratings are a forward looking opinion of creditworthiness,
not a backward looking verification of financial statements as
conducted by accountants. Creating an additional and separate
liability standard solely for NRSROs as envisioned by the bill
seems unprecedented and unnecessary. The bill also introduces
collective liability for rating agencies. This provision would
require us to share information with all other rating agencies,
much of it proprietary or from third party vendors. We cannot
turn that information over to other agencies. That idea also
that we should be responsible for verifying other NRSROs'
information and ratings seems to us quite problematic.
Finally, the bill also contains some provisions that we
find to be contradictory. For example, the bill requires
distinct symbology for structured finance ratings, yet also
mandates that we try to use all the same ratings and approaches
for all kinds of asset classes; this is confusing. And in
closing, Fitch has undertaken a wide variety of initiatives to
enhance the reliability and transparency of our ratings. I
believe we can continue to produce a significant amount of good
work with that in mind, and we are open to all improvements to
the industry and our own performance. Thank you.
[The prepared statement of Mr. Joynt can be found on page
88 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Joynt.
Next, we will hear from Mr. Robert Dobilas, president and
chief executive officer of RealPoint LLC. Mr. Dobilas.
STATEMENT OF ROBERT G. DOBILAS, PRESIDENT AND CEO, REALPOINT
LLC
Mr. Dobilas. Thank you for the opportunity to participate
in today's hearing. RealPoint successfully operates under the
investor pay business model. While we issue subscriber paid
ratings on around $1 trillion worth of securities, our market
specialty is CMBS, or Commercial Mortgage-Backed Securities. We
are one of 5 NRSROs designated under the TALF program as an
eligible rating agency for CMBS.
Last week, with strong investor support, the NAIC, or
National Association of Insurance Commissioners, unanimously
approved RealPoint as an acceptable rating organization for
CMBS securities. We believe the credit crisis is far from over,
but we believe that the SEC's recent efforts are working, at
least with respect to structured finance. New issues are
creeping back into the market and spreads are contracting from
their all-time highs of a year ago. Investor confidence is
starting to return. This momentum needs to be sustained. One
way to sustain it is to give investors choices in regards to
their selection of rating agencies.
It would be a mistake to legislate smaller NRSROs out of
business and force investors to rely only on a few large NRSROs
for ratings. We support the SEC's most recent announced changes
and believe any rating agency reform should be consistent with
those policies. The discussion draft may be intended to reform
the larger NRSRO but its measures may eliminate the smaller
ones. Legislation that creates barriers to entry in practical
levels of liability or increased internal costs for smaller
NRSROs furthers the interests of the larger ones.
The proposal to make all NRSROs jointly liable for an
unsatisfied civil judgment against another is impractical. No
one company should be forced to guarantee a competitors
obligation. A company should not have to risk responsibility
for a liability over which it has no control. The proposal to
reduce first amendment protections for credit rating agencies
is anti-competitive and further enhances the existing oligopoly
structure. A small company cannot guarantee trillions of
dollars of rated securities, merely because it provided a
forward looking independent opinion regarding their
performance. The proposal to require publication of ratings and
rating actions without a timeline will put subscriber based
NRSROs out of business.
The SEC has already announced rules requiring public
disclosure of ratings and rating actions with the specified
time lag. That protects the interests of subscriber-based
NRSROs. The proposal to require every agency to review and
improve every other NRSRO's work is impractical. Not every
agency rates every class of security. This requirement would
increase the cost of ratings and thereby reduce investor
yields. This requirement appears to include analytics and
proprietary information developed by an NRSRO and date of
purchase by that NRSRO, towards the goal of improved ratings
and competitive advantages. This requirement would therefore
reduce incentives to improve proprietary rating methodologies.
The proposed requirements for independent directors and
compliance officers may work for large, publicly-traded
companies, but would require small companies to incur
significant costs who had board members with a skill set and
depth of knowledge necessary to fully understand and improve
analytical models and methodologies and may expose those board
members to a level of liability.
The one-year prohibition on performing ratings for an
issuer that hired a former analyst would increase the cost to
attract and retain talented analysts. Rating agency employees
who may also wish to seek corporate work will not be willing to
impair their right to do so without increased compensation. The
proposal to require credit ratings symbols that distinguish
classes of securities is not in our experience desired by the
capital markets. Investors want to know that AAA means AAA, not
where one class is a real AAA whereas another represents a
lower version of AAA. As we have attempted to show with various
examples, the discussion draft and other well-intentioned
remedial proposals have a common flaw, namely their proposals
are aimed at two entirely different types of companies with
entirely different business models.
If Congress applies a multitude of new rules, regulations,
and procedure controls to NRSROs which disadvantage smaller
companies, the result is to punish the innocent and stifle the
progress we have made to date. In our view, the better remedy
is to specifically address the two fundamental problems, market
concentration and rating shopping. Competition can be further
enhanced across the broader range of public offerings and--by
having securities, at least in part, rated coequally by
subscriber-based rating agencies. No meaningful change can take
place while three agencies control over 95 percent of the
market. Thank you for the opportunity to appear at this
hearing. I look forward to responding to any questions you may
have.
[The prepared statement of Mr. Dobilas can be found on page
48 of the appendix.]
Chairman Kanjorski. Thank you very much.
Next, we will hear from Mr. James H. Gellert, President and
chief executive officer of Rapid Ratings International,
Incorporated. Mr. Gellert.
STATEMENT OF JAMES H. GELLERT, CHAIRMAN AND CEO, RAPID RATINGS
INTERNATIONAL, INC.
Mr. Gellert. Thank you. On behalf of my colleagues at Rapid
Ratings, I would like to thank Chairman Kanjorski, Ranking
Member Garrett, and the members of the subcommittee for
inviting me to provide testimony today. As the only non-NRSRO
on this panel, we appreciate your invitation all the more as we
and companies like us have what we believe is a critical voice
in these debates. As with the new subscriber-paid NRSROs, we
represent the potential for meaningful change to the status quo
if we are not inadvertently hindered by the consequences of
legislation and regulation along the way. Ours is a subscriber-
paid firm. We utilize a proprietary software based system to
rate the financial health of thousands of public and private
companies quarterly. We use only financial statements, no
market inputs, no analysts and have no contact in the ratings
process with issuers, bankers or advisors. We have not applied
for the NRSRO status. As I have testified to the SEC and the
Senate in recent months, there are still too many deterrents
for me to recommend to our shareholders that the designation
enhances value as opposed to puts it at risk.
That said, we believe that reform in our industry is
necessary and time is of the essence for restoring credibility.
However, we caution that some initiatives may have significant
and counterproductive consequences. In short, we do not believe
it is advisable to create more legislation for legislation
sake. Although we did not necessarily agree with all of the
elements of the Credit Rating Agency Reform Act of 2006. Its
intent of appropriate to promote competition to transform this
industry. Some say the Act has not had enough time to mature
and others that it wasn't sufficient.
Nevertheless, the Act is still the basis for constructive
change and the SEC's recent initiatives have made good progress
in adding reform and oversight to the prior legislation. These
improvements have set a better stage for competition than we
have had in years. The Commission has also been receptive to
input from industry players. When recently faced with criticism
about reading disclosure rules, adverse effect on subscriber
paid firms, the SEC created different standards for issuer paid
and subscriber paid NRSROs.
This showed admirable flexibility and not applying a one-
size-fits-all model to new rules. We encourage the subcommittee
to be guided by this flexibility.
The subcommittee's discussion draft joins a crowded field
of rating agency reform initiatives currently underway. There
are positive developments in the collection of initiatives, but
even these do not yet go far enough, and the negative ones
forge entirely new and unfortunately disturbing paths.
Competition is key to transform this industry. But
competition for competition's sake is not the answer.
Competition that effects change will enhance the credibility of
the ratings process. The new subscriber-based rating agencies
are the best hope for achieving these goals but are the ones
put most at risk by the discussion draft. For new players to
want to register NRSRO status must have value and not carry
massive compliance costs and legal liability. New players will
want the designation if they see it as a business asset, not as
a series of contingent liabilities.
In order to achieve this, legislation must foster the
following goals: accuracy in ratings; innovation in business
models and rating methodology; encouraging, not discouraging,
new players; equivalent disclosure of structured product
information; and recognition that many initiatives tacitly
support the status quo oligopoly.
Sadly, the trend toward greater and more complex
legislation and regulation will repel and not attract
competition and, hence, preserve the status quo, the very
problem you were hopefully trying to solve.
In particular, the emphasize on liability I believe is
being overdone. Should negligence and malfeasance be rooted
out? Yes. Should a one-size-fits-all legal framework be enacted
to punish all players jointly, irrespective of whether they
have sinned in the past? No.
A few specific notes on liability. Joint liability is a
great disincentive to NRSRO status. In fact, it is simply a
nonstarter for a potential applicant. Why would one want to be
an NRSRO, joining a group dominated by three players who have
an iceberg of lawsuits looming on their horizon? That would be
like swimming towards the Titanic.
Equivalent disclosure. The equivalent disclosure of data
used in formulating a ratings decision among NRSROs is a boon
to competition. If the perspective NRSRO sees the ability to
expand into a new asset class of ratings, for instance, CDOs
and CLOs, there is a material benefit to the designation.
Moreover, expanding this disclosure to outstanding issues is
critical. Likely no greater initiative could be taken to kick-
start liquidity revival in structured products.
Mandatory registration. Under current law, ratings firms
have the option to apply for NRSRO status. Requiring
registration while the hard and soft costs of being an NRSRO
are currently unquantifiable is a major hurdle to new players
and is likely a complete disincentive to the de novo firm. Add
this to joint liability and the potential costs to a new player
are astronomical.
Removal of ratings, references, and regulations. In
general, we are very supportive of removing references and
regulations because they protect the status quo dominance of
the ratings oligopoly.
I will conclude with the issue of conflicts of interest.
Central to the issuer-paid rating agencies argument for
defending their conflicted business model is that the
subscriber-paid rating agencies also conflicted, suggesting
that a modified version of the status quo is the only real
alternative. This is a red herring. Let's not miss the irony of
these issuer-paid agencies shifting public attention away from
their committed sins to the uncommitted sins of very small
competitors paid by investors who are seeking protection from
fiduciary irresponsibility.
To address all of these issues, legislation and regulations
must be flexible and not require a one-size-fits-all
straitjacket, recalling that subscriber-based rating agencies
are the future solution to the current problems, while issuer-
paid rating agencies were the cause.
Thank you very much.
[The prepared statement of Mr. Gellert can be found on page
76 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Gellert.
Now, we will finally hear from Mr. Kurt Schacht, managing
director of CFA Institute Centre for Financial Market
Integrity. Mr. Schacht.
STATEMENT OF KURT N. SCHACHT, MANAGING DIRECTOR, CFA INSTITUTE
CENTRE FOR FINANCIAL MARKET INTEGRITY
Mr. Schacht. Thank you, Chairman Kanjorski, and thank you,
subcommittee members, for having CFA here to provide you some
background and perspective that I think is not otherwise
represented here, which is the perspective of investors and
users of these products. So we are happy to have our 95,000-
member organization help with some of that perspective.
We have been commenting on these various aspects of credit
rating agency reform for the last couple of years. In my
written testimony, I reference some of those occasions. And as
we have commented before, I think there is a lot of confusion
on the investor side about just what is going on, whether we
are regulating, whether we are removing reference; and there is
a good deal of confusion on what is the role of CRAs going
forward, what should it be, and what can be trusted in this
process. So we are hopeful that this discussion draft moves it
along closer to some answers.
I will concentrate my verbal testimony this afternoon on
the five questions that you asked us in the invitation.
Regarding the discussion draft, we very much support the
efforts there to provide additional transparency of the
process. I think, most importantly, we support the efforts to
better align that process and activity with the interest of
investors, very basic, very important concepts.
There are sections where we have new Commission rules on
conflicts of interest. Section 5 is excellent. The look-back
reviews that you have there with respect to employees going to
work for firms that they have rated are excellent, and the new
rules on public disclosure of both ratings performance and
methodologies we think are very strong.
We are very concerned about a couple of things, the
proposed detail of the legislation on setting director pay for
credit rating agencies as well as setting by statute the roles
and responsibilities of directors. We think that it is rather
unusual to see that in statute, as does the some 13 different
subsections that you have in place related to the dos and
don'ts, shoulds and shouldn'ts for compliance officers. That
seems to be something that should be left to general principals
and articulated by the regulators as they implement this.
Regarding the liability question, you have heard a lot
about that today. I don't have to recast that.
Earlier this year, we help set up an Investors Working
Group, which put together a very comprehensive report on a lot
of pieces of regulatory reform related to the crisis, and that
is all part of our written testimony. I hope you have a chance
to take a look at it. It is comprised of very senior, very
well-known investors, former regulators, and experts.
This group was clear that they felt that NRSROs should not
be essentially exempt from civil liabilities under section 11
of the 1933 Act for issuer-paid ratings. We could not find one
instance where a credit rating agency has ever been held liable
for any sort of money damages at all in this area for their
doing things in the normal course of their ratings practice.
And so claims have been brought, but almost all have failed.
The Investors Working Group felt that this change would make
credit rating agencies much more diligent about the process and
much more accountable for negligent practices.
I won't comment on the freedom of speech issue. The first
amendment stuff, we are not experts on that, of course, but
just to say we are happy and glad to leave that to you to
referee. That will be an interesting discussion.
In any event, the group felt that they needed to have
increased liability. I think we feel that section 4, the
standards for private actions on page 31 of your consult, moves
us in that direction, moves us closer.
This morning, I think you heard this discussion about doing
something that would give reason for these firms to turn down
business, bad business; and I think that is probably the one
area where we should focus.
I won't say anything more about section 3. I don't think
anybody likes that idea, maybe with the exception of the
plaintiff's bar.
On the issue of the issuer-paid model, there will always be
an actual conflict of interest. In the research and opinions
where there is an issuer-paid model, the best we can do is to
mitigate that conflict. I think that is what this discussion
draft does. It is what the SEC has been focused on, it is what
other stakeholders in this debate have been focusing on, trying
to mitigate those conflicts of interest.
In the Investors Working Group report that you have, there
are further suggestions related to the fee area, that fees
earned for rating should vest over time, that the amount of
fees paid, they should be based on the performance of the
ratings over the course of the credit performance of the bond.
And I think you get to that in your section 5(f) on page 13.
There are many other discussions going on about the
somebody-else-pays model. We have not--this Investors Working
Group nor our organization has really focused much on these
other approaches, preferring instead to focus on, if we are
going to have an issuer-paid model, how do you mitigate those
risks?
Finally, on the issue of removal and unintended
consequences, we found this issue to be the trickiest of the
lot. There has much been said and already done, as you know,
globally on the removal of the references, but it still appears
everywhere. We are talking about putting back references
through this discussion draft, and it continues to appear
throughout private contract.
We are not sure what happens if you remove it all. We are
not sure what happens to the pace and the efficiency of
financial markets. What the Investors Working Group and CFA
have focused on is looking at this from the standpoint of the
investor, and what we do is we scold investors for the blind
reliance and the very bad habits that this credit rating
process has developed across many institutions and that is
using credit rating agencies as really a substitute for their
own analysis and due diligence.
Now, I think unless you are fully asleep at the switch,
investors should be on full alert that the ratings are not
government-sanctioned, that the quality and validity and the
accuracy are not examined or otherwise approved by the
government. We seem to be moving in that direction with the
discussion draft.
The Investors Working Group reasons that maybe further
removal and ultimately elimination of those references would
further drop that reliance. We just did a survey in the last
couple of days, and our member survey came back that 54 percent
of the members would like to see us move towards full
elimination of those references.
I will stop there. Thank you very much.
[The prepared statement of Mr. Schacht can be found on page
124 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Schacht.
I will start the questions simply because, to a large
extent, some of the issues that you raised are issues that I
put into the draft.
First and foremost, the explanation of the conflict of
interest--inherent conflict of interest with issuer pays. I
find it being exceptional. I cannot think of many examples and
certainly few good examples, but recently in a discussion with
a United States Senator, I suggested that I discovered the
methodology by which we could cut a significant cost out of our
budget in the United States. If we removed any expenses allowed
in the budget for the payment of judiciary and that we would
pay the judiciary by having the attorneys for the winning
litigants stand the expenses of the judges' salaries and
expenses.
And, of course, as I say that, I see some of the people in
the room smile and smirk. Nobody would even remotely suggest
that would be a reasonably acceptable standard in justice. And
yet, if you really analyze what I just said to you, it is
exactly what you are doing in the rating agency business.
Now you may be holier than nuns or cleaner than popes, but
I doubt that at all times there have not been compromises in
the situation--or else there would not be shopping around. Many
of the witnesses here talked about shopping. Now why would you
shop for something if you were not trying to buy a little
preference in a rating from your potential rater? I think we
have to concede it is there.
Now the next question is, can you remove it? And I have
come to the conclusion obviously this did not come about
because somebody envisioned just let's do it. It is obvious
that the other methodology, user pay, was not working too well
or sufficiently to support a rating agency, a business. So my
attempt was to find some compromise that would allow users to
pay but increase their liability--or issuers to pay but
increase their liability if there is knowing wrongful acts on
their part.
And then, secondly, encouraging a mechanism to find
exposure. What better than to have your competitors examine the
same figures and information and having them do a reasonably
good job of oversight? Because if they miss it or do not do it,
if they do not report actions to the regulator, that will raise
questions on the validity of the rating. They ultimately could
become sanctioned.
Now where we pulled that out, quite frankly, is by analogy
from the insurance industry. We basically do that in the
insurance industry, right now, in catastrophic disaster areas.
If an insurance company is insuring against hurricanes in
Florida, you could make a fortune. Go down and cut any ratings
in half, and everybody in Florida will flock to your house, pay
you the premium, and you can have the major proportion of
business in Florida. Then what you want to do cleverly is get
out of town before the hurricane arrives, and if you do that,
you will make a fortune. The problem is that we have had people
do that and stay in town and not be able to pay those damages
that resulted from the hurricane.
So in order to prevent that irresponsible levying of rates,
insurance rates, they started pooling. Basically, that is what
pooling is all about. It says, look, if the one that wrote the
policy underrated the proper premium to pay for the damage, or
made some fundamental errors, or did not make any errors at all
but just because of circumstances was unable to pay, the
insured should not be the responsible party taking all of the
loss. Instead, that loss will be shifted to a pool created by
an assessment of all the other underwriters in the area.
Now, I do not think that is the best thing in the world;
and, as a result, we have not even structured the language to
accomplish this idea.
What I am trying to encourage is outside-of-the-box
thinking. We obviously have a major problem of conflict of
interest. We obviously have rating agencies that are being
shopped. We obviously have had horrible results in the last
several years with rating agencies missing many of the
securitized areas by giving them rates of triple A when in no
way should they have had triple A.
I do want to point out that an insurance company came to me
very recently with a study in their industry; and that industry
in the United States is almost wiped out. And the reason being
they showed me that their competitors were buying securitized
mortgages. It got so bad in 2007 that 15 percent of the
mortgages included in the pools had never made the first
installment of the mortgage. There was a default by 15 percent
in the first installment due to the mortgages that were
included in the pool.
Now I do not know whether due diligence is being used. I do
not know whether proper study measures are being used. But when
you are including mortgages and marketing them, the securities
based on those mortgages, as triple A when the installments of
15 percent of the mortgages are missed in the first instance,
somebody is wrong and somebody is lax.
And to some of the testimony here, it seemed to me that you
are saying, well, sorry, we missed it, or the most important
thing is we have competition.
Competition is good and cures things, if competition really
works. Has anybody suggested the competition that is there now
is working? And if it is not working, what are your suggestions
of competition and how we get it to work, other than just
putting more people into the field when there are only 3 doing
95 percent of the work.
I see that my time has expired, so I will pass on my
comments and questions and hopefully get to the next round.
I will now recognize the gentleman from New Jersey, the
ranking member, Mr. Garrett.
Mr. Garrett. I am going to defer first to--
Chairman Kanjorski. I am sorry. Mr. Bachus.
Mr. Bachus. That is okay.
Mr. Chairman, can we have about 8 minutes on each side? I
know you took about 8 minutes, if that is all right. There is a
limited number of members.
Chairman Kanjorski. Just do not act like rating agencies.
Mr. Bachus. And I would maybe start my time after I ask
this question.
Chairman Kanjorski. Well, no, I think we should certainly
give you 8 minutes. For you, Mr. Ranking Member, we will give
you 10 minutes, if you want.
Mr. Bachus. Thank you. I know the timekeeper heard that,
too.
My first question is, we have heard a scenario where an
issuer gets a rating from one of the rating agencies and that
rating is not disclosed. Then they go to a second rating
agency, and they share that rating and say, can you do better?
Obviously, that could lead to some skewed ratings.
I would ask Mr. McDaniel and Mr. Sharma, does that happen?
Mr. McDaniel. Congressman, the issue of rating shopping, as
we said in--at least as I said in our prepared remarks, is
indeed a serious issue. It is not, however, an issue that I
think is driven by the business model and payment. It is an
issue that is driven by lack of information.
Mr. Bachus. What I am saying, Mr. McDaniel, are there cases
where someone goes to, say, S&P and then they come to you. They
haven't disclosed that rating. And they come to you and say, I
would like to you do another rating. And then you give a
different rating and say it is higher. Then they choose which
one to disclose. Does that happen?
Mr. McDaniel. Yes, I believe that does; and that is why I
believe it is a serious issue.
Mr. Bachus. And you would agree--and, Mr. Sharma, do you
agree that has happened in the past?
Mr. Sharma. Yes, Congressman, it does happen; and the
solution around putting more transparency as to where the
issuers have gone and who they have selected and why they
selected, such transparency will bring everything up.
Mr. Bachus. Would either one of you gentleman object to
saying that if you go to a second agency, you disclose both
ratings?
Mr. Sharma. The issuers and we could be asked to disclose.
Mr. Bachus. Mr. McDaniel.
Mr. McDaniel. I think the objective is a good objective. I
think that it would be difficult to make work. Because I think
that, to the extent the marketplace does not want to have
ratings disclosed, they would simply work around that. They
would ask hypothetical scenarios.
Mr. Bachus. What if you gave a preliminary rating and you
were under legal obligation to disclose that? Do you think you
could work around that?
Mr. McDaniel. To the extent that we give a preliminary
rating and are required to disclose that, we certainly would. I
think they would--to the extent that they are trying to avoid
having that happen, I think they would try to avoid having a
preliminary--
Mr. Bachus. Oh, I can bet you they will try to avoid it.
Mr. Gallagher, is that a problem and are you going to
address that at the SEC?
Mr. Gallagher. Congressman, thank you.
This is actually something that the Commission has taken
action on. In our September 17th meeting, the Commission
proposed rules geared specifically to issuers, going right to
the primary actor in the scenario that you outlined and
proposing rules that would require, as you say, under penalty
of law that they disclose whether they are rating shopping,
whether they are seeking either preliminary or other ratings.
Mr. Bachus. Mr. McDaniel, I think he has been quite candid;
and I compliment you for that, Mr. McDaniel.
There are ways to get around it. And even if, say, Mr.
McDaniel doesn't or Mr. Sharma, someone may try to; and I would
ask you to maybe even consult with them on ways not to get
around it.
Mr. Joynt and others, if you would maybe share with the
industry. Because they know better than anybody else how to get
around it and could tell you how to build a safer system.
Mr. Gallagher in his testimony said that analysts were
sometimes involved in the discussions concerning fees. That to
me appears--and he said in his testimony that is a serious
conflict of interest. Mr. McDaniel, do you agree that that
appears to be a conflict of interest, at the very least?
Mr. McDaniel. The involvement of analysts in fee
discussions I do think is inappropriate. We do not permit that.
Mr. Bachus. Mr. Sharma, do you permit that? Going forward,
will you permit that?
Mr. Sharma. Mr. Congressman, we have had long-standing
policies not to allow analysts involved in any commercial
activities, and we recently even reinforced that.
Mr. Bachus. And, Mr. Joynt, I assume you all are already
doing that.
Mr. Joynt. That is correct.
Mr. Bachus. I appreciate all of you saying that.
And even I think when you share e-mails, if they see the e-
mail traffic about those discussions, I think that you need a
safeguard there. Mr. Gallagher mentioned that, and I thought
that was very appropriate.
Mr. Gallagher. Congressman, I will just jump in and say
that we actually have a rule that is exactly on point with this
issue prohibiting that conflict.
Mr. Bachus. Is that a new rule or something you have had in
the past?
Mr. Gallagher. Since we have gotten the statutory
authority.
Mr. Bachus. Thank you.
Mr. Joynt, you mentioned there are certain things you do,
internal controls, that in the past that maybe S&P and Moody's
didn't have. What are some of those that you would like to
elaborate on?
Mr. Joynt. First of all, I don't want to sound holier than
thou, as the chairman pointed out.
Mr. Bachus. Oh, we welcome those kind of testimonies.
Mr. Joynt. But I do think it is important that, over a long
period of time, we have tried to build a culture of credit
orientation. And there has always been a conflict--we have
talked about that--between being paid by issuers and how we
have to have completely independent credit rating processes
with analysts who think independently and ratings that are done
by committee. And so we have to have at the forefront of our
mind the fact that the ratings are entirely independent.
There have been many instances--I am sure other agencies
have examples as well--where the consequence of taking
difficult ratings decisions, like downgrading companies, or
structured financings has resulted in financial impact. And I
was only pointing out that I think that we have--I have
examples of those, and I could cite more, where we feel the
impact of that rating decision, notwithstanding the fact this
rating decision would change our financial results, because of
the independence of the credit judgments.
Mr. Bachus. I actually have seen some articles that the
Senator confirmed that you have suffered from that.
Mr. Joynt. Thank you.
Mr. Bachus. Let me ask Mr. McDaniel--well, actually, let me
shift gears and say to Chairman Kanjorski, if I could, this
idea of joint and severable liability, as I understand it, even
rating agencies that didn't participate in the ratings could be
found liable. Is that any of you gentlemen's understanding?
Mr. Gellert, would you comment on that?
Mr. Gellert. Yes, that is my understanding. To my read or
at least the intention of the clause in the draft is exactly
that, that any NRSRO--just to clarify, not anyone who is
providing ratings or credit research services independently but
an actual NRSRO would have a joint liability if a problem was
found and a suit was pursued against one, that all would share
if collection was not available.
Mr. Bachus. That sounds--the asbestos legislation, I think,
was one of the worst things that has ever passed this Congress,
where you had innocent companies who did nothing wrong and yet
they were--in many cases, they actually had to file bankruptcy,
not because of anything they did. And I would hope the Congress
would not--that is something the Congress has tried to
straighten out for 30 or 40 years and, regrettably, has
resulted in some of the greatest inequities in our judicial
system.
I used to be both a plaintiff and a defense lawyer, and I
almost consider that practice un-American. It is certainly the
opposite of justice. I would hope that we can work with
Chairman Kanjorski on that particular issue, because I don't
think that is what most Americans would call justice.
Mr. Gallagher, what do you consider--are there some actions
you think have been taken that will go a long way to assuring
us that what has happened in the past won't happen again? I
think that ought to be our main motivation here.
There certainly is enough blame to go around for what
happened last year, and I think the credit rating agencies were
a significant contributor to that. But I think our motive ought
to be stopping in the future, and I think they have
acknowledged that.
Mr. Gallagher. Thank you, Congressman.
Since the Commission got statutory authority to oversee the
rating agencies in 2006, this is an area in which we have been
very active, there have been several sessions of rulemaking,
the last of which, as I mentioned earlier, was 2 weeks ago. The
rules address a whole number of issues: conflicts of interest
in particular; accountability; transparency. And we are just
now starting to see the net effect of some of those rules.
And so I would say it is an area where we have taken a lot
of steps. We are not resting on our laurels. We are looking
constantly to see where there are existing regulatory gaps, and
where we can do something better, more efficiently. I won't
promise that we are done by any means, but I think we have
taken a lot of steps, and we would like to see what the net
effects of those rules are.
Mr. Bachus. Thank you very much.
Thank you very much, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Bachus.
Mr. Donnelly for 5 minutes.
Mr. Donnelly. Mr. Joynt, let me ask you this: What would be
the problem if purchasers paid for the credit rating agency's
work instead of issuers?
Mr. Joynt. There is no problem with that. The reason why
the industry developed with an issuer pay model was cited
earlier. Going back to the mid-1970's, after the Penn Central
bankruptcy, the Wall Street community had gotten together and
suggested that a much stronger, independent rating agency
business was needed, better funded to do better analysis; and
they wanted all the ratings to be publicly available to all
investors. And so that was the germination of the issuer pay
model, it was to get the ratings out freely and broadly and
disseminated to everyone and to fund a much more vibrant and
better ratings business.
I think that has been accomplished. But there is nothing
wrong. If there could be developed a way to have all the
investors pay enough to fund a well-structured and good credit
ratings business, that would be a good solution, also.
Mr. Donnelly. Is there a concern, for instance, that on an
issue that the purchasers would not be able to properly fund
your work?
Mr. Joynt. I think that is the case, yes. Investors are
willing to be subscribers to our research and our ratings, but
the amount of compensation for that is restricted.
Mr. Donnelly. Let me ask you this, Mr. McDaniel. In the
legal profession, when you go to court, you don't get to pick
your judge, for obvious reasons. There is conflict of interest.
Can we use a blind pool system with credit rating agencies as
well so you don't get to, in advance when you bring out an
issue, pick the organization you want to work with?
Mr. McDaniel. I think to the extent that issuers are going
to rating agencies, they are doing so, at least in the
traditional context, in order to meet investor demand. That is
a model we would call a demand pool model. The issuers would
certainly like to make choices that would be most favorable to
themselves, but at the end of the day their securities must
satisfy the investor demand for independent, high-quality
opinions.
It is one of the reasons why we are supportive of a
reduction or elimination of the use of ratings and regulation.
Because I think that traditional system is a healthier system,
frankly, and would return more of the demand for ratings to the
investor choice, as expressed through who the issuer reaches--
reaches out to with its rating requests.
Mr. Donnelly. Mr. Dobilas, let me ask you this. What would
you think of a blind pool system?
Mr. Dobilas. You know, I am glad you mentioned that.
Because, just listening to everyone's ideas and brainstorming
out of the box, I think you have to remove competition from the
new issue side. I think what you want to do is what is best for
the investor. That is really what a rating agency was designed
to do. I think we lost sight of that several years ago when we
switched to an issuer-paid system. Ninety-five percent market
share for three companies is a lot, and nothing is going to
change without a meaningful change.
So what I was thinking is--I would agree with you. I think
if you, again, in the investor's best interest, sort of
promoted the subscription-based model but had a blind pool on
the new issue side, you would encourage the three companies
next to me to focus more on investor-paid models, while at the
same time breaking up the oligopoly at the new issue site.
It is really quite simple. Their revenue would have to be
derived from somewhere else besides rating shopping and where
else would they get that revenue? They would focus on building
investor-based products and tools and analysis that promote all
the values you are looking at promoting and selling those
directly to investors, and investors will pay for that.
Mr. Donnelly. And I know I don't have to tell you folks,
but the critical nature of what you do--in my State, the damage
caused to our economy was breathtaking, with company after
company unable to obtain credit because of the collapse of
credit markets. And there is a deep anger in our area toward
Wall Street, toward the work done there, that what you did
there caused our families to lose jobs.
And that is the perspective that we have in middle America,
is that--was this done by rating agencies alone? No. But the
work that was done caused so much damage that we had moms and
dads going home at the end of a day--I represent the
recreational vehicle area, the auto area--that they went home
and lost their jobs because the credit markets had been
destroyed. And so we had a lot of skin in the game.
I guess the question I will ask you is, short of the
liability discussions that we have had, what skin in the game
do you have or should you have or what can we put in there to
make sure that your work isn't done for one of the investment
banks but is done for accuracy and the American people so that
they have some sense of confidence in what you are doing? I
mean, what consequence is there to you? The consequence to us
is our companies are destroyed and our jobs are lost.
Mr. Sharma, would you be willing to help out here?
Mr. Sharma. Mr. Congressman, first of all, our focus is on
the investors, as to what we can do for the investors. And the
investors ultimately make a choice. They, in fact, even if we
are in the regulations, investors influence who the issuers
select as a rating agency. If they are not satisfied with it,
they are not going to invest in the securities that the issuers
issue. And that is something that the investors always have
that choice.
Second, we are accountable. We are accountable through the
regulatory process to SEC. If you don't comply with the
policies and procedures, they have provisions to penalize us
and even shut us down. Second, we are also accountable through
the private litigation. If we don't follow policies and
procedures and there is fraud, then there is security fraud
laws that we are liable against.
Third, we are scrutinized by the market everyday. We make
our criteria around which we rate public. We make our basis
around which we do the rating actions public. And if people
disagree with us, they speak up; and we hear that very loud and
clear. We do feel ourselves very accountable in many ways.
Mr. Donnelly. One last question. We heard from a number of
folks in regards to the conflict of interest piece.
One successful investor said, run it like a private
utility--like a utility, where there is a couple of pennies
paid on every trade or that there is a pool of funds available
to then fund--that it remains private, but the funding comes
from that pool instead of directly from an issuer.
And would anybody like to take a whack at that as to what
you think?
Mr. Gellert, we will throw you in the bucket, too.
Mr. Gellert. Sure, why not?
I think it is one model that is worth exploring, like
investor-owned rating agencies are worth exploring. I think the
devil is in the details when you talk about a public utility
model, because you really have to dive deep into what the value
is, what investors are going to believe is value being created
by an entirely new entity.
We face it. I am sure RealPoint faces it. We all face it as
newer entrants into the market, that we have to establish
credibility over an extended period of time. The market doesn't
immediately grant us the benefit of the doubt and say
everything that you do is fantastic. So it would take quite
some time, and I don't you could turn this industry on a dime.
I would then suggest that a public utility model or a
government-owned model, particularly in the context of the
joint liability and other liability issues that we are talking,
would be extremely problematic and probably not welcomed.
Mr. Donnelly. The reason it is all so important is the
extraordinary repercussions that come when we miss the mark in
the rating system. So--
Mr. Dobilas. I would like to add to that.
I think part of the reason why we missed the mark was
because surveillance of the securities was so poor or it just
didn't exist, and that is part of the reason why a subscriber-
paid model works so well. Because if we get a rating wrong we
lose a subscriber. That is the penalty. It is almost like we
are almost 100 percent self-insured. Because we will go out of
business if we made the mistakes that, again, few firms have
made in the past.
And, also, by focusing on surveillance, you really look at
things on a monthly basis, as opposed to an annual basis. I
think that is a big reason, too, why we saw so many mass
downgrades when we did see those downgrades. And why it
affected your home State so much. Because all at once it was
too much for the economy to absorbed. If these things would
have happened more gradual over time, I think the effect would
have been less traumatic.
Mr. Donnelly. Thank you very much.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Donnelly, and we will
now hear from the gentleman from Illinois, Mr. Manzullo.
Mr. Manzullo. Thank you, Mr. Chairman, for calling this
hearing.
Let me ask a question. Can the issuer-pays and the
investor-pays models for rating coexist in the marketplace? Mr.
Gellert or Mr. Dobilas?
Mr. Dobilas. I will take a crack at this.
I don't think they can. I honestly think you have to
confront the problem. And when the issuer chooses who does the
initial rating, I think that is a big problem, and you will
have rating shopping take place.
I think the mitigating factor which the SEC sort of put a
rule in place that really helps out is the fact that
subscription-paid agencies or any agency can focus on producing
the same report at the same time and trying to sell that. The
question is, are investors going to be willing to pay for that?
Historically, they have not. Historically, they are used to
getting this information for free and may go back to their old
ways by just relying on those issuer-paid ratings.
That is why I think the idea of a rotating structure where
all the agencies would then focus on making their money for the
benefit of investors by providing--
Mr. Manzullo. But even if you had that, you have three
large credit rating agencies, and that is not much of a pool.
You are going to pull one out of three. And eventually, let's
say there is some mischief on the part of one of them, then an
investor out there or issuers say, well, I reject that rating,
and then go back to the pool again. And then you are down to
two and then down to one. What have you accomplished at that
point?
Mr. Dobilas. But the good news is there are more than three
now. There are 10 registered NRSROs. And what you want to do is
encourage more companies to apply for the NRSRO.
Mr. Manzullo. What about one of the big three, do you want
to respond to my question?
Mr. Joynt. I think one point I would like to make is most
of what we are talking about seems to be surrounding structured
finance and the transactions rated there.
Mr. Manzullo. Except for the problem ones.
Mr. Joynt. In fact, the rating agencies rate corporations
and municipal entities. So I just ask you to bear in mind that
the question about whether we select ratings or not, Fitch has
been added as a third rating to almost all corporations that we
rated over the last 10 or 15 years. They didn't select to drop
someone else and add us. We have been added because they
respected our research. It wasn't a competition in that kind of
way.
So in public finance, I don't believe there is any other
rating agency among the newer entrants that is in position to
rate any public finance entities.
Mr. Manzullo. Mr. Joynt, let's say in 1 year your company
had a sales of, let's say, $100. How much of that $100 would be
represented by structured products? Just generally.
Mr. Joynt. Fifty percent.
Mr. Manzullo. Fifteen?
Mr. Joynt. Fifty, ``5-0.''
Mr. Manzullo. So it is about half the product.
An issuer wants to sell a product, can he effectively sell
that product if he does not have a rating at the same time that
he makes the offering to the public--a rating that goes along
with the product?
Mr. Joynt. If it is a public offering, typically they would
ask for at least for two ratings.
Mr. Manzullo. And investors demand that?
Mr. Joynt. Many investors, regulated or not regulated,
would expect to see at least two different rating opinions on
public securities that are offered, yes.
Mr. Manzullo. So even though there is obviously a built-in
conflict of interest with the issuer paying for the ratings,
there is no effective way around that?
Mr. Joynt. Over time, investors have been comfortable and
confident that management of the conflict of interest has been
done appropriately.
Mr. Manzullo. Anybody else want to respond to that? Mr.
Gellert.
Mr. Gellert. I think this is more about market norms than
it is about anything else. I think your typical corporate
issuer knows that, generally speaking, to get the best pricing
on your bond deal you need to ensure that there will be the
most liquidity potential in the secondary market for that bond;
and you will always have the most potential liquidity if you
have S&P and Moody's ratings on it and then, more recently,
Fitch's.
Mr. Manzullo. Okay. Let me ask this question. Perhaps it
goes to the heart of the collapse.
Many of us find it incomprehensible that, in the rating of
these mortgage-backed securities, the people doing the rating
simply failed to realize that mortgages that were given to
people who could not make the first payment were somehow
tainted and could end up poisoning the whole.
We are just--I don't know it got missed. When Members of
this Congress were saying that credit was too easy and other
groups said, no, it is not; and then everything went along--
yes, sir.
Mr. Dobilas. I think the answer is simple. Just like in the
commercial real estate market, it was missed because the models
that were rating these securities were developed for issuers,
not for investors. You know, over the last 5 years--
Mr. Manzullo. They were developed for issuers but not for
investors.
Mr. Dobilas. Yes, to get the deal. Over the last 5 years,
we have seen a deterioration of credit standards across-the-
board on an individual loan level. Commercial real estate,
which was a fairly conservative industry, again, 5 years ago,
we have seen the deterioration of credit standards. The rating
agencies rating those deals should have been the mitigating
factor to that, should have been the advanced warning signal to
investors that, hey, something is going on; deals are getting
riskier.
But that didn't happen, and I blame rating shopping for
that. They wanted to be on the deals. They didn't want to take
a stance. And I think you have to confront that. You have to
put an end to that.
Mr. Manzullo. Mr. Chairman, my time is up, but it is up to
you. If you want to--
Mr. Donnelly. [presiding] If you would like to take an
extra 2 minutes, that would be fine.
Mr. Manzullo. I appreciate that.
Mr. Gellert, then I want to hear from one of the big three,
a response to fairness. If you would like to respond to it. Mr.
Gellert and the--
Mr. Gellert. I think one of the key issues here as well is
the availability of information to rate the products,
particularly in the structured product market. The equivalent
disclosure initiatives that the SEC has undertaken and that are
picked up in the draft bill I think are key.
Because one rating agency that would be--one of the
traditional three may very well have a model that was geared
for something other than what it was used for or not. I am not
speculating. But I can say, if there are more opinions out
there and there are more of us who are interested in rating
those products as well, we have the ability to do the due
diligence that they currently are not doing, but only if we
have access to the information that is underlying those
securities. And that is the mortgage information underlying
residential mortgage bond CDOs and a whole slew of others,
particularly collateralized loan obligations, things that right
now we do not have access to.
And one of the absolute keys as we move forward is not just
being able to get access to that information on the new issue
basis but it is on the existing securities outstanding that are
on people's books. Before we can provide value on new issuance,
we need to be able to benchmark that new issuance against what
people are already holding. That means we have to have
ubiquitous access to information for all securities.
Mr. Manzullo. Did anybody want to--Mr. McDaniel?
Thank you, Mr. Chairman, for giving us the extra time.
Yes, sir?
Mr. McDaniel. I just wanted to again reinforce our support
for the availability of information. I think that is just
absolutely crucial, information available to the investing
public and to rating agencies which are not selected to rate a
security by an issuer. If that information is available to all
of us, as well as to investors, we have the ability to act as a
check and balance on each other and the institutional
investment community has the ability to act as a check and
balance on the analysis of rating agencies. I think that if we
have one solution to the rating shopping and competition
problems that are being raised, that is the solution.
Mr. Manzullo. Thank you, Mr. Chairman.
Mr. Donnelly. The gentlelady from California.
Ms. Speier. Thank you, Mr. Chairman; and thank you,
gentlemen, for being here today.
In my experience back home in the district, what I hear
more than anything is just outrage about the fact that no one
has really been held responsible. And so I guess my first
question--and my questions are going to be all around
accountability.
My first question is to each you at the credit rating
agencies. You had rated AIG and Lehman Brothers as triple A,
double A minutes before they were collapsing. After they did
fail, did you take any action against those analysts who had
rated them? Did you fire them? Did you suspend them? Did you
take any action against those who had put that kind of
remarkable grade on products that were junk?
Mr. McDaniel?
Mr. McDaniel. No, we did not fire any of the analysts
involved in either AIG or Lehman. Lehman did not have a double
A rating or a triple A rating. It had a single A rating. And an
important part of our analysis was based on a review of
governmental support that had been applied to Bear Stearns
earlier in the year. Frankly, an important part of our analysis
was that a line had been drawn under the number five firm in
the market and that number four would likely be supported as
well.
Additionally, AIG--
Ms. Speier. But that is not analysis. That is an opinion.
That is not--I mean, I could have that kind of an opinion, and
I am not an analyst. How can you possibly make that kind of a
decision based on an opinion when you have millions of people
relying on that?
Mr. McDaniel. Our opinion applies to whether we believe an
instrument will pay or will not pay.
Ms. Speier. That was a political determination that you
made, Mr. McDaniel.
Mr. McDaniel. A very important component of that analysis
is whether we believe there would be external support in the
event of distress; and that analysis is relevant to financial
institutions, to governmental entities--
Ms. Speier. Thank you. Mr. Sharma?
Mr. Sharma. Congresswoman, financial institutions are
very--
Ms. Speier. If you could just answer the questions, because
I have a series, and I have a limited amount of time.
Mr. Sharma. No, we did not fire anyone.
Ms. Speier. No one got fired. No one got their hand
slapped.
Mr. Sharma. Congresswoman, ratings had been downgraded over
time for both of those institutions.
Ms. Speier. AIG was still double A on the 14th or 13th. I
mean, it was--
Mr. Sharma. We had been changing the rating over a period
of time. And financial institutions are very confidence
sensitive. So, in Lehman's case, not only were they trying to
raise capital and they were about to raise capital and when
they weakened they had declared bankruptcy. And once there is a
run on an institution, then it is very hard--as you have also
experienced in California, when these institutions have a run
on them, it is very hard to manage that and process, because it
is very confidence sensitive.
Ms. Speier. All right. Mr. Joynt?
Mr. Joynt. No, no analysts were fired.
I would say our lead analysts in those cases, as well as
the analysts who participated in the committees, are
disappointed, surprised, went back and reflected on, well, how
do we reach our conclusion? There are committee deliberations.
It is not just one person who decides. I think we have done a
lot of thoughtful soul searching about how do we perceive this
going forward, how do we think about our analysis.
Ms. Speier. What are your opinions on consulting services?
Do you do consulting services in addition to doing the issuing
for a single client? I know you have done it historically. Are
you continuing to do that?
Mr. McDaniel. We do not offer any consulting in the rating
agency. We offer some professional services in the form of
credit training and risk management, risk measurement tools in
the Moody's analytic business, which is another company owned
by Moody's Corporation.
Ms. Speier. And there is no sharing of information?
Mr. McDaniel. That is correct.
Ms. Speier. Mr. Sharma?
Mr. Sharma. We do not offer any consulting services. We
have, in fact, reinforced the policies and added more checks
and balances that there is none of that even activity
happening--
Ms. Speier. Mr. Joynt?
Mr. Joynt. Any kind of advisory services have been housed
in a separate company from the rating agency, yes.
Ms. Speier. Mr. Dobilas?
Mr. Dobilas. No, we don't provide consulting services.
Ms. Speier. Mr. Gellert?
Mr. Gellert. No, we do not.
Ms. Speier. There is a regulation FD that the agencies
contend that the exemption is needed in order to fully evaluate
credit risk. Most notoriously, even though Enron made nonpublic
credit rating agency presentations, information about the risk
described in those presentations was not reflected in Enron's
credit ratings. So my question is, if we are talking about
accountability, if we are talking about greater disclosure, why
should you be eligible for this exemption from regulation FD?
Mr. McDaniel. We operated for 90 years before regulation FD
became effective. I think we were able to do a very fine job
during that period, and I think we would be able to operate
without regulation FD exemption now.
Ms. Speier. Thank you.
Mr. Sharma?
Mr. Sharma. Ratings are forward looking, and information
that allows us--that gives us more insight as to the future
helps us to make better decisions.
Ms. Speier. Mr. Joynt?
Mr. Joynt. I would agree. I think that regulation was
passed to allow issuers to more freely communicate with rating
agencies so they can make better decisions.
Ms. Speier. But we have lots of examples where it wasn't
used in that way. So the question is, is it going to hurt your
business if we get rid of that exemption?
Mr. Joynt. I believe we could continue to offer educated
opinions.
Ms. Speier. I see that my time has expired. Could I be
offered one more--
Mr. Donnelly. One more minute.
Ms. Speier. Thank you.
I just want to get to this liability issue, this private
right of action. As I understand it, you only want to be sued
if you knowingly make a false statement. Now that is akin to a
doctor only being sued when he knowingly leaves sponges in a
body during a surgery. And we all know that is just not the
case.
For most professionals in this country, you can be sued for
negligence. You can be sued for gross negligence. And most
professionals don't have this huge benefit that you have, which
basically allows you to not be sued by anyone unless you
knowingly make false statements.
I am going to read to you one little section here, and I
want you to tell me whether or not you could live with this
kind of a standard:
``Knowingly or recklessly failed either to conduct a
reasonable investigation of the rated security with respect to
the factual elements relied upon by its own methodology for
evaluating credit risk or to obtain reasonable verification of
such factual elements from other sources that it considered to
be competent and were independent of the issuer and
underwriter.''
Ms. Speier. So it is a different standard.
Mr. McDaniel. I am interpreting perhaps correctly, perhaps
incorrectly, the section that you just read to subject NRSROs
to the same liability under Section 10(b) of the 1934 Act for
knowing or reckless actions as other market participants would
be. While no CEO wants to volunteer for more liability for
their firm, that does not sound like an unreasonable standard
to me.
Ms. Speier. Thank you.
Mr. Sharma. I think my point--
Mr. Donnelly. [presiding]. I am sorry. Time is up. The
ranking member from New Jersey.
Mr. Garrett. Thank you. And I thank the panel for your
testimony. Before I begin, I guess I would echo the words
actually during part of your comments, Mr. Donnelly, with
regard to how middle America views much of what has transpired
over the last 9 or 12 months, having that real dilemma of
trying to find responsibility out there in the midsts of all
the doom and the gloom on the economic crisis morass that we
are in and unfortunately just not being able to see what
Congress is apportioning that liability and just who the
responsible parties are.
That is the quagmire that we are in at this point in time.
The forest is this piece of legislation. I just want to go
through some particular points on this. I guess I will start
from right to left or maybe in between to throw you all off.
Mr. Schacht, you I believe stated in your testimony that with
regard to the legislation, that maybe some of it might just be
too specific and some should best be left to the regulators to
imply. I guess some parts with the compensation, but also
dealings with the duties of the compliance officer. Can you
just spend a brief period of time--isn't that the
responsibility of us to get into that detail? Because obviously
the regulators haven't been doing that task in the past.
Mr. Schacht. Well, I think somebody needs to do it. That is
for sure. I think the question is whether it needs to be
committed to statute or whether we as I said--whether we just
articulate the general principle behind this and we leave to
the functional regulator to implement the various standards
associated with that. Our view was that it is best left at the
functional regulator level.
Mr. Garrett. Thanks. And Mr. Gellert, on another point,
your firm is not registered as an NRSRO?
Mr. Gellert. That is correct.
Mr. Garrett. And in a few seconds, since we are all on
time, why is that? Why was that decision made?
Mr. Gellert. It has basically been for the last number of
years, watching the evolution of the regulatory and legislative
debate around how to control the NRSROs and finding that there
has been too much uncertainty as the dust hasn't settled and
new ideas and concepts continue to come up and that now there
is an increased focus on litigation liability and there is a
significant amount of risk involved, and we don't see it so far
that the advantages outweigh the negatives.
Mr. Garrett. Okay. Now, one of the provisions that is in
this legislation is a proposal to remove the imprimatur of the
government approval by statute and regulation by removing that
designation. Anyone can answer this question. What are the
downsides if we implement that? Even if we did so over an
appropriate period of time, recognizing that the SEC is already
taking some actions and going through the review process and
picking a few out here and there. But if we just put a date
certain and said going forward for purposes of this, in a
reasonable period of time, what would be the downside
particularly on the--as far as the investors' perspective and
would there be something you could look to and say oh, my
goodness, pension funds are all the sudden going to have a
calamity in there or something like that that I am missing?
Some are nodding your head, but--
Mr. Dobilas. I could take a stab at that to start with. I
think there is a downside. I think the NRSRO being a regulated
entity serves its purpose as a benchmark for investors. I think
removing the NRSRO is going to create a lot of problems for
investors. They do depend on that minimum benchmark. It gives
them comfort in their decisions. But first and foremost is the
data issue. A lot of these securities are public-private
securities. A lot of information like rent rolls, financial
statements--
Mr. Garrett. We are not suggesting that you couldn't do
that, that institutions still could not make that choice to
actually go out and say we want to have an AAA rated by one of
the Big 3 and that is the way our town, county or State or
government is going to do it. It is just that we are no longer
going to have the stamp on it saying that you have to do that,
that it is up to the investors or the institutions.
Mr. Dobilas. Yes. And again my point is having that stamp
does encourage a certain bare minimum, a certain competency.
Are you going to go into broker/dealers and see if they have
the competency to put the securities together and really
subject yourselves to that kind of regulation or is the rating
agency--again, could that be a regulated entity where again it
is a bare minimum competency of risk?
Mr. Garrett. From the other rating agencies, do you have a
problem with that?
Mr. Joynt. A couple of thoughts. I think the money market
fund industries' response to the idea that the ratings would be
withdrawn from--I don't know the exact SEC rules, but--
2(a)(7)--sorry--is still being openly dialogued about. But they
were concerned about having no minimum standards. So new
entrants into that business were likely to take extraordinary
risks and sort of besmirch the reputation or the minimum
standard of the larger or more general population of money
funds. So whether there is a substitute or not for that, it is
a good example of the sort of benchmarks in place and it is a
constructive one, even if it is not a full solution. People
should be doing their own analysis. But it is perceived as
constructive.
Mr. Garrett. That is something--I will let you answer, Mr.
Sharma.
Mr. Sharma. Thank you. Ranking Member, we have never asked
for a designation like the NRSRO. So whatever the
policymakers--you and SEC and the investors make a conclusion
was the best interest of the investors, we would work with that
and we would be very comfortable with that, to go in that
direction.
Mr. Garrett. And if you did rank the removal, wouldn't it
be--I guess your sense on the money market funds, what have
you. But then the onus would be on them to either select the
concurrent process that they are doing now, or I guess the SEC
would take a look to see whether they have established their
own internal mechanisms for making sure that they are making
the proper investment decisions in those situations. And I
thought that would be sort of what we are all ultimately
striving for because there is this question mark remaining out
here, despite the best intentions. Comments? The liability side
and again with regard to this legislation, who sees that as
many of you mentioned this before, who sees as far as changing
the liability standards as we have here as a significant
impediment to entry into the field and whether it would change
the volatility of the ratings? Those are two separate
questions.
Mr. Gellert. Everyone is looking at me. It is clearly an
impediment, it is clearly a disincentive to enter the space,
and without question, it further solidifies the market share
that the three largest players have, without a doubt. I cannot
speak for the other NRSROs that are smaller and outside of that
Big 3, but without a question. it does. The more you have
entrenched--the more you have entrenched oligopoly and less
competition, the more likely it is that you will have stable
ratings. But they won't necessarily be accurate ratings because
they won't necessarily have the competitive and innovation--
Mr. Garrett. Let me flip it around. Does anybody see that
it would not be an impediment to--no. What about for you guys,
as far as insuring yourself, you have two provisions in here,
the liability as far as the pleading section on one hand and
you have the joint and several liability section there. Would
you be able to go out into the insurance market to insure
yourself? How will you intend to do that if either one or both
of those get through? Which insurance companies want to insure
you now I guess?
Mr. Dobilas. I can tell you being a smaller NRSRO that we
are down to a very limited choices of insurance companies that
will even insure us based upon the recent events of what is
happening with the lawsuits against some of the other NRSROs.
If that were to pass, we would most likely remove ourselves
from the NRSRO playing field.
Mr. Garrett. How about the big 3?
Mr. McDaniel. I cannot imagine being able to obtain a
satisfactory level of insurance when, in fact, the insurer is
being asked to insure an entire industry over which the
individual firms do not have any control over each other in
terms of their opinions. And I have to at least ask the
question whether this might have the unintended consequence of
reducing quality because to the extent that competitors do not
have any control over each other and one of them is performing
to a lower standard level, there is really not much reason to
form of a higher standard level because one is going to be
liable for the lowest common denominator.
Mr. Garrett. So it might be actually a race to the bottom?
Mr. McDaniel. That would be a question I think should be
considered more carefully in thinking about this, yes.
Mr. Garrett. Okay. And does anybody have an answer on the
volatility aspect as far as the ratings?
Mr. Sharma. The only thing, Mr. Ranking Member, is that it
would treat rating agencies at a different standard than all of
the market participants and as a consequence sort of we will
have to become more--we will have to look at the ratings at the
lower end of the rating categories because they are generally
more volatile. And that will restrict access to capital from
companies that are coming into the market or new and emerging
companies and technologies.
Mr. Garrett. I think there is another aspect, but I see my
time is up, and I appreciate it.
Mr. Donnelly. Thank you. I know the ranking member has a
few more questions. And first Ms. Speier, if you would like a
couple more minutes. Okay. Ranking member.
Mr. Bachus. Thank you. One thing Mr. Gallagher says in his
testimony is that the rating agencies relied on information
provided to them by the sponsor of the RMVSs for instance. But
let us just broaden that. Any time you rely on the company you
are rating for information and you have to do that--I mean,
there has to be a certain level of--you have to rely on them
for the accuracy. Many times when you relied on them, it turned
out that information in hindsight was not correct. Have you--is
there less of a reliance--and I would ask the Big 3 rating
agencies? Have you made any changes there? Or what were the
problems there?
Mr. Joynt. So it was and is our expectation that issuers
and their representative investment bankers in putting together
financings would be doing due diligence on any of the
information they were presenting in order to put together to
finance and market it and sell it.
So we certainly would be relying on that information just
like we rely on public financial statements audited by
accounting firms when we rate IBM and General Motors and other
companies.
So having said that, of course, we are way more cautious
now in thinking about that issue. So--and we are not in a
position to go do that kind of due diligence ourselves on
individual mortgage loans or auto securities and other things.
So we have taken the position that if we are uncomfortable with
the amount of information and the quality of information we are
getting, then we are unwilling to rate.
Mr. Bachus. Okay. That is a reasonable answer. Mr. Sharma?
Mr. Sharma. Mr. Ranking Member, similarly as you said very
appropriately, that this is a whole market share with different
participants and we have to rely on different market
participants sort of fulfilling their accountabilities. So we
do depend on the issuers and the arrangers to give us good
quality data. But we also do adjust our criteria to sort of
reflect the data that we are getting in our decision making.
And if we are not comfortable, we also do not rate it many
times.
Mr. Bachus. Mr. McDaniel?
Mr. McDaniel. Just add to these comments that, again, I
think a cure is to make the information that goes to rating
agencies available through the prospectus offering process to
the investing public. I think subjecting that information to
the standard of Federal securities filings would certainly help
with the voracity and completeness of that information.
Mr. Bachus. I would agree with you there. Are you all
doing--is that--Mr. Gallagher, can you update us on--
Mr. Gallagher. Yes. I think the chairman or some of my
colleagues have spoken publicly recently about an initiative
underway at the Commission to pursue further disclosure by
issuers of all of the relevant underlying information we are
talking about. On September 17th, the Commission took final
action on the rule that Mr. Dobilas has mentioned earlier which
provides that this information be provided to the other NRSROs,
but taking the next step and moving to the public is under
consideration.
Mr. Donnelly. Thank you very much. The Chair notes that
some members may have additional questions for this panel which
they may wish to submit in writing. Without objection, the
hearing record will remain open for 30 days for members to
submit written questions to these witnesses and to place their
responses in the record.
Before we adjourn, the following written statements will be
made part of the record of this hearing: Egan-Jones Ratings
Company; Assured Guarantee U.S. Holdings; Mortgage Bankers
Association; and Commercial Mortgage Securities Association.
Without objection, it is so ordered. The panel is dismissed and
this hearing is adjourned.
[Whereupon, at 5:14 p.m., the hearing was adjourned.]
A P P E N D I X
September 30, 2009
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