[Senate Hearing 110-931]
[From the U.S. Government Printing Office]

                                                        S. Hrg. 110-931




                               before the

                              COMMITTEE ON
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION




                     WEDNESDAY, SEPTEMBER 26, 2007


  Printed for the use of the Committee on Banking, Housing, and Urban 

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               CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania        ELIZABETH DOLE, North Carolina
JON TESTER, Montana                  MEL MARTINEZ, Florida

                      Shawn Maher, Staff Director
        William D. Duhnke, Republican Staff Director and Counsel
                       Dean V. Shahinian, Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                          Jim Crowell, Editor

                            C O N T E N T S


                     WEDNESDAY, SEPTEMBER 26, 2007


Opening statement of Senator Reed................................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     3
    Senator Schumer..............................................     4
    Senator Sununu...............................................     6
    Senator Casey................................................     7
    Senator Brown................................................     8
    Senator Bunning..............................................     9
    Senator Menendez.............................................    10
    Senator Allard...............................................    11
    Senator Martinez.............................................    13


Christopher D. Cox, Chairman, Securities and Exchange Commission.    14
    Prepared statement...........................................    47
John C. Coffee, Adolf A. Berle, Professor of Law, Columbia 
  University School of Law.......................................    27
    Prepared statement...........................................    53
Michael Kanef, Managing Director of the Asset Finance Group, 
  Moody's Financial Services.....................................    29
    Prepared statement...........................................    74
Vickie A. Tillman, Executive Vice President for Credit Market 
  Services, Standard & Poor's....................................    30
    Prepared statement...........................................   108
Lawrence J. White, Arthur E. Imperatore Professor of Economics, 
  Leonard N. Stern School of Business, New York University.......    32
    Prepared statement...........................................   135



                     WEDNESDAY, SEPTEMBER 26, 2007

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:34 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed presiding.


    Senator Reed. Let me call the hearing to order.
    I want to thank Chairman Cox for joining us this morning. I 
particularly want to thank Chairman Dodd and Senator Shelby for 
their leadership on this issue. Both have expressed significant 
concerns about problems with the subprime market and have 
raised serious questions about the role that credit rating 
agencies have played in the current situation.
    According to the FDIC, since the beginning of June 2007 the 
credit rating agencies have downgraded more than 2,400 tranches 
of residential mortgage-backed securities. The recent wave of 
downgrades have caused some investors to lose confidence in 
both the integrity and reliability of these ratings.
    This hearing provides us with an opportunity to examine the 
role of the credit agencies in structured finance products and 
consider their impact on financial markets.
    Back in April I chaired a Subcommittee hearing examining 
the role of securitization, where witnesses testified that 
problems in the subprime asset market area were confined to a 
small part of the market. Of course, since then we have learned 
that the fallout from the subprime turmoil was and is deeper 
and broader than we were led to believe. As a result, it seems 
that securitization not only distributes risk but that it can 
hide it as well.
    Credit rating agencies play a critical role in capital 
markets. The agencies can enhance or reduce investor confidence 
depending on the information they provide. The increasing 
complexity of structured products like mortgage-backed 
securities and CDOs, collateralized debt obligations, and the 
perceived lack of transparency in this investor appears to have 
made investors more dependent on the rating agencies to perform 
quality analysis. In that sense, the agencies have become 
gatekeepers for the multibillion-dollar structured finance 
    Furthermore, the credit rating agencies are the only market 
participants who make it their primary focus to evaluate and 
disseminate information and the importance of their central 
roles is further affirmed and supported by rules such as those 
that are used to determine pension investor guidelines and 
capital requirements for financial institutions. All of these 
factors indicate that the credit rating agencies have 
substantial responsibilities for providing timely and accurate 
information to other market participants.
    With the complexity and volume of new types of securities 
being created, the rating agencies are uniquely situated in the 
process of structuring RMBS products through their close 
interaction with the issuers. These close relationships have 
led many to question the integrity of the process. Former SEC 
Chairman Arthur Levitt has said that the credit rating 
agencies' decreasing dependence on revenues from structured 
finance products creates a conflict of interest that undermines 
their ability to provide fully independent ratings assessments. 
They are, in his words, ``playing both coach and referee in the 
debt game.''
    Finally, Lou Ranieri, the pioneer of MBS, suggested in 2006 
that the mortgage-backed security sector was ``unfettered in 
its enthusiasm'' and ``unchecked by today's regulatory 
    He further stated that ``We have a quasi-gatekeeper in the 
rating services and in the end the SEC is the regulatory of the 
capital market. It is the one who can touch this stuff and make 
a difference.''
    So I am eager here about the SEC's activity in this area.
    Last year, under the leadership of Senator Shelby, Congress 
passed the Credit Rating Agency Reform Act that gave SEC more 
regulatory and oversight authority over credit rating agencies. 
In June 2007, the Commission adopted implementing rules. These 
rules require a Nationally Recognized Statistical Rating 
Organization, an NRSRO, to disclose a general description of 
its procedures and methodologies for determining credit 
ratings. We are interested in learning how the recently adopted 
rules will help address investor concerns.
    Of course, we want to hear from the credit rating agencies 
about why there were so many downgrades of RMBS in such a short 
period of time. We want to know what did they fail to 
anticipate and what have they learned from recent events? How 
are they updating their models to account for changes in the 
market and the complexity of structured products.
    I hope everyone here today recognizes the seriousness of 
this issue. We have been down this road before. After Enron we 
addressed the relationships among corporate managers, auditors, 
and analysts. I worry whether there may have been lessons 
learned with respect to the importance of independent objective 
analysis in those cases which were not recalled in this 
particular situation.
    So steps need to be taken and all options are on the table. 
Ultimately our goal is to strike the right balance between 
voluntary and regulatory actions and, in doing so, to enhance 
and restore investor confidence in the capital markets.
    Before I call on Chairman Cox, I would like to recognize 
Senator Shelby, the ranking member, and other members of the 
Committee for their statements.
    Senator Shelby.


    Senator Shelby. Thank you, Mr. Chairman.
    Until the highly publicized failures to warn investors 
about the impending bankruptcies at Enron, WorldCom, and other 
large companies, credit rating agencies operated under the 
regulatory radar screen for decades in spite of their important 
role in capital markets.
    In recent months, widespread attention has been devoted to 
downgrades of credit ratings on structured financial products, 
particularly subprime residential mortgage-backed securities. 
Numerous reasons have been offered for why the rating agencies 
got it wrong. Some have suggested the rating agencies awarded 
high ratings to curry favor with the large investment banks. 
Others have criticized the rating agencies for playing an 
active role in structuring these complex deals, which presents 
a number of conflict of interest concerns.
    The purpose of this hearing is to explore these and other 
    In the 109th Congress, as Chairman Reed mentioned, the 
Banking Committee conducted a comprehensive review of the 
market in which the rating agencies operate. This investigation 
revealed an extremely concentrated and anti-competitive 
industry. Two of the most profitable public countries in the 
U.S. operated what has been called a partner monopoly, each 
controlling approximately 40 percent of the industry's revenues 
and issuing 99 percent of corporate debt ratings. This virtual 
absence of competition was repeatedly cited as a major factor 
leading to ratings of inferior quality and practices deemed to 
be abusive and anti-competitive. The business model of the debt 
issuers paying for their own ratings also led some to question 
whether the rating agencies could effectively manage the 
inherent conflicts of interest.
    The Committee's examination, culminated in the passage of 
the Credit Rating Agency Reform Act of 2006, as Chairman Reed 
alluded to. The Act is not quite a year old so it is premature 
to judge its impact. Moreover, SEC regulations implementing the 
Act have only been in place for a few months.
    The centerpiece of the Act replaced the opaque SEC staff 
licensing system with a more transparent and open registration 
system that will result, we hope, in a greater number of 
Nationally Recognized Statistical Rating Organizations, or 
    The Act also provided the SEC with broad authority to 
supervise the rating agencies. The Commission may examine 
registered rating agencies for compliance with the rules passed 
pursuant to the Act, such as the management of conflicts of 
interest, adherence to disclosed procedures and methodologies 
for determining ratings and recordkeeping requirements. I look 
forward to hearing about the examinations currently underway, 
the first such exams conducted pursuant to the Act.
    In light of recent difficulties, I would also like to know 
if the Commission has all the authority, Chairman Cox, it needs 
to conduct vigorous oversight of the rating agencies. I 
understand this is a very complex analytical discipline. The 
process of rating structured financial instruments can be 
confusing and very difficult to comprehend.
    What is not difficult to comprehend, however, is the fact 
that some specific ratings were just plain, plain wrong and the 
subsequent downgrading actions by the rating agencies have had 
a serious impact on a significant sector of our financial 
    It is my hope that we will be able to use today's hearings 
to explore what a rating is, what it is not, how it is 
determined, and what leads an agency to change its rating. 
Finally, we will want to hear what went wrong. If there have 
been lessons learned, what are they? And what can be done to 
make sure it does not happen again?
    I would like to thank all of the participants appearing 
here today, especially Chairman Cox. Welcome again to this 
hearing. You spend a lot of time.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Shelby.
    Senator Schumer.


    Senator Schumer. Thank you, Mr. Chairman.
    I want to thank you and Senator Dodd and Senator Shelby for 
holding this timely hearing, and thank Chairman Cox for being 
    I guess we can look at the subprime crisis in two ways, or 
in two parts really. First, how do we deal with the present 
problem, the 2 million homeowners who are likely to go into 
foreclosure? I believe that involves two things: one, finding 
people who can do workouts for the people on the edge of 
foreclosure. There is no one around so for so many of these 
people. Senators Casey, Brown, and I have put $100 million in 
the transportation appropriation to do that but we need more.
    Second, money for financing of these new refinancings. And 
there we are looking, some of us anyway, FHA reform has passed 
this Committee. That will affect a smaller number of homes. But 
getting Fannie Mae and Freddie Mac involved one way or the 
other will make a great sense.
    We also have to look at how to prevent this crisis from 
occurring again, how to prevent the poor people who were taken 
advantage of from being taken advantage of again. To that end 
some of us, I have proposed dealing with the mortgage brokers, 
the unlicensed mortgage brokers, who many of them are fine 
people and many of them are rapacious people who deserve future 
regulation, and punishment in a certain sense, although 
probably there is no law to do it for what they have done. That 
deals with the individual borrower, where the crisis started.
    But there is also the problem of how, with so many of these 
mortgages that were done on a bad basis, that were almost 
impossible to be repaid, that investors just scooped them up. 
And there we have the look, No. 1, at that credit rating 
agencies because you cannot expect an individual investor to 
know the details of these complex regulations, these complex 
packages whether they be mortgages or derivatives or anything 
else. We really depend more and more, as society gets more 
complicated we depend more and more on credit rating agencies.
    And the fundamental question here is what went wrong? What 
went wrong? I met with the head of one of the agencies and they 
were telling me nothing went wrong. I will tell all of the 
representatives of companies that I have worked with and 
defended in the past, they are good New York companies, to say 
nothing went wrong, that is not going to fly. It defies common 
    These were not AAA rated packages, just shown by what has 
happened now. But the point is they were not AAA rated because 
many of the mortgages in them were not repayable to begin with.
    Now maybe the agencies will say it was not our job to do 
that. But that, too, defies what we think a credit rating 
agency should do.
    And so I think we have to explore this. This is one of the 
untold chapters so far in the subprime story, how the risks 
associated with subprime mortgages were underestimated and then 
swept under the rug by eager investors. And that is why this 
hearing is so important.
    One of our witnesses spoke about the potential distorted 
incentives that result from the fact that most--at the Joint 
Economic Committee we had a hearing on this. One of our 
witnesses spoke about the potential distorted incentives that 
result from the fact that most rating agencies are paid by the 
companies they rate rather than by investors who use the 
ratings. Chairman Reed pointed out, I think very aptly, that 
the last crisis we had in terms of accounting problems there 
was the same problem. The accountants were paid by the people 
who were getting the ratings from them.
    And so the question is is this a conflict of interest? 
First the rating agencies market their rating services to the 
issuers who, of course, want better ratings. Could this be 
creating a tendency to inflate ratings in the marketplace?
    And second, rating agencies typically get paid after the 
issuer decides to accept the rating. Well, on its face, that 
one just seems ripe for potential conflicts of interest.
    So when the rating agency has done a thorough objective job 
of rating a security, the issuer can pull its business if it 
does not like the rating. Up until the 1970's, it was pointed 
out at our Joint Economic Committee hearing, all of the 
original credit rating agencies were funded by investors. It is 
the investors that care the most about the independence of the 
credit rating analysis, the integrity of the evaluation of 
credit quality, and the timely review of ratings.
    In the 1970's, a switch in payment structure took place and 
today the bulk of the major rating agencies, rating related 
income now comes from fees charged by issuers. So the question 
looms, should the structure be changed? Or should there be two 
types of agencies out there, one that is paid for by investors 
and one that is paid for by the issuer?
    Are there conflicts of interest in the other model, the 
investor related model? And do those conflicts of interest 
outweigh the conflicts of interest we potentially have seen 
here? We should discuss whether we should promote the entry of 
serious viable investor funded rating agencies to compete 
against rating agencies that are purely paid by the issuers or 
to provide incentives for today's rating agencies to go back to 
their roots and have investors pay for the ratings.
    I do not know the answer to that question. I have not made 
up my mind. But it is certainly worth exploring, both to see if 
we should move to a new model, and also to help us shine a 
light on what went wrong in the past.
    I look forward to the witness's testimony.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Schumer.
    Senator Sununu.


    Senator Sununu. Thank you very much, Mr. Chairman.
    I think, insofar as the credit rating agencies are 
concerned, their role in rating these securities is signaling 
the markets as to what the level of risk inherent in the 
securities is. The markets use that to price the risk.
    What we have seen really over the past 18 months, changes 
in the financial services markets, indicates that in many areas 
of financial services the pricing for risk was inaccurate, that 
there was not an appropriate premium placed on risk. Not just 
in mortgage-backed securities but in other areas of the market 
as well. We have seen the financial services industry and 
financial instruments respond to that.
    What we want to do today is to get a better understanding 
of how the rating services priced or estimated risk in these 
securities, whether they looked at the securities clearly, 
effectively, indifferently in the way that a rating agency 
should and to better understand what the impacts of re-rating, 
downgrading, or upgrading those securities has been. And to 
find out whether the legislation we passed last year will help 
address whatever problems may have existed in the rating 
agencies themselves.
    That was, I think, good legislation. I think it has been 
broadly supported as laying the groundwork for better assessing 
performance of credit rating agencies and also encouraging 
greater competition among credit rating agencies. And those 
that misprice risk or misgrade securities should be punished in 
the marketplace.
    However, I think it is important that we look at this, the 
problems here, with an understanding of what the larger 
fundamental economic problem is. And that is a collapse of the 
housing industry in the real estate market. Housing inventories 
are now at a 10 month supply. It is very likely that those 
inventories will go even higher as the sales situation in the 
housing market further deteriorates. And that, in turn, is at 
least in part what is driving foreclosures, reduction in price 
sales, loss of equity and creating an untenable financial 
situation for hundreds of thousands if not millions of 
    So we want to make sure we do not do anything, even as we 
take all of these steps, we do not want to do anything that 
ultimately will restrict consumer credit where credit should be 
made available and we do not want to discourage the 
securitization of mortgages because that is very important to 
making credit available to those that are trying to purchase a 
home or refinance a home. And we certainly do not want to 
discourage the ability of those who hold mortgages to go to the 
homeowner and work out a modification and write down part of 
that mortage so that someone can stay in their home.
    And bad legislation, bad regulation, could possibly do any 
one or all three of those things. Again, in an environment 
where it is much more likely than not that we are moving from 
10 months of inventory to 12 months of inventory to 14 months 
of inventory over the next six to 9 months, I think we need to 
be very thoughtful and cautious in making any changes to the 
regulatory structure so that we do the right thing for all of 
those that are in the most difficult of situations with regard 
to their homes.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Sununu.
    Senator Casey.


    Senator Casey. Mr. Chairman, thank you very much and I 
appreciate the opportunity to participate in this hearing.
    Chairman Cox, we appreciate your presence here and your 
testimony, which we will hear.
    I have just a brief statement. First of all, with regard to 
what brings us here, which is the crisis that is in the 
subprime problem we have across the country. I think the 
evidence now is irrefutable that this is a real and substantial 
problem for families. But as we know now, it has had an impact 
on credit and other financial measures across the world. So 
this is a major challenge. Part of this challenge is examining 
the role played by and the impact that our credit rating 
agencies have.
    I have to say in a personal way I have had some experience 
dealing with rating agencies as the Auditor General and State 
Treasurer of Pennsylvania. But in particular, when I was the 
State Treasurer, I remember waiting with great anticipation 
about whether or not a rating agency would give an investment 
grade rating to our tuition account program which I was in 
charge of and I had said I would make reforms to. And I could 
not, as a public official, reform or reintroduce that tuition 
account program that so many families depend upon without 
having the seal of approval, so to speak, of a rating agency.
    So I realize that as a public official, and I know I speak 
for probably lots of public officials and agencies, the 
importance we place upon that rating in terms of determining 
whether we can market or certify or at least point on a 
positive note to a program. So it is critically important and I 
realize the role that those agencies play in our system.
    But I think this question raises--or I should say this 
crisis raises some real questions about conflict of interest. 
It raises questions that we also encountered, I think our 
country encountered, in the lead up to the enactment of 
Sarbanes-Oxley. Like what happens when an entity is doing 
consulting services for entities that are involved with or seek 
ratings from that same entity?
    There are a lot of questions and we will be asking those 
today. But I think even, Senator Shelby mentioned the fact that 
the Credit Rating Agency Act is only a 2006 act. So we should 
not be precipitous in our judgments.
    But I think that when an act is in place, even for a year, 
I think it bears scrutiny and examination, especially in light 
of this crisis. So we want to make sure, Chairman Cox, that you 
have the resources that you need and also the authority that 
you need. We may determine that the authority is substantial 
and adequate but we want to make sure that that is among the 
many questions that we ask of you today and ask the panel that 
will follow you.
    Thank you very much.
    Senator Reed. Thank you very much, Senator Casey.
    Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you. I do not have a 
statement and look forward to Chairman Cox's testimony, as well 
as our witnesses on the second panel.
    Thank you.
    Senator Reed. Thank you very much.
    Senator Brown.


    Senator Brown. Mr. Chairman, thank you. Senator Shelby, 
thank you. Chairman Cox and other witnesses, it is good to see 
you again, Chris. Thank you for joining us to offer your 
    The Federal Reserve Bank of Cleveland this week held a 
conference in Pittsburgh on how to reclaim vacant properties. 
But the big question on the minds of the hundreds of local 
officials and others attending was where to find the money to 
tear these properties down. It is not just a house here and 
there. Whole neighborhoods in my State and the States many of 
you represent have been devastated. In many areas the only 
workout left is at the business end of a bulldozer.
    Chairman Schumer held a hearing earlier this year that 
focused on one neighborhood in Cleveland. One of the witnesses 
had a chart showing the loans of Argent Mortgage, a top lender. 
The purported value of these properties was two or three times 
the real value of these homes. On paper, the loan-to-value 
ratio for these loans might have been consistently 90 percent. 
But in the real world the ratio was 150 or 180 percent or even 
higher. More than a quarter of the loans Argent made over the 
last 4 years have already resulted in foreclosure.
    The current crisis is not simply the invisible hand at 
work. A lot of very visible hands peddled these loans to the 
people of Cleveland and elsewhere. I doubt that Adam Smith 
anticipated a financial product that was mass marketed and 
designed to fail on a slow fuse. Yet at every hearing on this 
topic we have heard that nobody was at fault. Not the brokers, 
not the lenders, not the issuers, apparently not the rating 
agencies. Evidently, we are witnessing the immaculate 
    I am sorry but, as Senator Schumer said, I do not buy that. 
Everyone is at fault. And everyone includes Congress. Congress 
needs to act quickly to enact the type of borrower protections 
contained in the legislation that Senators Schumer and Dodd 
have introduced. We also need to figure out how to get the 
financial markets to provide faster punishment for bad actors 
through pricing or plain lack of access to capital. It is not 
enough that these companies only go bankrupt because by that 
point they have left a trail of destruction in their path.
    The benefit of structured finance is the dispersion of 
risk. But today responsibility is dispersed, as well. We need 
to figure out to maintain responsibility through both legal and 
economic means.
    I appreciate the ideas that some of today's witnesses have 
suggested. It seems to me we can and we should try to refine 
the data that goes into rating products so that each actor is 
scrutinized on an ongoing basis with those available details.
    It may be, as our witnesses will testify, that it takes 
some time to decide whether an overall trend is in place. But 
it should take much less time to determine the outliers like 
Argent Mortgage and price them out of business.
    We can talk clinically about credit enhancement steps, such 
as the over-collateralization of security, but there is nothing 
excess about that collateral to the homeowner who lives in it. 
We must be much more careful in what we do.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you very much, Senator Brown.
    Senator Bunning.


    Senator Bunning. Thank you, Mr. Chairman.
    First of all, I would like to welcome Chairman Cox, who is 
my good friend.
    As easy as it would be to blame one bad actor in the 
housing markets, that is not the case. Numerous groups 
contributed to the mess, though some contributed more than 
    At the top of the list is the Fed and its former chairman 
and now author, Alan Greenspan. This hearing is not about the 
Fed or its role in the housing bust, but understanding 
Greenspan's Fed monetary policy is key to understanding what 
happened next.
    In 2000, Mr. Greenspan kept raising interest rates in the 
face of a slowdown, driving the market and the economy into a 
recession. In order to undo the problem created by tight money, 
he then went too far the other direction, taking rates as low 
as 1 percent. That easy money encouraged excessive risk-taking.
    Even though Mr. Greenspan knew it would lead to problems, 
he did nothing about it. With mortgage rates dropping to all-
time lows housing became hot and people rushed in. Things were 
going great until about 2005, when rising interest rates and 
housing prices appreciation overcame the abilities of borrowers 
to afford the house they wanted.
    But instead of accepting that the good times were coming to 
an end, borrowers and lenders looked for ways to keep the party 
going. What they found was a breakdown in responsibility and 
common sense by regulators, lenders, investors, brokers, and 
    By 2005 everyone believed they had figured out the way to 
take the risk out of the lending to home buyers, even those 
with poor credit. How was this miracle pulled off? By packaging 
loans into bonds that were given a gold star by the rating 
agencies and sold to investors seeking higher returns. The 
banks, rating agencies, and everyone else in the middle got a 
nice fee and washed their hands of the loans.
    Let me be clear that everyone involved in the process 
shares the blame for today's mess, including the borrowers. But 
we are here to talk about the rating agencies and their roles.
    As I just mentioned, the rating agencies sat right in the 
middle of the scheme and enabled the whole thing to happen. 
Their ratings created a sense of security and gave investors 
the green light to buy mortgage-backed bonds. But oddly enough, 
I find myself in agreement with Chairman Greenspan when he said 
last week that the rating agencies did not know what they were 
doing. The rating agencies simply got it wrong.
    In fact, downgrading of mortgage-backed securities have 
already surpassed the level from the last housing downturn and 
are almost certain to increase further. That kind of mistake 
matters when your decisions are relied on by the entire market.
    Important questions need to be answered. Why and how were 
the rating agencies so wrong? Why did the marketplace rely on 
them so heavily? How much risky lending did the generous 
ratings enable? Can their ratings be relied on in the future?
    Even the rating agencies will admit that their business 
models represent a conflict of interest. They get paid a 
substantial fee by the person wanting to get rated, who then 
uses that rating as a reason to buy their product. That is like 
a movie studio paying a critic to review a movie and then using 
a quote from his review in the commercials.
    Senator Shelby was right when he led this Committee to pass 
the Credit Rating Agency Reform Act last year. Under that act, 
we are finally going to get a look at how the agencies operate 
and how they try to manage their conflict of interest. More 
importantly, the public is going to get information that is 
    Chairman Cox, your Commission has just finished the rules 
and registered the first seven agencies. The information you 
learn from them will help us determine whether further 
regulation is needed or whether the market will be able to take 
their ratings for what they are worth in the future.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Bunning.
    Senator Menendez.


    Senator Menendez. Thank you, Mr. Chairman.
    Well, here we are, 6 months after our first hearing to 
examine the subprime crisis, and we are still seeing the 
effects of the fallout. As far as I am concerned, 
unfortunately, the storm is not over. In fact, in some respects 
it still seems to be picking up wind.
    Home sales dropped yet again last month and yesterday one 
of the Nation's largest homebuilders reported its worst ever 
quarterly earnings. This means much more than a ripple effect 
on our markets. It means Americans are still losing their 
    We still have to get to the bottom of the crisis and, as 
far as I am concerned 6 months into this, time is running out.
    Today we have a chance to examine one piece of the subprime 
puzzle. It is only one piece, however. I will reiterate a point 
I have made before at some other hearings, we have to look 
carefully at everyone who has had a hand in this chain from the 
point a loan is signed by the borrower until it is sold on the 
secondary market.
    The cracks in the system cannot be patched up with a few 
tweaks here and there, and I am convinced that the market 
cannot fix this alone. Until we have uncovered all of the root 
causes of what led to the tsunami in this market, it remains 
ripe for more turmoil.
    As a member of this Committee over the past few months, I 
have heard all of the players duck their responsibility and 
point the finger at anyone but themselves. This has become a 
game of hot potato and it has to stop.
    If you ask me, everyone is responsible and should be held 
accountable. The fact is these loans had a real impact on real 
lives. We are not just talking about lower annual earnings or 
stock prices that have dropped. We are talking about people 
whose dreams have been shattered. We are talking about homes 
being taken away. We are talking about disintegration for some 
of what is, in essence, the American dream.
    And yet no one, no one, is willing to step up and say what 
hand they had in the process. So while I do not believe this is 
just about placing fault I think we cannot lose sight of the 
larger picture, and that is that we still have not gotten to 
all of the root causes of this fallout. I hope the Committee 
will not seek to presume that the marketplace is going to take 
care of all of this. I hope that that will not be the view of 
the committee and that, in fact, we must act.
    Finally, while the credit rating agencies may not be at the 
center of this chain, they are still a link. The question is, 
in my mind, which I hope we will explore today--I certainly 
intend to do--is how much did the credit rating agencies affect 
the process and the end result? Did they provide less than 
accurate information? Did they react too slowly to changes in 
the market? And above all, did they become enablers of the now 
crisis? Did they do so by compromising ratings by potential 
conflicts of interest?
    I am not quite sure how you go about doing the rating and 
then going ahead and advising how to package it so you get the 
best ratings possible. I am not quite sure that that is really 
in the interest of other than those who wanted to package these 
products and get the best possible ratings. I am surely not 
convinced that that was appropriate by any stretch of the 
    So I am looking forward to that testimony to hear how it 
was proper to have the very essence of what would be a conflict 
be pursued as a normal course of business.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Menendez.
    Senator Allard.


    Senator Allard. Thank you, Mr. Chairman.
    First of all, I would like to thank you for holding this 
hearing. Earlier this year we held a Securities Subcommittee 
hearing to learn more about the role of securitization in the 
subprime markets, so we had a very interesting discussion. 
Credit rating agencies came up a number of times at that 
hearing so this will be a good opportunity, I believe, for the 
Committee members to follow up on many of those matters that 
were raised during our Securities Subcommittee meeting.
    Credit rating agencies or Nationally Recognized Statistical 
Rating Organizations play an important role in our financial 
markets. Confidence in those ratings has been shaken following 
a number of downgrades of residential mortgage-backed 
securities. In fact, just in July and August, Standard & Poor's 
issued 1,544 downgrades of residential mortgage-backed 
    The downgrades and lack of confidence have dramatic 
consequences. Besides the direct consequences in the financial 
market, the situation has curtailed securitization, which has 
made it more difficult for families to buy a home.
    Now former Federal Reserve Chairman Alan Greenspan has been 
quoted a number of times. I will give a more complete quote to 
the Committee. He issued a sharp rebuke in a newspaper article 
earlier this week. He said he believes that the volume of 
structured finance products will decrease. He said, and I quote 
``People believed they--'' meaning the credit agencies ``--knew 
what they were doing, and they do not'' said Greenspan. ``And 
then, quoted again, ``What kept them in place is a belief on 
the part of those who invested in that was that they were 
properly priced. Now everyone knows that they were not and they 
know they cannot really be properly priced. ``That is one of 
the things I want to follow up in my question is that last 
    In a foreshadowing of these concerns, Congress enacted the 
Credit Rating Agency Reform Act of 2006. Unfortunately, the law 
is still being implemented. But I am hopeful that once it is in 
place it will foster a stronger more robust system with better 
accountability in order to prevent this situation from 
    At today's hearing we will hear about a number of concerns, 
some that have already been mentioned by my colleagues here on 
the Committee. But I again would like to highlight that what I 
see as a potential Achilles' heel of this entire system is that 
credit ratings are not paid for the work of researching, 
analyzing, and creating a rating. Rather they are paid for the 
actual rating. It does not matter how much work they did or did 
not do that went into determining the rating. It is if the 
client does not like the final rating, they can walk away 
without paying a dime.
    The analogy that I can think of is if you are an accountant 
and you are doing the tax forms for somebody and you do not 
come up with the right tax balance, you would not expect them 
not to pay the accountant. I think if you want credit ratings 
to be accountable, I think you base it on the time and research 
and effort that goes into the program, not on the results and 
whether you like the results or not. So I think we need to 
check into that more closely during this hearing.
    I find this startling, especially when you put into other 
housing market context. For example, just like credit ratings, 
a number of entities rely on appraisals. Lenders use the 
appraisal in underwriting homes. Buyers use the appraisal in 
making their decisions, and so forth. To give the appraisal 
integrity, we value the objectivity of the appraiser. He or she 
is paid for the professional service of appraising a home, not 
just a specific number at the end of the process.
    Similarly, what if home inspectors were not paid for 
conducting the inspection but only for delivering the desired 
report on the end? So there are numerous examples that we can 
use where this is not a desirable business practice.
    So I am hopeful that the FCC will be closely examining this 
issue as part of its ongoing work. We have a good lineup of 
witnesses, I know, that have a great deal to say. And I look 
forward to their testimony.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Allard.
    Senator Martinez.


    Senator Martinez. Mr. Chairman, thank you very much. I will 
be very brief.
    I just wanted to say that I agree with my colleague from 
New Jersey that there is an awful lot of people or entities 
involved in this process. The outcomes are horrible.
    We saw a tremendous wave of home ownership, particularly 
among minority families, first-time home buyers, that are now 
facing the flip side of that coin as they face the potential 
for foreclosure.
    During the good times it is very difficult to focus on the 
problems that exist within the industry and the problems have 
existed and have been obvious. It is very difficult to convince 
anyone that there is broker abuse when the good times are 
rolling. It is equally difficult to convince anyone that RESPA, 
the Real Estate Settlements and Procedures Act, is deeply 
flawed and must be reformed, earnestly performed. Not during 
the good times, no one wants to think about that. We still have 
to look at that. It is part of the ongoing review that we 
should be doing as to all things that need to look in the whole 
    The Government-Sponsored Enterprises have a weak regulator. 
We have known that. These are enormous entities with the credit 
backing, presumed credit backing, of the U.S. Government. They 
can be tremendously at risk. Yet we have a weak regulator 
providing the oversight for these GSEs. We have got to have GSE 
reform. They may be part of the solution to the problems we 
currently face, but GSE reform also must be a part of it.
    So along with that I also believe that the rating agencies 
are part of the process and part of the circle of all that we 
need to examine and look at. I look forward to hearing the 
testimony of the witnesses. I will not prejudge whether, in 
fact, the current crisis is one that can be solved by us here 
in the Congress acting. It may be that, difficult as it is, we 
do not have the power to reverse the excesses of the past 
    But I do look forward to hearing the testimony from the 
witnesses today and probing into this important area of what it 
is we have to review, which includes the rating agencies as 
    Thank you for the hearing, Mr. Chairman and Ranking Member 
Shelby, we look forward to the testimony from the witnesses.
    Senator Reed. Thank you very much, Senator Martinez.
    Chairman Cox, thank you for joining us today and we all 
await your testimony. Thank you.

                      EXCHANGE COMMISSION

    Chairman Cox. Thank you very much, Chairman Reed, Senator 
Shelby, and members of the Committee.
    I am pleased to be here today to discuss the important the 
Securities and Exchange Commission is doing concerning credit 
rating agencies.
    When Congress gave the Commission statutory authority in 
the Credit Rating Agency Reform Act of 2006 to oversee credit 
rating agencies registered with the Commission, you explicitly 
found that Commission oversight would serve the interests of 
investor protection. And that it would foster competition, 
accountability and transparency in the industry.
    The rating agency act grants the Commission broad authority 
to examine all books and records of an NRSRO. This broad 
examination authority permits the Commission to examine every 
NRSRO on a periodic basis for compliance with the Commission's 
new rules governing rating agencies that we put into effect 
since the enactment of the law, including rules addressing 
conflicts of interest and rules prohibiting unfair, coercive or 
abusive practices.
    The law makes it clear that the commission's otherwise 
broad authority does not extend to the regulation of the 
substance of the credit ratings or the procedures and 
methodologies that a ratings agency uses to determine its 
credit ratings. In striking this balance, the legislation gives 
the Commission responsibility for promoting competition in the 
credit ratings industry and for policing ratings agency 
activities, including in particular conflicts of interest, as 
has been mentioned by virtually every Senator speaking this 
    At the same time, the law declares that it is not our role 
to second-guess the quality of their ratings.
    The rating agency act is still just months old and it set 
out an aggressive schedule for implementation. The Commission 
is ahead of that schedule. The SEC proposed six new rules on 
February 2nd of this year, just 4 months after the law was 
signed. We adopted the final rules on May 23rd, months ahead of 
the June 26th--pardon me, more than a month ahead of the June 
26th statutory deadline. And earlier this week the Commission 
issued orders granting registration under the rating agency act 
to seven credit rating agencies. Each of these applications was 
swiftly reviewed, evaluated, and determined within the 90-day 
timeframe specified by the act. As a result these seven new 
registered credit rating agencies are now subject to both the 
provisions of the act and the Commission's final rules 
implementing it.
    In recent months, the credit rating agencies have been 
heavily criticized for their ratings of structured finance 
products, especially subprime residential mortgage-backed 
securities. Critics have faulted the rating agencies for 
assigning ratings that were too high and for failing to lower 
those ratings sooner, as the performance of the underlying 
assets deteriorated.
    There has also been criticism that the agencies have failed 
to maintain appropriate independence from the issuers and 
underwriters of those securities.
    For their part, the rating agencies generally have stated 
that the incidence of mortgage delinquencies in 2006 far 
exceeded their original credit loss expectations. That was 
particularly so, they said, for subprime mortgages. They have 
also point out that in the past their expectations have turned 
out to be more conservative than the actual loss experience. 
They have noted several factors that seemed to have caused the 
unexpected losses this time around, including fraud in the 
mortgage origination process, deterioration in loan 
underwriting standards, and lending standards that became more 
restrictive very quickly, which in turn made it ever more 
difficult for over-leveraged borrowers to refinance.
    As of today, the SEC has not formed a firm view on any of 
these purported reasons that have been advanced by the credit 
rating agencies for what has happened. But we are carefully 
looking into each of them in the context of an overarching 
examination the Commission has begun with respect to these 
rating agencies that are active in rating residential mortgage-
backed securities.
    This examination, which is being conducted on a nonpublic 
basis, was commenced in response to the recent events at the 
mortgage markets. In particular, the Commission is examining 
whether the ratings agencies were unduly influenced by issuers 
and underwriters to publish a higher rating. This examination 
is also focusing on the NRSROs followed their stated procedures 
for managing conflict of interest that are inherent in the 
business of determining credit ratings for residential 
mortgage-backed securities. In this regard, the examination 
will seek to determine whether the rating agencies' role in the 
process of bringing RMBS to market compromised their 
    In addition to the Commission's examination that I have 
just described, the President has requested that the 
President's Working Group on Financial Markets examine the role 
of credit rating agencies in lending practices, how their 
ratings were used, and how the repackaging and selling of 
assets--the securitization process--has changed the mortgage 
industry. As a member of the President's Working Group, the SEC 
is taking a leading role in this study.
    The Commission is also a member of the Credit Rating Agency 
Task Force created by the International Organization of 
Securities Commissions. In that connection, we recently chaired 
an IOSCO meeting at which the rating agencies that are most 
active in rating residential mortgage-backed securities made 
presentations to the SEC and the securities regulators of 
several countries, focused on their role in developing 
structured finance products.
    Mr. Chairman, I appreciate the opportunity to provide this 
Committee with this update on the Commission's oversight of 
credit rating agencies, and I look forward to answering your 
    Senator Reed. Thank you very much, Chairman Cox and let me 
    You make the point that you do not feel the statute gives 
you the authority to examine the substance of the credit 
ratings or the procedures and methodologies. Would you want 
that authority, given the situation we have seen in the 
    Chairman Cox. No, Mr. Chairman, at this juncture it is my 
judgment that you and the Congress have struck a sound balance. 
We have a great deal of authority that we are on the very front 
end of exercising. It may be that more needs to be done in this 
area. We may learn that as a result of our examinations now 
under way.
    But it is very easy to see in the abstract what would 
become of competition, what would become of the market, what 
would become of the substance of the ratings themselves if they 
just disintegrated into following a Government regulation on 
how to do it. There would be no innovation. There would be no 
potential for improvement. Or at least there would be a real 
collar on that because we would have determined a priori here 
is right away.
    Particularly, as Senator Schumer pointed out, in a market 
that is becoming more complex we have got to recognize that the 
statistical models that are used, the stress tests that are 
applied, are constantly being reevaluated and updated, and so 
there has got to be room for that.
    Still whether or not ultimately the business practices, the 
resources that are being applied, and the outputs are all 
within the range that Congress in the law and the SEC in 
practice consider reasonable, I think do fall within the 
statutory authority that you have given us.
    Senator Reed. Mr. Chairman, among your responsibilities, 
and you listed how aggressively you have been pursuing them, 
which is to try to prevent self-dealing and conflict of 
interest which I think is appropriate, but it seems to me, too, 
you have to have an interest in--as the statute describes--that 
these agencies are consistently producing credit ratings with 
    How do you accomplish that unless you are able to go in and 
look at the substance of their procedures and methodologies?
    Chairman Cox. As I say, I think that you and the Congress 
have struck the proper balance here because----
    Senator Reed. We should restrike the balance which I think, 
at least in terms of discussion, that is on the table.
    Chairman Cox. Yes, of course.
    In implementing the law and adopting our rules earlier this 
year and fleshing this out we came to the tentative conclusion, 
similarly, that we have ample authority to disgorge information 
from the credit ratings agencies, to make it public in 
appropriate circumstances so that the market can judge and 
better understand what the methodologies look like, so that 
rather than putting a collar on innovation we have a lot more 
hot white light focused on how this is done. That will affect 
the pricing of the services offered by the ratings agencies 
because we will have, in the marketplace, a better idea of what 
they are worth.
    It will also affect the way that people use the ratings. I 
am sure we will hear soon a full throated defense from the 
rating agencies of what they have done, in part because they 
think people are trying to use the ratings for purposes for 
which they were originally not intended. The more disclosure, 
the more transparency there is here, the better the market is 
going to be able to deal with that.
    Senator Reed. Given the scope of your responsibilities, do 
you have a plan for regular examination of these credit rating 
agencies? And would that examination involve both the Office of 
Compliance and Inspection and the Division of Market 
    Chairman Cox. The very short answer to that question is 
absolutely, yes. The further answer is that we are in the 
midst, as I described, of just such an examination right off 
the bat with the law fresh on the books.
    Senator Reed. What are your instructions to these 
examiners? What are they looking for?
    Chairman Cox. First, they are focused on the bread-and-
butter of what the statute requires of these agencies. We want 
to look at their resources. The threshold questions that we 
also consider at the time, which is very recent, 48 hours ago, 
when we issued an order to register initially these seven 
agencies. Are you a fly-by-night operation or are you serious? 
Do you have the resources that are necessary to do a thorough 
job of this? What kinds of people do you have? What kinds of 
backgrounds and experience do they have? What is your 
management structure and so on? What are your financial 
    Next we move on to conflicts of interest. Those are 
inherent in the business, as has been described here. How do 
you manage those? What are your procedures? We have, in our 
rules, stated ab initio that several things are just flat 
prohibited. We, of course, examine against those and make sure 
that those rules are being followed, that associations between 
the credit ratings agencies and those whose products they are 
rating are either nonexistent or within the rule.
    And then last, we take a look at--although not last in 
importance--we take a look at unfair and abusive practices. 
This stems from the competitive, the pro-competitive charter 
that you have given the SEC.
    We will find, I think, over time, whether or not each of 
our authorities in those three main areas can be embroidered 
sufficiently to give us all of the power that I think you want 
us to have.
    Senator Reed. The possibility exists, given that scheme, 
that if they are reasonably capitalized and their operations 
are funded at an adequate level, and there are no overt 
conflicts of interest, et cetera, but they are consistently 
wrong in their ratings, they would still pass your test.
    Chairman Cox. I think that is theoretically correct. One 
wonders, however, if we are doing a much better job of 
providing transparency, how long that would last in the 
marketplace. How much can you charge for being wrong every 
    Senator Reed. Thank you very much, Mr. Chairman.
    Senator Shelby.
    Senator Shelby. Thank you.
    Chairman Cox, it is my understanding that the SEC never 
intended or expected that the National Recognized Statistical 
Rating Organization concept would become so widely relied upon. 
Given all of the problems we have seen over the years in the 
rating industry, conflicts of interest, a lack of competition, 
questionable ratings quality, abusive practices and so on, is 
it appropriate to reconsider the regulatory reliance on NRSRO 
    Or let me ask it this way: if you were to create a new 
system today would you design it differently? And if so, how 
so? Obviously, the system is flawed.
    Chairman Cox. The answer to the first question is yes. And 
the answer to the second question is almost certainly somewhat 
different because we would have so much benefit of hindsight.
    The reason I say yes so readily to the first question is 
that we are already doing that within the SEC. We are examining 
our own rules to take a look at whether or not the express 
mention and reliance upon the NRSRO concept in our own rules is 
appropriate and what its consequences are.
    This all started out in 1975. It has been an accretion of 
small steps. But it has included the Congress making express 
mention of it in the 1934 act. And so I think all of us in the 
Congress and in the SEC would do well to consider whether or 
not post-enactment of this landmark legislation, in a world 
where we expect there to be more competition and more 
transparency, whether all of that was really taken into account 
in the first instance dating back to 1975 when we first 
introduced this concept for purposes of our net capital rule.
    Senator Shelby. I appreciate that. We all, I believe, 
realize that there is something gone wrong here in the rating 
    Chairman Cox, would you support the forfeiture of an NRSRO 
status, either for all securities or a class of securities, by 
rating agencies that fail to satisfy minimum accuracy 
standards? There is some bad stuff out there.
    Chairman Cox. That is a difficult question to answer the 
way you put it because our authority to revoke registration or 
to limit it derives directly from the statutory language as it 
is written. So if you are asking me whether we would use our 
authority in that way, given the current statute I think it 
would be very difficult.
    If you are asking me whether I would urge the Congress to 
amend the statute to give us more clear authority to do what 
you have suggested, I would say that the answer to that 
question awaits a little more induction. We need to learn a 
little bit more than presently we know on the front end of 
these examinations.
    Senator Shelby. Professor Lawrence White of New York 
University, who will testify on the next panel, says--and I 
quote--``Capital markets have no way of knowing or discovering 
whether there are better, more efficient, and effective ways of 
assessing the creditworthiness of bond issuers.''
    Do you agree with Professor White that there is no more 
test for the rating agencies? Do they lose market share for bad 
performance? Do inaccurate ratings cost the rating agencies 
business? Will a more competitive ratings market, which we 
envision, create more significant ramifications for inaccurate 
    In other words, if people come out with inaccurate 
ratings--and they have, Enron, WorldCom, the subprime debacle--
are they really punished for that? The market punishes most 
people when they are wrong. It seems like the rating agencies 
are getting by and who is getting punished are the people who 
bought these homes, for the most part.
    Chairman Cox. Without question one of the major premises of 
credit rating agency legislation that Congress has just put in 
place is that competition is a remedy to these problems. We are 
now at the beginning of opening up that space to more 
    As a footnote, we should observe that anybody can rate 
bonds but not anyone can be an NRSRO. So using this process we 
will see whether or not the space really does open up. And 
given that we might move from an oligopoly to a more full 
throated competitive market, whether or not the transparency 
that comes along with that--because that is another leg that 
the legislation stands on--also provides discipline, including 
price discipline in the marketplace.
    Senator Shelby. There is no substitute for transparency and 
competition, is it not?
    Chairman Cox. Certainly when we are talking about pricing 
and risk allocation and so on, that is absolutely right.
    Senator Shelby. Thank you. Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator.
    Senator Casey.
    Senator Casey. Thank you, Mr. Chairman. Chairman Cox, thank 
you for your testimony and your service.
    I was struck by the juxtaposition of two parts of your 
testimony just for purposes of my first question. The question 
really focuses on I guess the threshold determination that the 
SEC makes when it seeks to commence an examination of the kind 
we are talking about here with regard to the rating agencies.
    The juxtaposition I am focused on is on page two of your 
testimony, you talk about the criticisms of the rating 
agencies. Your testimony says in part critics have faulted the 
rating agencies for initially assigning rates to those 
securities that were too high. That is one criticism, rates 
that are too high. Second criticism, failing to adjust those 
ratings sooner as the performance of the underlying assets 
deteriorated. That is the second criticism. And the third that 
you site, the third criticism, maintaining appropriate 
independence--or for not maintaining appropriate independence 
from issuers.
    Two paragraphs down you tell us what the Commission will 
examine. You say, in particular the Commission will examine 
whether the rating agencies were unduly influenced by issuers 
and underwriters--which seems to connect to that third 
criticism. And then second, you say the examination will focus 
on whether or not the rating agencies followed their procedures 
for managing conflicts of interest. And it goes from here.
    I guess I have two questions. One is in this case or in any 
case how is that threshold determination made as to what you 
will examine based upon a body of criticism or a body of public 
information or even other information that the SEC has?
    Chairman Cox. The broader canvas of the various criticisms 
that have been made provides the backdrop for what we do. But 
the statute tells us, and our rules that we have adopted in 
furtherance of the statute, tells us precisely in which 
direction to head. That is why we have a focus on managerial, 
financial resources, on the competition piece, unfair and 
abusive practices and on conflicts of interest.
    Senator Casey. So it is the SEC's opinion that when you 
talk about--in terms of what the critics have said--that either 
faulting the rating agencies for assigning too high a rate or 
not adjusting midstream, you think both of those lie outside of 
the statutory authority that you----
    Chairman Cox. No, I think it is clearly within the 
statutory authority to the extent that the reasons that we are 
examining are the cause. If conflicts of interest, for example, 
result in the credit ratings agency being too cozy with the 
person paying and with, therefore, the issuer or the 
underwriter of the security to be rated, and that is the reason 
for the pathology, the particular problem, such as too good a 
rating to start with and not a quick enough adjustment, then we 
would be right down the center lane of what you have authorized 
us to go after.
    Senator Casey. I wanted to ask you about the process. Once 
you make a determination about what you will examine based upon 
your statutory or other regulatory authority, what does the 
process entail from that point? How many people are you 
deploying on this? And what is the process? What is the 
timeline? If you can take us through how this process would 
    Chairman Cox. Certainly. One reason that we were able to 
beat the deadlines that you put in the statute was, watching 
the legislative process, we had fair notice that this might 
actually be signed into law. You had consulted with us during 
the legislative process. So from a budget standpoint, I was 
able to prepare budgets and submit them to the Hill and to OMB 
and the President that contemplate doing this work.
    Certainly for the next fiscal year we are in good shape, no 
surprises here. This is a big priority and we are putting 
people from the Division of Market Regulation, from the Office 
of Economic Analysis and the Office of Compliance, Inspections 
and Examinations on the job.
    I should also add that we are locating many of those people 
not in Washington but in New York, which is the locus of a lot 
of this activity.
    Senator Casey. My time is running out but maybe I will 
submit a question in writing for the record that speaks to this 
balance that I know we have got to strike, and it is a 
difficult balance. But I am wondering whether or not--we are 
out of time but I will just put it in for the record--that 
whether or not at the end of your examination, even if you are 
concerned about and compliant with striking the right balance, 
whether or not the SEC can recommend to these rating agencies 
that even on the question of the ratings themselves or changing 
or altering those ratings midstream, whether or not that is not 
an appropriate role for the SEC to play to make recommendations 
based upon expertise that you could retain or may have residing 
within the Commission.
    I will sketch that question out and send it to you.
    Thank you very much.
    Chairman Cox. Thank you, Senator.
    Senator Reed. Thank you very much, Senator Casey.
    Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Senator Reed and Senator Shelby both mentioned the concern 
about getting the ratings wrong, the degree to which 
inaccuracies in ratings done by the rating agencies should cost 
market share, the degree to which if you are getting the 
ratings wrong there should be some punishment, some discipline 
exercised in the marketplace. But all of that presumes that we 
have good information to determine whether or not they got the 
ratings right or wrong in the first place.
    And I think that is an issue that really has not been 
explored to any large degree in all of these discussions. I 
have the testimony here and there are some numbers about 
default rates and upgrades and downgrades but very little 
comparative information. And we are actually in a position 
where performance can be measured fairly accurately. Because 
these are ratings designed to give an indication of the 
likelihood of default. Over time you can determine whether, in 
fact, the securities went into default or companies, if it is 
an equity, went into default. We can actually measure 
    It would seem to me that it is relatively easy to calculate 
accuracy and performance over time, to disclose that 
information and then to naturally compare it. Compare one 
agency to another. It is I think great, as was indicated here, 
that we have seen the approval of seven agencies and people 
have talked about the need for greater competition in this 
area. But we would want competition to be based on performance. 
But again, competition based on performance requires that you 
have accurate performance statistics out there.
    My question is to what extent does either the SEC or market 
participants have access to historical default rates, accuracy 
for these securities or others rated by the agencies? And is 
that made available in a way that we can compare performance 
from one organization to another over time?
    Chairman Cox. That has not been the case in the past. It is 
now and will be the case in the future as a result of 
legislation, as a result of our rules. This is a very important 
change. Giving the marketplace this better information will, I 
think, provide a great more useful information than people have 
ever had before, which will in turn affect the way that ratings 
are used, the way that rating services themselves are priced, 
and certainly the way that the assets that are rated are priced 
and the risk is assessed.
    Senator Sununu. Will data reflecting accuracy and 
performance be made available across different types of 
securities, asset-back securities, debt instruments, and 
equities, as well?
    Chairman Cox. The ratings performance information is, I 
believe, going to be provided in a way that will make it 
susceptible to a good deal of intermediation by analysts. So 
that not only what you describe but perhaps a lot more 
granularity might be possible.
    Senator Sununu. Who is going to determine the format of 
presentation, the statistics and data that will be made 
available for all companies? In other words, is the SEC 
facilitating this? Or is it happening through the rating 
agencies themselves or through a cooperative effort facilitated 
by a third party?
    Chairman Cox. First, the form NRSRO that is provided under 
our new rules by the rating agencies provides a format--it is a 
forum--for this information. Second, what becomes of that 
information as people manipulate it and add it, subtract it, 
divide it, and so one is up to the marketplace.
    This is, however, an area that I should add, we are going 
to look at and see whether or not we cannot constantly find 
ways to cause the information to be reported in the first place 
so that is more useful to investors. Not only is this the case 
with respect to the way the information is divided up when it 
comes to us, but also the technology that is used to report it. 
We have an overarching initiative to use computer data tags to 
attach to the information so that it can be much more easily 
manipulated than presently any SEC report can.
    Senator Sununu. Is data regarding the rating agencies' 
accuracy for the 2006 class of subprime asset-backed securities 
available now for all of the agencies that rated those 
    Chairman Cox. I believe as a result of registration that is 
the case, but let me inquire and make sure.
    The additional information I can provide, with staff help, 
is that the firms are now making information publicly 
available. But if there is a failure here we will step in and 
make sure that it becomes available.
    Senator Sununu. I will interpret that to mean not quite yet 
but we all hope it is forthcoming. And I appreciate your 
willingness to help. I think that is very important information 
to have as part of the record of this hearing and I look 
forward to seeing it.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you very much.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman. Welcome, 
Chairman Cox. We appreciate your appearance here today.
    On an aside, I had submitted questions from your July 
appearance and have not received them yet. And I hope we can 
get answers soon.
    Chairman Cox. Senator, just to give you some insight into 
our Commission process, I finished with those answers some time 
ago but they go through a Commission-wide process. I will make 
sure that, with your public urging here, that you have those 
    Senator Menendez. Thank you, I appreciate that.
    Mr. Chairman, here we are here 6 years after Enron, long 
after we knew the vulnerabilities that existed surrounding 
credit rating agencies. But it seems that we are, in some 
respects, still at square one. Don't you think that we are 
behind the curve here?
    I know you just came to the Commission 2 years ago and we 
just passed a law last year. But there were other powers the 
SEC had before this bill.
    Chairman Cox. In fact, Senator, the powers that we have and 
had then extend to areas that I think are not the center of the 
action here. Obviously, we have got anti-fraud authority. We 
had some very minor opportunities to get to the real meat of 
this with respect to those, not all, firms who were registered 
as investment advisers because we could examine their books and 
records qua investment adviser.
    But not until this legislation did the SEC have the 
authority to inspect and examine credit rating agencies as 
credit rating agencies.
    Senator Menendez. I look at the report that the Commission 
issued in January of 2003 as required by Sarbanes-Oxley, and it 
is interesting to note on its final page, amongst the three 
major areas: potential conflicts of interest were listed. There 
were three different categories within that context.
    That is 2003. And here we are in 2007 still talking about 
potential conflicts of interest.
    Let me ask you this: do you----
    Chairman Cox. Senator, as you know, the conflict of 
interest piece is a centerpiece of the Credit Rating Agency Act 
and our rules now. And so that is very sturdy authority than 
presently we have. So the registrations that brought these are 
firms within our rules as of 48 hours ago give us authority 
that we just did not have before.
    Senator Menendez. I am only pointing out that in 2003 the 
Commission said that this was a challenge.
    Chairman Cox. Yes, we were aware of the problem.
    Senator Menendez. Four years later either it did not seek 
powers to look at it beyond it, and the Congress did not act 
before then. And so we have actually had warning signs for some 
    Let me ask you this. It seems to me that credit rating 
agencies are playing both coach and referee in the debt game. 
They not only rate these instruments but they also offer the 
issuer help in constructing the product in order to obtain a 
certain rating. For some agencies these structured finance 
deals have accounted for more than 40 percent of their total 
revenues. Isn't that a problem?
    Chairman Cox. It is certainly potentially a problem. If is 
one of the reason that we are examining and it is one of the 
very points that we are examining against.
    Senator Menendez. Let me ask you this: don't we need more 
oversight? Do you believe that you presently have the authority 
to set standards, monitor and evaluate compliance, discipline 
rating agencies for violations including, in the most egregious 
cases, revocation of the SEC recognition? Do you believe you 
have those powers today?
    Chairman Cox. Yes, we do.
    Senator Menendez. In that respect, isn't one of the things 
we should be looking at here is more transparency, the 
disclosure of any services a ratings agency has provided to the 
company in connection with the issuance or rating of debt, 
including any consulting on the structuring of the transaction 
and the amount of fees related to those services that were paid 
to the rating agency? Wouldn't that be something that would be 
    Chairman Cox. Indeed, providing such services in addition 
to ratings would fall within the category of identified 
conflicts of interest. Our current rules require the agency to 
self-identify those conflicts of interest, and beyond that to 
identify the procedures that it has put in place to mitigate 
those conflicts.
    Senator Menendez. So finally, what is your timeline, Mr. 
Chairman? What do you see as the timeframe in which the 
Commission will act so that we can all understand what we 
expect of these credit rating agencies so we do not find 
ourselves in a future debacle of this sort?
    Chairman Cox. The examinations are already underway. And so 
we are talking almost certainly months, not any longer period 
of time. But even during the pendency of the examinations, we 
are going to be learning things in real time. And so I would be 
very pleased to maintain a dialog with this Committee about 
lessons learned on an ongoing basis.
    Senator Menendez. I appreciate that. I think it would be 
helpful for us to know so that we do not wait an inordinate 
period of time if here is something that we can would respond 
    Thank you.
    Senator Reed. Thank you.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    I agree that we need to get more information to the 
investors and I appreciate your answer in that regard. I just 
want to make sure that they have good information.
    If we are talking about subprime loans, doesn't that 
indicate that there is some risk there?
    Chairman Cox. Indeed.
    Senator Allard. Is there a way of the investor knowing what 
portion of the portfolio that they may be investing in is 
    Chairman Cox. Almost certainly the disclosures that would--
certainly, if these are publicly registered debt instruments.
    Senator Allard. How does a company that has subprime loans, 
how do they get some of the higher ratings that we saw say 2 or 
3 years ago?
    Chairman Cox. I think that is very dependant on the facts 
and circumstances. As you know, there are a variety of complex 
instruments that have been and are being designed repackage 
these securities. Diversification of the risk, a combination of 
one type of underlying asset with another, tranching, all of 
these are ways to segment and allocate risk.
    Senator Allard. Does the consumer, when they buy a 
security, do they understand--as a general rule, do they 
understand those factors that go into----
    Chairman Cox. I am sorry, who is the ``they'' in this 
    Senator Allard. This would be your purchaser of stock or 
investor. Let's say the investor.
    Chairman Cox. One certainly would hope and expect so. But I 
think, looking back, it is also empirically true that everyone 
here ended up with something that they did not want or expect. 
And that certainly includes the investors.
    But the rating agencies themselves underestimated the 
default probabilities and they underestimated the loss that 
could occur in the event of default and overly relied, I think 
they have tacitly admitted, on historical data that was 
different from what actually happened in this case.
    The investors, perforce, who relied in part on that, on 
those ratings, were surprised and surely not all of them knew 
beforehand that this is what they were getting into.
    Senator Allard. One aspect that I would bring up is the 
valuation of the home. One of the problems we have had in these 
home failures is that we found that the appraiser--which is 
regulated by the State if they are regulated at all, or in some 
aspects maybe even their reputation is locally determined. And 
sometimes whether a bank uses an appraiser or not depends on 
whether they facilitate that loan being made or not.
    One of the key links is the actual appraisal of the home. 
Is there a way of knowing and identifying whether certain areas 
of the country have a greater problem with appraiser values 
than other parts of the country? And can that be plugged in to 
the evaluation? Do you see that as a problem?
    You understand, I mean, when it is overappraised, your risk 
is higher.
    Chairman Cox. I would imagine, because this is a subject 
that is inherently understandable and knowable, that if such 
data do not already exist, they could be readily compiled. And 
that further, putting together better information on the input 
side would almost certainly help is you aggregate the risk 
information. Senator Martinez earlier mentioned the possibility 
of RESPA reform as a way to improve the inputs.
    Senator Allard. I am not sure that can be readily compiled. 
I am trying to figure out how you can compile that. It can be a 
variable. It can be a pretty extreme variable, I think 
depending on maybe how these markets work out locally. I think 
it may be----
    Chairman Cox. It may not be readily compilable by you or by 
me right now with what is available. But it just strikes me 
that if this were a priority that things could be arranged so 
that it would be subject to ready compilation.
    Senator Allard. The reason I ask is I do want to see us get 
the information to the investor so they know what kind of risk 
that they are taking. One aspect of it is the actual appraisal 
of the property, the home itself. It seems to me like that 
would be very difficult to assess and put together and I see a 
lot a variation happening by region of the country and perhaps 
even from one time period to another time period depending on 
what the dynamics might be in a market in a certain locale.
    Thank you, Mr. Chairman. I see my time has expired.
    Senator Reed. Thank you, Senator Allard.
    Senator Martinez.
    Senator Martinez. Thank you very much, Mr. Chairman.
    Chairman Cox, thank you for being here and it is very fine 
work that you are doing.
    I noticed in your testimony that you mentioned that the 
President has requested the President's Working Group on 
Financial Markets examine the role of credit rating agencies. 
As a member of that Presidential working group, the SEC has 
been taking a lead role in that study. Can you tell us a little 
more about what you are specifically focusing on in that aspect 
of your work?
    Chairman Cox. Yes, the role of rating agencies in the 
process of bringing these securities to market, the overall 
economic impact, and of course, each of the members of the 
President's Working Group has a different perspective on this 
and we have different information. So when we put our resources 
together from the Fed, from the Treasury, from the SEC, and 
from the CFTC, we have a much better picture. And our staff are 
working on aggregating all of that information.
    Senator Martinez. From the SEC perspective, what is your 
focus as you participate in this analysis?
    Chairman Cox. We will be able, certainly, by order of 
magnitude more, post our orders earlier this week, to 
contribute real-time information as a result of what we are 
learning in our examinations.
    Senator Martinez. Thank you, sir. That is all I have.
    Senator Reed. Thank you, Senator Martinez.
    Chairman Cox, thank you for your testimony and for your 
service at the Commission. I am sure we will be involved in 
this issue going forward and we seek your advice and your 
counsel. Please do that.
    Chairman Cox. Thank you very much, Mr. Chairman. The SEC 
looks very much forward to working with you on this issue.
    Senator Reed. Thank you.
    I would now like to call forward the second panel.
    Let me thank all of our witnesses on the second panel for 
joining us today. I would like to introduce them and then call 
upon them individually for their statements.
    All of your statements will be made part of the record so 
you may summarize. In fact, we encourage summaries. I would ask 
you all to try to abide by the 5-minute timeline, so that we 
could engage in questioning after your comments.
    Mr. John Coffee is the Adolf A. Berle Professor of Law at 
Columbia University Law School and Director of its Center on 
Corporate Governance. He is a Fellow at the American Academy of 
Arts and Sciences, and internationally recognized authority on 
securities. He has testified before several Congressional 
Committees, including the Senate Banking Committee. It is good 
to see you back, Professor Coffee. We always welcome your 
presence and your testimony. We greatly appreciate his 
contributions, particularly to the drafting of the Sarbanes-
Oxley Act, and particularly Title V. Thank you, Professor 
    Ms. Vickie A. Tillman is Executive Vice President of 
Standard & Poor's Rating Services. Prior to assuming her 
current position in 1999, Ms. Tillman was Executive Managing 
Director of Standard & Poor's Structured Finance Ratings where 
she had worldwide operational and financial responsibility for 
directing rating activity for all S&P structured finance 
ratings services. Thank you, Ms. Tillman.
    Mr. Lawrence J. White, Dr. Lawrence J. White, is the Arthur 
E. Imperatore Professor of Economics at New York University's 
Stern School of Business and Deputy Chair of the Economics 
Department at Stern. From 1986 to 1989 he served as a board 
member of the Federal Home Loan Bank Board and from 1982 to 
1983 he served as Director of the Economic Policy Office and 
the Antitrust Division at the United States Department of 
Justice. He is currently the General Editor of the Review of 
Industrial Organization and Secretary-Treasurer of the Western 
Economic Association International.
    Mr. Michael Kanef is a Group Managing Director at Moody's 
Investor Services, where he has worked since 1997. He is the 
head of the Asset Finance Group, which is responsible for 
ratings on residential mortgage-backed securities, term asset-
backed securities, and asset-backed commercial paper issued in 
the United States, Canada, and Latin America.
    Thank you all for your presence here today. We look forward 
to your testimony.
    Professor Coffee, please.


    Mr. Coffee. Chairman Reed, Ranking Member Shelby, members 
of the Committee, thank you for inviting me.
    Because you have shown in your questions that this is a 
very informed panel, I am going to delete about five pages of 
background information and get right to the core of my 
    I want to make three proposals. But it summarizes what I 
say in my written testimony to say that the current market for 
debt ratings is one in which there is very little penalty for 
inaccuracy. It is one in which there are strong incentives for 
optimism and grade inflation. There is very little reason to 
downgrade a rating that you have already made. You do that only 
under pain of great embarrassment.
    The result is we have a market in which there is a tendency 
toward rating inflation and toward stale ratings. I am not 
suggesting that there were demons here. I am going to paint a 
picture of the gatekeeper in this market who is under great 
pressure and who is vulnerable to that pressure. And I think 
the proposals have got to look at how to create countervailing 
pressure to make this market more sensitive to the need for 
greater accuracy.
    What is causing this? I give a given number of reasons. But 
one distinctive factor in this market is behaving very 
differently in its rating of corporate bonds versus its rating 
of structured finance products. I think that is because 
structured finance gives new power to the investment banks. 
They are assembling large pools of securitized assets. They are 
repeat players. And they can remove their business if they do 
not get what they like. They have much more power than the 
traditional corporation, which was only 0.01 percent of the 
agency's business.
    Let me document this. The data that the agencies themselves 
are producing show a huge disparity. Moody's data--and I 
congratulate Moody's on presenting this data--Moody's data 
shows that for its minimum investment grade rating, Baa, over a 
5-year cumulative default period ending in 2005 corporate bonds 
that received the minimum investment grade had only a 2.2 
percent default rate. The collateralized debt obligations, 
CDOs, had a default rate of 24 percent. They both got the same 
rating. That is a ratio of over 10 to one.
    Now Moody's tells me, quite properly, that maybe 2005 was 
aberrational and they suggested we look at 2006. On that basis 
the ratings changed slightly. The corporate debt credit default 
rate for Baa was 2.1 percent and the defaults rate for CDOs was 
17 percent.
    I do not care whether you look at the 24 percent default 
rate or the 17 percent default rate, this was a default rate on 
securities labeled investment grade. And that means to each 
Senator who is here that there were public pension funds in 
your jurisdiction, there were also other institutional buyers, 
universities, hospitals, charities, who are thinly staffed and 
rely on, live or die on--perhaps improperly, perhaps too 
casually--whether or not the securities had an investment grade 
rating. That is all they are checking before they buy. The 
market may efficiently price these, but there are 
unsophisticated debt purchasers who are taking more risk than 
they intend because they are buying investment grade ratings 
that have a default rate that would be extreme for a junk bond. 
That is the current problem.
    What can we do? I will also give you one other fact. These 
gatekeepers are subject to great pressure. Moody's has told the 
Wall Street Journal, which quoted this just a month ago, that 
when they downgraded debt ratings in July of 2007 this year 
they experienced a market reaction. Their market share in 
residential real estate-backed CDOs went from 75 percent to 25 
percent. That means there is extreme pressure on this kind of 
gatekeeper and it is going to keep them from downgrading 
properly and it gives you stale ratings.
    What should be done? I want to make three quick 
suggestions. One, picking up on what has already been 
suggested, I think the SEC should compute the default rates 
using its own criteria, not letting the agencies do it 
themselves because they will all use different criteria. It 
should publish this on a computer screen on a real-time basis 
so for each asset class and for each investment grade we will 
see ratings that the SEC has verified.
    What am I trying to do? I am trying to establish a 
competition based on quality and accuracy. I am trying to 
create a reputational penalty and embarrassment cost because 
that is the only sanction we can really use easily.
    Second, I would suggest, as Senator Shelby already has 
suggested, that NRSRO status should be forfeitable for extreme 
inaccuracy. If the debt rating should be 3 percent default rate 
and you have a 20 percent default rate, I would suggest that at 
some level, whether it is 6 percent, 10 percent, or 12 percent, 
being outside that boundary could cost you your NRSRO status. 
You forfeit it until you get it back.
    The last point in just 5 seconds, the real hope in this 
field might be the entry of new competitors who are based on a 
subscription-funded system, not an issuer-funded system. They 
face an obstacle. They cannot get data from issuers. Corporate 
issuers do not want to deal with people they have not hired. 
They like their friendly allies. I would protect the new 
competitors who can play a useful watchdog role by extending 
Regulation FD, Regulation Fair Disclosure, so that if a company 
gave any data to an NRSRO rating agency, it would have to give 
the same data to all other NRSRO rating agencies. That is the 
way to protect the independence of the process and protect the 
objective new input. None of these are costly or intrusive.
    I will leave you on that note.
    Senator Reed. Thank you, very much, Professor Coffee.
    Mr. Kanef.


    Mr. Kanef. Good morning, Chairman Reed, Ranking Member 
Shelby, and members of the Committee.
    I am pleased to be here on behalf of my colleagues at 
Moody's Investors Service to speak about the role rating 
agencies play in the financial markets and to discuss some of 
the steps that we believe rating agencies and other market 
participants can take to enhance the effectiveness and 
usefulness of credit ratings.
    Moody's plays an important but narrow role in the 
investment information industry. We offer reasoned independent 
forward looking opinions about relative credit risk. Our 
ratings do not address market price or the many other factors 
beyond credit risk that are part of the investment 
decisionmaking process and they are not recommendations to buy 
or sell securities.
    Let me briefly assess the subprime mortgage market which 
has been part of the broader residential mortgage market for 
many years. While subprime mortgages originated between 2002 
and 2005 have generally continued to perform at or above 
expectations, the performance of mortgages originated in 2006 
has been influenced by what we believe are an unprecedented 
confluence of factors.
    These include three key factors. First, increasingly 
aggressive mortgage underwriting standards in 2006 and numerous 
sources also indicate that there have been instances of 
misrepresentations made by mortgage brokers, appraisers, and 
    Second, the weakest home price environment on a national 
level since the 1960's.
    And third, a rapid reversal in mortgage lending standards 
which first accommodated and then quickly stranded 
overstretched borrowers needing to refinance.
    Moody's response to these increased risks can be 
categorized into three broad sets of action. First, beginning 
in 2003, Moody's began warning the market about the risks from 
the deterioration in origination standards and inflated housing 
prices. And we published frequently and pointedly on these 
issues from 2003 onward.
    Second, we tightened our ratings criteria, steadily 
increasing our loss expectations for subprime loans and the 
credit protection we looked for in bonds they backed by about 
30 percent between 2003 and 2006. While Moody's anticipated the 
trend of weakening conditions in the subprime market, neither 
we nor most other market participants anticipated the magnitude 
and speed of the deterioration in mortgage quality by certain 
originators or the rapid transition to a restrictive lending 
    Third, we took prompt and deliberate action on specific 
securities as soon as the data warranted it. We undertook the 
first rating actions in November of 2006 and took further 
actions in December 2006 and April and July 2007, and will 
continue to take rating action as appropriate.
    In addition, we are undertaking substantial initiatives to 
further enhance the quality of our analysis and the credibility 
of our ratings. These include enhancing our analytical 
methodologies, continuing to invest in our analytical 
capabilities, supporting market education about what ratings 
actually measure in order to discourage improper reliance on 
them, and developing new tools to measure potential volatility 
in securities prices which could relieve stress on the existing 
rating system by potentially curtailing the misuse of credit 
ratings for other purposes.
    We also continue to maintain strong policies and procedures 
to manage any potential conflict of interest in our business. 
Among other safeguards: at Moody's ratings are determined by 
committees, not individual analysts. Analyst compensation is 
related to overall analyst and overall company performance and 
is not tied to fees from the issuers an analyst rates. And our 
methodologies are publicly available on our website. And 
finally, a separate surveillance team reviews the performance 
of each mortgage-backed transaction that we rate and that 
surveillance is a monthly basis.
    Finally, beyond the internal measures that we undertake at 
Moody's, we also believe that there are reforms involving the 
broader market that would enhance the subprime lending and 
securitization process. These include the Federal licensing of 
mortgage brokers, tightening due diligence standards to make 
sure all loans comply with law, and strengthening and enforcing 
representations and warranties.
    We are eager to work with Congress and other participants 
on these and other measures that could further bolster the 
quality and usefulness of our ratings and enhance the 
transparency and effectiveness of the global credit markets.
    Thank you. I will be happy to answer your questions.
    Senator Reed. Thank you very much.
    Ms. Tillman, please.


    Ms. Tillman. Mr. Chairman, members of the Committee, good 
    I am Vickie Tillman. I head the rating activities at 
Standard & Poor's.
    Recently, there has been much public discussion around 
credit rating agencies and problems in the subprime market and 
I appreciate the opportunity to clarify S&P's role in the 
financial markets, to discuss our record of offering opinions 
about creditworthiness, and to assure you of our ongoing 
efforts to improve.
    While ratings are not guarantees, S&P's record of 
evaluating the credit quality of RMBS transactions is 
excellent. As the chart on page six of my prepared testimony 
demonstrates, we have been rating RMBS for over 30 years. 
During that period of time, the percentage of defaults of 
transactions rated AAA is 0.04 percent. Even our lowest 
investment grade rating, BBB, has a historical default rate of 
only slightly over 1 percent.
    That said, we at S&P have learned some hard lessons from 
the recent difficulties in the subprime area. More than ever we 
recognize that it is up to us to take steps so that our ratings 
are not only analytically sound but that the market and the 
public fully understand what credit ratings are and what they 
are not. Our reputation is our business and when it comes into 
question we listen, we learn, and we improve.
    Credit ratings speak to one topic and one topic only, the 
likelihood that rated securities will default. When we rate 
securities, we are not saying that they are guaranteed to 
repay, but the opposite, that some of them will likely default. 
Even our highest rating, AAA, is not a promise to performance 
but an evaluation of the risk of default.
    Recognizing what a rating constitutes is critical, given 
the recent market turmoil has not been the result of widespread 
defaults on rated securities but rather the tightening of 
liquidity and to a significant fall in market prices. These are 
issues our ratings are not meant to and do not address.
    I want to spend a minute now on how and why ratings change. 
While ratings may not be as volatile as market prices, they are 
not static either. Our view of a transaction can and does 
evolve as facts develop, often in a way that is difficult to 
foresee. Changes in ratings reflect these developments. This 
has been the case with a number of recent residential mortgage-
backed transactions involving subprime collateral. In these 
transactions a number of the behavioral patterns emerging are 
unprecedented and directly at odds with historical data.
    At S&P we have been expressing in publications our growing 
concerns about the performance of these loans and the potential 
impact on these rated securities for the last 2 years. I have 
quoted a number of them in these publications and in the 
written testimony.
    We have also taken action including downgrading RMBS 
transactions more quickly than ever before and updating our 
analysis in terms of increased risk. Moreover, we continue to 
work to enhance our analytical processes by tightening our 
criteria and increasing the frequency of our reviews, modifying 
our analytical models, completing a recent acquisition that 
will help further enhance our analytics and our models, and 
analyzing areas in which we can do more, such as a way to 
enhance the quantity and the quality of the data that is 
available to us.
    We also take affirmative steps to guard against conflicts 
of interest that may arise out of the fact that we, like most 
other major rating agencies, use an issuer pay model. As the 
Committee knows, this issue was thoroughly debated by Congress 
during the consideration of the 2006 act. A number of 
independent commentators, including the head of the SEC's 
Division of Market Reg, apparently agree that any potential 
conflict of interest can be managed.
    At S&P our policies and procedures include the fact that 
analysts are neither compensated based upon the number of deals 
that they rate, nor involved in the negotiation of fees. These 
controls and others are set forth in a code of conduct modeled 
after the IOSCO code. Every employee receives training on this 
code and must attest to its compliance.
    Equally important, S&P has not and will not issue higher 
ratings so as to garner more business. From 1994 through 2006, 
upgrades on U.S. RMBS ratings outpaced downgrades by a multiple 
factor. This pattern would not exist if S&P deliberately issued 
high ratings to please issuers. Nor would we have our excellent 
track record of predicting the likelihood of RMBS defaults if 
our ratings were the subject of undue influence.
    Finally, Mr. Chairman, I would note that the issuer pay 
models helps bring greater transparency to the markets as it 
allows all investors to have real-time access to our ratings. 
Unlike under a subscription model, the issuer pay models allow 
for broader market scrutiny of ratings every day.
    Others have questioned S&P structured transactions that we 
rate. Again, my written statement responds to this point in 
detail but let me make our position clear. S&P does not tell 
issuers what they should or should not do. While we may discuss 
aspects of proposed transactions and our analysis, we do not 
compromise our criteria. Nor could we, as we make our basis 
criteria publicly available and deviations from it would be 
readily discoverable.
    Since my time is running very quick, let me end by 
reiterating our commitment to do all that we can to make our 
analytics the best in the world. Let me also assure you again 
of our desire to continue to work with the Committee as it 
explores developments affecting the subprime market.
    Thank you, and I would be happy to answer any questions you 
may have.
    Senator Reed. Thank you very much.
    Dr. White.


    Mr. White. Thank you.
    Mr. Chairman, Ranking Member Shelby, members of the 
Committee, my name is Lawrence J. White. I am a Professor of 
Economics at the NYU Stern School of Business. I thank you for 
the opportunity to testify this morning. I am pleased to be 
here. I am going to summarize my statement, which in its full 
length is available to you.
    As you have already heard this morning, there is a lot of 
blame to go around. I will not repeat the parties, we basically 
know who they are. The bond rating firms are among them.
    What I want to do is summarize how we got to where we are, 
provide some context, and make a plea to the Committee, to the 
Congress. Let's see what the new legislation can do before we 
enact--before you enact new legislation.
    How did we get here? Back in 1975 the Securities and 
Exchange Commission wanted to establish capital requirements 
for broker dealers, and it wanted to base those capital 
requirements on bond ratings, just as bank and insurance 
regulators had done in earlier decades. But whose ratings 
should be used for these purposes? To its credit, the 
Securities and Exchange Commission recognized the problem of 
the bogus rating agency that might hand out AAA ratings to 
everyone, or DDD ratings to everyone. And so it created the 
NRSRO category.
    Unfortunately, the NRSRO category became a protective ring 
around the incumbent bond rating industry. It protected 
incumbents and restricted entry. As recently as early 2003 
there were only three NRSROs. And the whole process for 
administering the NRSRO regime was exceedingly opaque. Until 
the Enron hearings in early 2002, NRSRO was one of the best-
kept secrets in Washington. Even today it is certainly not a 
household phrase.
    The importance of the NRSRO designation can not and should 
not be understated. Regulated financial institutions across the 
financial sector were and still are required to heed the 
ratings of the NRSROs in deciding what bonds they can and 
cannot hold in their portfolios. In essence, the financial 
regulators have been delegating to third parties, the NRSROs, 
safety judgments about what is or is not appropriate for 
financial institutions' portfolios.
    Because financial institutions are forced to heed the 
NRSROs ratings, the bond markets in general must heed those 
ratings even if they were to believe that the NRSRO ratings 
otherwise have no value.
    Senator Shelby earlier mentioned my earlier statements and 
I will repeat them again. There has been no clean market test 
of whether the NRSROs really are providing value to the 
financial markets under the until very recent regime.
    However, we do have the new legislation that is just 1 year 
old. The implementing registrations are just 3 months old. The 
new law was intended, is intended, to bring down the entry 
barriers in the bond rating business, open up entry, create 
more competition, more alternatives, let different business 
models be out there, and let the financial market participants 
make their decisions as to whose ratings are to be trusted and 
whose are not to be trusted.
    I would have preferred to have gone farther and to have 
gotten rid of the NRSRO category entirely, but I think the 
legislation provides a good start in the right direction.
    Accordingly, I urge the Committee to not enact new 
legislation. First, it would be extremely difficult, if not 
impossible, for legislation to prevent the kinds of mistakes 
that I believe the bond rating firms have made in the recent 
past. And efforts to do so really run great risks of 
stultifying the industry, of distorting the industry, and 
creating new barriers to entry.
    Second, as I just stated, the new legislation should be 
given an opportunity to work. We need to see what new 
competition, real competition, among rating companies with the 
different opportunities, different models, different ideas, 
what that can do. The financial markets, if given the 
opportunities, I think can make good choices.
    And the financial regulators should be given the 
opportunity to rethink this delegation question in light of the 
new market opportunities for bond rating firms with more bond 
rating firms out there.
    So let's see what the recent legislation can do before new 
legislation concerning this industry is considered.
    Thank you again for the opportunity to testify today, and I 
will be happy to answer questions from the Committee.
    Senator Reed. Thank you very much, Dr. White.
    Thank you all for your excellent testimony.
    Let me ask a question to both Mr. Kanef and Ms. Tillman. I 
will begin with Ms. Tillman first.
    You indicate and you take very seriously there is a code of 
conduct in your firm, and the same with your firm. Do you 
believe that independent of whatever we do that, that code of 
conduct should be strengthened in areas, for example post-
employment? When someone leaves your firm and goes directly to 
a client of yours it raises the specter--and frankly, that 
should be obvious.
    Second, we have been told in regard to these particular 
difficult products, structured finance, that the rating 
agencies were not only rating them but they were also helping 
structure them or advising the client as to what they could do, 
which raises I think an inherent conflict. Should those 
functions be totally separate or clearly disclosed or something 
in terms of what you can do today short of new legislation?
    Ms. Tillman. In terms of the first question about 
employment, I mean theoretically, I mean I do not necessarily 
think that that is either right or wrong in terms of whether 
somebody should be restricted.
    From a cost-benefit analysis, being that I do manage the 
ratings business, it may, in fact, have an unintended 
consequence of allowing us to hire the kind of skilled people 
that we need if they know that their career paths are going to 
be limited by where they could next.
    Senator Reed. I think the assumption would be for a 
suitable period of time, as is imposed upon----
    Ms. Tillman. Right. So in general, it is not something 
that, you know, I think could not work. But again, I have not 
thought through what the implications would be relative to the 
    In terms of your second question, relative to structuring 
debt, we do not structure debt, structure the transactions.
    If I can be given a few minutes to sort of explain what our 
role is relative to this. First of all, I would like to make a 
point clear, that our criteria is absolutely transparent to all 
of those in the marketplace. They understand it. they see it. 
The models that we use internally to look at the stress testing 
or look at the probability defaults around the loans that are 
packaged in these, these are readily available in the 
marketplace, as well.
    So there is a lot of understanding around what kind of loan 
characteristics, what kind of stressing we do in the 
    So as the originator originates the loan, the investment 
banker works with the originator to package the loan. They 
already have an idea of what kind of loans they are looking 
for, relative to the way Standard & Poor's looks at the almost 
70 different characteristics, if you will, on every loan that 
is put in a pool.
    Once that is packaged, I think there seems to be a point 
that needs to be made, that this is actually a very 
sophisticated investment community. Most of these bonds, if not 
a majority of them, are sold to institutional investors or had 
been sold to hedge funds who have their own staffs that not 
only look at ratings, which again is only speaking to credit 
risk. But the ratings does not speak to suitability of the 
investment, the pricing of the investment. They have their own 
firms there, their own people that run their models. Or they 
use our models as a benchmark and run their own proprietary 
models before they will make a decision as to whether that is 
an appropriate investment for a particular risk appetite.
    So they go through that process and they present to 
Standard & Poor's a package of pooled securities----
    Senator Reed. Let me just get to the point, because my time 
is limited.
    Ms. Tillman. I am sorry.
    Senator Reed. So there is no collaboration between Standard 
& Poor's and the issuer, in terms of how the product is 
structured? That you simply take what they present you, 
evaluate it, and give a rating?
    Ms. Tillman. We have a great dialog. We have an open dialog 
with the investment bankers. They need to understand what our 
criteria is. We need to understand better what their structure 
is. And if we tell them that it does not fit with our criteria, 
what we do is tell them why it does not fit with our criteria--
    Senator Reed. And how to make it fit.
    Ms. Tillman. No, sir. We do not tell them how to make it 
better. That is up to them to make the determination as to 
whether they want to change the structure, change the pool, 
change the over-collateralization.
    Senator Reed. I appreciate that. I do not want to be abrupt 
but I want Mr. Kanef to get a chance and I have another 
    I think, at least on the surface, there is a suggestion 
here that there is something going on more than simply being 
presented a group of loans or a product, here is our rating, 
take it or leave it. There is this dialog.
    Mr. Kanef.
    Mr. Kanef. Thank you, Mr. Chairman.
    With respect to the first part of your question, I think 
the British actually may call it gardening leave, a period of 
time before you can go to a client. Certainly, I think Moody's 
would be willing to consider such a thing, as well as other 
potential changes to our code if the SEC or yourselves were to 
feel that there were some aspects of that code that were not 
sufficient. Certainly, we would be willing to consider the 
things that you might suggest.
    With respect to your second question, as with S&P, our 
methodologies and models are publicly available and the parties 
that are participants with respect to the structuring of the 
deals, the investment bankers and their clients, are very 
    The process actually plays two important roles, from our 
perspective. The first is we gain additional information from 
the issuers and the investment bankers about their transactions 
that we may not have otherwise known. We also are able to 
provide them with feedback as to the way in which our publicly 
available methodologies, which are very broad, apply to a 
specific set of facts and circumstances.
    I guess the last point I would make--I know you are running 
short on time--is that this process is really very similar to 
the process that occurs on the corporate side, as well. For 
example, a corporation might come to Moody's, that Moody's 
rates, and say I would like to take out a loan for $4 billion. 
Would that have an impact on the rating of my company? And that 
sort of dialog happens across the rating spectrum, not just in 
structured finance.
    Senator Reed. Thank you.
    We will have the second round because of the--I do not know 
about the quality of the questions, but the quality of the 
    Senator Shelby.
    Senator Shelby. Thank you, Mr. Chairman.
    Professor Coffee, Professor White, I want to just 
personally thank you for your incisive and unvarnished 
observations regarding this whole ratings business which is 
obviously flawed and conflicted in many, many ways.
    A recent article by an American Enterprise Institute 
Visiting Scholar, Charles W. Calomiris, and a Drexel University 
Finance Professor, Joseph Mason--you might know them--says, and 
I will quote ``Unlike typical market actors, rating agencies 
are more likely to be insulated from the standard market 
penalty for being wrong, that is the loss of business. Issuers 
must have ratings--'' as you have pointed out ``--even if 
investors such as banks, insurance companies, and pension funds 
do not find them accurate. That fact reflects unique power that 
the Government--'' Dr. White alluded to ``--the Government has 
conferred on rating agencies to act, in a sense, as 
    Do you agree, Professor Coffee?
    Mr. Coffee. I think both Professor White and I agree that 
what the NRSRO rating agency is doing is two things. It is 
providing information and it is providing licensing power. The 
issuer needs that rating, even if the market rating is 
    Senator Shelby. They are delegating the job, in a way, are 
they not? They are delegating their job.
    Dr. White.
    Mr. White. That is thoroughly the phrase that I think is 
correct, delegating to third parties the assessment of the 
safety, of the portfolio, of their regulated institutions.
    Senator Shelby. Do both of you professors agree that credit 
rating agencies have power that no other gatekeeper possesses 
and an NRSRO can sell its services to issuers even if the 
market distrusts the accuracy of its ratings because it is, in 
effect, licensing the issuer to sell its debt to certain 
regulated investors?
    Mr. Coffee. I have said that and I still agree with that.
    Senator Shelby. Do you agree with that?
    Mr. White. Accountants may well have--auditing firms may 
well have similar powers. You said unique. I am not sure this 
is completely unique. But the power to issue that kind of 
license. I think Professor Partnoy, Frank Partnoy, has used 
that phrase of licensing.
    Senator Shelby. Something is wrong in the rating agencies, 
you both would agree?
    Mr. White. Yes.
    Senator Shelby. Mr. Kanef, a former Managing Director at 
Moody's, Mr. Mark Adelson--I am sure you know him--recently 
told, and this has been mentioned here already, told the Wall 
Street Journal that investment banks would take their business 
to another rating agency if they could not get the rating they 
needed. He said, and I quote ``It was always about shopping 
around for higher ratings'' although, he says, euphemisms were 
used for this process such as ``best execution'' or 
``maximizing value.''
    Given the highly lucrative nature of this sector, it has 
been reported that 40 percent of Moody's total revenues last 
year came from structured finance alone, it seems natural that 
the banks would have some leverage over rating agencies eager 
to profit from these deals.
    Could you comment on that?
    Mr. Kanef. Thank you, Senator.
    As an initial point, I would reiterate something that we 
mentioned just previously, which is that our methodologies for 
rating all of these assets are publicly available. They are 
available on our website free of charge. And they are widely 
distributed. So that most parties who have a desire can read 
the way in which we would be rating a transaction.
    Senator Shelby. Is that the methodology where you are 
talking about structured instruments?
    Mr. Kanef. Yes, that is correct, sir.
    Senator Shelby. And is that basically, and you correct me 
if I am wrong in my questioning, where you put some so-called 
better mortgages in a structure with some that are probably 
less desirable a rating, and then you tie them all together and 
you come up with some methodology and say in our judgment this 
is now investment grade ratings?
    I know this is a simplification, but isn't that what you 
    Mr. Kanef. Yes, I guess it is fair to say that what we do 
is explain to market participants and to regulators and others 
the desire to read the pieces, the way in which we will apply 
analysis to derive a rating in structured finance. So that 
would be a review of the pool of assets and a review of the 
legal structure.
    If I could just make one more statement with respect to 
rating shopping, which is the issue that I think you raised 
second, Moody's ratings are driven primarily by the desire of 
the purchasers of securities. We call it a demand/pull model 
where the purchasers of the securities are the ones that are 
requesting the rating. The investment bankers and the issuers 
that we deal with only work with Moody's and the other rating 
agencies that they choose to work with because of the pull from 
the investors.
    If the investors lose faith in the rating agencies 
themselves, that demand goes away and the desire for the 
ratings goes away.
    Moody's has not been shy about stepping away from markets 
in structured finance where we have not been comfortable with 
the risk that we saw. So for example----
    Senator Shelby. Were you comfortable when you issued the 
rating, though?
    Mr. Kanef. I misspoke, Senator. What I mean to say is there 
are whole markets that we have not rated at all, not from 
inception. So for example, the ABCP market, which is the Asset-
Backed Commercial Paper market, in Canada, which we felt had a 
structural flaw in it----
    Senator Shelby. Let's talk about the ones in the U.S. that 
you have rated and profited by rating and then you become 
uncomfortable later when you see that a lot of those mortgages 
are non-performing; is that correct?
    Mr. Kanef. Yes, sir. The ratings are not static statements 
of opinion. The ratings are made at inception as a forward-
looking opinion of the credit risk inherent in a transaction 
and in the securities issued pursuant to that transaction. As 
in any forward-looking opinion, as the facts that the opinion 
was based upon change, the rating changes as well.
    In fact, we view our role as participants in the market to 
provide current up-to-date rating opinion to the market. So 
when we see changes in the market, either changes in economic 
situations or changes in performance, that were not initially 
anticipated, we change the ratings to communicate that to the 
    Senator Shelby. Does it ever bother you in any way that the 
people that you rate these for pay you for rating them? I mean 
that is an obvious conflict to a lot of people that study 
    Mr. Kanef. We acknowledge at Moody's that there is a 
    Senator Shelby. There should be a better way, should it 
not? In other words, there has got to be a better method of not 
paying you to rate bonds and you profit from it and then people 
now are holding the bag, so to speak, and will so in the 
    My last question to you, because I hope I will be around 
for another round but I am not sure. And I have some questions 
for the record.
    Did it bother you when you were looking at these structured 
mortgages, so to speak, so many subprime, that a lot of these 
mortgage rates would be reset in 2 years, more than likely 
upward rather than downward, they generally always are? And 
that payments consequently to an individual borrower would go 
    Now having realized that a lot of people pay very little, 
if anything, down on these mortgages, having realized or should 
have realized that the credit of a lot of these people was kind 
of spotty to begin with, does it not defy common sense to think 
that a lot of these mortgages would not go into default, if not 
before they were reset, but certainly after they were reset? 
Because a lot of these people are working folks all over 
America that I think people have taken advantage of.
    Does that bother you at all? Did it bother you when you 
were rating these things?
    Mr. Kanef. Mr. Chairman, do I have time to answer that 
question? I apologize, Senator. I am just looking at the clock. 
I do not know if I am permitted.
    Senator Reed. You are permitted.
    Mr. Kanef. Thank you, sir.
    Senator Shelby. Are you apologizing to the people that have 
been victimized or are you apologizing for taking the time?
    Mr. Kanef. I am apologizing for taking the time right now. 
But I would like to answer both of your questions, sir.
    The first question you raised was one with respect to the 
conflicts of interest in the issuer pay model, which is the 
model whereby the issuer who is seeking the rating pays for the 
    Moody's acknowledges that there are conflicts in this model 
and we have several procedures and processes in place which we 
believe insulate the ratings process from those conflicts. I 
know that the SEC has newly provided ability to review that and 
comment upon the degree to which we have been successful in 
limiting those conflicts of interest.
    The basis of that is the committee's decision is not an 
individual's decision. So although there will be a lead analyst 
that interacts with an issuer, there is a committee of five to 
eight people who make the determination with respect to what a 
rating is. And the pay for analysts is not tied to the 
individual number of deals that an analyst rates. It is tied to 
the quality of the work that that analyst performs.
    Senator Shelby. But the more deals you handle and the more 
issuers, the more money you get paid; is that right?
    Mr. Kanef. That is fair, but we are a global institution 
    Senator Shelby. That does not mean that you do not get paid 
for what you do.
    Mr. Kanef. That is fair.
    Senator Shelby. And you do not benefit from your conflicts 
of interest.
    Mr. Kanef. The other point that I would make is that the 
other models that have been suggested, including the investor 
pay model, also have conflicts of interest. So for example, if 
you are paid by an investor, the investor may wish for you to 
provide a lower rating which would enable them to receive a 
higher yield on the security issued.
    In addition, if an investor pay model is adopted, the 
benefit of the public good of the rating, the fact that the 
rating is made publicly available to regulators, to 
governments, to other investors, would not necessarily remain 
in place.
    So there are issues with the other forms of payment for 
ratings, as well as the existing one.
    Senator Shelby. My time is up but it seems to me that money 
is trumping ethics in this area of ratings.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Shelby.
    Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    I want to ask both Ms. Tillman and Mr. Kanef a question I 
asked your companies in April of this past year when we had a 
hearing. Do you think you have any responsibility or are in any 
way to be held accountable for the mortgage market meltdown? A 
simple yes or no would do.
    Ms. Tillman. I am not sure it is a simple yes or no, but 
certainly we have stated publicly that the assumptions that we 
used in the 2006 originated deals did not meet the 
expectations. They far exceeded, in terms of early payment 
loss, what happened. I think one thing we do recognize is that 
while we have used historical information to make predictions 
of the future, that we have to find better ways of doing it.
    So we certainly understand that some things did not work in 
our analysis and we are looking into what the root causes are 
and what we can do to improve that.
    Senator Menendez. But not meeting expectations is not the 
same thing as saying you performed in every way as you should 
    Ms. Tillman. I think in terms of the process and the 
procedures that we followed, we did follow. We gave an 
independent assessment of what the probability of default was 
and the risk.
    Senator Menendez. Mr. Kanef.
    Mr. Kanef. I think that with the information that we had at 
the time that we made these ratings, we provided our best 
opinion to the market of the credit risk inherent in these 
    Senator Menendez. So the answer is no.
    Let me ask you this then, you have both discussed changes 
that you have made either to your methodologies or additional 
data that you are collecting to make more informed decisions 
about ratings. If you do not think you had any responsibility--
any responsibility--to contributing to the subprime crisis, 
then why is there a need for change now? Could some of these 
changes have affected a different outcome?
    Mr. Kanef. Senator, the rating process is a continually 
improving one. As we learn new information about the market and 
about the type of information that we have received, we adjust 
our rating process and we continually strive to improve our 
methodologies. In that way we try to ensure that on a going-
forward basis all of the information that we have is 
incorporated in the ratings that we provide.
    Ms. Tillman. I would just agree with Mr. Kanef and say that 
ratings are not static and ratings can be for 7 years, the term 
of maturity over a longer period of time, and things change. 
One of the things that is important to understand is that we 
rate in terms--the initial rating is for the expectation of how 
we think things are going to happen.
    On the surveillance side, we actually get live information 
of is this performing the way our expectations, in fact, 
expected? So it is actual behavior as opposed to what we 
assumed might have happened.
    As those things change, we look into what are the 
challenges associated with it or what are the assumptions that 
we made that are causing these things to perform differently.
    Senator Menendez. Ratings certainly are not static. That is 
for sure. On August 21st Standard & Poor's, in a single day, in 
a single day, cut its rating on two sets of AAA bonds to a CCC 
rating. And Moody's also drastically downgraded in late August.
    That was not a slight shift in a rating. Those were pretty 
massive changes, just like scratching the surface off of a bar 
of gold to find out it is only lead.
    I hope when you talk to us about static that that type of 
action is not the action that you subscribed to in the market 
not being static and that your reviews are not static.
    My main concern, which I still do not get the sense that 
the rating agencies see themselves as having any responsibility 
here, I still do not get that. I did not get it in April, I do 
not get it today.
    How many other gold-plated blocks of lead are out there? 
Are you expecting any more downgrades of this magnitude in the 
coming months?
    Ms. Tillman. To comment, I do not know which security that 
you are referring to. But if it was one called a SIV-Lite, the 
structure of those deals are such that if the value of the 
collateral exponentially changes within a month, then it hits a 
trigger and therefore causes the deal to unwind very rapidly. 
We call it a credit cliff, if you will. So if it does not meet 
the value requirements as expected--and we have not seen that 
happen ever.
    That has got to be one of the first time, and I have been 
in the business for 30 years, that we have seen the value of 
the collateral within a bond change so quickly within 1 month.
    So if that is the one you are thinking about, the way they 
are structured actually has embedded in it a trigger that 
requires the SIV or the SIV-Lite, which is a structured 
investment vehicle, to unwind.
    Senator Menendez. But you did not look ahead to look at the 
value of that----
    Ms. Tillman. Absolutely, we looked at----
    Senator Menendez. So you went from AAA to CCC and so your 
judgment sometime had to be pretty faulty.
    Ms. Tillman. Well, what I am saying is we have never seen 
the value really unwind and deplete as much as it did in a 1-
month period. So we do stress it. We do stress it in terms of 
what happens in the event of this and what happens in the event 
of that.
    Senator Menendez. Let me just follow, if I may----
    Ms. Tillman. In terms of responsibility----
    Senator Menendez. I have only got a minute left. So let me 
follow up where Senator Shelby left off, because I think he 
made some excellent points, and I agree with them.
    If, Mr. Kanef, you have 40 percent of your Moody's total 
revenue last year from structured finance deals, and I listened 
to your answers to these questions, Ms. Tillman, you said we do 
not tell them what to do. We have a dialog. And Mr. Kanef, you 
said we have a feedback.
    Clearly, someone comes to you and in this dialog, in this 
feedback, I assume that there are conversations going on to say 
well, if you did this or if the entity comes to you and says 
what if we did this, then you would say we would do X, in terms 
of rating. Is that a fair assumption?
    Mr. Kanef. Yes sir, I believe it is.
    Senator Menendez. So then the dialog and the feedback goes 
into a process in which the entity is molding how they are 
going to present to you in order to achieve a certain rating, a 
higher rate hopefully for their purposes. Is that not a fair 
    Mr. Kanef. I think, Senator, that that is a fair statement. 
I believe that the question is not to what extent that we are 
responding to an issuer's request for feedback on a proposed 
structure, but what happens to that rating overall over time. 
Again, the demand/pull model that we operate in means that if 
our ratings are not right over a long period of time we will 
not be in business.
    I would suggest to you that we have seen very significant 
adverse economic situations relating to the subprime market 
this year. But for the period from the end of 2001, 2002, 2003, 
2004 and into 2005, in fact, the subprime RMBS ratings that 
Moody's had produced performed significantly better than the 
expectations that we had.
    In fact, even in 2006--and we acknowledge that the economic 
situation, the liquidity situation, and the information that we 
had provided all worked together to cause a very difficult 
situation for those bonds----
    Senator Menendez. Mr. Kanef, it does not take a rocket 
science--and I will stop here, Mr. Chairman.
    It does not take a rocket scientist to figure out that if I 
have no document loans, if I have no down payments, if I have 
ARMs that clearly within the income scheme are not going to 
allow me to be able to meet the future, that that security-
backed instrument is weak in its potential.
    And so I assume that that is part of what you do in your 
analysis. And yes, maybe your analysis changes over time. But 
it is the initial analysis that drives the marketplace, 
certainly at the beginning where the hedge funds decided to go 
and spend a lot of money and then fuel the whole process, even 
though the instruments that were being used were clearly weak 
in terms of its security and its underpinnings.
    I just do not understand why we make it so complicated. It 
seems to me it is pretty simple. It just seems to me that some 
people missed it along the way. And why they missed it is the 
heart of the problem.
    Thank you, Mr. Chairman.
    Senator Reed. Thank you, Senator Menendez.
    I propose several more questions, if my colleagues would 
want to stay, that is fine. We will make this brief.
    Professor Coffee, I was listing to Chairman Cox and he 
seemed to suggest that he would be amenable to posting 
information about performance of the rating agencies. You 
suggested in your testimony that the SEC could calculate a 5-
year cumulative default rate, put it out there, and do it in a 
way to give the market another benchmark for their decisions.
    Mr. Coffee. This is not a radical proposal. Essentially, I 
am saying that sunlight is the best disinfectant. I would like 
to take credit for that line, but I think Justice Brandeis said 
it first.
    What I want the SEC to do, however, is to compute the 
default rate because each rating agency will use different 
methodology and each will be more favorable to it.
    If you just had one screen where we saw the default rates 
on structured finance and a small pension fund out in your own 
State could look at that screen and realize that these seven 
new agencies were rating this below investment grade and the 
old agencies were rating it an investment grade, they would 
have some pause for concern.
    And the default rate really is the output. All I am saying 
is that the proof is in the pudding. And I would like to focus 
us on the output data, what the default rates are, and less on 
the input data, how many hours did you spend agonizing over 
this problem?
    Senator Reed. Given your review of the legislation that 
Senator Shelby authored, they have the authority to do this 
    Mr. Coffee. I thought we had a very interesting sentence of 
dialog in which that question was asked by Senator Shelby of 
Chairman Cox. Chairman Cox said, quite properly in my judgment, 
that it is highly ambiguous.
    The statute is framed in terms of basically input data. 
What were your processes? What were your methodologies? You 
might have great processes, but if you consistently get it 
wrong, I think you should forfeit your status as a NRSRO.
    It is like an umpire who might have great training, but he 
cannot tell the difference between a strike and something that 
is five feet wide of the plate. That is where I think we should 
    Senator Reed. I noticed, in my quick review of the statute, 
is that the agency, the Commission has the authority to 
actually revoke the status if there is not managerial and 
financial resources producing consistent ratings over time.
    Mr. Coffee. That does focus on the input data. It is very 
hard for the agency to prove that you did not have a good staff 
or you did not work hard. I would just say if you are 
consistently wrong, that is a basis for forfeiting your status.
    Senator Reed. So that might be a change, Professor White, 
that you would at least consider?
    Mr. White. Certainly in the old regime I was consistently 
advocating a focus on output rather than inputs. In the new 
regime, if Jack is right that it is going to take new 
legislation, I worry that who knows where new legislation--with 
respect to the bond rating firms and I am only focusing on the 
bond rating firms--would go.
    I think the markets will, with more NRSROs out there, with 
more choices, more alternatives, more opportunity to decide 
what business model, investor pay, issuer pay, I do not know 
who else might pay, let the markets figure this out.
    In the old machine, they could not. They were forced to 
heed the NRSROs. That kind of forced participation, restrictive 
entry, naturally we would expect to see poor results. We would 
expect to see high prices, high profits, sluggish behavior. And 
I think we saw that sort of thing.
    I want to see what a new more competitive regime can offer.
    Senator Reed. Mr. Kanef and Ms. Tillman, again thank you 
all for your excellent testimony.
    One of the issues that was raised, I think by Professor 
Coffee, is the notion that for corporate debentures, corporate 
debt, it is a pretty straightforward analysis. You look at the 
company's sheet. As you mentioned, a company could come to you 
and say if we borrow $5 million what are you going to do? That 
is a pretty straightforward transaction.
    In these new instruments, highly complicated, in fact 
people that I respect suggest that it is very difficult to 
understand even if you devote a lot of time and attention. 
Should there be red flags, i.e. a AAA on a corporate debt of 
Mobil Oil, in the mind of a pension fund, was the same as a AAA 
in one of these esoteric mortgage funds?
    Were you safe in making that sort of its all the same? 
Because frankly, there are hedge funds and private equity 
people that are buying this stuff. But there are also a lot of 
managers of county pension systems and people like former 
Treasurer of Pennsylvania Senator Casey buying this. And they, 
I would assume, rely almost exclusively on well, if it is AAA 
it is the same stuff. I am buying Mobil debentures at AAA and I 
am buying whatever life mortgage company of the world CDOs.
    Was that not--looking back was that something that should 
have been much more clearly designated in your ratings?
    Ms. Tillman. I cannot speak to Moody's statistics on what 
Professor Coffee has outlined. But in the same timeframe that 
Professor Coffee was talking about Moody's statistics, our 
statistics relative to lowest investment grade BBB, in terms of 
its default rate was probably around 2 or 2.5 percent. In that 
same timeframe our corporate ratings default rate were around 
2.5 to 3 percent. So in terms of what we are looking at, we did 
not really see these huge distinctions around the default rates 
of a corporate bond versus a default rate of a structured bond.
    In fact, if you look--and by the way, all the transition 
and default studies that we do are publicly available and have 
been publicly available for a very long time. They do go by 
sector. You can look at a corporate bond default. You can look 
at an ABS, you can look at RBS. We will continue to make sure 
that those are publicly available.
    But if you look at the default rates relative to structured 
debt versus corporate debt, actually structured debt has been, 
since 1978, actually performed better than corporate debt.
    So again I am not--so I will let Mr. Kanef respond to the 
rest of it.
    Senator Reed. But that structured debt, particularly the 
residential structured debt, a lot of that was guaranteed 
mortgage-backed securities by Fannie and Freddie and others.
    Ms. Tillman. No, we actually do not rate those.
    Senator Reed. You do not rate those at all?
    Ms. Tillman. No. We rate the non-agency debt.
    Senator Reed. I want to make sure we are doing apples and 
    Mr. Kanef. Mr. Chairman, could I respond as well, please?
    Senator Reed. Yes, you may. Please.
    Mr. Kanef. As a preliminary matter, our transition studies, 
the studies of what ratings move up or down to, as well as our 
rating default studies, are also publicly available, as is the 
data that underlies those studies. So we make both of those 
things available to the public, as well. So certainly we are 
all for sunshine and disclosure.
    With respect to the total structured finance universe, the 
same item that Ms. Tillman was speaking to, Moody's has a 
similar result. That is if you look at all of the investment 
grade structured finance issuance and you compare that to all 
of the corporate investment grade issuance over I think pretty 
much a 15 year time period going back from the present, you 
find that the overall default rates for the total investment 
grade buckets are very, very similar. So that there are 
differences based on specific product in specific time period. 
But over a longer term you find that, in fact, the performance 
is very similar.
    Senator Reed. Professor Coffee, do you have a comment?
    Mr. Coffee. I do not have any stake in this debate between 
Moody's and Standard & Poor's.
    All I would suggest is if the institutional investor out 
there who does not have its own staff could see the default 
rates disclosed on one SEC screen and could see a 17 percent 
default rate, I do not think they would buy that security at 
any price
    Senator Reed. Let me ask another question about 
methodology, because you have said your methodology is fully 
available on the Web, you can see it. Did anyone ever come to 
you and say your methodology is all screwed up with respect to 
these exotic mortgages?
    For example, I am told that for a long period of time some 
of the NRSROs were not including the debt-to-income of the 
borrowers in their models. Which, to me, is an interesting 
point which now has been reincorporated. So to what extent does 
this public exposure of methodologies actually result in any 
changes or feedback?
    Mr. Kanef. I guess, Senator, I appreciate you raising that 
point because this is something that has been widely reported 
in the press and it is just not a true statement of fact. For 
the record, I would like to correct that.
    Senator Reed. No, that is your role.
    Mr. Kanef. For the subprime RMBS transactions that we rated 
in 2006, for over 99 percent of those transactions we received 
DTI or debt-to-income and we, in fact, considered that in our 
valuation. So I very much appreciate the opportunity to change 
    With respect to your question, though, if I could respond, 
we actually do receive a significant amount of feedback on our 
methodologies, some positive, some negative. We try to 
incorporate that which we feel helps move the process forward.
    Senator Reed. Let me ask another question with respect to 
methodology. Do you similarly publish the methodology of your 
surveillance activities, the frequency of your reviews, the 
information, the specifics? And how detailed is this? If this 
is general, an equation that says we take these five factors 
into consideration, that might be very difficult to match up 
with a specific investment that an investment fund has made or 
a pension fund has made.
    Mr. Kanef. Senator, we do publish, and we have published, 
methodologies of our surveillance process. It is always a 
balance between exactly what to include in that methodology for 
publication to ensure that people actually get to read through 
it. I do not know exactly--I guess I can only say that we do 
make that available and we are certainly willing to discuss 
questions that market participants have about that.
    Senator Reed. Let me ask a final question, because you have 
been very patient. That is, a lot of the criticism has been 
directed against the rating agencies but also against the 
issuers because of the incredible complexity of these 
instruments, with several different tranches including--was 
there any public transparency on the actual instruments you 
were rating?
    Ms. Tillman. Absolutely. I think that is one of the main 
things that we make available is why the different tranches are 
rated a specific way. That goes into the transparency in terms 
of what we provide.
    The other thing I would like to add, and I believe Moody's 
does the same thing but I will let Mr. Kanef speak to himself. 
We have investor counsels, we have issuer counsels, we have 
counsels, we speak to the investment community. And sometimes 
when they are--in terms of what our methodologies so there can 
be a discussion. Again this is away from any transaction so 
that we have a dialog and get input from the community in terms 
of what it is that we are doing.
    In fact, when we are thinking of a major criteria change 
relative to specific types of bonds, we have put out an RFP to 
the community to get input from them, to see what their--and it 
is not just to the investment bankers, it is to a larger 
broader community that extends beyond that in terms of what do 
you think about the way we are thinking.
    Because we cannot operate really insular around a lot of 
the stuff that we are doing. And so that process in itself 
takes on and really is an open dialog around they are more than 
happy to tell us that we are crazy around what our thoughts 
are. They do not hold back. But that dialog, in itself, does 
take place as well.
    Senator Reed. I want to thank you. I think this could go 
longer. The issue is complex and multifaceted. But you have 
been extraordinarily patient and we thank you for your 
attendance and your testimony.
    The record will remain open for an additional week. There 
may be following on questions from my colleagues. If you have 
additional information that you would like to send us, please 
do so.
    At this time, I would adjourn the hearing.
    [Whereupon, at 12:04 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]