[House Hearing, 111 Congress]
[From the U.S. Government Printing Office]

                        RATING AGENCY REGULATION 



                               BEFORE THE


                       INSURANCE, AND GOVERNMENT

                         SPONSORED ENTERPRISES

                                 OF THE


                     U.S. HOUSE OF REPRESENTATIVES


                             FIRST SESSION


                              MAY 19, 2009


       Printed for the use of the Committee on Financial Services

                           Serial No. 111-33

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                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York         PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois          EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York         FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina       RON PAUL, Texas
GARY L. ACKERMAN, New York           DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California             WALTER B. JONES, Jr., North 
GREGORY W. MEEKS, New York               Carolina
DENNIS MOORE, Kansas                 JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts    GARY G. MILLER, California
WM. LACY CLAY, Missouri                  Virginia
JOE BACA, California                 SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts      J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina          JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia                 RANDY NEUGEBAUER, Texas
AL GREEN, Texas                      TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri            PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois            JOHN CAMPBELL, California
GWEN MOORE, Wisconsin                ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire         MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota             KENNY MARCHANT, Texas
RON KLEIN, Florida                   THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio              KEVIN McCARTHY, California
ED PERLMUTTER, Colorado              BILL POSEY, Florida
JOE DONNELLY, Indiana                LYNN JENKINS, Kansas
BILL FOSTER, Illinois                CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana                ERIK PAULSEN, Minnesota
JACKIE SPEIER, California            LEONARD LANCE, New Jersey
JOHN ADLER, New Jersey
JIM HIMES, Connecticut

        Jeanne M. Roslanowick, Staff Director and Chief Counsel
 Subcommittee on Capital Markets, Insurance, and Government Sponsored 

               PAUL E. KANJORSKI, Pennsylvania, Chairman

GARY L. ACKERMAN, New York           SCOTT GARRETT, New Jersey
BRAD SHERMAN, California             TOM PRICE, Georgia
MICHAEL E. CAPUANO, Massachusetts    MICHAEL N. CASTLE, Delaware
RUBEN HINOJOSA, Texas                PETER T. KING, New York
CAROLYN McCARTHY, New York           FRANK D. LUCAS, Oklahoma
JOE BACA, California                 DONALD A. MANZULLO, Illinois
STEPHEN F. LYNCH, Massachusetts      EDWARD R. ROYCE, California
BRAD MILLER, North Carolina          JUDY BIGGERT, Illinois
DAVID SCOTT, Georgia                 SHELLEY MOORE CAPITO, West 
NYDIA M. VELAZQUEZ, New York             Virginia
MELISSA L. BEAN, Illinois            ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin                J. GRESHAM BARRETT, South Carolina
PAUL W. HODES, New Hampshire         JIM GERLACH, Pennsylvania
RON KLEIN, Florida                   JOHN CAMPBELL, California
ED PERLMUTTER, Colorado              MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana                THADDEUS G. McCOTTER, Michigan
ANDRE CARSON, Indiana                RANDY NEUGEBAUER, Texas
JACKIE SPEIER, California            KEVIN McCARTHY, California
TRAVIS CHILDERS, Mississippi         BILL POSEY, Florida
CHARLES A. WILSON, Ohio              LYNN JENKINS, Kansas
JOHN ADLER, New Jersey
JIM HIMES, Connecticut

                            C O N T E N T S

Hearing held on:
    May 19, 2009.................................................     1
    May 19, 2009.................................................    49

                         Tuesday, May 19, 2009

Auwaerter, Robert F., Principal and Head of The Fixed Income 
  Group, The Vanguard Group......................................    11
Dobilas, Robert G., President and Chief Executive Officer, 
  Realpoint, LLC.................................................    13
Joynt, Stephen W., President and Chief Executive Officer, Fitch 
  Ratings........................................................    17
Pollock, Alex J., Resident Fellow, American Enterprise Institute.    19
Smith, Gregory W., General Counsel, Colorado Public Employees' 
  Retirement Association.........................................    21
Volokh, Eugene, Gary T. Schwartz Professor of Law, UCLA School of 
  Law............................................................    15


Prepared statements:
    Kanjorski, Hon. Paul E.......................................    50
    Garrett, Hon. Scott..........................................    52
    Auwaerter, Robert F..........................................    54
    Dobilas, Robert G............................................    58
    Joynt, Stephen W.............................................    70
    Pollock, Alex J..............................................    84
    Smith, Gregory W.............................................    89
    Volokh, Eugene...............................................   123

              Additional Material Submitted for the Record

Kanjorski, Hon. Paul E.:
    Letter from the Association for Financial Professionals......   133

                        RATING AGENCY REGULATION


                         Tuesday, May 19, 2009

             U.S. House of Representatives,
                   Subcommittee on Capital Markets,
                          Insurance, and Government
                             Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 2:08 p.m., in 
room 2128, Rayburn House Office Building, Hon. Paul E. 
Kanjorski [chairman of the subcommittee] presiding.
    Members present: Representatives Kanjorski, Ackerman, 
Sherman, Capuano, McCarthy, Baca, Scott, Klein, Perlmutter, 
Donnelly, Wilson, Foster, Minnick, Grayson, Himes; Garrett, 
Castle, Royce, Biggert, Hensarling, Gerlach, Neugebauer, and 
    Ex officio present: Representative Bachus.
    Chairman Kanjorski. This hearing of the Subcommittee on 
Capital Markets, Insurance, and Government Sponsored 
Enterprises will come to order. Pursuant to committee rules, 
each side will have 15 minutes for opening statements. Without 
objection, all members' opening statements will be made a part 
of the record.
    Today we meet to examine the operations of credit rating 
agencies and approaches for improving the regulation of these 
entities. Given the amount of scrutiny that these matters have 
garnered in recent months, I expect that we will have a lively 
and productive debate.
    The role of the major credit rating agencies in 
contributing to the current financial crisis is now well 
documented. At the very best, their assessments of packages of 
toxic securitized mortgages and overly complex structured 
finance deals were outrageously optimistic. At the very worst, 
these ratings were grossly negligent.
    In one widely reported internal e-mail exchange between two 
analysts at Standard and Poor's in April of 2007, one of them 
concludes that the deals ``could be structured by cows and we 
would rate it.'' I therefore fear that in many instances the 
truth lies closer to the latter option, rather than the former 
    Moreover, if we were to turn the tables today and rate the 
rating agencies, I expect that most members of the Capital 
Markets Subcommittee would agree that during the height of the 
securitization boom, the rating agencies were AA, if not AAA 
failures. Clearly, they flunked the class on how to act as 
objective gatekeepers to our capital markets.
    Along with the expressions of anger, outrage, and blame 
that we will doubtlessly hear today, I hope that we can also 
explore serious proposals for reform. Unless we can find a way 
to improve the accountability, transparency, and accuracy of 
credit ratings, the participants in our capital markets will 
discount and downgrade the opinions of these agencies going 
    One could hope that the agencies would do a better job in 
policing themselves. But if past is prologue, we cannot take 
that gamble. This time their failures were not in isolated, 
case-by-case instances. Instead, they were systemic problems 
across entire classes of financial products and throughout 
entire industries. Stronger oversight and smarter rules are 
therefore needed to protect investors and the overall 
credibility of our markets.
    As a start, the rating agencies must face tougher 
disclosure and transparency requirements. For example, 
investors receive too little information on rating 
methodologies. The financial crisis has illustrated the danger 
flawed methodologies pose to the system. If methodologies 
remain hidden, there exists no check by which to expose their 
    In addition to establishing an office dedicated to the 
regulation of rating agencies within the Securities and 
Exchange Commission, oversight must also focus more intently on 
surveillance of outstanding ratings. The industry has done an 
inadequate job of downgrading debt before a crisis manifests or 
a company implodes. Moreover, we must examine how we can 
further mitigate the inherent conflicts of interest that rating 
agencies face.
    In this regard, among our witnesses is a subscriber pay 
agency. This alternative model is worthy of our consideration. 
At one time, all rating agencies received their revenues from 
subscribers, but they evolved into an issuer pay model in 
response to market developments. I look forward to 
understanding how a subscriber pay agency succeeds in today's 
    Additionally, the question of rating agency liability is of 
particular interest to me. The First Amendment defense that 
agencies rely upon to avoid accountability to investors for 
grossly inaccurate ratings is generally a question for the 
courts to determine, but Congress can also have its say on 
these matters. Much like the other gatekeepers in our markets, 
namely lawyers and auditers, we could choose to impose some 
degree of public accountability for rating agencies via 
statute. The view that agencies are mere publishers issuing 
opinions bears little resemblance to reality, and the threat of 
civil liability would force the industry to issue more accurate 
    In sum, the foregoing financial crisis requires us to 
reevaluate how rating agencies conduct their business, even 
though we enacted the Credit Rating Agency Reform Act just 3 
years ago. As this Congress considers a revised regulatory 
structure in a broader context, this segment of our markets 
also needs to be examined and transformed. By considering 
proposals aimed at better disclosure, real accountability, and 
perhaps even civil liability, we can advance that debate today 
and ultimately figure out how to get the regulatory fit just 
    Now, I will recognize the gentleman from New Jersey for 5 
    Mr. Garrett. And I thank the chairman for holding this 
important hearing today.
    I believe it is critical, as he says, that this 
subcommittee conduct proper oversight of the credit rating 
agencies and examine all of the issues surrounding the role 
that they played, if any, in the lead-up to the Nation's 
current situation.
    I would like to thank all the witnesses of the panel 
attending. Unfortunately, we don't have a representative from 
the SEC. That's the government agency tasked with overseeing 
and regulating the NRSROs here with us to testify.
    And so I feel it's essential that before this committee 
does formally consider any regulatory reforms regarding the 
rating agencies, that we should at some point hear directly 
from the SEC, as to what, if any, additional powers or changes 
they see necessary.
    Over the past decade, we have seen a large increase in the 
role that credit rating agencies have in determining the 
creditworthiness of financial institutions and different type 
of securities. Whether it is corporate, municipal, or 
structured finance, any entity seeking to assure investors of 
the quality of the debt must receive a good grade from one of 
these entities.
    And so investors have become increasingly, and too often 
solely, reliant on the use of these ratings in determining the 
safety and soundness of an investment. This situation, like 
many of the other problems of this financial crisis, has, in 
large part been created by government policy itself.
    For literally hundreds of Federal and State government 
statutes and regulations, there are specific government 
requirements mandating certain grades from approved agencies. 
It is this formal requirement that provides an implicit stamp 
of approval, if you will, to the investors.
    When an investor sees that the government has required a 
specific grade to make a ``safe investment,'' it basically 
reinforces the belief that any investment attaining such a 
grade is a safe investment.
    But to its credit, the SEC recognizes this problem, as 
well, and they are moving to address it. So in December of last 
year, the SEC proposed several new rules, one of which would 
reduce the reliance on the NRSROs' ratings in the SEC's 
    I believe it was Commissioner Casey who had it right when 
she said, ``These requirements have served to elevate NRSRO 
ratings to a status that does not reflect their actual purpose, 
much less the limitations of credit ratings.''
    So Congress really should try to follow suit and reexamine 
all the areas where statutes mandate the ratings of NRSROs. 
Credit ratings are only one piece of the puzzle--I think we'll 
hear that from the panel--in determining creditworthiness. 
Investors must be encouraged to do their own due diligence in 
evaluating issuer credit quality.
    Now, one of the other areas that needs to be addressed is 
increased competition within the industry, and I hear from the 
panel that they may be amenable to that, as well.
    The 2006 Act made a number of significant improvements to 
the process. Unfortunately, the law was just beginning to be 
implemented at the time when the financial system started to 
hemorrhage; and the very worthwhile goals of the 2006 laws, as 
far as fostering more competition, enhancing transparency, and 
increasing accountability may still be achieved.
    So two things I do not think Congress or the SEC should do 
are to eliminate specific types of pay models or prescribe 
exact analytics that NRSROs must use. This would go against the 
intent of the legislation by providing a further reduction in 
competition and increasing investor reliance on the ratings.
    In regards to competition, a recent rule issued that also 
runs contrary to the goals of 2006 is from the Fed, the 
requirement that any securities used as collateral in their 
Term Asset-Backed Securities Loan Facility, the TALF, must have 
an A-1 rating from a major NRSRO. So this major NRSRO term is 
entirely new and refers to the Big Three rating agencies.
    While I assume that the Fed added this requirement due to 
the perceived better quality of the Big Three firms, I would 
remind the Fed that the Big Three rated Lehman, unfortunately, 
as A-1 on the day of bankruptcy.
    Another area in which I would like to see increased 
competition is the manner in which credit quality is 
    And I know that some of my friends on the committee would 
like to demonize credit default swaps as a horrific gambling 
bet made by fat cats smoking cigars and sitting in luxurious 
boardrooms, but the fact of the matter is, credit default swaps 
are actually additional measures of assessing the 
creditworthiness of different corporations or securities, and 
during the height of the financial panic and collapse of many 
major firms, credit default swaps provided a more accurate 
gauge or risk that some of the credit rating agencies.
    So in conclusion, Mr. Chairman, I believe that the 
government must continue to wean investors off being solely 
reliant on credit ratings and encourage them to conduct their 
own more due diligence.
    I do greatly appreciate the chairman holding this very 
important hearing, and I look forward to all the witnesses' 
testimony today.
    Thank you.
    Chairman Kanjorski. Thank you very much, Mr. Garrett.
    You have heard the bells. We have about 5 minutes remaining 
on the first vote. There are three votes. We estimate it will 
take us about 25 minutes.
    So we will stand in recess until we complete those votes 
and reassemble here immediately thereafter.
    Chairman Kanjorski. The committee will reconvene.
    I now recognize the gentleman from New York, Mr. Ackerman, 
for 3 minutes.
    Mr. Ackerman. Thank you, Mr. Chairman.
    This is not the first time that the committee has explored 
the role and the future of credit rating agencies in our 
financial system.
    Time and again, we have heard from the agencies that their 
ratings were really sound, despite the billions of dollars in 
losses that investors realized on so-called AAA rated mortgage-
backed securities.
    I would disagree with them. For mortgage-backed securities 
to collateralized debt obligations and the structured finance 
market, the bond markets, the types of products that receive 
inaccurate ratings in the markets in which those products were 
traded are far too vast to support the argument that the overly 
favorable ratings of 2006 and 2007 were just a fluke. Clearly, 
a systemic approach to the ratings process is needed.
    Mr. Castle and I have introduced legislation that would 
institute such an approach. The bill, H.R. 1181, would require 
the SEC to promulgate rules that would determine the types of 
structured finance investments that are eligible to receive 
NRSRO ratings from credit rating agencies that have been 
designated as nationally recognized statistical rating 
    The bill also defines the credit rating agency to which 
NRSRO-rated finance products must adhere. You cannot accurately 
predict performance of newer products that have no long-term 
track records. That doesn't mean that you can't sell them.
    To be clear, we do not want to stifle creativity, and 
nothing in our bill restricts the ability of originators to 
continue to securitize less predictable or riskier products.
    The legislation permits NRSROs to continue to provide 
ratings for securities that do not meet the proposed NRSRO 
criteria, as long as they are not designated as NRSRO ratings. 
These, you know, are the ratings upon which pension fund 
managers, who are collectively tasked with managing the nest 
eggs of millions of Americans, rely.
    I'm also concerned by the assertion of many of the credit 
rating agencies that their ratings are mere opinions, and 
therefore, are protected by the First Amendment.
    Of course, I might be more inclined to support the 
agencies' position if the companies didn't have an implied 
government license, and by their financial relationships with 
issuers. In my view, the often inappropriately favorable 
ratings that the agencies assign to products issued by their 
clients amounts to nothing more than paid advertisements and 
endorsements, not an expression of opinion.
    I hope that the subcommittee will continue to work towards 
restoring transparency and objectivity to the credit rating 
agencies, as the future of our financial markets depends upon 
    I look forward to hearing from our expert witnesses, and I 
yield back the balance of my time.
    Chairman Kanjorski. The Chair recognizes Mr. Bachus for 3 
    Mr. Bachus. I thank the chairman.
    It's not normally my tendency to be overly critical, but 
I'm going to make an exception in this case.
    I think surely everyone now recognizes that the credit 
rating agencies have failed, and failed spectacularly and 
broadly. Inaccurate rating agency risk assessments are one of 
the fundamental factors, in my opinion, in the global financial 
crisis, and effective correction action must address these 
    As Mr. Ackerman alluded to, the rating agencies say that 
these assessments or ratings are opinions, predictive opinions, 
and I think from a legal standpoint, that's true. But in the 
real world, that's not reality.
    The SEC special examination report of the three major 
credit rating agencies uncovered significant weaknesses in 
their rating practices for mortgage-backed securities, and also 
called into question the impartiality of their ratings.
    As the SEC report detailed, the rating agencies failed to 
accurately rate the creditworthiness of many structured 
financial products. Investors and the government both over-
relied on these inaccurate ratings, which undoubtedly 
contributed to the dramatic collapse of the United States and 
its financial market, or near-collapse.
    In order to avoid future meltdowns, we must return to a 
time where the rating agencies are not deemed a valid 
substitute for thorough investor due diligence. My own view is 
that while the SEC report did not address municipal securities, 
the rating agency practices were also significant factors in 
the problems that plagued municipal issuers.
    The Federal Government must also share the blame for 
fostering over-reliance on rating agencies. The Federal 
Reserve's recent designation of certain rating agencies as 
major nationally recognized statistical rating organizations 
implies a government stamp of approval that does not exist.
    What we have is what I would call, and others have called, 
a government-sanctioned duopoly. I think that's a mistake.
    As we move forward with regulatory reform proposals, the 
committee should consider removing from Federal laws, 
regulations, and programs all references that require reliance 
on ratings. The SEC also should take action to remove similar 
references in its own rules as quickly as possible.
    At a minimum, the committee should consider changing NRSROs 
from nationally recognized to nationally registered statistical 
rating organizations, to further reduce the appearance of 
government support or approval.
    As Mr. Garrett said, I think credit swap derivatives have 
been an accurate predictor of credit risk, and more so than 
credit ratings, and the credit ratings have become almost--
well, I won't go into all that, but what I would say, this 
should give us caution in discouraging the use of credit 
default swaps, and it's critical that this committee doesn't 
restrict these CDS contracts in the marketplace as we consider 
broader regulatory reform.
    Let me close by saying, to say what has occurred in the 
marketplace since 2006 has been volatile and frightening is an 
understatement. Correcting inadequacies of the credit rating 
process is absolutely essential to restoring investor 
    There must be further changes in the current rating system 
to respond to very serious concerns expressed by investors, 
market participants, and policymakers alike.
    I look forward to hearing from the witnesses concerning 
these matters.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Bachus.
    Next, we will hear from Mr. Castle for 2 minutes.
    Mr. Castle. Thank you, Mr. Chairman.
    Credit rating agencies occupy a very important place in the 
world of finance, as we all know. Therefore, I think this 
committee needs to more fully understand things about the 
industry and its practices.
    Our present circumstance leads us to many questions.
    How did the agencies repeatedly miss the mark on structured 
finance products only to have to lower ratings or watch a 
record number of these products default?
    What experience in history did the agencies have with some 
of the products they were rating, and even if their ratings 
were accurate, were subsequent downgrades made public fast 
    What about the relationship the agencies have with company 
management, representatives of the same businesses or products 
they are engaged to rate?
    Investors, governments, broker dealers, investment banks, 
and others all rely upon credit rating agencies to more 
precisely understand credit risk. They have to do a first-rate 
job, Mr. Chairman. However, in some instances, they are the 
problem, or at the very least, part of the problem, and need to 
become part of the solution.
    I recently joined Representative Gary Ackerman, who just 
spoke to this, and reintroduced legislation that proposes 
reforms for the industry.
    Under H.R. 1181, credit rating agencies would only be able 
to give an official rating to asset-backed securities that have 
been sufficiently tested with a proven track record or where 
their performance can be reasonably predicted.
    The SEC would have the authority to strip nationally 
recognized statistical rating organizations of their NRSRO 
designation if the rating agency fails to comply with 
provisions set forth in the legislation.
    We need to address this problem as part of our efforts to 
reform the financial system to ensure financial products are 
adequately examined and restore investor confidence.
    I thank you, Mr. Chairman, and I yield back.
    Chairman Kanjorski. The gentleman from California, Mr. 
Royce, is recognized for 2 minutes.
    Mr. Royce. Thank you, Mr. Chairman.
    You know, the extent to which our entire financial system 
was and continues to be dependent upon the grades issued by 
NRSROs is really remarkable. Rating agency grades are 
incorporated into hundreds of rules, laws, and private 
contracts, and that affects banking, insurance, mutual funds, 
and it affects pension funds.
    By making the agencies' opinions count toward determining 
whether banks had an adequate amount of capital in essence gave 
their opinions a quasi-official status, basically, from the 
    And considering how badly the rating agencies misjudged the 
risks in recent months, the quasi-official treatment of their 
opinions should be reevaluated.
    The Federal Government's over-reliance on the rating 
agencies compounds the market-wide perception that these 
ratings are in some way more than just opinions, and are, in 
fact, the best indicators of risk.
    This signal to the market lessens the perceived need for 
counter-party due diligence that a well-functioning market 
    Both our over-reliance on the major rating agencies and the 
poor performance of these entities during the recent market 
downturn has led me to believe that major reforms to the 
industry are needed.
    I believe Congress should focus on encouraging alternative 
tools to assess potential gains or losses, which would enable 
consumers and institutions to better comprehend investment 
    Further, Federal regulators should reevaluate their 
dependence on these ratings before the Federal Government is 
asked, once again, to dedicate another $13 trillion due to the 
economic consequences of this lack of foresight.
    And Mr. Chairman, again, I thank you for this important 
hearing, and I yield back the balance of my time.
    Chairman Kanjorski. Thank you very much, Mr. Royce.
    Mr. Capuano, for 3 minutes.
    Mr. Capuano. Thank you, Mr. Chairman.
    Mr. Chairman, first of all, thank you for having this 
hearing, and I'm looking forward to both this testimony and 
actually moving some legislation further in the year.
    I haven't been able to go through all the testimony here 
before me, but I know there has been a lot of talk by some that 
somehow the freedom of speech amendment allows people to say 
and do anything they want, and I would respectfully disagree.
    I consider myself a major defender of the First Amendment, 
and I would do whatever I can to maintain the freedom of 
speech. However, I don't think freedom of speech applies when 
you are getting paid. When you are getting paid, you should be 
held to a higher standard. And if you want freedom of speech, 
stop getting paid, write an op-ed in the paper, not a problem. 
Say whatever you want. People can listen to you, or not listen 
to you. That's all well and good.
    But when your words can and do, number one, ask people to 
rely on you and, number two, move markets, I do think you 
should be held to--I think it's unequivocal that you should be 
held to a certain standard. What that standard is, I think 
that's fair.
    I don't think it's fair to say that people can't be wrong. 
Everybody can and is wrong, on a regular basis, and it is a 
hard thing to distinguish between what is simply an appropriate 
and fair and reasonable error of judgment versus some other 
action that might require some reaction.
    So anyway, I'm looking forward to this hearing, Mr. 
Chairman. I thank you very much for doing this, and I actually 
look forward to being able to improve the market for investors 
and to make it so that people can actually rely on the opinions 
of the credit rating agencies.
    Chairman Kanjorski. Thank you very much, Mr. Capuano.
    The gentleman from Texas, Mr. Hensarling, is recognized for 
2 minutes.
    Mr. Hensarling. Thank you, Mr. Chairman.
    We know there are a number of causes of our Nation's 
economic turmoil. Most have their genesis in flawed public 
    To state the obvious, the three major credit rating 
agencies missed the national housing bubble. This doesn't 
necessarily make them duplicitous, doesn't necessarily make 
them incompetent, but it does make them wrong--very, very 
    Unfortunately, many investors, due to legal imperatives or 
practical necessity, relied exclusively on ratings from the 
three largest CRAs, without performing their own conservative 
due diligence.
    We now know that the NRSRO term has been embedded in our 
law, approximately 10 Federal statues, approximately 100 
Federal regulations, roughly 200 State laws, and around 50 
State rules.
    I believe the failure of the credit rating agencies would 
not have generated the disastrous consequences that it did had 
the failure not been compounded by further misguided government 
policies which effectively allowed the credit rating agencies 
to operate as a cartel.
    By adopting the NRSRO system, the SEC has established an 
insurmountable barrier to entry into the rating business, 
eliminating market competition among the rating agencies. 
People assumed, wrongly, that the government stamp of approval 
meant accurate ratings.
    Now, we took a step in the right direction with the Credit 
Rating Agency Reform Act of 2006, but it was too little, too 
    There's a vitally important lesson we must all learn 
regarding implied government backing. We have seen the results 
from the government stamp of approval on Fannie Mae and Freddie 
Mac. We now see the results, the impact of denying a 
competitive market for credit rating agencies.
    We must certainly consider this in a development of a 
potential systemic risk regulator designating specific 
institutions as too-big-to-fail, creating a self-fulfilling 
    Outcomes in the market cannot and should not be guaranteed 
by the government. It causes people to become reliant, 
dependent, and engage in riskier behavior than they otherwise 
    When people believe that the government will perform their 
due diligence for them on the front end, or will bail them out 
on the tail end, this is very dangerous for the investor, and 
disastrous for the Nation.
    I yield back the balance of my time.
    Chairman Kanjorski. The gentleman from Georgia is 
recognized for 2 minutes.
    Mr. Scott. Thank you very much, Mr. Chairman.
    This is a very important and timely hearing.
    As we continue to monitor the current economic climate 
we're in, and look towards solutions and improvements that can 
be made, I believe that this hearing is very, very timely, as 
the credit rating agencies did in fact play a considerable role 
in what has transpired, what will also impact, what transpires 
in the near future.
    Once our financial institutions achieve the desired quality 
grade on a product, it pays the agency for the rating. This 
process, as some claim, is rife with conflict, as they believe 
the agencies are acting as the market regulators, the 
investment bankers, and as a sales force, all the while 
claiming to be providing independent opinions. That's it, the 
problem in a nutshell.
    As these organizations are extremely important to the 
financial world, we should realize they did have a role to play 
in where we are now, but I also want to more intently focus on 
finding some consensus on how to move forward.
    These organizations determine corporate and government 
lending risk, and are an integral part of our financial 
services sector, and as such, I want to ensure we take all 
issues into account, including conflicts of interest, as well 
as the international finance world, in reforming just how we 
rate financial products.
    More examination of these agencies is indeed in order, to 
evaluate the need for improvement, as many have complained that 
the rating agencies did not adequately assess the risky nature 
of mortgage-backed securities.
    The credit rating agencies have grown more powerful over 
the years, maybe more powerful than anyone had really intended.
    However, I do look forward to the witnesses' testimony and 
how their review of and opinions on this subject will shape the 
committee's further review of this issue.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you very much, Mr, Scott.
    We will now hear from the gentlewoman from Kansas, Ms. 
    Ms. Jenkins. Thank you for holding this hearing today, Mr. 
    I am by no means an expert on the topic of credit rating 
agencies, so I'm certainly glad that we have this opportunity 
to learn more about this issue.
    The credit rating agencies' role in the economy is a 
straightforward one. They are to provide independent analysis 
of the quality of various financial assets.
    These agencies, led by Standard and Poor's and Moody's, for 
quite some time have been relied on by the capital markets to 
provide independent, meaningful analysis. Investors relied on 
the supposedly independent ratings, giving these agencies, for 
investment decisions, where a AAA rating had become the stamp 
of approval inferring that the investment was a safe one.
    Over time, the original business model, where agencies were 
paid by the investors, was replaced with a model where the 
agencies were paid by the issuers themselves. Some would say 
this led to an inherent conflict of interest that led to the 
financial collapse that we have been witness to.
    Others have said that, over time, the agencies became 
little more than a mirror of the market's assessment of risk of 
a particular bond, providing minimal additional value.
    The question can also be asked whether ratings replaced 
investor due diligence.
    Thank you, Mr. Chairman. I yield back the remainder of my 
    Chairman Kanjorski. Thank you very much.
    And now we will hear from the gentleman from California, 
Mr. Sherman, for 2 minutes.
    Mr. Sherman. Thank you.
    Most entities will eventually work in their own interest. 
Patriotic speeches and appeals to patriotism only go so far.
    This is an industry that gave AAA to Alt-A, and is as 
responsible for where we are now as anyone else playing on Wall 
    Two things create this self-interest. The industry is 
picked by the issuer, and believes it cannot be sued by the 
investor. One of those two needs to change.
    Now, the public accounting forms are picked by the issuer, 
but they're subject to lawsuits. The auditing firm that audited 
WorldCom doesn't exist anymore. And in the old days, they were 
general partnerships, so 100 percent of all the partners' 
personal equity would be gone. That provided even more 
incentive to provide for a good audit.
    If we're not going to force the firms to renounce any First 
Amendment arguments as a condition for doing business on Wall 
Street, then we need to end the system where they're picked by 
the issuer. Otherwise, there will be a race to satisfy the 
issuer by providing the highest ratings to the issuer and we'll 
get AAA on Alt-A. It won't be mortgages next time, it'll be 
some other kind of bond. And we'll be back here in another 
economic crisis.
    We don't allow the pitchers to pick the umpires. If we did, 
the strike zone would go from the ground to well above the 
head. We cannot allow the issuers to pick the bond-rating 
agencies or the credit rating agencies unless we're going to 
then bring in trial lawyers with instant replay cameras. That 
would assure that the umpires wouldn't cater to the pitchers, 
if they were subject to lawsuits and instant replay. But one of 
those two things needs to change, or the fear of God will 
prevent us from being in this situation with mortgages for a 
few years, but we'll be back here in another semi-depression 
with some other kind of credit instrument.
    I yield back.
    Chairman Kanjorski. Thank you very much, Mr. Sherman.
    I will now introduce the panel, and I want to thank you all 
for appearing before this subcommittee today.
    Without objection, your written statements will be made a 
part of the record. You will each be recognized for a 5-minute 
summary of your testimony.
    First, we have Mr. Robert Auwaerter, principal and head of 
the Fixed Income Group, Vanguard.
    Mr. Auwaerter.


    Mr. Auwaerter. Mr. Chairman, and members of the 
subcommittee, thank you for the opportunity to testify at this 
important hearing.
    I am the head of the Fixed Income Group at Vanguard, which 
is the world's largest mutual fund company.
    Credit ratings provide a useful purpose in the financial 
markets for the small investor. They act as a way to provide a 
standardized way for investors to do an initial screen of 
potential investment choices. For institutional investors, they 
provide instructions to their managers on how to limit risk.
    They also serve a constructive purpose in government 
regulations, the most prominent being SEC Rule 2-A(7) governing 
money market funds.
    Their NRSRO ratings protect investors by limiting the 
funds' ability to chase higher yields through riskier 
securities based on the funds' own subjective assessment. While 
NRSRO ratings serve as an objective and necessary qualification 
for buying a security, on their own, they are not sufficient to 
warrant an investment.
    Importantly, credit ratings are a starting point. Investors 
must do their own analysis when determining the appropriateness 
of an investment.
    Investors choose Vanguard to invest on their behalf in part 
because of our ability to employ significant resources toward 
assessing credit risk in our bond portfolios. In total, 
Vanguard has 25 senior credit analysts with over 400 years of 
cumulative industry experience.
    It's important to recognize that in order to avoid the 
mistakes of the past, 100 percent perfection and accuracy in 
ratings cannot be the goal. However, we believe there's need 
for further regulation of credit rating agencies.
    The focus of these efforts should be on improving the 
transparency and reliability of credit ratings, while at the 
same time controlling disclosing the conflicts of interest that 
exist in all credit rating agency business models.
    For example, the ratings process for corporate borrowers 
must address the need to protect material non-public 
information from being disseminated.
    Currently, issuer-paid credit rating agencies will take 
material, non-public information, such as management forecasts, 
into account in the ratings assessment process.
    We are concerned that proposals which force full disclosure 
of all credit rating material from corporate issuers, including 
non-public information, to all potential credit rating agencies 
will, in the end, end up limiting disclosure to all credit 
rating agencies. Under this scenario, we would expect credit 
ratings to become less reliable, not more reliable.
    However, on the other hand, we're in favor of greater and 
more frequent disclosure by issuers of municipal and structured 
finance securities. Structured finance, and for that matter, 
municipal ratings, are impaired by a lack of transparency of 
key credit rating determinants by the issuer of the security. 
We would like to see greater transparency and disclosure from 
the issuers to the investors as a feature of improved 
    Regardless of the business model, the ratings product must 
be subject to very high standards of independence, diligence, 
and accountability. For that reason, Vanguard supports an 
increase in the authority of the SEC to provide appropriate 
oversight of the NRSROs.
    Improved regulations and oversight should focus on 
transparency and reliability of the ratings process. The NRSROs 
should be subject to regular audits that test compliance to 
internal procedures, the independence of rating actions, and 
the diligence of the ratings process.
    The goal of these should not be to regulate the actual 
ratings, but rather, the process by which the rating agencies 
derive these ratings.
    The NRSRO designations should also be limited to CRAs that 
are in compliance with strict regulatory requirements. There's 
opinion out there that by inducing greater competition to the 
CRA marketplace, rating quality will automatically improve. 
While competition itself can be constructive, it may come at a 
significant cost.
    By artificially leveling the playing field, inducing many 
new participants, the market will be littered with a wide 
dispersion of credit ratings for issuers in structured finance 
    It's very important in designating a credit rating agency 
as an NRSRO that the SEC determines there is sufficient 
analytical and operational resources to perform an appropriate 
level of independent credit analysis. By definition, NRSROs 
should have a wide market appeal, and should not be niche 
rating agencies focusing on narrowly defined segments of the 
    Importantly, under these new rules, the ability to pull an 
NRSRO designation would provide a powerful incentive for 
    Regulators should finally consider creation of a standing 
advisory board comprised of key rating agency constituents. It 
could serve an important role in providing feedback on new 
product types, ratings performance, and regulatory proposals to 
both the credit rating agencies and the appropriate regulators.
    In summary, we think the credit rating agencies serve a 
useful purpose in the market and in government regulations, and 
we support an increase in authority of the SEC to provide 
oversight to ensure that credit rating agencies have the 
appropriate resources and procedures to deliver a ratings 
product that meets very high standards of independence, 
diligence, and accountability.
    Thank you.
    [The prepared statement of Mr. Auwaerter can be found on 
page 54 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Auwaerter.
    Next, we will hear from Mr. Robert Dobilas, president and 
chief executive officer of Realpoint, LLC.
    Mr. Dobilas.

                    OFFICER, REALPOINT, LLC

    Mr. Dobilas. Thank you for the opportunity to participate 
in this hearing.
    The rating agency legislation passed by Congress in 2006 
was an important step forward. It greatly improved the 
regulatory process by which a rating agency can receive a 
national designation from the SEC, and it has in fact increased 
the number of competitors.
    But given the worldwide collapse of the credit markets, and 
the loss of trillions of dollars by individuals, companies, and 
governmental entities, it is now clear that Congress needs to 
take further action addressing the conflicts of interest which 
have arisen in the context of having rating agencies paid by 
the corporations whose debt they are evaluating.
    As the Congressional Oversight Panel has stated, the major 
credit rating agencies played an important and perhaps decisive 
role in enabling and validating much of the behavior and 
decisionmaking that now appears to have put the broader 
financial statements at risk.
    Realpoint uses a different business model than S&P, 
Moody's, and Fitch. We are an independent, investor-paid 
business, which means our revenues come from investors, 
portfolio managers, analysts, broker dealers, and other market 
participants who typically buy a subscription to our services.
    We produce in-depth monthly rating reports on all current 
commercial mortgage-backed securities. Moody's, S&P, and Fitch, 
on the other hand, are paid by the issuers of the securities. 
They are paid substantial upfront fees on a pre-sale basis by 
the corporations selling securities or investment banks which 
are underwriting the sales. The fees can exceed $1 million in a 
single transaction.
    In a word, the results of the issuer-paid business model 
have been miserable. The SEC recently published data showing 
that Moody's has had to downgrade 94.2 percent of all the 
subprime residential mortgage-backed securities it rated in 
2006. This is the equivalent of a major league baseball player 
striking out 19 out of 20 times at bat. We see a similar trend 
developing now in the CMBS market.
    In contrast, Realpoint's ratings were lower from the 
outset, and have proven to be more stable than those of the 
issuer-paid agencies. Even during these unprecedented times, 
downgrades at Realpoint are less than 30 percent on all current 
CMBS transactions, and have generally taken place 6 to 12 
months sooner than the corresponding rating actions taken by 
other rating agencies.
    The core problem with the issuer-paid system, and the most 
important message I would like to leave with the subcommittee 
today, is that the integrity of the rating process is 
undermined by the pervasive practice of rating shopping.
    When an issuer decides to bring a new security to market, 
it generally begins the process by providing data to the three 
rating agencies. The three rating agencies are more than 
willing to provide preliminary levels on ratings, knowing that 
the issuer will tend to hire the agencies that provide the 
highest ratings.
    We hear a lot about complexities of modern finance, but the 
rating process is hardly complex. The solution is equally 
simple, and it only takes one step. Let all the designated 
rating companies have the same information and prepare their 
own pre-sell ratings, regardless of whether or not they are 
ultimately paid by issuers or by investors.
    In our view, there is simply no better or more 
straightforward way to enhance the integrity of the ratings 
process than to share the information with all agencies which 
the SEC has deemed as worthy of being a nationally recognized 
agency. In fact, the SEC has already proposed precisely such a 
rule, through an amendment to its fair disclosure rules.
    The public benefits of taking this simple step are 
immediate and manifestly obvious.
    Last year, the Federal Reserve began implementing the Term 
Asset-Backed Securities Loan Facility, or TALF Program. 
Initially, the ratings component of TALF was limited to 
Moody's, S&P and Fitch.
    We are pleased to learn that the Federal Reserve is now 
taking steps to increase the number of rating agencies eligible 
to participate in this program. As a matter of fact, we just 
learned that Realpoint and DBRS are now part of the TALF 
    We believe that this will increase competition and lead to 
more accurate ratings behind the taxpayer guarantees which 
stand behind these programs.
    TALF and other comparable programs utilize the standard 
industry practice of requiring two ratings in order for 
securities to be deemed suitable collateral. There is likewise 
no valid public policy reason for not insisting that at least 
one of these ratings be an independent investor-based rating.
    In this manner, the TALF program serves not only as a 
catalyst for restarting the securitization market, but as a 
vanguard to reform the credit rating industry.
    A mandate to have TALF and other government assisted 
programs utilize the ratings of at least one independent rating 
agency would enhance investor confidence in those programs and 
set the stage for ultimately resurrecting reliable ratings in 
the private sector.
    In short, the American taxpayers should not be subject to 
the same failed rating shopping syndrome I described earlier.
    In conclusion, the integrity of the ratings process is 
deeply flawed, but this is not a complex problem, and, in fact, 
it is not that different from when we were all in high school 
and everyone sought out the teachers who were known as easy 
    We simply need to put an end to the rating shopping process 
that encourages issuer-paid rating agencies to inflate their 
    Thank you very much for your time.
    [The prepared statement of Mr. Dobilas can be found on page 
58 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Dobilas.
    We will now next hear from Mr. Eugene Volokh, Gary T. 
Schwartz professor of law at UCLA School of Law.
    Mr. Volokh.

                       UCLA SCHOOL OF LAW

    Mr. Volokh. Mr. Chairman, members of the committee, thanks 
very much for having me here.
    I was asked to provide an objective First Amendment 
analysis of the free speech issues raised by regulation of, and 
liability for, the speech of ratings agencies.
    I am a scholar of the First Amendment. I am not a scholar 
of commercial law. And I will try to stick to what I think the 
First Amendment law sets forth, without opining on what I think 
is sound financial policy here.
    So my first point is that the ratings issued by rating 
agencies are, generally speaking, speech of the sort that is 
presumptively protected by the First Amendment. They are 
predictive opinions based on factual investigation, and based 
on some degree of expertise.
    In that respect, they are quite similar to the work product 
of investment newsletters, or, for that matter, of the 
financial pages of well-respected newspapers. Those, too, offer 
predictive opinions based on factual investigation with some 
degree of expertise on the part of the author.
    Now, those, too, are for-profit entities, or at least they 
try to be for-profit entities. This does not strip them of 
First Amendment protection. The First Amendment protection has 
long been understood as covering for-profit entities. In fact, 
otherwise, newspapers, magazines, movie studios, all of them 
would be constitutionally unprotected.
    To be sure, rating agencies are particularly, or at least 
were particularly respected, and their speech was found 
particularly valuable, but the fact that speech is especially 
valuable generally does not diminish the scope of First 
Amendment protection that is offered it, and the fact that 
people rely on that speech, generally speaking, does not 
diminish the scope of First Amendment protection.
    So, generally speaking, the First Amendment is 
presumptively in play here. That is not just my view. That is 
the view of the Federal circuit courts that have considered 
this issue in the related context of libel lawsuits by the 
ratees against the rating agencies. The Sixth and the Tenth 
Circuits have spoken to this very issue, and have said this 
speech is generally protected by the First Amendment.
    Now, to be sure, not all such speech ends up being 
protected by the First Amendment. So, for example, if an agency 
is actually paid to issue a favorable report, not just issue a 
report, but issue a favorable report, that would probably make 
it commercial advertising, which is much less protected under 
the First Amendment, much as if a newspaper were paid to write 
a favorable article about a company--which I believe is 
considered quite unethical in newspapers, though I am told that 
it is not uncommon in fluff entertainment magazines and the 
like--that would presumably be commercial advertising.
    The fact, though, that there is a payment being made not 
for the positive review, but a payment being made by a company 
to the subject of the review, does not make the review 
commercial advertising. Newspapers routinely take advertising 
from the very same companies whose products they review, and 
there is some degree of possible pressure to bias the reviews 
in this respect. If you want to keep getting advertising from 
Ford, you may want to write positive reviews of Ford, 
counteracted by the desire to maintain the value of the 
newspaper's own brand. But generally, while that risk may lead 
some papers to be very careful about such practices, those 
payments do not strip speech of full protection.
    Likewise there are certain situations in which a company 
may be hired specifically to give personalized advice to an 
investor, much like an accountant or a lawyer or a 
psychotherapist or what have you could be hired to give 
personalized advice to a client. That would presumably fit the 
speech into the category of professional-client speech, which 
is much less protected. And that might, in fact, describe what 
some rating agencies do in certain circumstances. There are 
some cases in which rating agencies have been found to do just 
    But, generally speaking, the fact that they are 
professionals who offer expert commentary does not make them 
subject to this kind of restriction. So long as they are 
speaking to the world at large, and they are not addressing 
their advice to the personalized circumstances of a particular 
person whom they are counseling, their speech generally remains 
fully constitutionally protected.
    So such speech would likely be protected categorically to 
the extent it is treated as a matter of opinion, and would 
likely be protected under the New York Times v. Sullivan actual 
malice standard, to the extent that it implies specific, 
verifiable facts. That means that it wouldn't be judged by a 
negligence standard, but rather by whether the ratings agencies 
knew the statements were false or likely to be false. Again, 
there is lower court case law on that very point.
    So those, I think, are the constraints in direct regulation 
or litigation against rating agencies.
    However, say that the government chooses to say, we will 
give some special status to certain agencies on condition that, 
for example, they don't take money from the companies that they 
rate, or that they only take money from subscribers, and if 
they don't want to be subject to those conditions, they are 
free to express their opinions but they will not get this 
special government-provided status.
    That kind of restriction on agencies that are given this 
specialized status as a condition of getting that status would 
probably be constitutionally permissible.
    Thank you.
    [The prepared statement of Professor Volokh can be found on 
page 123 of the appendix.]
    Chairman Kanjorski. Thank you very much.
    We will now hear from Mr. Stephen W. Joynt, president and 
chief executive officer of Fitch, Incorporated.
    Mr. Joynt.

                     OFFICER, FITCH RATINGS

    Mr. Joynt. Thank you, Chairman Kanjorski, Ranking Member 
Garrett, and members of the committee.
    I would like to spend just a few minutes summarizing my 
prepared statement.
    Nearly 2 years has passed since the onset of the credit 
crisis. What began as stress focused on the global capital 
markets has evolved into a more severe economic slowdown.
    An array of factors have contributed to this, and these 
have been broadly analyzed by many market participants, the 
media, and within the policymaking and regulatory communities.
    During this time, the focus of Fitch Ratings has been on 
implementing initiatives that enhance the reliability and 
transparency of our ratings. More specifically, we are 
vigorously reviewing our analytical approaches and changing 
ratings to reflect the current risk profile of securities that 
we rate.
    In parallel, we have been introducing new policies and 
procedures, and updating existing ones, to reflect the evolving 
regulatory frameworks within which the credit rating agencies 
operate globally.
    I have provided details in my written statement, so I would 
like now to move on to the primary focus of today's hearing: 
where do we go from here?
    As this committee considers this important topic, we would 
like to offer some perspective on a number of the important 
    Transparency is a recurring theme in these discussions, and 
at Fitch, we are committed to being as transparent as possible 
in everything we do. But transparency also touches on issues 
beyond the strict control of rating agencies.
    All of Fitch's ratings, supporting rationale, and 
assumptions, and related methodologies, and a good portion of 
our research, are freely available to the market in real time, 
by definition, transparent. We do not believe that everyone 
should agree with all of our opinions, but we are committed to 
ensuring that the market has the opportunity to discuss them.
    Some market participants have noted that limits on the 
amount of information that is disclosed to the market by 
issuers and underwriters has made the market over-reliant on 
rating agencies, particularly for analysis and evaluation of 
structured securities.
    The argument follows that the market would benefit if 
additional information on structured securities were more 
broadly and readily available to investors, thereby enabling 
them to have access to the same information that mandated 
rating agencies have, in developing and maintaining our rating 
    Fitch fully supports the concept of greater disclosure of 
such information. We also believe that responsibility for 
disclosing such information should rest fully with the issuers 
and the underwriters, and not just with the rating agencies. 
Quite simply, it's their information and their deals, so they 
should disclose that information.
    A related benefit of additional issuer disclosure is that 
it addresses the issue of rating shopping. Greater disclosure 
would enable non-mandated NRSROs to issue ratings on structured 
securities if they so choose, thus providing the market with 
greater variety of opinion, and an important check on perceived 
ratings inflation.
    The disclosure of additional information, however, is of 
questionable value of the accuracy and reliability of the 
information is suspect. That goes to the issue of due 
    While rating agencies have taken a number of steps to 
increase our assessments of the quality of the information we 
are provided in assigning ratings, including adopting policies 
that we will not rate issues if we deem the quality of the 
information to be insufficient, due diligence is a specific and 
defined legal concept. The burden of due diligence belongs with 
issuers and underwriters.
    Congress ought not to hold rating agencies responsible for 
such due diligence, or requiring it from others. Rather, 
Congress should mandate that the SEC enact rules to require 
issuers and underwriters to perform such due diligence, make 
public the findings, and enforce the rules they enact.
    In terms of regulation more broadly, Fitch supports fair 
and balanced oversight and registration of credit rating 
agencies and believes the market will benefit from globally 
consistent rules for credit rating agencies that foster 
transparency, disclosure of ratings, and methodologies, and 
management of conflicts of interest.
    We also believe that all oversight requirements should be 
applied consistently and equally to all NRSROs.
    One theme in the discussion of additional regulation is the 
desire to impose some more accountability on rating agencies. 
Ultimately, the market imposes accountability for the 
reliability and performance of our ratings and research. That 
is, if the market no longer has sufficient confidence in the 
quality of our work, the value of Fitch's franchise will be 
diminished and our ability to continue to compete in the market 
will be impeded.
    While we understand and agree with the notion that we 
should be accountable for what we do, we disagree with the idea 
that the imposition of greater liability will achieve that. 
Some of the discussion on liability is based on misperceptions, 
and while those points are covered in my written statement, 
it's worth highlighting that the view that the rating agencies 
have no liability today is unfounded.
    Rating agencies, just like accountants, officers, 
directors, and securities analysts may be held liable for 
securities fraud, to the extent a rating agency intentionally 
or recklessly made a material misstatement or omission in 
connection with the purchase or sale of a security.
    Beyond the standard of existing securities law that applies 
to all, fundamentally, we struggle with the notion of what it 
is that we should be held liable for. Specifically, a credit 
rating is an opinion about future events, the likelihood of an 
issue or issuer that they will meet their credit obligations as 
they come due.
    Imposing a specific liability standard for failing to 
accurately predict the future, that in every case strikes us as 
an unwise approach.
    Congress also should consider the practical consequences of 
imposing additional liability. Expanded competition may be 
inhibited for smaller rating agencies by withdrawing from the 
NRO system to avoid specialized liability. All rating agencies 
may be motivated to provide low security ratings just to 
mitigate liability.
    In closing, Fitch has been and will continue to be 
constructively engaged with policymakers and regulators, as 
they and you consider ideas and questions about the oversight 
of credit rating agencies. We remain committed to enhancing the 
reliability and transparency of our ratings, and welcome all 
worthwhile ideas that aim to help us achieve that.
    Thank you.
    [The prepared statement of Mr. Joynt can be found on page 
70 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Joynt.
    We will now hear from Mr. Alex Pollock, resident fellow, 
American Enterprise Institute.
    Mr Pollock.

                      ENTERPRISE INSTITUTE

    Mr. Pollock. Thank you, Mr. Chairman, Ranking Member 
Garrett, and members of the subcommittee.
    As many of the members said in their opening statements, in 
the housing and mortgage bubble of our 21st Century, the 
government-sponsored credit rating agency cartel turned out to 
be a notable weakness. The regulatory NRSRO system made the 
dominant rating agencies into a concentrated point of possible 
failure, which then failed.
    Considering this history, Deven Sharma, the president of 
S&P, has rightly said that we need to, in his words, ``avoid 
inadvertently encouraging investors to depend excessively on 
    Let me add, we certainly need to avoid intentionally 
encouraging investors to depend excessively on ratings, and to 
treat them as one of many inputs.
    As Congress made clear in the 2006 Credit Rating Agency 
Reform Act, greater competition in the credit rating agency 
sector was a key objective, and indeed, this is the right 
    At the beginning of 2005, I published an essay entitled, 
``End the Government-Sponsored Cartel in Credit Ratings,'' and 
that still summarizes my view.
    I do think there has been significant progress in the right 
direction by the SEC since the 2006 Act, for example, 
registering Realpoint as an NRSRO, but we can go further.
    In the ideal case, as Congressman Bachus said, we would get 
rid of all statutory and regulatory references to ``NRSROs.'' I 
don't know if that is doable.
    I would also strongly support his suggestion of replacing 
the meaning of ``R'' as ``recognized'' with ``registered,'' so 
that we had only nationally registered rating agencies. That 
would be a step in the right direction.
    As I remember, we talked about that in 2005-2006, maybe 
even had it in bills at one point, but it didn't make it into 
the final Act.
    Now, what everybody in financial markets wants to know is 
the one thing that nobody can know, namely, the future. So Wall 
Street continually invents ways to make people confident enough 
to buy securities, in spite of the fact that they can't know 
the future. These assurances, as has been said, are, of course, 
opinions, and the credit rating agency ratings are an extremely 
important form of such opinions.
    In the course of financial events, some such opinions will 
inevitably prove to be mistaken, some disastrously mistaken, as 
has been evident in the 21 months since the beginning of the 
financial panic in August 2007.
    We would all like to have infallible knowledge of the 
future. Can't we somehow ``assure'' credit ratings which are 
``accurate,'' to borrow terms from a current bill in the 
Senate? Can't we guarantee having models which are right?
    And the answer is, no. No rating agency, no regulatory 
agency, no modeler with however many computers, can make 
universally correct predictions of future events.
    The worst case would be to turn the SEC, through the 
regulation of ratings process, which could easily turn into 
regulating ratings, into a monopoly rater, which would also 
suffer from the same lack of ability to predict the future. So 
would any--to touch on a separate topic--so-called systemic 
risk regulator, should we make what I believe to be the mistake 
of creating one.
    But having more credit rating competitors, especially those 
paid by investors, in my view, increases the chances that new 
insights into credit risks and how to conceptualize, analyze, 
predict, and measure them, will be discovered.
    It will also reduce the economic rents to the present 
dominant rating agencies, and should we create this increased 
competition, we should expect and welcome greater dispersion of 
ratings. That will tell us we're getting different points of 
view, and whether ratings are concentrated around a mean or 
dispersed would be very important information for investors.
    A particularly desirable form of increased competition, as 
others have said, is from rating agencies paid by investors, 
which do have a superior alignment of incentives. A frequent 
objection to competition in credit ratings is that there would 
be a so-called race to the bottom, but this does not apply at 
all to the logic of investor-paid ratings.
    In my view, all regulatory bodies, not just the SEC, all 
regulatory bodies whose ratings supported over-reliance on the 
government-sponsored ratings cartel should develop and 
implement ways to promote the pro-competitive objective of the 
2006 Act, and all regulatory rules concerning rating agencies 
from all regulators, not just the SEC, should be consistent 
with encouraging competition from the investor-paid model.
    I have previously proposed that a group of major 
institutional investors, maybe Vanguard, should set up their 
own rating agency, capitalized and paid for by these investors, 
working from their point of view. It continues to seem to me 
likely the market would demonstrate a preference for the 
ratings of such an agency, and a successful competitor would 
find ways to distinguish itself by creating more valuable 
ratings, perhaps, as suggested by our colleague, Rob, in his 
testimony, by superior ongoing surveillance.
    In sum, Mr. Chairman, competition in the rating agency 
sector has made some progress since the 2006 Act, and greater 
competition remains, in my opinion, not only an essential, but 
also an achievable objective.
    Thanks again for the opportunity to be here.
    [The prepared statement of Mr. Pollock can be found on page 
84 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Pollock.
    I now recognize the gentleman from Colorado, Mr. 
Perlmutter, to introduce our final witness.
    Mr. Perlmutter. Thank you, Mr. Chairman.
    It gives me great pleasure to introduce my friend, Greg 
Smith, who is general counsel of the Colorado Public Employees' 
Retirement Association, of which I was a member.
    Greg is the co-chairman of the Council of Institutional 
Investors. He is also the chair of the subcommittee which deals 
with the credit rating agencies. He has a background in 
business and commercial matters, having represented pension 
plans, as well as a variety of business interests over the 
    He holds a Bachelor of Science degree from the University 
of Colorado, and a law degree from the University of Denver.
    And we look forward to his testimony.
    Thank you.


    Mr. Smith. Thank you very much. Thank you, Chairman 
Kanjorski, Ranking Member Garrett, Congressman Perlmutter. I 
appreciate the kind words.
    I am here to speak on behalf of the Colorado Public 
Employees' Retirement Association, a pension fund with more 
than $29 billion in assets, which is responsible for the 
retirement security of over 430,000 plan members and 
    I greatly appreciate the opportunity to be heard and talk 
about what I believe is the right direction for credit rating 
agency reform. My brief remarks will include an overview of how 
Colorado PERA uses credit ratings, a suggestion on how the 
Securities and Exchange Commission can provide better oversight 
of the ratings industry, and views on the need to strengthen 
NRSROs' accountability for their ratings.
    Credit ratings are an important and sometimes mandated tool 
for many market participants, including pension funds. Most 
institutional investors do not rely exclusively on ratings. 
This holds true for Colorado PERA, as well as most of our 
peers. Ratings are a part of the mosaic of information that we 
consider during the investment process.
    Initially, we define our risk tolerance and we determine 
what percent of allocation is necessary to stay within that 
range. Ratings serve as a first cut to identify securities for 
further consideration and analysis. Without such a tool, we and 
many other investors would have no initial way to screen the 
tens of thousands of new instruments available for investments 
each year.
    Because of their significance in the capital market, and 
their status as financial gatekeepers, we believe NRSROs must 
be held to a high standard of quality, transparency, and 
independence. Congress and the SEC must work to strengthen and 
extend oversight in several areas, ranging from disclosure to 
policies to methodologies.
    My written testimony provides more detail, but I would like 
to highlight a few suggestions for action here.
    Like many institutional investors, we encourage the SEC to 
expand its proposal regarding the delayed disclosure of credit 
rating actions and credit rating histories, to include all 
outstanding credit ratings, regardless of whether or from whom 
the NRSRO received its compensation.
    Similar to the provisions governing auditors, NRSROs should 
be required to disclose business relationships and should be 
prohibited from providing ancillary services. They should also 
publicly disclose fee schedules and the amount of compensation 
received for individual ratings and from individual clients.
    A mandatory 1-year waiting period should be in place for 
any NRSRO employee seeking a position with a client. And the 
SEC should strengthen the current responsibilities and 
requirements pertaining to NRSRO compliance officers. That's 
their internal compliance officers.
    At a bare minimum, more detailed information regarding 
NRSROs' rating methodologies should be made available publicly 
and in a user-friendly model.
    Providing the SEC with the additional authority and 
resources, however, will not itself create an adequate system 
of checks and balances. The market must have a path of 
recourse. Where these financial gatekeepers fail to adhere to 
the reasonable industry standards, they should be held 
accountable for those failures.
    Expressions of concern regarding the business viability of 
NRSROs in the event a private right of action were recognized 
by legislation are premised on the contention that NRSROs would 
become guarantors of the performance of the instruments that 
they rate, or would somehow become liable in the event a 
particular rating has changed and the value of the instrument 
is negatively impacted.
    While this premise serves the interests of those desiring 
to maintain a lack of accountability, the reality is that no 
market participant is seeking that form of accountability.
    Rather, we are seeking to have these officially sanctioned 
gatekeepers held to a reasonable industry standard for the 
process and methodology that is employed, including the 
adequacy of the diligence and the unbiased nature of the 
    The threat presented to NRSROs by a private right of action 
is in essence no different than that presented to other 
participants in the marketplace, including institutional 
fiduciaries like my organization.
    We, like others, are responsible for the process we adhere 
to. Our honesty and our lack of conflicts of appearances of 
conflicts of interest in the discharge of our responsibilities 
is imperative to our success.
    We protect our organization from liability by creating a 
robust process and strictly monitoring our adherence thereto. 
We see no legitimate barriers to such a risk management 
approach by the NRSROs.
    Thank you for the opportunity to be here. I look forward to 
your questions.
    [The prepared statement of Mr. Smith can be found on page 
89 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Smith.
    Let me start off with my first question to you.
    When you buy a security, how deeply do you look into the 
security? Do you do due diligence to see how the security was 
supported, what the pool was made up of, and who the 
participants are in the mortgages?
    Mr. Smith. Absolutely. We look--we drill as far as we can 
drill. We look at who the issuers are, obviously, what their 
creditworthiness is--
    Chairman Kanjorski. Issuers being the underwriters, or the 
individuals who have mortgages?
    Mr. Smith. Well, it depends on what kind of instrument 
we're talking about, but if we're talking about mortgage-backed 
    Chairman Kanjorski. Mortgage-backed securities.
    Mr. Smith. --mortgage-backed securities, we would attempt 
to go back to where the mortgages are, but that's a difficult 
thing for us to do. There's--
    Chairman Kanjorski. Well, if you cannot do that, then where 
do you get the information on whether or not you should buy 
that type of security, except that it is rated AAA?
    Mr. Smith. What we do as a large institution is, we go out 
and buy the research from the very people who are issuing the 
ratings, so we try and drill into it by buying that research 
from the rating agencies themselves.
    Chairman Kanjorski. So they not only rate the security, 
they get paid to sell you the materials they use to rate the 
particular security?
    Mr. Smith. There are certainly research relationships where 
we purchase research from the very institutions that issue 
ratings, yes, sir.
    Chairman Kanjorski. Very good.
    Mr. Fitch, how many people does your organization employ? I 
am sorry. Mr. Joynt. That is a Freudian slip, sir.
    Mr. Joynt. I think our present employee count globally is 
about 1,900.
    Chairman Kanjorski. 1,900. And you are one of the three 
largest in the world; is that correct?
    Mr. Joynt. Yes.
    Chairman Kanjorski. And how many employees would you have 
had, say, in 2002?
    Mr. Joynt. 2002. I would be guessing. We had--
    Chairman Kanjorski. About the same amount?
    Mr. Joynt. No. It would have been much less. Fitch grew by 
both growing on its own and merging with other, smaller rating 
agencies, so we made some acquisitions of Bank Watch Rating 
Agency, Duff and Phelps Rating Agency, GIBCA. So it's very hard 
to answer the question. But I would say we may have been half 
that size in 2002.
    Chairman Kanjorski. Half that size. Okay.
    How many of those people are involved as analysts in 
mortgage-backed securities?
    Mr. Joynt. In mortgage-backed securities, I can get you 
that answer. I don't have that answer off the top of my head, 
globally how many--
    Chairman Kanjorski. Would you be much different than one of 
the other three major rating agencies that showed a profit, or 
an income in 2002 of $3 billion and then in 2006, $6 billion? 
Had your revenue changed as much as that over that 3- to 4-year 
    Mr. Joynt. Well, our revenues have grown both through 
combining with these other rating agencies and growth on our 
own. The size of our company is much--is smaller than the other 
rating agencies. Our revenue base would be less than $1 
    Chairman Kanjorski. $1 billion?
    Mr. Joynt. Less than that, $600 million or $700 million. 
That would be at its peak. So we're smaller than the other two.
    Chairman Kanjorski. Now, in your testimony, it seemed to 
say that you are really only giving an opinion here, and you 
should not be held for doing the due diligence that would 
support that opinion. Is that correct, substantially?
    Mr. Joynt. In the technical way, or legal way that due 
diligence is described, yes, that's correct. We do a lot of 
thoughtful research and analysis.
    Chairman Kanjorski. Do you do a professional analysis and 
present a professional study? I think I saw in your written 
testimony that it is non-professional. Is that correct?
    Mr. Joynt. I'm not sure I know the--I believe that we're 
highly educated and do thoughtful analysis. How you would 
describe professional, I think we act very professionally. If 
that's a legal sort of characterization, I'm not sure.
    Chairman Kanjorski. Okay. Well, do you think it is the 
responsibility of a rating agency to practice due diligence?
    Mr. Joynt. No.
    Chairman Kanjorski. It is not?
    Mr. Joynt. No.
    Chairman Kanjorski. Categorically not. So what would--
    Mr. Joynt. Due diligence, the way I understand it--
    Chairman Kanjorski. Under law.
    Mr. Joynt. --as a legal term, yes. I'm not a lawyer, so--
    Chairman Kanjorski. Right. Well, what would you say, just 
off the cuff, not based on studies, that if the first payment 
of a mortgage was not made, and if there were no records or 
support documents of income level, what likelihood would that 
reflect on the likelihood of default or failure of that type of 
a mortgage?
    Mr. Joynt. I would think that would be pretty poor.
    Chairman Kanjorski. That would be a poor operation?
    Mr. Joynt. I would think so.
    Chairman Kanjorski. Would you be surprised that a 1998 
study of major insurance companies showed that mortgage 
securities that were AAA rated by the three major agencies, not 
all rating, but in various amounts, that only 3 percent had a 
failure as a result of defaulting on payments, particularly the 
first payment. Moreover, in 2000, only 4 percent failed that 
defaulted on the first payment. But in 2007, 15.6 percent of 
the mortgage holders failed to make the first payment on the 
mortgage. Would you find that remarkable, if those figures came 
to your attention?
    Mr. Joynt. Yes. Similar to--I'm not an expert, of course, 
on mortgage finance, but having said that, I think we all 
recognize that the origination of riskier and lower quality 
mortgages accelerated during the period of the mid-2005, 2006, 
and 2007. I think we all now see that more clearly.
    We also have gone back and studied mortgages and securities 
that we have rated, and feel like there was a significant 
incidence of poor origination and maybe significant fraud in 
the origination.
    Chairman Kanjorski. My time has run out. I just want to get 
this last question in, if I may.
    Assuming those facts that I have related to you are 
correct, what system would you recommend so that kind of 
information could be made available and brought to the 
attention of Mr. Smith and his pension fund when he is making a 
purchase of securities?
    Mr. Joynt. Very clearly, we have stated that we think all 
the disclosure that can be made by anybody in the market that 
helps educate all investors, and not just rating agencies, but 
all investors, should be supported.
    So I would be in support--
    Chairman Kanjorski. Well, who is the agent or the person 
who should be responsible to make that report? Not you, because 
you are not responsible for due diligence.
    Mr. Joynt. I would think the issuer of the securities and/
or their underwriter should be presenting the information that 
supports the--
    Chairman Kanjorski. And nobody is to check the authenticity 
or what material has been presented to anyone? In other words, 
liars get to keep their lies and get to benefit from their 
lies; is that correct? We have no checks and balances in our 
    Mr. Joynt. No, I would not suggest that. So there are 
checks and balances--
    Chairman Kanjorski. What is a check and balance? If I'm the 
guy who is issuing the pool, and 15 percent of the mortgages in 
my pool have failed to pay the first payment on their mortgage, 
who is supposed to tell Mr. Smith about that problem?
    Mr. Joynt. There should be some kind of check in the 
system, some kind of expert--
    Chairman Kanjorski. Well, knowing the system, is there?
    Mr. Joynt. --that can underwrite or re-underwrite those 
securities, those individual loans.
    It has not been our expertise. We have not developed 
expertise to underwrite individual loans in these securities.
    Chairman Kanjorski. So it is not my fault, it is Mr. 
Garrett's fault, is that what you are saying?
    Mr. Garrett, you are recognized for--
    Mr. Garrett. I missed that point. What was my fault?
    Chairman Kanjorski. I just blamed it on you.
    Mr. Garrett. I know. I was blamed in the last election for 
a lot.
    I thank the panel for your testimony.
    Mr. Pollock, in your testimony, you said an astounding 
thing. You said we would all like to have infallible knowledge 
of the future, so we can somehow assure credit ratings are 
accurate. Can't we guarantee having models that are right?
    Well, apparently, you haven't been coming to these 
hearings, because we already are coming up with a model. It's 
called a systemic risk regulator, and that individual or 
individuals is going to be able to do what the credit rating 
agencies and investors and everybody else have not been able to 
do, and that is predict the future for all these.
    Any comment?
    Mr. Pollock. I think your point is absolutely right, 
    Mr. Garrett. Mr. Pollock or somebody else mentioned this 
earlier. As far as the regulator right now, and we had a 
discussion earlier today on this matter with regard to who 
regulates the rating agencies, the SEC, and that they're out 
there doing the audits and what have you.
    Does anyone on the panel have any comments on the SEC? And 
my opening comments was, I wish we would have them here, maybe 
in a future hearing have them here, as them being the arbiter 
or the regulator of the industry?
    You can say something nice about the SEC, if you're 
    Mr. Auwaerter. I think with the SEC, they are the proper 
regulator. I question whether they have the resources to do it 
right now, to go out to the agencies and determine that the 
processes are working right.
    Mr. Garrett. Mr. Smith?
    Mr. Smith. I think also that in the 1996 Act, or I'm sorry, 
the 2006 Act, there were some restrictions put on the SEC that 
I think they're committed to doing a better job of regulating 
credit rating agencies if they're given the full range of 
powers to do so.
    Mr. Garrett. And I'll just throw out the one idea. Is there 
anyone else out there--I mean, banks have to deal with credit 
issues all the time, so should we switch this over to bank 
creditors, the banking regulators, to look at this? Does 
anybody suggest that?
    Mr. Pollock?
    Mr. Pollock. I just have a comment, if I may, on the 
banking regulators.
    Of course, what has happened historically is, increasingly, 
the banking regulators have outsourced the credit judgment to 
the credit rating agencies, notably, as I think someone 
mentioned in an opening statement, through the so-called Basel 
II capital requirements, which not only outsourced the credit 
decision but also the capital requirement decision to the 
    I think you have to say on behalf of the rating agencies, a 
lot of them commented that was a bad idea, and it was a bad 
    Mr. Garrett. Just very quickly, and then I'll go to Mr. 
Dobilas on this--if I'm pronouncing it correctly--Mr. Pollock, 
since we can't get an all-seeing, all-knowing person out there, 
and my question for the panel if we have enough time will be, 
what do we really need, what does the--and sir, this is along 
your line of questioning--what do the agencies really need to 
be looking at in order to make these proper determinations?
    First--saying even if we do away with regulations, it 
really comes down to whether you have someone out there, 
whether they are a regulator or not a regulator, coming up with 
a methodology to try to do the best they possibly can to 
predict the future, and then my question following that, Mr. 
Dobilas, will be, how come, according to your testimony, you 
said that--you alluded to the fact that even in the midst of 
this, Realpoint has been able to issue accurate credit 
downgrades 6 to 12 months sooner than your largest competitors. 
How were you able to evaluate it better?
    Mr. Pollock. One important point is who is making a 
decision to hire the credit rating agency. An investor-paid 
rating agency has to convince investors that its ratings are 
worthwhile buying.
    Mr. Garrett. Okay.
    Mr. Pollock. That's a really good check and balance, right 
    Mr. Garrett. I'm sure the credit rating agency would say 
that there's a separate--there's a Chinese wall through on 
    Mr. Dobilas. I guess Alex is stealing some of my thunder 
here, but I think you have to understand the basic difference 
between subscriber and issuer paid.
    We are paid by investors, and they have cancellation 
rights. We actually are very proactive in our methods with 
regards to surveillance and transparency.
    Issuer-paid agencies today make a lot of their money 
upfront when a deal is initially hired.
    Subscriber-paid agencies have more of a focus on the 
surveillance process, on an ongoing basis, meaning we review 
every CMBS transaction, every single month, and have a detailed 
review. What we try to do is be fully transparent to investors.
    Mr. Garrett. And you would suggest, and you don't work 
there, that the Big Three don't have the same modeling; is 
that, in essence?
    Mr. Dobilas. They do not have the same basic philosophy 
when it comes to surveillance. Their major emphasis has always 
been on the pre-issue, the new issue marketplace. That's where 
they make most of their money.
    The surveillance model wouldn't be in existence today if 
the rating agencies were doing a good job on the surveillance 
side. Monthly surveillance, we listen to investors, investors 
are our clients.
    I started in the rating agency business about 15 years ago, 
and I can tell you, there has been really no major changes with 
regards to clarity and transparency to investors until 
Realpoint came along on the CMBS side. We are offering a 
different business model to investors, which investors are very 
supportive of.
    We don't want to tell them what the right answer is, but we 
want them to understand fully what our analysis is and how we 
got to that analysis. By underwriting all of the underlying 
commercial properties, showing them our underwriting, you know, 
they're seeing something that they have never seen before, and 
it proves to be a more reliable rating than the reactive 
ratings of our counterparts.
    Mr. Garrett. I appreciate that. I need to better get my 
arms around the differences, but I appreciate the testimony. 
    Chairman Kanjorski. Thank you very much, Mr. Garrett.
    We will now hear from Mr. Ackerman.
    Mr. Ackerman. Thank you, Mr. Chairman.
    Mr. Joynt, if I may read from your testimony two lines:
    ``A Fitch rating is our opinion about the future financial 
capacity of a company or other issuer to pay its debt. It is 
not a statement of fact or a professional judgment.'' It's your 
opinion. You're entitled to your opinion.
    There are 300 million Americans. Do you know how many have 
opinions? I would say about 300 million.
    My cousin, Sheldon, has opinions. He has opinions on 
everything. He is not a professional, either, and sometimes his 
statements of fact aren't.
    You get paid sometimes, I understand, $1 million by clients 
for your opinion, and the reason you get paid so much money for 
your opinion is because some people think that this is a 
professional judgment. And you get paid because you are 
something that is called an NRSRO. My cousin Sheldon isn't.
    My cousin Sheldon can't put AAA on some company that 
they're going to market. Nobody would pay him 2 cents for his 
    You get paid that much money because you have a government 
franchise from the SEC. Of the 300 million people, plus I don't 
know how many entities in America, I understand there are only 
10 so designated by the government, and the reason is, then 
people rely on that, because they think this now has the 
government's imprimatur to issue very professional statements 
based on some expertise that you have.
    Now, if these are only your opinions, which you may think 
are better than Sheldon's, would you be adverse to putting a 
warning on your ratings, much like on cigarette cartons, that 
says, ``This rating is not a statement of fact,'' which is what 
you say, ``nor is it a professional judgment, and it's just as 
good as my cousin Sheldon's,'' and put that in a box?
    Mr. Joynt. Not knowing your cousin Sheldon, I wouldn't 
reference him, but I suppose I would respond this way. We try 
to be very clear about what the ratings are intended to mean 
and what they're not intended to mean, so they're not an all-
purpose recommendation of anything, they're--
    Mr. Ackerman. But the point I'm making is there's a 
difference in Cousin Sheldon's free speech, coming from a guy 
called Cousin Sheldon, who has no other credentials and isn't 1 
of 10 entities or people in America who have been selected by 
the government to represent themselves as nationally 
    Once you're nationally recognized, and you bear this 
franchise, given so rarely by the government, you get to charge 
$700 billion, last year is what I think you said--$700 million, 
I get carried away--$700 million to people who value the fact 
that you bear that franchise and Cousin Sheldon doesn't.
    So there's a responsibility there for the exercise of your 
speech, which is not free, it's $700 million worth of charges. 
That's different than Cousin Sheldon's free speech.
    Mr. Joynt. I believe one of the reasons why we receive 
remuneration for what we do is because, over a period of time, 
many participants in the capital markets, including large, 
sophisticated institutional investors, have learned to develop 
our opinion across a wide range of ratings and research that we 
    Mr. Ackerman. People make life-changing decisions based on 
your rating. It is not something that is casual. If it's 
something that people rely on, that they think that we have 
empowered the SEC to license you, in effect, to exercise the 
world's greatest judgment and tell people what the best 
judgment in the world can say, shouldn't you bear a 
    You can't just say, ``I'm not a doctor, but I play one on 
TV,'' or ``I'm not a professional, but I play one in the 
    Mr. Joynt. I believe we feel quite accountable and 
responsible for the quality of the work that we do, and we work 
very hard to make sure that we're educated in what we're doing 
and undertaking, you know--
    Mr. Ackerman. I'm sure that Cousin Sheldon feels the same 
way, but the problem is if that is just your opinion, why don't 
we just strip away the fact that you have a government license 
to operate, that you have been franchised as 1 of only 10 
entities in the country that's qualified to make that non-
professional, non-statement of fact judgment?
    Mr. Joynt. I know in my--and I have been--I think it's wise 
for you to think in that way. I believe that NRSROs were 
designated and ratings were used for constructive purposes, 
including in each of these regulations at the time they were 
put in place.
    All I have suggested is people think about changing the 
regulations or the recognition of rating agencies, that it be 
thought about over time, carefully, and consistently. There was 
a constructive reason why they were used, and so rather than 
just creating a sort of a blanket change, I think it would be 
more constructive to not throw the baby out with the bathwater, 
to carefully consider it over time. I think that's exactly what 
the SEC is doing right now, for many of the regulations that 
they have.
    Mr. Ackerman. Mr. Volokh gave us a brilliant treatise on 
the First Amendment, much of which I subscribe to 
    Newspapers don't have to have a license. They have a First 
Amendment right. It's not like if the country decided, and we 
decided we're going to license newspapers, and only license 10 
of them. There would be a big difference in the world, in our 
interpretation of free speech.
    And newspapers are self-policing. They make their own 
rules, and put advertisement over something that's an 
advertisement, not required by any law or rule. It's their own 
judgment to do so.
    Your industry, the credit rating industry, does not have 
the sense of integrity that those other purveyors of free 
speech, the real purveyors of free speech have, and they self-
police and say, ``This is an ad.''
    Why don't you just say, ``This is an advertisement, it's 
AAA. It's my endorsement.''
    You endorse products, is what you do, for a price, like a 
baseball player endorses sneakers.
    Mr. Joynt. So, Mr. Ackerman, I might also add that at the 
recent SEC hearings last month, when confronted with the same 
question, both Standard and Poor's and Moody's, I believe, 
responded that they thought it was wise that the rating 
agencies be taken out of regulation.
    And so I was asked my opinion at that time, because I had a 
different view, which was I thought that should be thought 
about carefully. So because I think there are constructive 
reasons to be designated NRSROs and using ratings, and also I 
believe that without designating anyone, the present incumbents 
would be more likely to be used by investors for the good 
reasons that they're used right now, in referencing ratings, 
and I think it might inhibit competition and diversity of 
    Mr. Ackerman. Let me just say, because my time has expired, 
and the chairman has been very generous, that free speech 
cannot be charged for. You don't charge anybody for exercising 
free speech.
    If you want to exercise free speech, you shouldn't have a 
government license, and if you have a government license, and 
are only one of a few designated to have that, there's nothing 
wrong with paying for the license. You pay for a fishing 
license. And the price you pay, or the price you should pay, is 
the price of being responsible in the marketplace, to be held 
accountable by people who feel they might have been misled by 
your endorsement of a product that should not have been 
    I yield back the balance--I guess I have no balance. Thank 
you, Mr. Chairman.
    Chairman Kanjorski. Do not push it, Mr. Ackerman.
    Chairman Kanjorski. The Chair now recognizes Mr. Bachus for 
5 minutes.
    Mr. Bachus. Thank you. Thank you, Mr. Chairman.
    Mr. Ackerman, your Cousin Sheldon, what does he do, what 
line of work is he in?
    Mr. Ackerman. Last I heard, he was with the Department of 
    Mr. Bachus. All right, then.
    Mr. Bachus. That pretty much sums it up.
    I ask the panel, do any of you plan to rely on Congressman 
Ackerman's Cousin Sheldon for risk assessment? Probably not, 
    Let me ask you this. Mr. Joynt, first of all, let me say 
this: I admire you for being here. It's my understanding that 
S&P and Moody's were not invited, but you were. That sort of 
leaves you out on the point.
    I want to ask you, just ask you some questions, just to try 
to understand where we go from here, as you said.
    If the debt issuers don't pay for these risk assessments--I 
mean, individual investors can't pay for them, so who would pay 
for them? Is there a practical--and I know people have talked 
about conflicts of interest. But who would fill that gap if the 
issuers did not?
    Mr. Joynt. So, investors now receive--pay for research, but 
they receive the benefits--all investors, retail investors, 
institutional--receive the benefit of the public and 
transparent nature of the rating agencies that come from the 
issuer-paid ratings.
    I don't believe that there would be enough payment, 
sponsorship, organization of investor payment for the ratings 
to support the kind of staffs that we now have in place to do 
what I think is, you know, quite a deep and educated job in 
analyzing securities.
    So I believe somehow we would lose the benefit of the 
positive of what with have now in the form of, at least, Fitch.
    Mr. Bachus. Yes. And I ask the other panel members, and the 
law professor--this may be outside your field, but other than 
the professor--who--you know, we all say there appears to be a 
conflict when an issuer pays for it, but who else would pay for 
it? I mean, is there a practical substitute?
    Mr. Smith. Well, as I said earlier, from the institutional 
investors' perspective, we buy the research and we get some of 
the benefit there, but that doesn't solve the issue, and the 
issue, I think you're getting to is, who is going to pay for 
the determination by whatever gatekeeper it is, whether or not 
a particular instrument meets capital requirements, etc., and I 
don't have a good answer for you.
    I don't think that turning to an investor-pay model instead 
of an issuer-pay model really fills all of the need that there 
is for making this determination. There's going to have to be 
something else that's identified, or else we're going to have 
to make credit ratings something we can actually rely on.
    I think that can be accomplished. I think it could be 
accomplished through transparency and accountability, and when 
there's a price to be paid for not just being wrong in that the 
instrument didn't perform as it was expected to--I don't expect 
them to predict the future; I think that's a red herring--what 
we expect them to do is create a robust process, free of 
conflicts, free of bias, and carry out that process 
consistently throughout all the products, and put the product 
out there for us to buy. And it seems pretty straightforward.
    Mr. Bachus. Anyone else?
    Mr. Dobilas. Yes, I would like to comment.
    You know, I would like to make a distinction, too, in 
saying that I only speak for CMBS.
    You know, when we look at a subscriber-paid model, it works 
very well in the surveillance arena. Now, on the new issue side 
though, I have to say there is a real problem with the issuer-
paid model. And that really isn't a problem that can't be 
solved, but it's going to need a long-term approach. It's going 
to need somebody to set the example and show investors what 
subscription-paid models can do in that arena, and somebody is 
going to have to absorb the cost, because when you do look at 
these new issue deals, there's a very large cost structure 
involved for a rating agency when they do go in to rate a new 
issue security.
    On the CMBS side, you have to visit every property, you 
have to underwrite those properties, you have to travel. You 
know, somebody is going to have to pick up those expenses.
    But I do think that if investors can see the light at the 
end of the tunnel, they will wean themselves of, you know, the 
dependency on those two, you know, new issue ratings, but 
somebody is going to have to step in in the interim and make 
sure that the playing field is equal, and investors will 
eventually buy those analyses.
    Realpoint, we were looking at offering a very cost-
    Mr. Bachus. Let me thank--I mean, I appreciate that, and I 
think, really, though, we're saying, I'm not sure how we do 
    Mr. Pollock. Congressman, if I could comment on that, the 
rating agency world I picture is one that has both investor-
paid and issuer-paid competitors in it. I don't think there is 
any chance that the issuer-paid agencies are going to go away. 
They are going to still be there. There is a large set of free 
riders in the public who get the ratings, and they'll continue 
to get the ratings, but there will be competitive pressure for 
quality from the investor-paid models.
    We should say, of course, the ratings, as I said in my 
testimony, are very valuable to all sellers of fixed-income 
securities, because they're a great part of the ability to move 
those securities, and they'll have an interest in making sure 
such ratings are available.
    Mr. Bachus. And I think part of that answer, if you expand, 
and you don't--you know, these nationally recognized, I think, 
people have relied on that as somewhat of a guarantee, and we 
need to expand that number.
    But also, I mean, I would have to say that we also--you 
know, there have to be some qualifications for registration.
    Can I ask one other question? I know you have gone over 
with everybody else.
    Mr. Joynt, is the problem--you have mentioned fraud. 
Obviously, that can be a problem, when they fail to disclose 
information. But how about expertise, I mean, or competence? I 
mean, that, on occasion, you know, there probably just wasn't 
the competence there, because of the complexity. Is that true?
    Mr. Joynt. So for mortgage-backed securities, I would say 
the accelerated environment and pace of origination and the 
change to broker origination, and usage by financial firms, 
which happened quite quickly in large volumes in that period of 
2005 and 2006, I think, contributed a lot to a change in the 
basic competence of the origination of the mortgage process, 
and so the need to have checks on that arose quickly. The 
checks probably weren't in place. The reliance, therefore, on 
the historical data, of what defaults and delinquencies had 
occurred in the past compared to what actually was happening or 
about to happen, especially with the weakest-quality mortgages, 
would indicate to me that all the competence, up and down the 
chain, was not there.
    Mr. Bachus. Let me ask you this. Not you, S&P, you know, 
Moody's, what is the rate of just saying, ``We decline to rate, 
we don't have the expertise?''
    Mr. Joynt. So I think the philosophy of the three largest 
rating agencies has been to say, ``Let us collect the 
information. Let's see if we can rate something. We probably 
can analyze it best and offer some kind of analysis or opinion 
to investors.''
    So there have been occasions where Fitch, particularly, 
declined to rate some securitizations, because we were 
uncomfortable with the structure or the credit enhancement 
level that we would think was appropriate for the given rating 
wasn't appropriate. In the case of SIVs, the special investment 
vehicles, we were uncomfortable rating the junior capital 
    And so there have been instances where rating agencies 
declined to rate, but if there's something that we're 
uncomfortable about the analysis, we probably would be 
assigning, in many cases, lower ratings, and less frequently, 
unable to assign any rating.
    Mr. Bachus. Okay, thank you.
    Mr. Joynt. There have been some.
    Chairman Kanjorski. Thank you very much, Mr. Bachus.
    And now we will hear from Mr. Sherman for 5 minutes.
    Mr. Sherman. Thank you, Mr. Chairman.
    Responding in part to the gentleman from Alabama, I think 
it's important not who pays the credit rating agency, but who 
selects the credit rating agency. And I'll give you a baseball 
analysis on that.
    Imagine a baseball league in which the league pays the 
umpires, but the home team gets to select anybody they want to 
be the umpire. That's going to be a home team that's going to 
win a lot of games.
    In contrast, imagine a baseball league where the home team 
has to give $100 to the umpire, each umpire, but the league 
sends out the umpires. Those are going to be umpires who are 
answerable to the league, whose livelihood depends upon the 
league thinking they're doing a good job.
    As long as issuers are selecting the credit rating agency, 
then the way to be successful as a credit rating agency is to 
make the issuers happy, and then conceal from the public that 
the way to be successful is to make the issuers happy. It's who 
selects, not who pays.
    Now, one approach we could have to all this is to try to 
make the credit rating more reliable. The other, and I think 
our first witness kind of took this approach--I'm sure I'm 
over-simplifying--we could just tell everybody how unreliable 
these credit ratings are, and tell them not to rely upon them, 
or only as a first step.
    Now, Vanguard has the advantage of hiring, what did you 
say, 30, 40 different credit analysts. I won't ask you whether 
it's 30 or 40.
    Investors ought to be allowed to invest directly in debt 
instruments, without hiring a team of 40 people. They should be 
able to rely on the credit rating.
    And even--and I have all my money at Vanguard. But when I 
even--and so I'm relying on your analysts, but not entirely, 
because I have to compare your funds to other funds that tell 
me they get better yields. But then I look, and I see which 
fund invests more safely. Well, how can I determine that?
    I could rely upon your name, although there are some big 
names on Wall Street that have tanked recently. I don't know 
which names are good and which aren't. Or, I can rely upon the 
fact that your bond funds are mostly AA and partially AAA, and 
somebody else's high-yield fund--as a matter of fact, that's 
what distinguishes your high-yield fund from the lower-yield 
    Professor, you said if somebody gathers information, 
analyzes it, and expresses their opinion, that would be 
protected by the First Amendment. I would add, that's what my 
doctor does, but boy, if he's wrong, I'm going to sue him.
    But more to the point, that's what accountants do and 
that's what legal opinions do, in offering materials, private 
placement memorandums, SEC regulations. I think I'm the only 
CPA up here.
    And what does, when you look in the offering materials, or 
financial statements, and then there are two paragraphs, 
usually, written by the auditors. They say, ``In our opinion, 
the attached financial statements accurately reflect, according 
to generally accepted accounting principles.''
    So I'll ask you to respond for the record, how the credit 
rating agency is different from the accounting firm, both in 
public offerings and in private placement memoranda, but also, 
you have, if there's a tax advantaged investment, you usually 
have an opinion letter from a tax counsel, saying, ``Here are 
what the tax consequences are.''
    I have been the auditor. I have been the tax counsel. And 
in every case, I knew I would get sued if I was wrong. 
Otherwise, you would be--well, I would have--my professionalism 
would have restrained me, but I have colleagues that would have 
issued just about any kind of opinion.
    What I'll ask you to respond to orally--those other 
questions are for the rating--is, is there any constitutional 
bar to us saying, certain credit rating agencies will register 
with the SEC, and as part of that registration, should they 
choose to register, they have to waive the right not to be sued 
for their negligence?
    Mr. Volokh. Before I answer, could I ask, what is it that 
they get out of the registration? Is it that they have to be 
registered in order to--
    Mr. Sherman. No. Anybody can register, but then the--well, 
the SEC then says, ``If you want to issue a debt instrument, 
you must get one of our registered SROs to rate you.'' But, of 
course, you can go out and hire 12 other people, even--what was 
the cousin? Sheldon. And you could even get Sheldon, and you 
could, you know, you got free speech. You can talk all you want 
about your offering. But you have to pick one from our panel if 
you want to sell it.
    Mr. Volokh. Sure. Let me speak in order to both of the 
matters that you raised.
    The first is the status of professional client speech and 
to what extent these rating agencies are the equivalent of a 
doctor or a lawyer or an accountant--
    Mr. Sherman. Well, in this case they would be registered 
professional agencies. If you didn't want to be a 
professional--I see that Fitch is saying it's not a 
professional judgment--but the SEC would say you can't register 
unless you want to be a professional.
    Mr. Volokh. Got it. So if somebody wants to go out there 
and convey their opinion and have other people pay for the 
opinion, they are free to do so, but if they want a special 
government imprimatur that allows an issuer of bonds to include 
that opinion as part of its issue, they have to comply with 
certain things.
    I tried to speak to that in some measure in my remarks, and 
I think that, generally speaking, that would be 
constitutionally permissible if, going forward, the government 
were to say, as a condition of getting this particular special 
government benefit, we demand that you comply with certain 
kinds of accounting procedures or that you not take any money 
from the organization that you are rating, or even that you 
agree to be liable under a negligence standard, then I think as 
a condition--
    Mr. Sherman. I have to try to squeeze in one more question. 
That is, I'm going to propose that the SEC identify which 
credit rating agencies are qualified. In fact, they have 
already identified 10, but which are qualified for particular 
categories of debt instruments.
    And then, every issuer, when they want to take an issue 
public, of debt, they call the SEC and the SEC assigns one at 
random, the same way the league assigns a team of umpires.
    Mr. Joynt, this would mean that you would never have to 
please an issuer. As a matter of fact, if you regard it as a 
really tough rater, that might be fine, because it would 
improve your image with the SEC.
    That would change your business model. It would allow 
perhaps other competitors to emerge, in that having a big name 
like your company does wouldn't matter as much as being rated 
as qualified by the SEC.
    Do you see--what disadvantage do you see to someone like 
myself who would like to invest $10,000 or $20,000 in debt 
instruments and get a rating that I can rely on?
    Mr. Joynt. I guess I would come back to try to understand 
the goal of diversifying that widely among market participants. 
From our personal interest, of course, we spent a lot of time 
building up our professionalism and our global reputation. I 
think we serve investors well as a global rating agency, able 
to rate a wide variety of things.
    If there was--
    Mr. Sherman. Well, you would be qualified in all the 
different categories, or maybe there should just be one or two 
    Mr. Joynt. So then the question turns to what I mentioned 
earlier, which is on what basis would the SEC or anyone choose 
among the rating agencies, and if it was just a random sort of 
rotation, I suppose that would be just adjusting the market 
shares of as many participants joining the system, is what it 
would be.
    So there would be--I think many people would try to join. 
There would be 20, 30, 50 different rating agencies. It would 
certainly impact the business dynamics of the existing rating 
agencies, including--
    Mr. Sherman. But then I would get a rating from an agency 
that the SEC thought was qualified to do the job. That rating 
agency would be absolutely unaffected by the desires of the 
issuer. What's not to like?
    Mr. Joynt. So, I believe that we're unaffected by the 
desires of the issuer today, so that the difference between 
your statement and mine is that--
    Mr. Sherman. Look, I have never been in your profession, 
but my doctor seems to care whether I'm pleased as a patient. 
When I was a lawyer, I wanted to please my clients. When I was 
a CPA, I wanted to please my clients. I want to please my 
    You're the only--you don't even claim to be a professional, 
but you claim a level of professionalism so high that you don't 
care about the business effects to your enterprise of what you 
do, and in particular, you don't care about whether you please 
the people who can decide whether to give you the next $1 
million contract.
    Mr. Joynt. But our--
    Mr. Sherman. So you're claiming a level of professionalism 
I never aspired to, while disclaiming being a professional.
    Mr. Joynt. Our credibility comes from building our 
reputation, not just with issuers, but with investors, 
regulators, and everyone, over a long period of time, so 
keeping the proper balance and being independent and doing a 
thorough job is very important--
    Mr. Sherman. I could have bought that last year, but now I 
have seen Alt-A get AAA, and I'm not buying it.
    I'll yield back.
    Chairman Kanjorski. Thank you very much.
    I will now recognize Mr. Neugebauer for 5 minutes.
    Mr. Neugebauer. Thank you, Mr. Chairman.
    Mr. Smith, have you ever used credit default swaps to 
insure any of the securities, debt securities that you bought 
to provide additional protection for the organization that you 
    Mr. Smith. In fact, we have not.
    Mr. Neugebauer. You have not?
    Mr. Smith. No.
    Mr. Neugebauer. And why is that?
    Mr. Smith. Because we judge them to not be something we 
wanted to invest our beneficiaries' money in. We did not 
participate in that field.
    Mr. Neugebauer. I think in your testimony, Mr. Joynt, that 
you didn't--you criticized proposals to replace ratings with 
bond spreads or CDS spreads, because you think the market 
prices, by definition, are inherently volatile than a 
fundamentally driven credit rating.
    When you were looking at your ratings and kind of, you had 
your story and you were sticking to it, were you monitoring the 
spreads on some of the credit default swaps to say, ``Hmm, 
there's some risk premiums there that other people think are 
there, that we're not recognizing.'' I mean, did the bell go 
off for somebody?
    Mr. Joynt. Yes. We would take all market inputs, prices, 
CDS spreads, anything into account when trying to think about 
the risks that we analyzed. Individual analysts would receive 
market price information and spreads. Our central credit policy 
group would monitor CDS prices, and in fact go back to analysts 
and individual groups and say, ``Have you thought about and 
seen what's happening with these prices?''
    So I would say we're aware of, it's an important factor, 
it's an influence, and just to respond to what you originally 
suggested, we see value in market prices for investors to 
reflect and think about the risk. I believe those are more 
volatile than fundamental analysis. They are influenced by 
market events, volatility, liquidity. And so I think they are 
    So yes, we use them to help think about the fundamental 
analysis, as well.
    Mr. Neugebauer. So when those risk premiums started going 
up, at what point did you start changing? In other words, if I 
went back and looked at a security that you rated and I started 
looking at the risk premium in that CDS, when would you have 
said, ``You know, maybe we don't have this rated right?'' As 
opposed to--I mean, how much did the premium--well, how much 
premium increase would I see before I saw a rating change?
    Mr. Joynt. I can't answer that question specifically, but I 
should say that there have been times when market spreads have 
widened out, and contracted back, and it wasn't reflective at 
all of the fundamental credit risk of a company, and there have 
been times when market spreads have widened out and 
subsequently the company's performance has proved to be weaker, 
ratings were changed subsequently, as well.
    So I mean, there are good examples with the auto companies 
in the past 10 years, where their credit has weakened and 
ratings have weakened, and where market spreads have been 
dramatically different than what the fundamental analysis might 
have said at the time.
    So it's a wide range, I would say to you.
    Mr. Neugebauer. I wonder what the difference of the 
analysis that the people who were taking on those risks for, 
you know, a relatively small amount of money. You have to be 
right on those, because they're taking a relatively small 
premium for a fairly large risk. I mean, so what did they know 
that you didn't know?
    Mr. Joynt. I'm not sure how to react to that. There's--
whomever was selling or buying protection, there would have 
been two people thinking two different things about that risk 
at that price. So one might have been thinking, ``That was a 
great trade, I'm glad I got this premium,'' and another was 
thinking, ``I'm glad I shed that risk.''
    So--also, the CDS market is a synthetic and a derivative 
market. It's not physical securities. So the people who trade 
or act in that market aren't necessarily--they can act with 
leverage and volumes that might indicate they have much greater 
rewards than holding physical securities or risks.
    Mr. Neugebauer. Well, the issuers are taking a real risk. I 
mean, it's not synthetic, it's real. If there's a default on 
that security, they have to--there's performance.
    Mr. Joynt. No, that I understand, but they don't own 
physical securities.
    Mr. Neugebauer. Some of them do.
    Mr. ``Dobilas''--am I saying that right?
    Mr. Dobilas. No, but that's okay. It's ``Dobilas.''
    Mr. Neugebauer. ``Dobilas.'' You would think somebody with 
a name like Neugebauer could pronounce that, wouldn't you?
    So, in your particular business, you do not do any issue 
ratings on new issues. When do you start coverage?
    Mr. Dobilas. Since the NRSRO designation, you know, we are 
eligible to do new issue, but we would have to fall under the 
same model, being paid by the issuer, you know, and be sort of 
a hybrid rating agency.
    Most of our subscription-based business is all--well, 
actually all of our subscription-based business is paid for by 
    We tend to pick up the deal as soon as the information is 
available to the public. We're not actually privy to the post-
sale information that the hired NRSROs have access to.
    So usually, it is 30, about 30 days or after the first 
payment of the bond that we have access to all the information, 
enough information to do a detailed analysis on.
    One of our recommendations is definitely to open up that 
post-sale analysis and allow all NRSROs to have access to that 
information, so we can, in a timely manner, prepare an analysis 
that can be available to investors for direct purchase, as 
opposed to having a reliance, or over-reliance on issuer-paid 
    That way, if, again, an investor felt it necessary to get 
more information or additional information, it is available to 
    Mr. Neugebauer. So one of the--would one of the ideas be 
that companies before, that are thinking about issuing, whether 
they have selected your firm or not to rate the issuance, that 
you be given the same amount--the same information that they're 
giving to the rating agency that they have selected to do that; 
so if I'm one of your subscribers, and somebody comes out and 
says, ``This is a AAA,'' so that's one opinion, and then I call 
your firm up, and you say, ``No, Randy, we think that's an A?''
    Mr. Dobilas. Yes, we think more opinions at the post-
issuance, you know, level, the better. Let the investors really 
know what kinds of risks are out there, don't limit it to just 
two rating agencies.
    Mr. Neugebauer. But you're not privy to the information 
that, say, if Fitch has been selected, you do not get the same 
information up front until after issue; is that what you're 
    Mr. Dobilas. That is what I'm saying. Now that we are a 
registered NRSRO, though, we can actually join Fitch and, you 
know, bid on deals in the same pre-sale analysis that they do.
    Mr. Neugebauer. You can bid on it, but if you don't get the 
bid, or do you get the information?
    Mr. Dobilas. No. We're not privy to share that information 
with our clients at this time. Both Regulation AB and FD sort 
of prohibit that from happening.
    Mr. Neugebauer. Prior to issue, if you have not been 
    Mr. Dobilas. Correct.
    Mr. Neugebauer. So you can't issue your opinion on that 
until after issuance?
    Mr. Dobilas. About 30 days after issuance, and we can't 
even use the data if we did take a look during the bidding 
process. It's a separate group. We can't--
    Mr. Neugebauer. Is that one of the solutions?
    Mr. Dobilas. We think the solution is definitely make that 
information available and disclose it to any registered NRSRO. 
There's a lot of private information in that data, so you need 
to regulate that somehow, and we think having a NRSRO 
designation, you know, would be, again, all the regulation you 
need to make sure that information stays private, and then 
allow the rating agencies to analyze that information and 
prepare their analysis.
    And we think having--again, there's no getting rid of 
issuer-paid models or no getting rid of subscriber-paid models, 
and necessarily, I don't think one is better than the other. I 
think the fact is, having more opinions at that post-issuance 
is in the best interests of investors.
    Mr. Neugebauer. Last question, to the panel.
    Under Mr. Sherman's proposal, if somebody else chooses, is 
there some validity to, if you are all equally competent, that 
a third party would choose--in other words, you would be in a 
pool and a third party gets to pick who that is?
    Mr. Dobilas. I guess if I could just jump in again, you 
know, the Federal Reserve, it's interesting, because they're 
faced with that now with regards to the TALF Program.
    And I should also just commend the Federal Reserve, because 
the level of analysis they did on the rating agencies that 
participated in TALF was very detailed and analytic and 
quantitative in nature, a very, very thorough process. But 
they're faced with sort of a similar distinction now.
    I do not think it's necessarily a bad thing to take that 
out of the issuer's hands and have a trustee, for instance, be 
hired to randomly select the rating agencies. The only thing 
you would want to avoid at all costs is stifling competition 
and quality, more quality than competition.
    You know, you wouldn't want to see the industry just result 
in, you know, just, ``Hey, I have a deal coming up in a month, 
you know, we'll just hang in there and put out a rating.'' You 
know, you definitely want an evolution of transparency for 
    Chairman Kanjorski. Thank you, Mr. Neugebauer.
    We will now have Mr. Capuano for 5 minutes.
    Mr. Capuano. Thank you, Mr. Chairman.
    Gentlemen, I want to be clear. I have my problems with the 
way credit agencies work, credit rating agencies work, but I 
absolutely agree that there is a role for them in the free 
market world.
    Let me ask you, my problem is trying to figure out a way to 
get the credit rating agencies to be independent, so that their 
judgment can be trusted. I can't believe any of you really 
believe that credit rating agencies' judgments, right now, is 
trusted by anybody in their right mind. It isn't. And I want to 
get to a point where it is.
    Let me ask you, what are the consequences when a rating 
agency gets it wrong?
    Mr. Joynt, I think, I may as well just start with you. And 
I apologize. I don't mean to pick on you. But--
    Mr. Joynt. That's all right.
    What's the question?
    Mr. Capuano. What are the consequences if a rating agency 
gets it wrong? What are the consequences to your business if 
you get it wrong?
    Mr. Joynt. So we put out our rating and our research, and 
if we get it wrong, it means we would have been changing our 
opinion quickly, downgrading the rating substantially, and 
having a surprisingly different rating result or credit 
    Mr. Capuano. But do you lose an investment? Does anybody go 
to jail? Does anybody lose a license? Anything?
    Mr. Joynt. So investors that would have purchased those 
    Mr. Capuano. I know what they get. What are the 
consequences to your company if you get it wrong?
    Mr. Joynt. So they would not be interested in using our 
services, if we consistently got it wrong.
    Mr. Capuano. That's fair and reasonable, but that goes to 
Mr. Pollock's comment, which I thought was very good, of a 
    Now, Mr. Pollock, you would agree that a cartel doesn't 
necessarily have to be just three or just 10, a cartel could be 
100, if they operated as such; is that incorrect?
    Mr. Pollock. Congressman, it would be really hard to run a 
100-member cartel, but I think the key about what happens to 
the credit rating agency, which is an excellent question, is 
whether the credit rating agency is judged by the content and 
value of its ratings, or whether the rating agency is operating 
by providing a regulatory value, which is what the old system 
had. Professor Frank Partnoy has discussed this at length, that 
when you convey a required license, you are conveying the fact 
that, ``I'm just passing on this regulatory license I have,'' 
whether your ratings have content or not.
    I'm not saying the ratings don't have content, but that 
there is a regulatory value which is different from the content 
value, and the more we could move the market toward what 
happens to rating agencies being based on the informational, 
intellectual value of the rating, the better we would do.
    Mr. Capuano. Content, qualitative analysis, analytical 
analysis, not opinion, and understanding that, at some point, 
there's always opinion. I get that.
    If that's the case, I have a proposal, at least when it 
comes to municipal bonds, to simply require agencies to base 
their opinion on the ability to repay that debt. And yet, the 
industry thinks that's some kind of a major problem, and 
opposes the bill.
    It simply says, ``Base your opinion on the sole factor of 
whether that city, town, county, or State can repay the debt.'' 
Where's the problem if that's all we're asking? Simply base 
your credit rating on that. Where's the problem with that?
    [no response]
    Mr. Capuano. Good. Nobody has one. So you're all in favor 
of the bill? Mr. Chairman, I guess we can mark that one up next 
    Again, let me ask another question. At Enron, there were 
consequences for a lot of people. Several people went to jail 
from the company. Arthur Andersen, at the time one of the top 
two largest accounting firms in the world, went out of 
    What happened to the credit rating agencies that rated 
Enron's financial status?
    Mr. Dobilas. I guess I just want to make a point.
    They're still in business. You know--
    Mr. Capuano. Bingo.
    Mr. Dobilas. --but in a subscription-based service like 
Realpoint on the secondary side, I mean, we would be out of 
business, too. Our clients would just walk away. I mean--
    Mr. Capuano. I get it. And that's one of the things I'm 
trying to get at. I think that is one of the key factors.
    I don't understand why I have to accept the fact that 
issuer-paid business will continue to go on forever. I mean, 
again, if that's the case, big red stamp on the front of this, 
you know, ``Endorsed by us,'' as opposed to, ``Endorsed for 
    And I guess the last factor I have is, we talk as if 
somehow credit rating agencies are just out there doing God's 
work, and that's it. Most, up until recently, most of the large 
investors, up until the last 5 years, were institutional 
investors. Now we get hedge funds, private equity firms, and 
all that, and different problems we're trying to deal with.
    But most institutional investors are required to invest 
only in certain rated stock, or actually prohibited from 
investing in other stock. That's a captive audience. That means 
your rating is critical.
    As we see here right now, one of the biggest problems I 
have, or the biggest disagreements I have, probably maybe the 
only one, at the moment, of major import, with account 
administration is the proposal on this public-private 
investment program. I hate it. I hate it for lots of different 
    One reason I hate it is, in this program, it says you can 
only buy AAA-rated bonds. Excuse me? You rated them AAA. They 
went bad. They're now junk, toxic, whatever words we're not 
using this week. And yet we can only invest in those. I'm 
missing something. Your ratings matter.
    And as far as the free speech goes, let me be very clear. 
You have every right to say anything you want. Go right ahead. 
You don't have a right to sell it. You don't.
    And I understand, I'm a lawyer, lawyers will disagree, and 
you know much more about the First Amendment than I do. I know 
one thing. You can't be running down the halls screaming, 
``Fire,'' and you can't be running down the halls saying, 
``There is no fire. Don't worry about it. Don't worry about 
that smoke that you see over there. Calm down.'' Well, you can, 
but you're going to be held liable for it.
    Now, we will find out whether the courts have completely 
gone completely nuts, which on occasion they do, and then 
luckily we get Presidents who get to appoint members of that 
court. I don't know where they're going to come down. But there 
is no rational person who can step back from the actual, maybe 
some of the specific cases, to say that you should have a right 
to sell and to move a market on the basis of, ``Don't worry 
about this fire.''
    Or, as a lawyer, one of the things I'm taught, don't ask 
questions you don't know the answers to, or don't ask questions 
you don't want to hear the answers to.
    Now, I don't know that any--have any of you ever been 
rated? Have you ever worked for a company that was rated? Any 
of you?
    Mr. Pollock. Yes, I have, Congressman.
    Mr. Capuano. Okay. I have, as well. And let me tell you 
something. My job, when you were rating me--actually, Fitch 
wouldn't do it--I don't know if--probably still not. I only had 
two to pick from, two, because the rest of you weren't in 
business. Fitch was the only one.
    And by the way, now that we're talking 10, just as a point 
of information, how much business is there that is controlled 
by S&P and Moody's? What's their share of the market, about?
    Mr. Pollock. About 80 percent.
    Mr. Capuano. About 80 percent, and Fitch is probably 10, 
give or take?
    Mr. Joynt. I think 13.
    Mr. Capuano. Okay, 15. So that leaves, you know, 5 to 10 
percent of the market to the other seven. I would suggest that 
we're not at non-cartel type of competitive market yet.
    I understand some of the concerns you have, and I want to 
be clear. I have been one of the leading critics of the way 
credit rating agencies work. I'm not out to put you out of 
business. That's not what I want. I actually think I want you 
to be there. I want a strong, independent voice to help make--
allow the market to make thoughtful judgments on investments. I 
think that's a good thing.
    I want independent auditors. I want independent lawyers. I 
think some of the lawyers have gotten away with murder, too. 
But we need independent, thoughtful, credit rating agencies who 
are not beholden to the people that they're working for.
    And with that, I'm actually just hoping that you help us 
find the way to get there, because otherwise, you're going to 
leave it up to us, and believe me, maybe I'm wrong, but I think 
this year, we're going to do it.
    So you have two choices. Either let us do it and not have 
any input, or help us do it the right way.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Capuano.
    Mr. Volokh, one question that I had. You mentioned that the 
First Amendment privilege was argued and decided in two circuit 
courts within the United States. However, I would imagine the 
defense of First Amendment privilege was used in cases, say, in 
Europe or Asia, and since they do not have the benefit of the 
First Amendment over there, do you recall any specific cases? 
Was there liability held that was not recognized as a defense?
    Mr. Volokh. You know, I have a hard enough time keeping up 
with American law. I can't claim any real expertise as to 
foreign law. They don't have the First Amendment, and our free 
speech regime and our free speech history is notoriously much 
more protective of speech across a wide range of contexts than 
in Europe or certainly in Asia.
    My sense, also, is that, at least from what I have heard, 
we also have a much more aggressive tort liability system in 
the United States than there, so it may be that there was no 
free speech protection for you, but there are also no legal 
causes of action.
    In fact even in the United States, until recently, the 
dominant rule, and perhaps today still is the dominant rule, 
that just as a matter of tort law, there is generally only 
recklessness or knowledge-based liability, not negligence 
liability, in speech that's said to the public at large in 
these contexts.
    But I don't know much about foreign precedents in this. My 
guess is they're not going to be terribly enlightening.
    Chairman Kanjorski. I think I hear a lot of lawyer boots 
running down the hall right now to buy steamship tickets. I am 
being facetious, relating it to ambulance chasing.
    Mr. Joynt, are you aware of any cases that are pending in 
Europe or suggested to be--
    Mr. Joynt. I think also, like you suggested, that the tort 
prevalence in Europe is lower than it is here. I believe the 
rating agency, credit rating agency industry has just been 
thought about and reviewed in Europe by the European 
Parliament, and they chose not to move forward with some kind 
of expanded or specialized liability, but, you know, so easily, 
the SEC could inform you about why they chose not to do that, 
and how it might inform your judgment in this matter.
    Chairman Kanjorski. Thank you very much.
    I did not realize you had come in, in the meantime, Mr. 
Royce, and here I am taking some of your time. So we will give 
you a little of whatever is left. I will recognize you for 5 
    Mr. Royce. Mr. Chairman, I thank you for this hearing.
    I only have one question, but I think we have to get past 
the point of the hard-wiring of these rating references that 
exist in statutes, because we have set up a regulatory agency, 
or a cartel out of this, and I think that a lot of the 
problems, you know, Von Meese has had this theory, after he 
looked at the cartel arrangements in Europe, and all of them 
were drawn from a government franchise or a government-enabled 
or created cartel.
    And so if you could figure out a way to get this back to a 
market-based system where the regulators are not using these 
scores to determine whether banks are adequately capitalized, 
then you begin to signal that this isn't the score that you key 
off of.
    Right now, we certainly see, while the credit ratings 
issued by the NRSROs are intended to be opinions, as you 
discussed, and of course protected as opinions by the First 
Amendment, it appears that the treatment of these ratings by 
market participants is way beyond opinions. It seems that, you 
know, as Schwazerman, Steve Schwazerman of the Blackstone Group 
said, the grades issued by rating agencies, he said AAA has 
almost a religious connotation in finance, and if you call it a 
AAA, you don't have to analyze it. That's why it's a AAA--as he 
    So one of the more egregious abuses of these grades 
occurred when AIG used their AAA rating to sell abstract 
derivatives based on nothing more than junk mortgages.
    So to what extent do you believe the reliance upon the 
major credit rating agencies by Federal regulators encourages 
the belief that these ratings are more than just opinions? That 
would be my first question to the panel.
    And from a regulatory standpoint, how can we lessen the 
dependence upon NRSRO grades?
    Mr. Pollock. If I could start, Congressman, I fully agree 
with your point that the regulatory treatment raises these 
ratings to beyond opinions, whereas what they really are is, 
indeed, opinions.
    And secondly, it would be very good, as I suggested in my 
testimony, to set all regulators, not only the SEC, to try to 
lessen the mandating of ratings in their regulations and to 
increasing competition in this sector.
    Mr. Royce. Thank you, Mr. Pollock.
    Mr. Auwaerter. Congressman, I think in the case of that 
discussion that you quoted about AAA securities being almost 
religious and the investor didn't have to do any analysis, that 
was errors on the part of the investor. They abrogated their 
fiduciary duties.
    I think regulations--excuse me--ratings have a place in 
regulation, sort of as a minimum standard, but it's still 
incumbent upon the investor to do the work.
    For example, in Rule 2-A(7), the regulations regarding 
using a credit rating agency set a minimum floor, and that's a 
minimum hurdle that, I, as a money fund portfolio manager, have 
to get over, but I am still required, under the SEC rules, to 
do my own independent analysis.
    What we get concerned about at Vanguard, in particular in 
the case of money market funds, is that you have a small money 
market fund that doesn't put the proper resources in, doesn't 
do their own homework, and they just say, ``Okay, we don't have 
to rely upon a rating agency, we just make a subjective 
assessment, and we end up being the best house in a block 
that's burning down.''
    Mr. Royce. Thank you.
    Any of the other members on the panel?
    Mr. Joynt. I'm not sure you were here earlier when I had 
mentioned that the recent SEC hearings, that SEC--S&P and 
Moody's both had suggested that removing ratings from 
regulation in that way would be something they think would be 
okay with them.
    So I'm not here representing a different, an industry view. 
I happen to think that the reason ratings are used in 
regulation in many places is because when they were put in 
there, it was deemed constructive and helpful, so that was just 
one example there.
    So I suggest if we're going to go back and think about 
their usage now, because of the way we perceive rating agencies 
as being over-relied upon, that it just be done carefully and 
sort of individually, not in a blanket kind of way, because 
there must have been some good reasons.
    Mr. Royce. Would you agree with getting them out of 
statutes, and would you agree with Alex's point?
    Mr. Joynt. I think it depends. I think the use of ratings 
as a basic benchmark in 2-A(7) is a constructive use. If there 
was an alternative, then I think that could be used.
    In other cases, maybe the ratings' usefulness is not as 
great as it was originally intended for.
    Someone cited the number of regulations that are used, 
including State ones, and it's 200 in the States and 50, and I 
think they ought to be looked at individually.
    I think the SEC is doing that right now, I believe, so 
looking at least at the ones that they use for net capital 
rules for broker dealer and other things.
    Mr. Royce. Any other responses?
    Mr. Dobilas. I would just echo that, as well. I think what 
ratings really do is, you know, give you a minimum standard. I 
think that is really important.
    I think it also enables small investors and small upstart 
companies to get into the field without adding, you know, a 
staff of 40, you know, individuals, who are going to try to 
rate the securities.
    What we're really there to do is provide, you know, again, 
I hate to beat a dead horse, but an opinion on credit, and 
identify possible risks within the deal, and I think some of 
those statutes were meant to, you know, ensure there is some 
sort of analysis done.
    I mean, we ran into problems when we relied too heavily on 
broker dealer research. Ratings were supposed to be seen as 
more independent, and, you know, give you that basic sense of 
security in the sense of opinions.
    Mr. Royce. Mr. Smith?
    Mr. Smith. I think that my answer would be along the lines 
of what's going to come in place of them, and I don't mean to 
be flippant by that at all.
    I mean that there has to be something, some measuring stick 
for us to know what the insurance company can hold as reserve 
capital for their obligations, or what the money market can 
have in its portfolio and continue to represent itself as same 
as cash type of an investment. What tool are we going to use to 
fill that need?
    And really, these regulations, in my view, came about to 
allow insurance companies and banks and so forth to not just 
have to hold cash. We wanted to look for what's secure enough 
that we can rely that it's always going to be there, but it 
doesn't have to be cash. You can make just a little bit of a 
margin, a little bit of money on it on the edges, and you don't 
have to flat-out hold cash.
    That's really how this all started. That's where we started 
identifying, well, as long as it's AAA, then you can hold it 
and meet your capital requirements with your AAA-rated 
instruments. And--
    Mr. Royce. And we're still left with the reality that AIG 
used their AAA rating to sell abstract derivatives based on 
nothing more than junk mortgages.
    Mr. Smith. Absolutely, and that's because the AAA rating is 
unreliable, and that's what we have to get back to, to me, to 
say, well, we're not going to call it AAA anymore, fine. That's 
fine. What are we going to use as our measuring stick to 
identify what those entities can hold, unless we're going to 
make them hold cash, which I don't think is going to be 
productive for everybody. How are we going to measure it now? 
How are we going to define it now? If we're not going to define 
it by terms of these credit ratings, how are we going to define 
    Mr. Royce. Any further commentary?
    [no response]
    Mr. Royce. Thank you. Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Royce.
    The gentleman from Alabama seeks recognition?
    Mr. Bachus. Thank you. Yes, please.
    Chairman Kanjorski. You are recognized.
    Mr. Bachus. You know, one thing, we received word, I guess 
just today, or the last day or so, that the regulators are 
going to expand the number of companies who can issue opinions 
on the CMBS market and TALF, which is--at least, I think 
they're moving in the right direction.
    And I know, Mr. Pollock, you have pointed out that you felt 
like that was--they were going too much to endorse certain 
companies or create a duopoly.
    Mr. Pollock. Yes, sir.
    Mr. Bachus. So I do commend the agencies for doing that.
    Mr., and it was ``Dobilas,'' is that--I heard you and Mr. 
Neugebauer; is that right?
    Mr. Dobilas. That's perfect.
    Mr. Bachus. Is that what you came down with?
    Mr. Dobilas. Yes.
    Mr. Bachus. On Page 4 of your written testimony, you say, 
even in the midst of the unprecedented economic conditions, 
that Realpoint was able to issue accurate credit downgrades 6 
to 9 months sooner than your largest competitors.
    Mr. Dobilas. Correct.
    Mr. Bachus. How were you able to evaluate the 
creditworthiness so far in advance of the other rating 
agencies, and can you give us an example of this?
    Mr. Dobilas. Sure. Our emphasis is really on, you know, 
surveillance of these bonds. You know, our company is a small 
company compared to the Big Three, and I would label us as a 
niche company into CMBS securities. We have approximately 50 
employees. All 50 are dedicated to the review and surveillance 
of the underlying collateral.
    And I think a big difference is, we have monthly 
surveillance, and we try to be fully transparent to our 
    So, we gather information on a monthly basis. We analyze 
information. We see trends happening. And we're very proactive 
with regards to our ratings and those trends.
    You know, at one point, before Realpoint became an NRSRO, 
every rating agency subscribed to our service as a research 
provider for the basic surveillance capabilities we offered.
    When we got the NRSRO, you know, that's when things changed 
a little bit, and again, we lost some market share, you know, 
at that time.
    But the most part is, we have monthly surveillance, we do a 
very good job with regards to understanding data, understanding 
market trends, and we have to service our clients, who are the 
    The investors really don't want to know 6 months after the 
fact that a security has gone bad, and we try to provide that 
service through better quality and better service.
    Mr. Bachus. Do you think that some of the other rating 
agencies that lag behind, were they seeing the same data, or do 
you think it was--
    Mr. Dobilas. They were seeing the same data, and I don't 
think all rating agencies on the surveillance front are equal, 
in the sense I think some rating agencies do a much better job 
at surveillance than others, but they--we were all seeing the 
same amount of information and data. It's when do you process 
that information.
    If you're focused on the new issue markets, and getting 
into that business, and all your energy and resources are 
there, you're really not going to focus too much on 
surveillance, especially in a busy market. And again, not all 
rating agencies have that same focus.
    You know, I would like to stick up for Fitch in this sense, 
and say they have a very good surveillance program, and were 
seeing a lot of data, and again, their ratings, you know, have 
not seen the increases that Moody's and S&P have.
    Mr. Bachus. So they did a better job?
    Mr. Dobilas. They did a better job.
    Mr. Bachus. Okay. That's some good news.
    Mr. Joynt, do you have some--
    Mr. Joynt. Yes. It's nice to be endorsed by someone.
    Mr. Bachus. Thank you. Maybe that will get in a newspaper 
article tomorrow. You'll be rewarded for being sent out here 
all by yourself.
    Thank you.
    Chairman Kanjorski. Thank you very much.
    I assume Mr. Garrett has no further questions, and I have 
100 questions, but you all have been here very long and 
tediously. We appreciate it. I think it was very helpful to the 
committee. I think we had some interesting questions.
    And maybe I should, Mr. Joynt, thank you, because it was a 
bit of courage on your part to come forward and put your head 
out there, and you must really trust the operators of the 
    Mr. Joynt. I'll come again if asked.
    Chairman Kanjorski. That is very good. And we will welcome 
you back.
    Thank you all very much. We appreciate it. And the Chair 
notes that some members may have additional questions for the 
panel, which they may wish to submit in writing. Without 
objection, the hearing record will remain open for 30 days for 
members to submit written questions to these witnesses and 
place their responses in the record.
    Mr. Bachus. Mr. Chairman?
    Chairman Kanjorski. Yes, sir?
    Mr. Bachus. S&P and Moody's at some later time, I guess, 
and maybe Sheldon, the cousin, will be called before the 
    Chairman Kanjorski. Well, if you would like, we are going 
to try. We have a host of hearings. You know how many issues 
lie in our subcommittee. But I would be perfectly willing to 
find the time, if you will cooperate with us.
    Mr. Bachus. I will. I would like to hear from all three.
    Chairman Kanjorski. We will work on that.
    Before we adjourn, the following will be made part of the 
record of this hearing: A letter from the Association for 
Financial Professionals. And there being no further business 
before the committee, without objection, it is ordered that the 
letter be made a part of the record.
    The panel is dismissed and the hearing is adjourned.
    [Whereupon, at 5:12 p.m., the hearing was adjourned.]

                            A P P E N D I X

                              May 19, 2009