    [Senate Hearing 107-471]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 107-471

            RATING THE RATERS: ENRON AND THE CREDIT RATING AGENCIES

    =======================================================================

                                    HEARING

                                   before the

                                  COMMITTEE ON
                              GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                          ONE HUNDRED SEVENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                 MARCH 20, 2002

                                   __________

          Printed for the use of the Committee on Governmental Affairs

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                       COMMITTEE ON GOVERNMENTAL AFFAIRS

                   JOSEPH I. LIEBERMAN, Connecticut, Chairman
    CARL LEVIN, Michigan                 FRED THOMPSON, Tennessee
    DANIEL K. AKAKA, Hawaii              TED STEVENS, Alaska
    RICHARD J. DURBIN, Illinois          SUSAN M. COLLINS, Maine
    ROBERT G. TORRICELLI, New Jersey     GEORGE V. VOINOVICH, Ohio
    MAX CLELAND, Georgia                 PETE V. DOMENICI, New Mexico
    THOMAS R. CARPER, Delaware           THAD COCHRAN, Mississippi
    JEAN CARNAHAN, Missouri              ROBERT F. BENNETT, Utah
    MARK DAYTON, Minnesota               JIM BUNNING, Kentucky
               Joyce A. Rechtschaffen, Staff Director and Counsel
                         Cynthia Gooen Lesser, Counsel
                           Beth M. Grossman, Counsel
                   Thomas J. Holloman III, Legislative Fellow
                  Richard A. Herlting, Minority Staff Director
                   William M. Outhier, Minority Chief Counsel
                       Jana A. Sinclair, Minority Counsel
                         Darla D. Cassell, Chief Clerk

                                C O N T E N T S

                                     ------
    Opening statements:
                                                                       Page
        Senator Lieberman............................................     1
        Senator Thompson.............................................     4
        Senator Levin................................................     5
        Senator Bunning..............................................     6

                                   WITNESSES
                           Wednesday, March 20, 2002

    Ronald M. Barone, Managing Director, Corporate and Government
      Ratings Group, Standard & Poor's...............................     6
    John C. Diaz, Managing Director, Moody's Investors Service.......     8
    Ralph G. Pellecchia, Senior Director, Global Power Group, Fitch
      Ratings........................................................     9
    Hon. Isaac C. Hunt, Jr., Commissioner, U.S. Securities and
      Exchange Commission............................................    40
    Jonathan R. Macey, J. DuPratt White Professor of Law, Cornell Law
      School.........................................................    43
    Glenn L. Reynolds, Chief Executive Officer, CreditSights, Inc....    45
    Steven L. Schwarcz, Professor of Law, Duke University School of
      Law............................................................    46

                         Alphabetical List of Witnesses

    Barone, Ronald M.:
        Testimony....................................................     6
        Prepared statement with attachments..........................    55
    Diaz, John C.:
        Testimony....................................................     8
        Prepared statement...........................................   116
    Hunt, Hon. Isaac C., Jr.:
        Testimony....................................................    40
        Prepared statement...........................................   131
    Macey, Jonathan R.:
        Testimony....................................................    43
        Prepared statement...........................................   138
    Pellecchia, Ralph G.:
        Testimony....................................................     9
        Prepared statement...........................................   129
    Reynolds, Glenn:
        Testimony....................................................    45
        Prepared statement...........................................   148
    Schwarcz, Steven L.:
        Testimony....................................................    46
        Prepared statement with an attachment........................   168

                                    Appendix

    Article entitled ``Private Ordering of Public Markets: The Rating
      Agency Paradox,'' submitted by Mr. Schwarcz....................   175
    Chart entitled ``Project Margaux: Whitewing Associates, L.P.
      Financing Transaction, September 24, 1999'' (submitted by
      Senator Levin).................................................   207

    Responses to Questions posed by Senator Levin during hearing
      from:
        Ralph G. Pellacchia..........................................   208

    Questions for the Record and responses from:
        Hon. Hunt....................................................   211
        Mr. Macey....................................................   212
        Mr. Reynolds.................................................   213
    Mr. Schwarcz.....................................................   215

            RATING THE RATERS: ENRON AND THE CREDIT RATING AGENCIES

                                  ----------

                           WEDNESDAY, MARCH 20, 2002

                                           U.S. Senate,
                             Committee on Governmental Affairs,
                                                        Washington, DC.
        The Committee met, pursuant to notice, at 9:35 a.m., in
    room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
    Lieberman, Chairman of the Committee, presiding.
        Present: Senators Lieberman, Levin, Thompson, Bennett, and
    Bunning.

                OPENING STATEMENT OF CHAIRMAN LIEBERMAN

        Chairman Lieberman. Good morning, and welcome to this
    fourth in a series of Governmental Affairs Committee hearings
    on the collapse of Enron and the implications for Enron
    employees, investors, and the American economy as a whole.
        We are engaged in an ongoing investigation here into
    whether the private and public watchdogs did all they could
    have done to prevent or at least anticipate and warn the rest
    of us of Enron's collapse.
        Today, we are going to look at the private sector credit
    rating agencies that wield immense power--to me, quasi-
    governmental power--to determine which companies within the
    corporate world are creditworthy and which are not. In pursuit
    of our purpose here, which is to learn the lessons of Enron and
    craft solutions to avoid future corporate calamities of this
    sort, we will ask why the credit raters continued to rate Enron
    as a good credit risk right up until 4 days before it declared
    bankruptcy.
        In this particular part of our investigation, I must say I
    have learned a lot that I didn't know before about credit
    rating agencies. A credit rating, I suppose self-evidently, is
    an assessment of a company's creditworthiness or its likelihood
    of repaying its debt. The entire corporate credit rating
    industry consists of just three entities, three agencies--
    Moody's Investors Service, Standard & Poor's, and Fitch
    Ratings--three agencies that exercise significant power over
    corporate America, the markets, and, therefore, our entire
    economy. These are private companies, but the enormous scope of
    their influence comes largely as a result of their government-
    conferred power.
        John Moody, the founder of what is now Moody's Investors
    Service, is recognized, I have learned, for devising credit
    ratings in 1908, and he did so for public debt issues, mostly
    railroad bonds at that time. Moody's credit ratings, first
    published in 1909, met a need for accurate, impartial, and
    independent information on these bonds.
        Now, almost a century later, an investment grade credit
    rating has become an absolute necessity for any company that
    wants to tap the resources of the capital markets. The credit
    raters really do hold the key to capital and liquidity, which,
    after all, are the lifeblood of corporate America and of our
    capitalist economy. The ratings they give affect a company's
    ability to borrow money. It affects whether a pension fund, for
    instance, or a money market fund can invest in a company's
    bonds, and it affects stock price. So the difference between a
    good rating and a poor rating can be the difference literally
    between success and failure, or more intensively stated,
    prosperity and poverty.
        The government, through hundreds of laws and regulations,
    requires ratings. Corporate bonds, for instance, must be rated
    if they are to be considered appropriate investments for
    institutional investors. Most of the laws that require credit
    ratings involve banks and securities, but their reach, actually
    quite interestingly, also extends into education where schools
    must be rated in order to participate in certain financial
    assistance programs, and even into transportation where highway
    projects must receive a rating to qualify for Federal funding,
    and into telecommunications where companies must be rated in
    order to receive Federal loan guarantees. These rating
    requirements, quite understandably, have been placed by
    lawmakers in a whole series of economic activities as a way to
    give some independent assessment of the strength of the
    company.
        Along with this power that the credit rating agencies have,
    comes special access and special protections. The credit
    raters, for example, I learned, are allowed to look at a
    company's inside information when making assessments, and they
    are exempted from liability when they participate in securities
    offerings, which are two benefits that give them more
    information than other analysts have who work within our
    system.
        Someone once said that raters hold ``almost Biblical
    authority.'' On a ``NewsHour with Jim Lehrer'' program in 1996,
    New York Times columnist Tom Friedman went so far as to say,
    ``There are two superpowers in the world today: The United
    States and Moody's bond rating service. And, believe me, it's
    not clear,'' Friedman said, ``sometimes who is more powerful.''
        With so much power, access, and protection, it's not
    surprising that profitability also follows close behind. Not
    all the agencies' books are open because some of them are
    subsidiaries of larger corporations, but Moody's was spun off
    into a separate company a few years ago, and by one calculation
    my staff came across, it is worth $6.2 billion. So nothing
    wrong with that, except it just indicates the scope of the
    enterprise.
        It seems reasonable that a power of this magnitude should
    go hand in hand with some accountability, and yet once the SEC
    anoints or accepts the status of a credit rating agency which
    is now enjoyed by the three, the agencies are essentially left
    alone. So I think it is appropriate, as we try to learn the
    lessons of Enron, to ask whether these agencies should have
    some more ongoing sense of accountability, some oversight from
    the SEC, for instance, as we ask whether they are adequately
    and as fully as possible performing a function as watchdogs or
    gatekeepers.
        In the Enron case, it seems to me that the credit raters
    were no more knowledgeable about the company's problems than
    anyone else who was following its fortunes, including those who
    were following it in the newspapers. I just want to briefly go
    over some of the events leading to the raters' decisions to
    withdraw their assessment of Enron as a good credit risk.
        Remember after a summer of last year during which Enron
    stock steadily declined, it was reported in the third week in
    October that the SEC had asked the company to disclose its ties
    to outside investment partnerships set up by the company's
    chief financial officer. Enron stock dropped 20 percent that
    day, October 22, to a closing price of $20.65 per share. On
    October 24, CFO Andrew Fastow resigned, and the stock went down
    another $5 to $16.41. Five days later, on October 29, S&P's
    credit rating analyst appeared on CNN. By this time, the
    agencies had put Enron on a credit watch, but the company was
    still literally investment rated as a good risk. The S&P's
    analyst predicted that, ``Enron's ability to retain something
    like the rating that they're at today is excellent in the long
    term.'' When asked about the off-balance sheet partnerships
    which had become public, as I mentioned, the analyst assured
    investors that there would be no long-term implications.
    ``That's something that's really in the past,'' he said.
        Now, I want to go back to the last hearing we held in this
    series when a Wall Street analyst said to this Committee that
    his ``buy'' recommendation was supported by the confidence
    expressed by the credit rating agencies, which he specifically
    pointed out had access to inside information about Enron's
    liabilities that he didn't have. So S&P's confidence had an
    effect on others, and I want to ask the witnesses about that
    today.
        We know that as time went on, the market was not convinced.
    The stock price continued its descent, dropping to $8.41 on
    November 8, when Enron disclosed it had overstated earnings by
    over half a billion dollars since 1997. But, still, the rating
    agencies kept Enron at investment grade. By November 28, the
    day Moody's and Standard & Poor's downgraded Enron to junk bond
    status, effectively, the company's stock was trading at just
    over $1, and 4 days later, of course, it went into bankruptcy.
        In other words, the credit raters, despite their unique
    ability to obtain information unavailable to other analysts,
    were no more astute and no quicker than the others to act in
    warning and responding, and I want to ask about that today. The
    agencies, I understand, defend their ratings as opinions
    protected by the First Amendment. They refer to their
    assessments as the world's shortest editorials. But the fact is
    that their endorsement, if I can use the metaphor of the
    editorials, is required by law unlike, fortunately, other
    endorsements that newspapers give or don't give, which are not
    required by law.
        So the point here is that almost all the watchdogs who
    should have barked before a lot of good people were hurt by
    Enron's collapse didn't. Among them were the credit rating
    agencies who had more access to Enron's books than most of the
    other watchdogs, and the fundamental question we want to ask
    today is: Why did that happen? And what can we do together,
    hopefully, to make sure that the authority that credit rating
    agencies have is used as actively as possible to protect and
    defend the integrity of our capital markets, let alone the
    confidence of the millions of average investors and not-so-
    average investors who are institutional investors. So I look
    forward to the hearing today, and I thank the witnesses who are
    here for being here.
        Senator Thompson.

                 OPENING STATEMENT OF SENATOR THOMPSON

        Senator Thompson. Thank you, Mr. Chairman. I think you have
    framed the issues very well, and I will just simply ask that my
    full statement be made a part of the record.
        I was given a summary here that I think accurately
    summarizes the issues, and it says basically that these rating
    organizations are delegated responsibility by the government
    for certifying certain debt. They have the opportunity to
    access information that other professionals and the public
    cannot due to their exemption from Regulation FD. They are
    protected from competition by the SEC as a result of their
    status. They have the ability to effectively collect a tax from
    companies issuing debt, and they operate virtually free from
    liability. And yet some think that there is very little
    accountability, so the issue here is whether or not that is a
    good situation, and if not, what, if anything, should be done
    about it.
        I think there are First Amendment implications. I think it
    is clear that people need to understand these organizations do
    not recommend buy or sell. They deal in broad categories, and
    perhaps, if nothing more, we can illuminate exactly what they
    do and what they do not do for the benefits of investors and
    the extent to which investors should or should not rely upon
    what they are looking at.
        So I think that very well frames the issues, and I look
    forward to our witnesses today.
        Chairman Lieberman. Thanks, Senator Thompson. Your full
    statement, of course, will be printed in the record.
        [The prepared statement of Senator Thompson follows:]

                     PREPARED STATEMENT OF SENATOR THOMPSON

        Mr. Chairman, thank you for holding this hearing today. I
    appreciate the way this series of hearings has focused on the
    gatekeepers. Obviously, there is not much congress can do about
    individuals who choose to skirt or violate the law. However, I think it
    is appropriate for us to review the actions of regulatory agencies or,
    as we are looking at today, private entities with special dispensations
    from the government. That is the way I believe we can affect some
    positive change.
        During our first hearing which covered a number of topics,
    Professor Frank Partnoy testified about problems he saw in the
    structure of the credit rating agencies. Since that time, we have had
    an opportunity to delve deeper into that topic.
        The issues raised about credit rating agencies are not unlike those
    raised during our hearing on Wall Street analysts. For example, the
    Wall Street analysts maintained ``buy'' and ``strong buy'' ratings
    until very late in the year last year. Similarly, each of the three
    credit rating agencies on our first panel maintained investment grade
    ratings until just four days before Enron declared bankruptcy. Like the
    Wall Street analysts, some of the reasons given for the positive
    ratings on Enron are that the credit rating agencies were misled, they
    are not auditors and had to rely on Enron's financial statements and
    the work of Arthur Andersen, and because of the anticipated merger with
    Dynegy which never occurred.
        The difference with the Wall Street analysts is that the credit
    rating agencies do not have similar conflict of interest concerns
    because they do not have the same investment banking relationships.
    However, questions about conflicts and incentives to dig deep have been
    raised as a result of the unique regulatory setup involved here.
        My understanding of that setup is that three specific credit rating
    agencies currently have Nationally Recognized Statistical Rating
    Organization, or NRSRO, status. Several regulations and statutes
    require issuers or debt holders to rely on NRSRO ratings. As a result,
    issuers have little choice but to pay for ratings. Credit rating
    agencies, by virtue of their exemption from Regulation FD, have the
    opportunity to obtain information that others cannot. And they are
    basically free from liability.
        However, despite this special status, there appears to be little
    accountability. Some writers have noted that the requirements for NRSRO
    status appear to be ``inputs''--their reputation, access and
    organization--but does not include ``outputs.'' that is, for example,
    some method of following the agencies to see how timely and accurate
    their ratings are.
        A number of proposals have been floated from adding more NRSROs, to
    eliminating the NRSRO status altogether, to maintaining the status quo
    and providing more oversight. I look forward to hearing from the three
    credit rating agencies today to hear their explanation for their
    decisions. I would note that during the hearing on Wall Street
    analysts, we had to pick and choose among a number of firms, but
    because of the oligopoly associated with the NRSROs, we have all three
    of those firms here today. I am also pleased that in these hearings on
    government oversight we finally have a government official here today
    and I look forward to the testimony of Commissioner Hunt. I also look
    forward to hearing the experts discuss the current regulatory framework
    and what, perhaps, should be done to provide stronger incentives and to
    engender greater confidence.

        Chairman Lieberman. Senator Levin.

                   OPENING STATEMENT OF SENATOR LEVIN

        Senator Levin. Thank you, Mr. Chairman, for your continuing
    determination to get to the bottom not just of the Enron
    disaster, but also as to whether or not the problems disclosed
    are more endemic, more generic, and, therefore, require us to
    take some very determined and specific actions to try to
    restore confidence in our markets and in financial statements.
        As the many failures of various players come to light and
    as we dig deeper and deeper, the credit rating agencies clearly
    have a role here that we have to investigate and, if necessary,
    take action to see if we can't improve this situation so that
    their ratings can be more reliable.
        As our Chairman pointed out, one of the big questions that
    we are looking at is why were the rating agencies so slow to
    downgrade after the deceptions and the decline of Enron became
    public. Even before the deceptions and decline became public,
    the agencies were given access to information long before. Why
    didn't they see early signs, for instance, of the extreme use
    of structured finance deals, the use of undisclosed guarantees
    not made public but which apparently were made available to the
    rating agencies, which clearly affected the financial
    circumstance and situation of Enron? Not just the undisclosed
    guarantees here, which were not made public apparently, but
    also items which were left off these financial statements--
    liabilities which were omitted, which it would seem to me, with
    an inside view that the credit rating agencies have, would have
    shown that liabilities of Enron were omitted from the financial
    statements, which should have been disclosed.
        So there is a whole host of questions here. I am glad that
    the agencies are represented this morning, all of them, and
    that you, Mr. Chairman, are pursuing this investigation because
    there are many, many layers that need yet to be uncovered, to
    be disclosed, to be analyzed, and for corrective action to be
    taken.
        Thank you.
        Chairman Lieberman. Thanks very much, Senator Levin.
        Now we will go to the first panel: Ronald Barone, John----
        Senator Bunning. Mr. Chairman.
        Chairman Lieberman. Oh, I am sorry. How could I forget the
    big man.

                  OPENING STATEMENT OF SENATOR BUNNING

        Senator Bunning. That is all right, Mr. Chairman. I
    understand you want to get to the witnesses, but I do have some
    background that I would like to----
        Chairman Lieberman. I apologize. Please.
        Senator Bunning. Back in March 2001, Fortune Magazine
    published an article by Bethany McLean titled, ``Is Enron
    Overpriced?'' Now, this is March 5, 2001. In that article, she
    asked several individuals to explain how Enron made its money.
    The responses were not encouraging, according to the article.
    An analyst from Standard & Poor's said, ``If you figure it out,
    let me know.'' An analyst from Fitch, who I believe is also
    testifying on our first panel today, said, ``Do you have a
    year?''
        While these may have been off-the-cuff statements, they are
    very disturbing. Many of the people the public and the
    investors depend on to give them independent, unbiased, and
    accurate information dropped the ball. There is certainly
    enough blame to go around from the accountants to the analysts.
    Of course, most of the blame rests solely on the shoulders of
    those Enron executives who apparently were not truthful to
    their employees, investors, or analysts. But that doesn't let
    the rest of you off the hook.
        Last month, this Committee held a hearing on why Wall
    Street analysts continued to recommend Enron stock even as the
    company was collapsing. Those analysts told us that Enron
    withheld information and that the company's financial documents
    were not properly audited. This may be true. However, the one
    independent financial analyst on the panel, Howard Schilit,
    from the Center for Financial Research and Analysis, said that
    there were clear warnings in Enron's public filings and that
    just by reading over the statements the night before the
    hearing, he was able to pick out multiple problems. He said,
    ``For any analyst to say there were no warning signs in the
    public filings, they could not read the same public filings
    that I did.''
        The question that must be asked and answered is: How did
    Enron get away with the questionable business practices for so
    long? And what changes need to be made to ensure other
    companies cannot follow in Enron's footsteps?
        I appreciate the time the panelists testifying today have
    set aside to be here, and I look forward to gaining their
    perspective on this important issue.
        Thank you, Mr. Chairman.
        Chairman Lieberman. Thank you, Senator Bunning.
        Now we will go to the first panel: Ronald Barone, John C.
    Diaz, and Ralph Pellecchia. Gentlemen, as is the custom of the
    Committee, I would ask you all to stand at the table and raise
    your right hands so I can administer the oath. Do you solemnly
    swear that the testimony that you will give this Committee
    today is the truth, the whole truth, and nothing but the truth,
    so help you, God?
        Mr. Barone. I do.
        Mr. Diaz. I do.
        Mr. Pellecchia. I do.
        Chairman Lieberman. Thank you very much. Please be seated,
    and let the record show that the witnesses have answered the
    question in the affirmative.
        Mr. Barone, Managing Director of Standard & Poor's, we
    thank you for being here, and we look forward to your testimony
    now.

    TESTIMONY OF RONALD M. BARONE,\1\ MANAGING DIRECTOR, CORPORATE
            AND GOVERNMENT RATINGS GROUP, STANDARD & POOR'S

        Mr. Barone. Good morning, Mr. Chairman and Members of the
    Committee. I am Ronald M. Barone, a Managing Director in the
    Corporate and Government Ratings Group of Standard & Poor's.
    From 1994 until Enron's bankruptcy in December 2001, one of my
    roles was to serve as an analyst and then a manager with
    respect to our ratings work for Enron. On behalf of Standard &
    Poor's, I welcome this opportunity to appear at this hearing.
    As a member of the financial community that relied on Enron for
    complete, timely, and reliable information, and instead
    received incomplete, deceptive, and, it now appears, fraudulent
    representations, Standard & Poor's supports the Committee's
    urgent sense of the need to investigate the circumstances
    relating to Enron's collapse.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Barone with attachments appears
    in the Appendix on page 55.
    ---------------------------------------------------------------------------
        Standard & Poor's credit ratings have gained respect
    because they are based on objective and credible analyses. Our
    reputation ultimately depends on the credibility of our
    opinions. In order to ensure maximum objectivity and in-depth
    analysis, ratings are assigned by a Committee, not by an
    individual, and no portion of an analyst's compensation is
    dependent on the performance of the companies the analyst
    rates. The record bears out our method, as there is a
    longstanding and strong correlation between the ratings we
    initially assign and the eventual default record.
        At their core, our ratings opinions are based on the
    issuer's public information, including audited financial
    statements. We also may have access to certain confidential
    information--we did with Enron--but only to the extent the
    company is willing to provide such information. We expressly
    rely on the companies we rate not only for current and timely
    information at the time of the initial rating but for material
    updates to that information.
        From December 1995 until November 1, 2001, Standard &
    Poor's rating of Enron was BBB-plus, which we define as
    adequate ability to repay debt but subject to worsening
    economic conditions. This placed Enron at the lower levels of
    investment grade ratings, well below what Enron repeatedly, and
    unsuccessfully, sought.
        Standard & Poor's made continuous efforts to monitor
    Enron's credit quality closely. When Enron's troubles began to
    surface late last year, we changed Enron's outlook to negative
    on October 25. Over roughly the next month, we downgraded Enron
    three times, despite Enron's announced acquisition by
    financially stronger Dynegy. Indeed, we stated publicly that
    without the proposed merger, Enron's credit rating would likely
    fall below investment grade.
        On November 28, the day we determined that the merger was
    unlikely to occur, yet still before Dynegy publicly called it
    off, Standard & Poor's lowered Enron's rating to B-minus, a
    non-investment grade rating.
        We now know things we did not know when we were rating
    Enron. Despite our repeated requests for all information
    material to our analysis, Enron appears to have intentionally
    concealed the true nature of its debt obligations by treating
    almost $4 billion worth of in-substance loans as financial
    hedges. Moreover, as documented in the report of Enron's
    special committee, the company also failed to adequately
    disclose its material dealings with the Chewco, LJM1, LJM2, and
    Raptor partnerships.
        In fact, beginning in October 1999, and prompted by
    Standard & Poor's express request for full information
    regarding Enron's off-balance sheet partnerships, Enron made a
    series of formal presentations to us which they labeled as ``a
    kitchen sink analysis'' of all the non-recourse debt for its
    off-balance sheet affiliates. But in the presentations, two of
    which I have included with my testimony, there is no mention of
    any of these partnerships.
        Had Enron told Standard & Poor's the truth about its
    financial condition during the ratings process, as it was
    required to do, the impact on Enron's rating would necessarily
    have been significant. In addition to having a financial
    impact, Enron's disclosure failures related directly to Enron's
    honesty and, thus, to the validity of all its numbers. Enron's
    deceptions about its true debt burdens and off-balance sheet
    dealings not only hid many of its debt obligations from view,
    but were done, the Powers Report concluded, to accomplish
    favorable financial statement results, not to achieve bona fide
    economic objectives.
        Enron hid its true financial picture and, more
    specifically, its true creditworthiness from Standard & Poor's.
    Standard & Poor's publishes thousands of ratings that are
    subject to market scrutiny every day. We welcome that scrutiny,
    and I welcome the opportunity to testify here today.
        Thank you, Mr. Chairman.
        Chairman Lieberman. Thanks, Mr. Barone.
        Now we are going to hear from John C. Diaz, who is the
    Managing Director of Moody's Investors Service. Thanks, Mr.
    Diaz. Please go forward with your testimony now.

       TESTIMONY OF JOHN C. DIAZ,\1\ MANAGING DIRECTOR, MOODY'S
                           INVESTORS SERVICE

        Mr. Diaz. Good morning, Mr. Chairman, Senator Thompson, and
    Members of the Committee. My name is John Diaz, and I am a
    Managing Director of Moody's Investors Service. I am pleased to
    have the opportunity to appear before you today to discuss
    Moody's, the role that rating agencies play in the markets, and
    Moody's actions in rating the Enron Corporation and its debt
    instruments.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Diaz appears in the Appendix on
    page 116.
    ---------------------------------------------------------------------------
        Moody's Investors Service is owned by Moody's Corporation,
    a New York Stock Exchange-traded company. Moody's is the oldest
    credit rating agency in the world. Our roots trace back to
    1900, when John Moody & Company first published Moody's Manual
    of Industrial and Miscellaneous Securities. From its beginning,
    Moody's Investors Service has focused on rating debt
    instruments, and as early as 1924, Moody's was rating nearly
    every bond in the U.S. bond market.
        Moody's and other rating agencies occupy a niche in the
    investment information market. Ratings express relative
    creditworthiness. The heart of our service lies in ratings on
    long-term fixed-income debt instruments. We also provide, for
    instance, short-term ratings, deposit ratings for banks, and
    various rating services in foreign countries. Moody's has nine
    primary long-term debt rating categories. Investment grade
    ratings range from AAA at the high end down to a low of Baa.
    Ratings below Baa are considered to be speculative grade, or
    junk. Moody's supplies this long-term scale to ratings on other
    types of financial obligations and to companies. We also assign
    short-term ratings--mainly to issuers of commercial paper--on
    an independent scale that ranks obligations Prime-1, Prime-2,
    Prime-3, or Not Prime. In all, Moody's ratings are designed to
    provide a relative measure of risk, with the probability of
    default increasing with lower ratings.
        As part of Moody's commitment to predictive ratings, we
    review the relationship between defaults and our ratings. We
    publish an annual study, which we call our default study, which
    consistently shows that higher-rated bonds default less
    frequently than lower-rated bonds, although the rates of
    default may vary over time. Our default studies show the
    predictive nature of our ratings. Put simply, as a forward-
    looking opinion, ratings effectively distinguished bonds with
    higher credit risk from bonds with lower credit risk.
        Our strong record is due in large part to the availability
    of reliable information. The combination of the financial
    disclosure regime in the United States, audited accounts,
    information that is provided directly to Moody's, and issuers'
    good-faith dealings have normally been sufficient. Enron was an
    anomaly, partly in the nature of its activities, and certainly
    in the disclosure of its activities. As we have come to learn,
    Enron's public disclosures and its responses to our specific
    requests for information were misleading and incomplete.
    Although we do not have investigative authority, our analysts
    are encouraged to exercise skepticism with respect to an
    issuer's claims and promises. That skepticism led us to assign
    Enron a long-term rating that, at all times, was no better than
    low investment grade and contained speculative elements.
        Throughout Moody's rating history with Enron, we followed
    processes and practices that conformed to our established
    methods of credit analysis--methods that have been proven to
    predict relative creditworthiness. In the case of Enron,
    however, that methodology was undermined by the missing
    information upon which our ratings should have been based and
    the misleading information on which the ratings were, in fact,
    based.
        Having said that, my colleagues at Moody's and I wish we
    had discovered the information that would have allowed us to
    serve the market more effectively in this instance. We
    acknowledge that the public bond markets look to us for our
    opinion forecasts of long-term creditworthiness, and we
    recognize that the market does not expect a very large issuer
    of bonds, which we have rated investment grade, to default very
    shortly after holding such a rating.
        The integrity and reliability of our ratings and rating
    processes are the essence of our business. We are constantly
    striving to enhance rating processes and quality, and we have
    examined the circumstances around the Enron bankruptcy to see
    what lessons can be learned. For example, we are looking more
    comprehensively at the role of so-called rating triggers, which
    can cause payment obligations to accelerate or require the
    posting of collateral based upon a rating downgrade. We have
    enhanced our analysis of short-term corporate financial
    capacity, that is to say, liquidity, and we are reviewing more
    thoroughly the sufficiency and certainty of an issuer's near-
    term sources of cash and credit under conditions of stress. We
    have also contacted the large asset management firms in a
    coordinated review of their use of ratings in the marketplace.
    Finally, we commend this Committee, along with Congress in
    general, for your efforts to ensure the continued health of our
    financial markets.
        I thank you for your time, and I look forward to your
    questions.
        Chairman Lieberman. Thanks, Mr. Diaz.
        Finally, we are going to hear from Ralph Pellecchia, Senior
    Director of the Global Power Group of Fitch Ratings. Good
    morning.

     TESTIMONY OF RALPH G. PELLECCHIA,\1\ SENIOR DIRECTOR, GLOBAL
                       POWER GROUP, FITCH RATINGS

        Mr. Pellecchia. Thank you, Mr. Chairman and Members of the
    Committee. My name is Ralph Pellecchia, and I am a Senior
    Director in the Global Power Group of Fitch Ratings. I joined
    Fitch in July 1989 as an analyst in the natural gas and power
    sector. I have been the lead analyst following Enron at Fitch
    since May 1997. At Fitch, I am the primary analyst for 14
    companies in the Global Power Group and one of 15 Fitch
    analysts covering the North American Global Power sector.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Pellecchia appears in the
    Appendix on page 129.
    ---------------------------------------------------------------------------
        Fitch is in the business of publishing independent ratings
    and credit analysis of companies around the world. I am
    responsible for coordinating this activity for the companies
    assigned to me. My work includes regularly visiting companies I
    cover, maintaining contacts with members of the finance staff
    and other important personnel at those companies and staying
    current on events affecting the companies and the industry that
    I follow. I also conduct much of the quantitative and
    qualitative analysis that Fitch uses to assess credit of the
    companies we rate in my area.
        Finally, my role as the primary analyst is to synthesize
    the quantitative and qualitative analysis and to propose a
    rating, with the final rating outcome to be determined by a
    credit committee. The credit committee is comprised of a
    minimum of five voting members typically specialists from the
    industry/sector, but frequently includes members from other
    groups within Fitch.
        In my role as primary analyst, I am guided by procedures
    and practices followed at Fitch. The ratings process related to
    Enron was in all respects consistent with those procedures and
    practices.
        The assessment process itself is a blend of quantitative
    and qualitative factors. The quantitative factors that are
    parts of the rating process include an evaluation of published
    financial information, supplemental financial information, and
    peer financial performance. Qualitative factors include
    business fundamentals, competitive position, growth
    opportunities, the regulatory environment, and our view as to
    the abilities of management.
        Our analysis of Enron followed the rating process described
    above. Over the past several years, because of a significant
    shift in its business mix and a rapid revenue growth, Enron's
    reported financial profile, in size alone, as presented in its
    income statement and balance sheet, changed significantly. Yet
    although the market capitalization of Enron increased
    dramatically over the past several years, the various credit
    ratios and other factors used by Fitch supported a constant
    BBB-plus rating during the period from 1993 until the fourth
    quarter of 2001. It should also be noted that of the more than
    300 entities rated by our Global Power Group, the senior debt
    rating of more than 60 percent of the companies in the sector
    is above BBB-plus. BBB-plus is in the lowest investment grade
    category.
        In mid-October 2001, Enron released third quarter results
    that reflected a $618 million third quarter loss and a $1.2
    billion reduction in shareholder equity. Shortly thereafter,
    adverse press reports appeared, an informal SEC investigation
    was announced, and the CFO was replaced. Following these
    events, on October 25, Fitch placed Enron's rating on Rating
    Watch Negative warning that ``the loss of investor and
    counterparty confidence, if it continues, would impair Enron's
    financial flexibility and access to capital markets, therefore,
    impacting its ability to conduct its business.'' Eleven days
    later, on November 5, Enron's senior debt rating was downgraded
    to BBB-minus, the lowest possible investment grade rating, and
    left on Rating Watch Negative, an indication of the possibility
    of future downgrades.
        On November 8, Enron restated its earnings for a 5-year
    period, and on November 9, 2001, Enron announced its merger
    agreement with Dynegy. This announcement caused Fitch to revise
    the rating watch status to ``evolving.'' It was Fitch's opinion
    that Dynegy was a financially viable and knowledgeable
    purchaser with a sound financial and business profile on a
    stand-alone basis supplemented by a strong financial backer and
    investor through its affiliation with Chevron-Texaco. The
    merger agreement with Dynegy provided Enron with $1.5 billion
    in cash, which supplied needed liquidity. We also held the
    opinion that Dynegy, as a direct competitor, was quite familiar
    with Enron's operations. The evolving status, however,
    reflected a high level of execution risk compared with other
    acquisitions by entities rated higher than the target company.
    In those cases, Fitch would typically place the target's
    ratings on Rating Watch Positive. Fitch warned in its
    commentary accompanying the ratings action of November 9 that,
    ``If the merger were to terminate, Fitch believes Enron's
    ability to manage its business would be severely impaired and
    would expect to downgrade its securities to highly speculative
    grade. Termination provisions to the merger agreement add an
    element of uncertainty to completing the merger.''
        In the 3-week period following the merger agreement, Enron
    disclosed additional liabilities and incurred substantial cash
    outflows that compromised its financial condition. Fitch
    commented on these developments on November 21, stating that in
    the absence of a merger agreement with Dynegy, Enron's
    financial condition was ``untenable.'' At the time we published
    that comment, based upon discussions with Enron and Dynegy
    management, it was our understanding that the parties were
    committed to the merger, but at revised terms that reduced the
    value received by Enron shareholders. Based upon the inability
    to execute a revised merger agreement, as well as obtain
    additional secured bank financing, Enron's ratings were lowered
    to CC on November 28, indicating probable default.
        Thank you.
        Chairman Lieberman. Thank you, Mr. Pellecchia. Interesting
    opening statements by the three of you. We will do 7-minute
    rounds of questions on the Committee.
        As I listened to your statements and familiarize myself
    with this whole Enron saga, one thing that struck me is,
    although you have reported the different levels of concern that
    each of you had about Enron as last year went on, the market in
    some way was better reflecting increasing concerns about Enron
    than the credit rating agencies were, because in some sense the
    market during the year was going like that, whereas the
    agencies were maybe going like that, [gesturing] and
    notwithstanding the additional access that we know that you had
    to information.
        Let me go to some of the remarks, Mr. Barone, that I quoted
    from you and Mr. Shipman--Mr. Shipman's were the quotes from
    CNN in October, and then I didn't quote this in my opening
    statement, on November 2 at S&P's public conference call
    according to a transcript that was provided to my staff. You
    said, ``We have a great deal of confidence that there are no
    more surprises to come. We're confident we capture or are privy
    to the obligations that Enron has. I think it's going to take a
    little more time before everybody can get fully comfortable so
    that there's not something else lurking out there, but at this
    point we feel very confident that that's unlikely.''
        So my question, obviously, is: What was the basis for your
    confidence then that the off-balance sheet problems, which were
    known, were in Enron's past or that nothing else would come out
    soon?
        Mr. Barone. Thank you, Senator. The confidence we had was
    gained from discussions with Enron's management at that time,
    the new president, Greg Whalley, and CFO Jeff McMahon. They
    explained to us that, as much as they knew, from their
    investigation, there were no further partnerships that had debt
    obligations that they were unaware of. But that, indeed, and as
    my comments stated, they had not fully completed all that the
    investigation was to provide. The Powers Report was not yet
    completed at that time. But for all that they saw, what they
    knew, that was their assessment. And we gained confidence from
    that discussion.
        Chairman Lieberman. Let me ask the other two witnesses,
    because my concern is that with your remarks, notwithstanding
    the slight downgrade, although you still kept them at
    investment grade at that point, in early November, a month
    before Enron goes bankrupt, because of the way in which
    information was conveyed through CNN and other newspapers,
    etc., that you were still sending a message to the market that
    everything would be OK at Enron.
        Now, I understand what you have said about why. I want to
    engage the other two of you in this conversation, which is--how
    does the communication typically go between the rating agencies
    and a company like Enron, particularly at moments like this
    where there is alarm? Are you calling them or--and we know from
    other indications all over the history of this company, they
    were very aggressive--were they calling you to make the case
    don't worry? Mr. Diaz.
        Mr. Diaz. Mr. Chairman, thank you. Maybe I can go back a
    little bit to the beginning of the crisis at Enron. On October
    16, the company announced their earnings restatements and their
    equity charges. On that day, we placed the company on review
    for possible downgrade on our fundamental concerns about their
    accounting and about a potential crisis of confidence.
        Chairman Lieberman. You do that just based on the public
    announcement of what has happened?
        Mr. Diaz. No. We had talked to Enron a few days before that
    and they had given us a heads-up on the writedowns that were to
    come and began to explain to us the equity charge. And we were
    very surprised at not only the asset writedowns they were
    taking but also at the nature of the equity charge. And we were
    questioning and scratching our heads about the type of
    accounting that they were using for that charge and how did
    that $1.2 billion of equity actually come about.
        They made a rough attempt to explain to us the complexity
    of the hedges, but we were not satisfied with their
    explanations. So we told them that we would likely put them on
    review for downgrade and then take a harder look at the
    situation.
        So throughout that crisis stage, we had become increasingly
    concerned. At that time, Andrew Fastow was no longer involved
    in the discussions, so we were talking primarily to Tim Despain
    and then Jeff McMahon, who had joined as the new CFO.
        Our discussions during that time were concentrated on
    understanding the liquidity position of the company and how
    that was impacting the trading business. When we became further
    concerned on, I think, October 24--my recollection is not
    exact--we had asked them about their availability of commercial
    paper, and they told us they were still able to place
    commercial paper, but that the price was getting much higher
    for them. So as we got ready to go to committee to act on the
    rating, they announced that they had drawn down their credit
    lines.
        So the bottom line at that point was that we were
    increasingly concerned about the liquidity, and we downgraded
    them on October 29, and then kept the rating on review for
    further downgrade. We also put the commercial paper rating
    review for downgrade.
        Chairman Lieberman. Mr. Barone, I quoted you on the
    November 2 conversation, so I should give you an opportunity to
    say a little bit more about what Enron may have told you before
    that.
        Mr. Barone. Yes, generally going back to your question,
    Senator, we were calling Enron, and----
        Chairman Lieberman. They were not initiating calls with you
    by and large?
        Mr. Barone. There was an active dialogue back and forth,
    Senator, as we do with many issuers. If they have news to tell
    us, they would be active and do that, or respond to questions.
    They would research our questions and they'd call us back with
    answers.
        Chairman Lieberman. Were they more active than most
    companies, even at this point, in trying to convince you that
    everything was OK?
        Mr. Barone. Not unusually so. They've had a campaign for
    years to try to be higher rated, as many firms try who have a
    different opinion than we do.
        Chairman Lieberman. How do you carry out such a campaign?
        Mr. Barone. They try to show us, whether it be a financial
    or qualitative assessment, that we take one view of the
    information and they take a different view of it. They try to
    get at the heart of our review, and we try to get at the heart
    of their review. And often we have to agree to disagree.
        Chairman Lieberman. Am I right that in conversations with
    our staff leading up to the hearing, Mr. Barone, you told them
    that Enron officials told you that they didn't know what else
    was out there?
        Mr. Barone. That is correct.
        Chairman Lieberman. This was at the end of October, and
    that they had a special committee investigating?
        Mr. Barone. That's correct.
        Chairman Lieberman. But, still, you felt confident enough
    to make the statement you did on November 2?
        Mr. Barone. That is correct. They explained to us that in
    the investigation: (1) they found, I believe, the LJM1, LJM2,
    Chewco, and Raptors; (2) they had started to scrub down
    everything they could get their hands on; and (3) they would be
    surprised if they would find anything further. And while they
    said clearly that they did not have the full report, they
    believed they had uncovered the majority of what there was to
    uncover, and that this was what they expected.
        Chairman Lieberman. I am over my time. Mr. Pellecchia, I
    will come back to you in the next round. Senator Thompson.
        Senator Thompson. Thank you very much.
        In listening, it is surprising to me the extent to which
    you seemingly rely on the management leadership for your
    information. You know, Mom and Pop can read these public
    documents, and it seems that what we are learning from all of
    this is that there is really not much value-added for the
    average investor in looking at either the--what the analysts
    are saying or what the raters are doing; that when you have a
    complex set of documents, that you don't really go behind the
    documents, even though you have a right to; that when the
    company officials refused to divulge certain information, they
    can get away with that; and that you rely an awful lot--when
    things pop up that seem troublesome, you rely an awful lot, if
    not exclusively in some cases, on what the corporate management
    tells you.
        Is that an unfair assessment or is that about the way it
    is?
        Mr. Barone. Senator, we do rely on what senior management
    tells us. It is in their best interest to tell us and be
    forthright and not convey a different message, because if we
    convey a message to the market that is different than what the
    market perceives over the long term, then the credibility of
    Standard & Poor's and then ultimately the credibility of the
    company is at risk. And you saw what happened with Enron as to
    what happened when the market loses confidence in their
    credibility. And so it is in their best interest to tell us the
    truth, and we rely on that.
        Senator Thompson. That is kind of a chicken-and-egg deal.
    Are you saying you don't think it is ever in--strictly from a
    self-interested standpoint, it is never in the interest of a
    corporate executive to minimize bad news and stretch the truth?
    Clearly it is sometimes in their interest to play the short-
    term game and hope things turn out better, right?
        Mr. Barone. Yes. Many of the firms put forth their best
    foot, but they don't put forth fraudulent information.
        Senator Thompson. What is it exactly that Enron put out
    that was most deceptive in retrospect, do you think? Did it
    have to do with these related-party transactions?
        Mr. Barone. I would say it had to do with the total amount
    of their obligations, whether it be these related-party
    transactions or other partnerships----
        Senator Thompson. Mr. Diaz, briefly, could you pinpoint
    anything?
        Mr. Diaz. Senator, it's less what they put out. It's more
    what they didn't put out. It's the fact that the off-balance
    sheet partnerships were never disclosed anywhere. We've come to
    learn about names like Braveheart, Raptor----
        Senator Thompson. Is that what we now know was apparently
    being referred to in footnote 16, related-party transactions?
        Mr. Diaz. I believe that was related to LJM2, one of the
    Fastow partnerships. There are a lot of other partnerships,
    Senator, partnerships like Braveheart, Raptor, Southampton, and
    Rawhide. The names just seem to be coming out.
        Senator Thompson. In retrospect, is not footnote 16 also
    referring to them? I mean, it is in the plural here.
        Mr. Diaz. I believe that, having looked at it in some
    detail and tying it back to the Powers Report, I believe that
    it's talking about the LJM2 transactions, the Chewco
    transactions, and the Raptors, which I think are embedded in
    their LJM2. It's still difficult to understand exactly what
    they were doing.
        Senator Thompson. I think that makes the point, that we are
    still here today trying to figure out what they are talking
    about in footnote 16.
        Mr. Diaz. That's right. It's a very obtuse footnote. You
    know, there is some disclosure there, but it's extremely
    difficult to understand what is going on.
        Senator Thompson. The question becomes: What should the
    rating agencies' obligations be? You can't audit every firm
    that you deal with. On the other hand, some are bigger than
    others. Some are more obtuse than others, I guess, in their
    public documents. What should the rating--if you are just going
    to look at this and say this is very confusing and obtuse and
    call up the corporate executive and say is everything all
    right, and he says everything is all right, if that is it, you
    can see----
        Mr. Diaz. I understand the point, Senator. I think in
    looking at a footnote like 16, clearly what needs to be done in
    those situations is try to get behind it and try to understand
    a lot more of what's there.
        Looking in hindsight at how that impacted the ultimate
    confidence in the company, it's pretty clear that there were--
    and from my point of view, we certainly look at it as a
    situation where we could have dug more into and tried to get
    behind that.
        Senator Thompson. It would be fair to say that if you ran
    across this same situation again, you would delve into it
    deeper?
        Mr. Diaz. Yes, sir.
        Senator Thompson. I noticed here that on November 8, after
    reviewing a copy of the merger terms, the merger with Dynegy,
    you were concerned there were too many conditions that would
    allow parties to walk away from the merger, and Moody's
    informed Enron that it might drop its rating to below
    investment grade. Subsequently, Moody's received a number of
    telephone calls from interested parties, including Richard
    Grasso, CEO of the New York Stock Exchange, Robert Rubin of
    Citibank, Michael Carpenter of Salomon Smith Barney, and
    William Harrison of J.P. Morgan Chase. The banks assured
    Moody's that they were not planning on getting out of the
    merger. Again, the next day, Moody's downgraded Enron, but not
    below investment grade.
        Clearly, Enron had called all these investment bankers up
    to get them to call you, right?
        Mr. Diaz. Senator----
        Senator Thompson. And I am asking whether or not that is
    correct. And, second, what are we to make of this? Here clearly
    are interested parties trying to presumably have some impact on
    what your rating was going to be. Is this normal in the
    business?
        Mr. Diaz. Senator, what I'd like to say is, first of all,
    we were ready to downgrade Enron that morning. The first bit of
    information was that there was a significant change in the
    transaction. There was going to be up to $1 billion of new
    equity put in, and they were going to be changing the terms of
    the agreement. That was what we were led to understand--so that
    we held off on the press release.
        Throughout the course of the day, we had calls from
    bankers, and we also had a meeting with bankers--and I can't
    recall if Dynegy was actually in the room. But the bottom line
    there was that the agreement was changed. There were
    substantial changes made that made it more difficult for Dynegy
    to walk away. They eliminated a material adverse change clause.
    They eliminated rating triggers that were in the financing
    agreement. And, also, they agreed to collapse the structure of
    the combined entity so that the bonds of Enron and the bonds of
    Dynegy were pari passu.
        From our point of view, we were looking at the combined
    entity as having an investment grade rating of Baa, at the low
    end, so we gauged the probability that the deal would go
    through to be high. We gauged the probability that Enron's
    liquidity would be shored up enough for Enron to survive----
        Senator Thompson. I understand what you are saying, but
    without getting into the merits of the deal and the reason, I
    understand you were concerned there were too many ways to walk
    away and then they began to close that door somewhat.
        Mr. Diaz. Right.
        Senator Thompson. But in the meantime, these bankers were
    calling you to tell you, I suppose, that they, according to
    what I have got here, were not planning on getting out of the
    merger. Of course, that is like a politician saying they are
    not planning on running for office, I suppose. They are not
    presently planning.
        Senator Bunning. Except in your case. [Laughter.]
        Senator Thompson. Of course, they did walk away from the
    merger, what, 20 days later, I think, after I guess S&P's
    downgraded them. I am just asking for information. Is this a
    normal kind of interplay? I mean, do you get calls like this
    telling you we know you are concerned about this deal that
    would affect the welfare of the company, I am in on this deal,
    and I want you to know here is our present intention?
        Mr. Diaz. In general, we do get calls from banks and
    companies when the company's rating is under pressure. That is
    not an anomaly. Certainly, the intensity of that day was pretty
    high given the situation of Enron, but that did not--was not an
    influencing factor on our decision. The influencing factor on
    the decision was the change in the merger--in the terms of the
    merger agreement.
        Senator Thompson. Well, I am not suggesting it was. All I
    am suggesting is clearly they were--from their standpoint they
    were making the call for some purpose. And if it wasn't to
    influence your decision, I am not sure what it was.
        Mr. Diaz. It was to get us to wait-- that is to say--listen
    to the new terms of the deal, is really what they were trying
    to do. They weren't saying please don't do this because Enron's
    going to go bankrupt. They were saying we have a new deal on
    the table.
        Senator Thompson. Thank you, Mr. Chairman.
        Chairman Lieberman. Thanks, Senator Thompson.
        If I may, just following on the line of a question Senator
    Thompson raised, I assume you allow for the, if I can call it
    this, self-interest of the people calling and having Enron's
    rating remain high.
        Mr. Diaz. Sure, right.
        Chairman Lieberman. In other words, various of people, of
    the institutions that Senator Thompson has cited, we know from
    public sources were either heavily--were creditors of Enron or
    perhaps had fees which would be gained by the completion of the
    Dynegy-Enron proposed merger. But I presume you allow for that
    as you consider what they are saying.
        Mr. Diaz. That's right. There were a lot of self-interested
    parties in that situation. We certainly understand that. But,
    we're still looking at whether or not the deal was going to go
    through and what the impact on the combined companies was. That
    was the bottom line for us.
        Chairman Lieberman. OK. Senator Levin.
        Senator Levin. Thank you, Mr. Chairman.
        I want to pursue the line of Senator Thompson's questions
    as to what was not disclosed to you that you now know should
    have been disclosed to you, and what was deceptive and
    fraudulent. Mr. Barone, you used the word ``fraudulent,'' which
    means there was a representation of something which wasn't
    true. Can you give us some examples of what was represented to
    you that was not true?
        Mr. Barone. Yes, Senator Levin. Enron had presented to us
    something called its ``kitchen sink analysis,'' which purported
    to show the full extent of all its obligations with
    partnerships, third parties, related parties, and the like. And
    we have come to learn that this representation of the kitchen
    sink--and I think they wrote the words ``100 percent
    disclosure''--did not include all of the so-called third-party
    related transactions.
        Senator Levin. Would you supply that document to the
    Committee?
        Mr. Barone. I believe, Senator, it's included with my full
    testimony.
        Senator Levin. That is fine. Thank you.
        Can anyone else give examples of what was not disclosed to
    you or what was disclosed to you and misrepresented in the
    disclosure? Mr. Diaz.
        Mr. Diaz. Yes, Senator. We also received the ``kitchen sink
    analysis.''
        Senator Levin. Is that the same analysis?
        Mr. Diaz. I can't say it was exactly the same analysis, but
    it was supposed to represent the complete picture of the
    company's total obligations, and it clearly did not. As I've
    said earlier, there have been quite a few names of partnerships
    that have come out in the press and all the reports that we had
    no knowledge of and were not included in that.
        Senator Levin. Mr. Pellecchia.
        Mr. Pellecchia. Well, I would add, in addition to the fact
    that the company restated its financial statements back to
    1997, the types of information they would supply us--and we
    also got a ``kitchen sink analysis''--as far as the company's
    off-balance sheet debt and guarantees was consistent with what
    was provided the general public. So there wasn't any real
    additional information that we had. And I would say to the
    question of whether these presentations were fraudulent, what
    we read in the Powers Report certainly seems to say that they
    entered into transactions for a very different purpose than
    what was represented to us, particularly with what was called
    these LJM transactions, which were presented to us as a
    technique to transfer risk to sophisticated investors.
        Mr. Barone. Senator, may I----
        Senator Levin. Please.
        Mr. Barone. I want to add, too--and I noted this in my
    opening remarks--that what was also hidden from us, not
    disclosed fully--or at all, I should say, are those almost $4
    billion of in-substance loans that Enron made with financial
    institutions that were originally reported as financial hedges.
    And that was not disclosed as well.
        Senator Levin. Was it falsely disclosed or not disclosed?
        Mr. Barone. I believe it was not disclosed as a loan, as it
    worked.
        Senator Levin. Was it disclosed as a hedge?
        Mr. Barone. I don't know for sure, sir.
        Senator Levin. What is the understanding that you have with
    your clients as to what is disclosed? Do you have a written
    agreement with them, a contract as to the amount of disclosure
    and what your access will be, inside access that is not
    publicly disclosed? Is that all set forth in a contract, Mr.
    Barone?
        Mr. Barone. We have an agreement--I don't know if it's
    contractual or not, but it's an agreement that is included in
    our rating letter, that they provide us full, timely, and
    accurate disclosure of all material information relating to
    their rating. I don't know the exact words, sir, but it is
    quite broad and comprehensive.
        Senator Levin. And they sign that, they agree to that?
        Mr. Barone. Yes.
        Senator Levin. Is that true with the other companies, too?
        Mr. Pellecchia. We have a similar representation, but it's
    not a signed agreement.
        Mr. Barone. Senator, I don't know--excuse me, I apologize.
    I'm not exactly sure they're signed or not. I don't want to
    represent----
        Senator Levin. All right. Mr. Diaz.
        Mr. Diaz. We have applications for ratings in which the
    maintenance of the rating is based on our satisfaction with the
    information that's being provided, but there's no specific
    agreement about the kind of or the type of information that has
    to be given to us.
        Senator Levin. All right. Let me go through one of the
    transactions with you. Enron North America was trying to show
    strong cash flow on its 1999 end-of-year statement. According
    to the Powers Report, what Enron North America did or ENA did
    was pool a group of loans that it held into a trust. The trust
    then sold about $324 million of those notes and provided the
    purchasers with certain rights to cash flow from repayments of
    the loans. So these were collateralized loan obligations.
        When they sold the loans, ENA was able to report an
    increase in cash flow, and since the risk of default on the
    loans was transferred to the trust, ENA didn't report or
    account for the possibility of a default. They left that out
    from their own reports.
        Now, the trust that purchased those loans then sold
    interests in those loans to investors, but the sales did not go
    well. According to the Powers Report, the lowest-rated notes,
    those with the last claim on repayments of the loans, were
    extremely difficult to sell and no outside buyer could be
    found. At the end of 1999, LJM2 purchased about $20 million of
    those lowest-rated notes.
        So LJM bought the notes that nobody else would buy, but
    some credit rating agency would have had to have rated those
    notes. And I think it was your agency, Mr. Pellecchia.
        Mr. Pellecchia. We did.
        Senator Levin. Is that correct?
        Mr. Pellecchia. Yes.
        Senator Levin. Now, how can your credit rating agency give
    an investment grade to those notes when nobody else would buy
    them? How does that work?
        Mr. Pellecchia. Well, I'm a corporate analyst. This
    transaction was one that was structured in a way that the
    credit quality of the pool of loans--and I would say these
    loans were on a stand-alone basis very weak companies, loans to
    very weak companies--was structured in such a way so that there
    were different tranches of ratings that apply to different
    groups of securities that were sold, and they were able to
    attain high ratings through this enhancement that is much
    higher than you could individually for each of those individual
    loans.
        Senator Levin. So even though nobody else would buy them,
    they were given investment grade rating because of the
    guarantee?
        Mr. Pellecchia. Well, I believe that this particular
    transaction--again, I'm not a structured analyst--was one that
    met all the qualifications that you would need for separateness
    and other qualifications for doing a structured transaction,
    and it was marketed and it was sold.
        Senator Levin. Could you try to answer that, or get the
    answer for the record on that question for us?
        Mr. Pellecchia. As to----
        Senator Levin. How is it possible that those specific notes
    can be listed as investment grade if, in fact, nobody would buy
    them? Can you talk to the person who did the analysis on that--
    you said it wasn't you--and give us the answer?
        Mr. Pellecchia. My answer was also I think they were sold,
    and----
        Senator Levin. They were sold to LJM. They were sold right
    back to Enron.
        Mr. Pellecchia. That might have been in the secondary
    market, but I will provide that information.
        Senator Levin. All right. Now, according to an Enron
    employee who worked on the transaction, the head of ENA
    finance, told one of the investors that if the note defaulted,
    Enron would make the investors whole. Enron had agreed, in
    other words, to repurchase the notes at face value, which
    guaranteed the investment. Now my question to you is: Was it
    publicly known that that guarantee existed?
        Mr. Pellecchia. I do not know the answer to that. I would
    say as far as a rating agency's obligation, we would have rated
    the securities based upon the risk to the investors, and----
        Senator Levin. Would the guarantee affect that risk?
    Wouldn't it be less risky to buy it if there was an Enron
    guarantee?
        Mr. Pellecchia. It certainly would, yes.
        Senator Levin. OK. Was it publicly known that there was an
    Enron guarantee?
        Mr. Pellecchia. I do not know if it was publicly known, and
    I'm not sure there was an Enron guarantee.
        Senator Levin. So you don't know yourself whether there was
    an Enron guarantee?
        Mr. Pellecchia. Apparently, LJM, as you explained--and I
    didn't know the facts on that--stepped up and bought securities
    which probably in effect would have done the same thing as
    providing a guarantee.
        Senator Levin. So my specific question is: Was it known to
    your agency that there was such a purchase guarantee?
        Mr. Pellecchia. I know that we had discussions with Enron
    personnel as to the situation with the loans, and I'm not sure
    exactly what agreements were struck, if anything, or what we
    learned from that.
        Senator Levin. Well, wouldn't that affect the
    creditworthiness of the notes?
        Mr. Pellecchia. It would have, certainly.
        Senator Levin. And your rating?
        Mr. Pellecchia. Yes.
        Senator Levin. But you are not sure because of memory, or
    you are not----
        Mr. Pellecchia. Well, I'm not sure about exactly what was--
    --
        Senator Levin. Your ratings are affected by whether there
    is a guarantee, but you are telling us you don't know whether
    there was a guarantee.
        Mr. Pellecchia. I do not know if there was a guarantee.
        Senator Levin. But whether or not there was a guarantee
    would have affected your rating?
        Mr. Pellecchia. I would assume it would be considered, yes.
        Senator Levin. OK. Can you find out for us whether anyone
    in your company knew whether or not there was a guarantee?
        Mr. Pellecchia. Yes.
        Senator Levin. And can you also then answer this question:
    If there had been a guarantee, assuming it went back to Enron,
    would that have affected the value of Enron's stock?
        Mr. Pellecchia. I would answer from the credit rating
    standpoint. What we try to assess is the types of guarantees
    and the amount of guarantees Enron has. So the fact that if
    Enron had a guarantee, that would be a consideration in the
    credit rating.
        Senator Levin. OK. But also not on the credit rating----
        Mr. Pellecchia. Of Enron Corp.
        Senator Levin. Of the Enron Corporation, so that would
    affect their stock.
        Mr. Pellecchia. It would be considered in the credit
    rating. They had approximately $2 billion of guarantees
    outstanding to affiliated companies. Some of those guarantees
    were supported by collateral, some weren't. So you would make
    judgments, basically, upon what the effect of a guarantee would
    have on Enron Corp.
        Senator Levin. Would you say this: To the extent that those
    guarantees were not known to the public, that they were,
    therefore, telling the public that their company was in a lot
    better shape than it really was, because guarantees which were
    outstanding wouldn't have been disclosed? Is that a fair
    statement?
        Mr. Pellecchia. If Enron had a guarantee----
        Senator Levin. If Enron had guarantees outstanding which
    were not disclosed publicly, that, therefore, they would have
    been--their financial statements would have looked better than,
    in fact, they should have because it wouldn't have disclosed
    outstanding potential obligations. Is that a fair statement?
        Mr. Pellecchia. Yes, I do not believe Enron--and I'm not
    aware that Enron guaranteed that debt.
        Senator Levin. I am not talking about that debt. I am
    talking about in general.
        Mr. Pellecchia. In general, we would recognize guarantees
    in the context of all its obligations, yes. That would be a
    consideration.
        Senator Levin. My question is: If the guarantees were not
    disclosed publicly, would that----
        Mr. Pellecchia. That--we should be aware--they should be
    disclosed publicly, and as far as I know, every guarantee that
    Enron had was--that we were aware of was consistent with the
    guarantees that they published in their information, the public
    information. As far as I know.
        Senator Levin. I see my time is up, but the bottom line is
    that you are not answering my question about failure to
    disclose guarantees publicly. But what you are saying to us is
    this: That you believe that every single guarantee that you
    were aware of was disclosed publicly?
        Mr. Pellecchia. Yes.
        Senator Levin. Thank you.
        Chairman Lieberman. Thanks, Senator Levin. Senator Bunning.
        Senator Bunning. Thank you, Mr. Chairman.
        Just a little background for the average American and
    average person who looks at credit ratings as a means of
    investing. The SEC grants credit rating companies NRSRO status,
    and currently only your three companies--S&P's, Moody's, and
    Fitch--are those companies. You have special access to the
    companies that you deal with. In that, you can have private
    conversations with companies' management that analysts cannot
    have. You can see financial information about companies that is
    not public, and you are shielded from fraud under the security
    laws. All that true?
        Mr. Barone. That's true.
        Senator Bunning. Well, you realize in 1997 the SEC looked
    at this and said maybe there is a monopoly here, maybe you
    three shouldn't be the only ones doing this because the only
    three people that you could go to for a credit rating was
    Standard & Poor's, Moody's, and Fitch. Is that correct? And
    they tried to change the rules, and you fought them tooth and
    nail. The Justice Department fought them tooth and nail also.
    They criticized the new rules that pertained perpetuating the
    anticompetitive environment of credit agencies. The Justice
    Department was for changing the rules. The rule was never acted
    upon.
        Now, I think you have a major obligation to look beyond
    what is given to you by any corporation. If the people rely on
    your ratings, investment grade or non-investment grade,
    particularly institutional investors, particularly anyone whose
    stock is on a roller coaster in a down spiral, and your three
    companies are still rating that as investment grade material.
        Now, I don't even want to get to November. But I want to
    get to March and the document that Fortune Magazine put out.
    Someone said how can you rate these companies--how can you rate
    Enron specifically investment grade, and people from your
    companies made light of it. S&P's said, ``If you figure it out,
    you let me know.'' Is that a quip or is that a serious
    statement by S&P's? This is quoted in Fortune.
        You, Mr. Pellecchia, said, ``Do you have a year?''
        Mr. Pellecchia. Here's what I--could I answer that?
        Senator Bunning. I mean, is that a correct quote or not?
        Mr. Pellecchia. I believe what I was asked was exactly how
    does Enron make its money, and my response was, ``Do you have a
    year?'' That was----
        Senator Bunning. In other words----
        Mr. Pellecchia. That was a glib answer. But the spirit----
        Senator Bunning. OK. I know it is a glib answer, but you
    are responsible for the ability to grade that either investment
    grade security or non-investment grade security.
        Mr. Pellecchia. Yes.
        Senator Bunning. And you are making light of the fact that
    you are not sure how they are making their money?
        Mr. Pellecchia. Well, I think the spirit of the answer was
    Enron's a big company, it's a complex company----
        Senator Bunning. Your duty was to get beyond the bigness
    and just the words coming out of the corporate mouths. Is it
    true or is it not true that the CFO and the chairman of the
    board made calls to Mr. Diaz and Mr. Barone that they were
    aggressively trying to get a higher grade credit rating for
    their company? Is that true or false?
        Mr. Barone. That's false. Mr. Lay did not call aggressively
    seeking a higher rating for the company. Mr. Lay called to----
        Senator Bunning. He didn't call you personally?
        Mr. Barone. He called me personally, but not for that
    reason, sir. He called me to let me know that he was committed
    to the current credit quality of the company, that they would
    take steps necessary to preserve what he thought was a very
    important credit rating, and the similar steps to those that he
    had taken in the past by issuing equity or selling assets----
        Senator Bunning. Was there any pressure exerted by Enron to
    get a similar upgrade or remain the same kind of credit rating
    from your company?
        Mr. Barone. During this period of time, sir, no.
        Senator Bunning. Is it normal for the president and CEO of
    a company to call you?
        Mr. Barone. There are some that do, sir, and some that
    don't. It depends. This was the first time I had heard from Mr.
    Lay, but there are other firms that we follow under my purview,
    and some of them call and some of them don't.
        Senator Bunning. Don't you think there should be a
    separation, a separation between the analyst making a credit
    rating and the company executives? I mean, if somebody can
    testify before this Committee, it was right in the filings
    before the SEC that I could pick up that there were problems in
    the company. You as experts in credit ratings couldn't see
    that?
        Mr. Diaz. Senator, I spoke with Mr. Lay one time only, and
    that was just before putting them on review for downgrade, and
    what he was trying to do is keep us from putting him on review
    for downgrade.
        Senator Bunning. Thank you.
        Mr. Diaz. And we did not----
        Senator Bunning. That doesn't answer my question.
        Mr. Barone. Sir, we often speak with the senior management
    of the firm----
        Senator Bunning. I understand that----
        Mr. Barone [continuing]. Because strategy is a very key
    element to rating.
        Senator Bunning. What about the filings that they filed
    with the SEC as of all during this time that you were in charge
    of their credit ratings? You couldn't pick anything out to give
    you a heads-up or a red flag----
        Mr. Barone. No, from the----
        Senator Bunning [continuing]. And some other analyst could?
    Why were you not able to pick up the red flags?
        Mr. Diaz. Maybe I can address that. Senator, I mean,
    hindsight is a great thing and----
        Senator Bunning. We all know that.
        Mr. Diaz [continuing]. People looking at this situation now
    can go back and sort of look for flags and situations where----
        Senator Bunning. It is your job.
        Mr. Diaz. But what I'm trying to say, Senator, is
    fundamentally we were looking at a company that on its face
    looked like it had a very strong franchise in wholesale
    trading. It looked like it was showing earnings, increasing
    earnings, because of the mark-to-market accounting.
        Senator Bunning. Then why was the stock plummeting? If all
    of those things be true, why was the stock going straight down?
        Mr. Diaz. The stock started to plummet in--I believe in the
    spring of----
        Senator Bunning. Inside traders were selling the devil out
    of it.
        Mr. Diaz. We're not equity analysts, so we don't focus
    necessarily on stock.
        Senator Bunning. I understand that, but there is a reason
    for a stock to react.
        Mr. Diaz. Sometimes, Senator, there are many reasons why
    stocks go down. I mean, bear markets cause stocks to go down.
    Enron stock had been hyped by the broadband euphoria, and it
    had gone from the mid-40s to 90, and we didn't upgrade the
    company then because we thought Enron is doing great. We kept
    the same low investment grade rating that we had because of the
    fundamental issues that we always looked for at the company.
        Senator Bunning. But somehow, sir--and I beg to differ with
    you--you have to be more responsible to the many people who
    rely on your ratings. And if you are not more responsible, then
    we have got to get more people rating.
        Mr. Diaz. Senator, I guess----
        Senator Bunning. My time has expired.
        Chairman Lieberman. Go ahead.
        Senator Bunning. Go ahead, Mr. Diaz.
        Mr. Diaz. Could I answer? Thank you. Senator, we stand on
    our record. We have a 100-year record that we publish every
    year----
        Senator Bunning. It just takes one.
        Mr. Diaz. One company that misleads.
        Senator Bunning. Billions and billions, and millions of
    employees lost every penny they ever had.
        Mr. Diaz. I understand that, Senator. But the reason was
    because the company misled. Their executives have----
        Senator Bunning. You have never had a company mislead you?
        Mr. Diaz. Not to the extent of Enron. Not a company that,
    in effect, has their executives refuse to testify, that have
    had their accountants indicted for shredding documents. You
    know, we're in a situation--we believe that Enron is an
    anomaly, that Powers Report, a board-commissioned report, that
    points out to the dealings of the CFO. In my experience----
        Senator Bunning. I don't doubt that they are an anomaly,
    but, in fact, Global Crossing could be another Enron.
        Mr. Diaz. I'm not aware of--I don't rate Global Crossing,
    so I don't know the details----
        Senator Bunning. Well, OK. You don't grade it, but it is in
    the same situation.
        Mr. Barone. Senator, this was not a ratings problem. This
    was a fraud problem.
        Senator Bunning. It was also a rating problem. Your
    reaction was way too late and too little.
        Mr. Barone. The market expects us, with all due respect,
    Senator, to take a tempered, deliberate approach. And as my
    colleague----
        Senator Bunning. No. The market expects you to anticipate
    what happens and also warn people if something is red-flagging
    you. You didn't----
        Mr. Barone. And that's exactly what----
        Senator Bunning [continuing]. Do it until after the fact.
    Thank you.
        Chairman Lieberman. Thank you, Senator Bunning. Senator
    Bennett.
        Senator Bennett. Thank you, Mr. Chairman, and I apologize
    for having to slip out, but I appreciate the fact that the
    panel is still here for my questions.
        Now, follow me through this and see if I have it right, and
    if I don't, set me right.
        We, of course, start from the fact that is pretty well
    established that the Enron management was engaged in fraud.
    They were hiding things. They were lying. So you weren't used
    to that. You weren't expecting that. And you were caught by
    surprise by that.
        However, would it be accurate to say that their accounting
    gimmicks, the things they did to perpetuate that fraud, relied
    heavily on the credit ratings? Whenever Enron credit ratings
    dropped below investment grade levels or triggers, the special
    purpose entities required that the Enron parent guarantee the
    value of the SPE. That trigger was written into the deal, as I
    understand it. So as long as the credit ratings were high, the
    SPE does not demand the collateral, and Enron does not have to
    pledge its stock. Is that an accurate description of the way
    this was constructed?
        Mr. Barone. In general, yes, sir.
        Mr. Pellecchia. Yes.
        Senator Bennett. OK. Now----
        Mr. Diaz. Senator, that's an accurate description of two
    SPEs that we rated. There are apparently many others out there
    that we didn't know about.
        Senator Bennett. OK. But as long as the credit rating is
    above the trigger, the stock does not have to be pledged, does
    not have to be delivered, and, therefore, Enron can say to the
    analysts and everybody else, well, it is unencumbered because
    this is a contingent liability, but it is a contingent that is
    not going to come to pass because the credit rating is
    sufficiently high.
        So when the credit rating triggers the trigger, that is
    when things begin to be really, really difficult. So the credit
    rating does play a critical role in how this whole structure
    operates. Am I all right so far?
        Mr. Barone. In general, yes, sir.
        Senator Bennett. OK. So when the credit rating hit the
    trigger, and that is when former Secretary Rubin called the
    Treasury, as I understand it, because he could clearly see that
    this is where everything was going to go, the question is: Did
    the credit rating firms understand how crucial the triggers
    were as you were drawing up your credit rating? Did that enter
    into your decision making? I am not just issuing a garden
    variety rating here that some investor will say, ah, I don't
    think I want to take a chance on this stock or, what the heck,
    I made a lot of money in junk bonds, and if they are going to
    say this is junk, why, I will jump in, I prospered during the
    Michael Milken era, whatever.
        It is not just that with an individual investor making that
    kind of analysis and that kind of a decision. It is a trigger
    that could bring the whole thing down. Were you aware of the
    significance of the trigger? And did that enter into your
    analysis as to where you were going to place it?
        Mr. Barone. Yes, sir. We were well aware of the triggers'
    existence in some of the partnerships that we knew about,
    specifically Marlin, Osprey-1, Osprey-2. And we do take into
    account the existence of those triggers in affecting Enron's
    credit rating. And, indeed, the assets that are in those
    entities as they began to lose value, we would then, because of
    the likelihood of Enron having to pony up, as it were, this
    contingent obligation, we put back to Enron some amount of that
    obligation and utilized that information in determining its
    credit rating.
        On the sum, over the years we have placed roughly--and not
    just for these two or three partnerships, but for the ones that
    we did know--all the ones we knew about, placed roughly $2 to
    $4 billion of additional liabilities back to Enron for these
    contingent-like or related-party obligations, guarantees,
    leases, and other things that appear off-balance sheet. So,
    yes, Senator, we do take them into account.
        But the other--going to your point, there's--as you get
    closer to it, clearly there's a heightened awareness of the
    impact that this could have. Again, Enron's stock trigger--
    there was a stock trigger. There was a credit trigger. It was
    an ``and'' situation. So when they blew through the stock
    trigger, we were still at BBB-plus. I believe the other
    agencies, because it was either of the agencies, if they
    lowered it below investment grade, here still at BBB-plus
    level, felt comfortable at that range that there was no--you
    know, no reason for alarm, so to speak.
        Mr. Diaz. Senator, can I follow up on that?
        Senator Bennett. Sure.
        Mr. Diaz. Certainly we were aware of the triggers. I'd just
    like to point out one thing. When we held our rating
    committee--I think it was November 7; it's in the record if I'm
    incorrect--that evening, we concluded that we would downgrade
    Enron to Ba2, non-investment grade, and we were ready to put
    that press release out the next day. We were aware of the
    consequences to Enron, yet we made that decision.
        The reason that we ultimately did not bring it down to non-
    investment grade had to do with the changes they made in the
    merger agreement and the additional equity they were willing to
    put in. And that's why we ended up with a Baa3 rating as
    opposed to Ba2. But we were aware of the circumstances, and
    that would not have stopped us from downgrading to below
    investment grade because we felt that fundamentally the company
    no longer merited that rating.
        Senator Bennett. So the thing that saved your rating and
    gave them a temporary reprieve from the harshest of all
    triggers was your conviction that the merger was going to give
    them sufficient capital to survive?
        Mr. Diaz. Three things: That the merger would give them the
    capital to survive; the probability that the merger would go
    through based on the changes they had made; and that the
    combined entity would be investment grade because of the
    structural changes they made to the deal.
        Senator Bennett. Well, those are all three if's. In order
    for the thing to make it, all three have to fall in place. If
    any one of them falls out of place, the whole thing collapses.
        Now, we are here with the brilliance of hindsight, and I
    recognize that and don't want to put myself in your position
    when you are trying to look at it in foresight. But it does
    seem to me, to just summarize it, in order for Enron to avoid
    the disaster of the non-investment grade rating, three things
    have to happen. There is no absolute assurance--of course, I
    guess in this world there is no absolute assurance of anything.
    It was your judgment that it was likely that all three would
    happen.
        Mr. Diaz. Right. Yes, Senator. We based a lot of that
    judgment on probabilities. So we felt there was a high
    probability that because of the equity infusion that was coming
    into Enron, Enron would have sufficient capital to get through
    the period and so forth.
        Senator Bennett. Yes.
        Mr. Diaz. And we felt that the outs in the agreement were
    taken care of, and it had Chevron-Texaco behind it and
    motivated banks to make the deal happen.
        Senator Bennett. OK. Well, I have gone over my time, Mr.
    Chairman, and we are mixing this panel with the previous
    hearing. But the question obviously arises why an analyst faced
    with this kind of circumstance--and you are not analysts like
    the stock pickers that we had--wouldn't say, OK, they are on
    the brink of disaster, and the only thing that can save them is
    if the three following things all come to place simultaneously,
    and life being what it is, if one of the three falls out, it
    ain't going to work. And as an investor, I would really love to
    have had that understanding of just how tenuous it was before I
    make a decision. That is assuming I had any money to invest.
        Thank you. This has been helpful.
        Chairman Lieberman. Thanks, Senator Bennett. A very
    interesting line of questions. You can feel the frustration, I
    think, of the Members of the Committee as we look back, and
    this is the basic question about whether you could have done
    more. I don't think anybody is accusing you--I am certainly
    not--of sort of malfeasance here. Nobody is accusing you of
    conflicts of interest, which were rife in some of the other
    cases that we have held investigations on. The question here is
    whether you were aggressive enough and used the power that you
    have. And these rating triggers, your ratings had enormous
    impact on the companies.
        Let me go back to this critical--and ask a few questions
    about it--moment when the merger was being discussed, and you
    had a decision to make as to whether to downgrade. You put
    Enron on a credit watch, but you didn't lower them below
    investment grade rating. Obviously this is a significant
    decision. You have conversations. You receive a call, I believe
    at that time, from Ken Lay, or certainly people from Enron. You
    receive calls from people that Senator Thompson mentioned, from
    the New York Stock Exchange, from various investment banks
    involved, etc.
        I have got to ask: Did you receive calls from anybody else?
    For instance, did you receive calls from any government
    officials which were aimed at urging you to not downgrade
    Enron's rating?
        Mr. Barone. Through the whole process, sir, the only folks
    we were in conversation with were Enron and Dynegy about the
    merger prospects. We were never called by the banks, investment
    bankers, any government officials, or anyone else.
        Chairman Lieberman. Mr. Diaz.
        Mr. Diaz. No, we never received any calls from government
    officials.
        Chairman Lieberman. And as far as you know, no one else at
    the company?
        Mr. Diaz. As far as I know, no one else at the company.
        Chairman Lieberman. Mr. Pellecchia.
        Mr. Pellecchia. We received no calls from anyone either in
    government, investment bankers, in any way to try to persuade
    us to do anything with the rating. However, in the course of
    our analysis and what we do as analysts is to get and receive
    and respond to calls from all types of people who work for
    financial institutions. So probably every major investment bank
    and commercial bank called me one time or another between
    October and December relative to Enron. But none of those calls
    were in any way indicative of any pressure to do anything with
    the rating.
        Chairman Lieberman. And not at the level presumably that
    Senator Thompson indicated. Did you agree that you had heard
    from Mr. Grasso and Mr. Rubin?
        Mr. Diaz. I believe we did get calls. I was not in those
    calls, but I don't believe that any material discussions ensued
    from those calls.
        Chairman Lieberman. OK. But, in any case, none of you heard
    from government officials.
        Here is what is obviously agitating all of us, which is
    that this--credit rating agencies have grown up in some ways
    like Topsy, with an enormous power, with this sort of semi-
    sanction of the SEC NRSRO designation, but not that much that
    goes into them approving you for it. Then hundreds of statutes
    come along, Federal, State, and local, I presume, that say you
    have got to get the approval of these credit agencies to be out
    in the markets. And yet you are exercising real quasi-
    governmental authority, power, and yet there is--and I must say
    in fairness that, by and large, your record is a very good one,
    I mean, judged in the most objective way that the number of
    defaults of companies that you have rated as investment grade
    is quite low. I think on AAA it is at 1 percent, and maybe on
    the others it is at 6 percent. Is that about right?
        Mr. Barone. Less than 1 percent on AAA.
        Chairman Lieberman. But this is our frustration. You have
    got a big actor--Enron--comes along and its downfall has
    disastrous consequences for its employees, for average--for
    their retirement security, for investors, for the economy, in
    fact. And we look and say, now, OK, you are the one that had--
    you had more access to them, and yet I think our--if I can
    summarize, I will say it for myself, I feel as if you weren't
    as aggressive as you should have been in asking for more
    information with the authority that you had.
        Even some of the--I know it was a glib answer, but I know
    that even some of the questions that have been--that your
    answers have raised in my mind about the concern about their
    accounting practices, about the partnerships--and let me ask
    the baseline question. I assume each of you is saying that if
    you knew then what you know now about Enron, you would have
    downgraded Enron below investment grade. Is that correct?
        Mr. Barone. Senator, if we knew then what we know now, we
    would have withdrawn Enron's rating for failure to disclose
    proper information.
        Chairman Lieberman. Which would have had the effect of
    basically putting them out of business, probably.
        Mr. Barone. I don't want to speak for what the market's
    reaction would be.
        Mr. Diaz. We would have had a lower rating on Enron for--
    probably for a few years before.
        Chairman Lieberman. For a few years before.
        Mr. Diaz. Yes, I mean, it looks like their partnerships
    began to be put together back in at least 1999.
        Chairman Lieberman. But you didn't know about them. Mr.
    Pellecchia.
        Mr. Pellecchia. I would say the same answer. We would have
    had a lower rating well before 2001.
        Chairman Lieberman. So looking back now at the confusion of
    their accounting practices, which you, I think, knew about, you
    had some sense that something--it was hard to understand
    everything there. Don't you feel that you should have asked
    more of them as you look back? Mr. Barone.
        Mr. Barone. Senator, we rely on the audited financial
    statements, and insofar as we read and understood fairly well
    where they were making their money based on the representation
    of those audited financial statements, we would ask questions,
    and we would receive answers and use that information in our
    ratings analysis.
        Chairman Lieberman. But you are expert----
        Mr. Barone. We are not forensic accountants, if that is the
    question, and we don't have subpoena power, and so there's a
    lot that----
        Chairman Lieberman. You know, maybe--in some ways I have
    been thinking, What is the analogy? You have authority here
    over the markets and companies that is somewhat comparable--the
    first thing that comes to mind is the FDA, Food and Drug
    Administration. They don't let a drug go out on the market--
    this is a controversy in itself--until they have gone over all
    sorts of investigations to guarantee that it is safe, and then
    doctors prescribe the drug, people use it in reliance on that.
        To some extent, we have asked you to play--to a real
    extent, we have asked you to play a similar role with regard to
    corporations, and yet--and you do have power, but the power is
    the threat that you will lower their rating or remove it. You
    can put people out of business. And it just looks--again, I
    want to be fair to you. Most of the cases people are leveling
    with you, and your record is pretty good, a low percentage of
    defaults. But here was one that as we look back, understanding
    hindsight is always clearer, you want to say to yourself: Why
    didn't you press harder for more information on accounting? Why
    didn't you press harder on partnerships? Even in that ``kitchen
    sink'' disclosure that they made, it just doesn't--it seems
    like it left a lot of questions in your mind.
        Actually, Mr. Diaz, let me ask you this question. I
    appreciate the end of your opening statement because you said
    Moody's has gone around and talked to a lot of people, held
    interviews, and--let me read it--you are going to do some
    things differently. ``Going forward, we are enhancing the
    ratings process by putting increased focus in several areas. We
    have substantially intensified our assessment of liquidity risk
    for issuers with both investment grade and speculative grade
    ratings.'' And Enron had a speculative grade rating, correct?
        Mr. Diaz. They had a low investment grade rating at the
    lowest level for pretty much their whole history, and then
    became speculative grade at the end.
        Chairman Lieberman. Right. ``We're also focusing''--it is
    interesting to me--``on corporate governance and how aggressive
    or conservative are accounting practices.''
        Now, I am encouraged by that, but isn't that a way of
    saying that you wish you had done that earlier as well?
        Mr. Diaz. Senator, again I would hark back to our
    fundamentally good record. But we didn't sit on it. We look all
    the time at ways that we can improve. We've, over the years,
    constantly put out comments on the rating process, on
    securitization, on other issues. So certainly the Enron debacle
    focuses our attention on certain areas that we would like to
    get better understanding of, including rating triggers. But it
    is our ongoing--that's not something that we just started
    because of Enron. It's something we've had ongoing for a while,
    and certain areas are going to be a focus of more intense
    activity going forward.
        Chairman Lieberman. OK. My time is up. I appreciate it.
    Obviously in the next panel we are going to hear from some
    people who have ideas about how to alter the status quo to give
    you the authority or give you some sense of accountability for
    the enormous authority that you do have that really matters in
    a case like this. Senator Thompson and I were just talking
    about it. He said to me, you know, the bridge only collapses
    very rarely, but when it does, we wonder why the inspectors
    hadn't noted the crack that led to the bridge falling and a lot
    of people getting hurt. And that is essentially the tough, but
    I think reasonable, question that we are asking of all of you
    today.
        Senator Thompson.
        Senator Thompson. Yes, just one or two points, Mr.
    Chairman. Studies indicate that for the most part credit rating
    agencies do get it right, and companies rated in the AAA range
    rarely default, companies rated in the BBB range default only
    at slightly higher percentage. And I think it is important for
    us to keep in mind that these companies do not recommend buy or
    sell, that basically what they are dealing with is a broad,
    general category with regard to the ability of a company to
    fulfill its financial commitments; and that while there is a
    relevance between the stock price and the rating, it is
    certainly not directly tied. A company could see its stock go
    down for any number of reasons, and it still may be practically
    unaffected in terms of its ability to fulfill its financial
    commitments. Is that correct?
        Mr. Barone. Or vice versa.
        Senator Thompson. Or vice versa. So I think we need to
    understand that.
        One of the things that interests me in looking at some of
    this history here is the statements that representatives of
    your companies make with regard to these stocks. I am
    wondering--of course, we are in the age of constant television
    coverage and cable and all of that, and some of the analysts
    have become superstars, and maybe the raters are going in that
    direction, and I guess it is strange for a politician to be
    commenting on that. But it looks to me like you have got your
    ratings, but then you have got your statements. And October 25,
    S&P's changed Enron's rating to a negative, but retained its
    BBB bond rating. Fitch also placed Enron on the watch for a
    downgrade on October 29. Moody's downgraded Enron one notch to
    B2A2, and kept it on review for another downgrade.
        The same day S&P's primary Enron analyst Todd Shipman went
    on CNN, even though S&P's had placed Enron on credit watch
    negative, Shipman said, ``Enron's ability to retain something
    like the rating they are at today, investment grade, is
    excellent in the long term.''
        When asked about the off-balance sheet partnerships,
    Shipman remarked that S&P's was ``confident that there is not
    any long-term implications to that situation, that that's
    something that's really in the past.''
        Then S&P's met with Enron on October 31 and was told that
    Enron would sell off assets to shore up its access to capital.
    The next day, November 1, S&P's downgraded Enron to BBB and
    placed it on a negative credit watch.
        Still, in its press release announcing the downgrade, S&P's
    said it ``continues to believe that Enron's liquidity position
    is adequate to see the company through the current period of
    uncertainty.''
        It looks to me like that you are making your ratings, which
    are clearly broad category ratings--you are right, you are not
    making recommendations of buy and sell, but then either through
    your analysis on CNN or your press release you get into the
    stuff that the analysts get into, and you really are getting
    into painting a picture of long-term viability of the company.
    I guess the question--I don't know how long your ratings are
    supposed to apply. I mean, suppose you have questions long
    term, but the current situation looks OK, that sort of thing. I
    mean, should you really be getting into all of that? Is this a
    recent phenomenon? Your ratings are one thing, but any analyst
    that comes out of there under questioning and he doesn't know
    what the questions are going to be, he clearly doesn't want to
    say anything that is going to cause a lot of problems for the
    company, then go back to headquarters and get this handed to
    him. So he is put in a really awkward position, it looks to me
    like, the same position that an analyst is in, really, to be
    positive, and it looks like touting the stock, in effect.
        Is this what you consider to be part of your obligation? Is
    this a phenomenon that hasn't been around that long? Or have
    you always had your people out there commenting on their
    opinions as to various aspects of the company and not being
    content simply on putting out the ratings?
        Mr. Barone. I think it all depends on each market, sir, and
    the energy market has had a lot of attention, say, the last 3
    or so years. I think there has been a stepped-up media
    interest, investor interest in the market. And so when we are
    called upon to provide an opinion beyond what we have written,
    whether it be in a news broadcast or an interview with a
    publication of sorts, we comply when and where we can.
        Senator Thompson. So you have an analyst function. You see
    yourself as providing an analyst function as well as a rating
    function.
        Mr. Barone. Well, again, what we're providing, sir, is just
    our opinion. It goes back to the credit analyses that we have
    performed. Obviously we cannot convey anything greater in terms
    of confidentiality or anything like that than what we may have
    received. We just try to put forth what we may have written
    already in various articles or rationales on the company's
    credit. We are not recommending--we are not there recommending.
    We are not there supporting. We are not a company's advocate.
    We're not their dis-advocate. We really don't care. We're there
    just to call it as we see it, as a third-party, objective,
    credible opinion, as our default studies have proven.
        Senator Thompson. What do you see your appropriate role as
    in this?
        Mr. Diaz. Our role is simply to gauge the company's
    creditworthiness. It's an opinion of the company's ability to
    repay its debt. And we do talk to the press and to other
    interested investors and lay out the weaknesses and strengths
    of a company. But it's not our role to recommend or to tout any
    company, simply to lay out what goes into our analysis.
        Senator Thompson. Here, Mr. Barone, the S&P's Enron analyst
    says, after making your rating, your representative comments on
    Enron's ability to retain that rating in the long run. It says
    not only are we giving this rating today, but we are telling
    you that it's our opinion that you're going to--they're going
    to have this rating for a long time.
        Mr. Barone. Ratings generally go from an intermediate to
    long-term purview, the long-term rating.
        Senator Thompson. Well, then does that really add anything
    to the rating itself in this comment?
        Mr. Barone. I am not sure I follow your question.
        Senator Thompson. I get the impression you are saying that
    he is saying nothing more than what the rating itself says.
        Mr. Barone. Right, and I don't believe he was asked
    anything further than that. Our view at that time was, given
    the information we had to our avail, that there was a strong--
    that we had an opinion----
        Senator Thompson. Mr. Pellecchia, do you have any comment
    on that?
        Mr. Pellecchia. I think our commentary is particularly
    important, specifically the commentary that is written that
    goes along with the rating, for instance, the warnings that you
    can give investors, such as what we said during the Dynegy-
    Enron merger period, and we said if the merger goes away,
    Enron's ratings will drop several notches to speculative grade.
    So I think that that gives a warning to investors that this
    is----
        Senator Thompson. You give a balanced treatment background
    as to how you came to that rating.
        Mr. Pellecchia. Yes.
        Senator Thompson. I venture to say that is something you
    would never be able to do on CNN or any of the other cable
    shows.
        Mr. Pellecchia. To be honest, some of these conversations
    that we have talked about involve an hour conversation with a
    reporter.
        Senator Thompson. Complicated situation.
        Mr. Pellecchia. That picks up the most provocative----
        Senator Thompson. And investors watching the show want to
    know----
        Mr. Pellecchia. But I think that's an important----
        Senator Thompson [continuing]. If you guys say a stock is
    going to be--this company is going to be in good shape.
        Thank you, Mr. Chairman.
        Senator Levin. Thank you. Let me just follow up with a few
    questions. We have talked about a couple of trusts and about
    some triggers. The trust names were referred to as Osprey and
    Marlin, and you were aware that there were triggers that would
    guarantee that investments in those trusts would, in fact, be
    repaid, I believe, Mr. Barone, right? You knew about the
    triggers. In fact, I think you testified that was relevant to
    your assessment of Enron's credit rating because they
    ultimately were the guarantor of that investment in those
    trusts. Is that a fair----
        Mr. Barone. That's correct, sir.
        Senator Levin. Now, I just want to go through the timetable
    on this and discuss what these triggers were and when the gun
    went off. My understanding is that the stock price of Enron
    fell below a certain level on May 5, so that was one of the
    triggers at that point. Enron then was on the verge of having
    to pay $2.4 billion back to investors in that Osprey trust.
        What were the other criteria? Do you remember offhand?
        Mr. Barone. That the ratings fall below investment grade
    from either of the agencies.
        Senator Levin. Now, when that happened, you were aware of
    the trigger on the stock price.
        Mr. Barone. Yes.
        Senator Levin. And you also were aware that the other
    criteria depended on your own rating, so that if you responded
    to the gun going off on that date by changing your rating, that
    would have certain massive consequences for Enron.
        Did you on that day when that happened consider lowering
    your rating?
        Mr. Barone. No, sir, not at all.
        Senator Levin. Did you know about it?
        Mr. Barone. Yes.
        Senator Levin. All right. If, in fact, that trigger was
    relevant to the rating, why would the fact that the gun went
    off not be relevant to a changed rating?
        Mr. Barone. Again, the stock price dropping could be tied
    to multiple reasons. Whereas, the credit rating, the thing that
    I knew and knew best about, tied to the creditworthiness, is
    something that we can manage and we can monitor. The stock
    price dropped for many reasons. There was a general market
    decline. Most stocks had dropped from the last 2 years from
    general economic conditions. So it didn't cause us any alarm
    because we were looking at the fundamentals of the company, its
    business models, financial profile as we believed it to be, and
    its qualitative assessment, and we were still at BBB-plus. We
    had three notches to go before this trigger, the second part of
    that, the ``and'' clause would have been tripped.
        Senator Levin. You were the tripper?
        Mr. Barone. We could have been, sure.
        Senator Levin. It was in your hands as to whether it was
    tripped or not.
        Mr. Barone. Sure. Absolutely.
        Senator Levin. But the first criteria had been met.
        Mr. Barone. Right.
        Senator Levin. Was that public?
        Mr. Barone. Which part, sir?
        Senator Levin. The triggers.
        Mr. Barone. I think these were private--I believe these
    partnerships were set up privately under 144(a) rules, so I do
    not know whether they were disclosed, whether the general
    market knew about them. Clearly, the investors who invested in
    them knew, and many of those who decided not to invest in them
    would have known because it was marketed to quite a few people
    on Wall Street.
        Senator Levin. But the people who invested in Enron would
    not have known?
        Mr. Barone. The common equity shareholders? I can't say,
    but probably not, sir.
        Senator Levin. It seems to me that this permeates this
    problem, the fact that there were hidden guarantees here that
    affected Enron's stock. This is a guarantee that could trigger
    a $2.4 billion repayment from Enron or Enron stock, not known
    to the public but known to you.
        Mr. Barone. I would say, sir, the Mom and Pop investors
    were not likely to know about it, but the institutional holders
    of the common shares were probably aware of it. It's just
    speculation on my part. I don't have firsthand knowledge.
        Senator Levin. Well, this is one of the reasons that Mom
    and Pop got the shaft. There were guarantees here that were not
    disclosed to that average investor that you folks knew about.
    You folks knew about those guarantees, right?
        Mr. Barone. Right. Yes, sir.
        Senator Levin. There is something wrong here. Something
    very wrong, because we have advisers who know parts of the
    investment banking--part of what an investment bank knows, you
    folks know.
        Mr. Barone. Right. This was a private deal, sir.
        Senator Levin. I understand, and you are aware----
        Mr. Barone. We would have breached confidentiality if we
    had disclosed this.
        Senator Levin. You are aware of it, though, and you are
    rating Enron's credit. So you know something. You don't act on
    it here even though you are aware of it. That bothers me, by
    the way. It seems to me that it was relevant to your rating;
    therefore, when it was triggered, it should be relevant to a
    re-rating. I will state it that simply. OK? If it is relevant
    to begin with, then the change in it makes it relevant to the
    re-rating.
        Mr. Barone. Are you asking a question----
        Senator Levin. No, I will just make a statement on that.
    Since you are the one who said that it was relevant to your
    determination as to how to rate their debt, the fact that there
    were these triggers, that was relevant; the fact that the
    trigger went off, it seems to me would be relevant as well to
    your rating of debt. I will make that as my statement.
        Mr. Barone. It was specifically written, sir, with an
    ``and'' clause so that it wouldn't be subject to general market
    condition, as I understand it. They purposely put both triggers
    in, the slide of the common equity price as well as a decline
    in credit, knowing fully if both occurred that that would
    clearly indicate a significant impairment of their financial
    profile.
        Senator Levin. I will just repeat: The second part is in
    your hands. That is the rating issue that is in your hands. So
    it is not some outside objective factor. It is whether you rate
    them below market grade.
        Mr. Barone. Or my colleagues.
        Senator Levin. Of course, your colleagues. I am looking at
    you, but it is all three of you.
        One other question here. I want to show you a typical
    structured financing deal. Hundreds of these structured finance
    deals were rated by you folks, or at least were entered into by
    Enron. If you look hard enough, you will find Enron on that
    chart. It is up somewhere in the top left bowl of the
    spaghetti. There is a little piece of spaghetti way up there.
        This is a diagram of the Whitewing part of the financing of
    Project Margaux,\1\ which is a European energy deal. This is a
    document which was produced from one of subpoenas issued by the
    Permanent Subcommittee on Investigations.
    ---------------------------------------------------------------------------
        \1\ Chart entitled ``Project Margaux'' appears in the Appendix on
    page 207.
    ---------------------------------------------------------------------------
        Now, wouldn't something as incomprehensible as this raise
    some questions to you about the purpose and the viability of
    this project? Because you are going to give a rating now to the
    instruments which result from that project. When you look at
    this and you realize there are hundreds of these things that
    Enron is getting into, Enron had more structured financing
    deals, I think, than any typical company, $15 to $20 billion a
    year in structured financing deals from 1997 to 2001. Here is
    one of them.
        Two questions. Were your companies aware of the huge amount
    of structured financing deals at Enron? Second, shouldn't this
    have triggered some questions in your mind, this kind of a
    haystack where you are supposed to find the needle of debt?
    Shouldn't that have raised some questions in your mind as to
    the purpose and viability of the project? Let me start with
    you, Mr. Barone.
        Mr. Barone. We were aware of many of their structured
    finance deals, and Enron's aggressive use, if you will, of
    structured finance deals was one of the many reasons we only
    rated it BBB-plus, sir. If you looked at Enron's financial
    profile on its face, you would have come to a conclusion that
    this could have been a company with a much higher credit
    rating, and yet we take into account the aggressive use of
    financial structures and such.
        Senator Levin. Would you agree this is a relatively
    incomprehensible structure?
        Mr. Barone. Not necessarily. I'm not a structured finance
    analyst, but we have structured finance analysts at Standard &
    Poor's, very capable ones, who make it their livelihood to
    understand structures like----
        Senator Levin. We would appreciate if one of them would
    take a look at this and tell us whether that is a typical
    structured deal and whether it is comprehensible. Let the
    Committee know for the record, would you?
        Do you have any comment, Mr. Diaz.
        Mr. Diaz. I would, to a great extent, echo Mr. Barone's
    comments. We were aware of a lot of their structured
    transactions. We rated a couple of them. But we were not aware,
    obviously, of a lot of the off-balance sheet partnerships. And,
    also, I also am not a structured finance analyst, but this kind
    of structure doesn't look dramatically different, all the
    wiggly lines and all that, than a lot of the ones that are done
    by our structured people.
        Senator Levin. That looks to you like a typical structured
    finance deal?
        Mr. Diaz. It looks like the kinds of deals that I have seen
    other companies put together, and again I wouldn't rate them
    myself. I don't have the expertise to do structured financing.
    But it's not, on the face of it, out of the ordinary.
        Senator Levin. OK. Perhaps you could ask one of your
    structured finance folks to tell us if that is typical, too, as
    well.
        Mr. Pellecchia.
        Mr. Pellecchia. Well, my response would be certainly that
    the complexity of the company and the types of transactions
    that it entered into was a factor in keeping Enron's rating in
    the BBB category. I don't think there's any question about
    that.
        Senator Levin. Thank you. Thank you, Mr. Chairman.
        Chairman Lieberman. Senator Bunning.
        Senator Bunning. Yes, sir. Thank you, Mr. Chairman.
        Can I go back to March 2000? Both S&P's and Fitch rated
    Enron as BBB-plus and Moody's rated Enron as Baaa-1, which is
    in the slightly higher than ordinary but not at the top like a
    AAA rating. It is somewhere between BBB-plus and----
        Mr. Diaz. The Baa category is at the low end of the
    investment grade spectrum. It has----
        Senator Bunning. Baaa.
        Mr. Diaz. Baa, we call it, B-a-a. So a Baa-1 rating would
    be at the top of the low investment grade rating category.
        Senator Bunning. But it is still an investment grade
    rating?
        Mr. Diaz. It is an investment grade rating, yes, sir.
        Senator Bunning. OK. However, even as Enron's stock, common
    stock, crumbled through most of 2001, the credit rating
    agencies--that is you three--didn't downgrade Enron from
    investment grade status until 4 days before it declared
    bankruptcy--4 days.
        Now, I know you are not security analysts as far as having
    the ability to understand why a stock would be going down so
    fast. But insider trading is published constantly on the
    Internet. As Senator Levin said, you were part of a two-pronged
    deal that said Enron was going to have to cough up $2.4
    billion, their stock had hit $20 a share on the down side, but
    as long as they held their investment grade rating, they didn't
    have to do any of the $2.4 billion. The insider selling in that
    stock was unbelievable. Everybody that knew anything about the
    company was bailing out as fast as they could get their market
    shares to the market.
        Now we also have a lockdown on their 401(k) plan, so the
    ordinary people in the company can't sell their stock.
        Now, doesn't that ring a bell with you and say why in the
    world are all these people bailing out if this is such a sound
    corporation? And why in the world would I sell a share at $20
    that was just $90 a few months prior if, in fact, I believed it
    was going to turn around and go back up? That makes no sense to
    me at all. And it should have triggered your investigation
    because you were part of that two-pronged deal. As long as they
    held an investment grade status, they didn't have to ante up
    the $2.4 billion.
        Didn't that set off any alarms in your financial rating of
    those companies?
        Mr. Barone. No, sir. We see insider trading from firms
    quite frequently, and determining why a director or an officer
    of the company is selling its shares of stock----
        Senator Bunning. This was massive. This wasn't just one or
    two or three people. This was anybody who knew anything about
    the company. They were bailing. They had bad feelings about the
    company. And all you had to do was trigger the other half of
    that and make them come up with $2.4 billion if their stock is
    under $20, and that would have done it completely in, the $2.4
    billion, because you know darn well they couldn't pay it off.
    They had no means of paying $2.4 billion off.
        I would like to know why you held that rating to 4 days
    before they filed bankruptcy.
        Mr. Barone. For us, Senator, we were aware of the Dynegy
    merger on----
        Senator Bunning. Well, the Dynegy merger is an if. If they
    are successful in merging with Dynegy, then maybe they would be
    able to survive.
        Mr. Barone. It is our practice and the practice that the
    market has come to recognize, when mergers occur, to take into
    account the probability of the merger. We deal in
    probabilities, as my colleagues said. And our assessment was
    that there was a strong probability at the time that it would
    succeed. And when we lost confidence in that probability,
    that's when we decided to act prior to the merger being dis-
    consummated, so to speak.
        Senator Bunning. That is a pile-on, as far as I am
    concerned. That is after the fact. You are depending on
    something that the potential of it happening is not going to be
    50/50 maybe.
        Now, you are supposed to have inside information that we
    don't have, that the average investor doesn't have, and yet you
    didn't flag it.
        Mr. Barone. I'd say, sir, our assessment was that there was
    a greater, much greater, chance than 50/50 at the time when we
    made that assessment on November 1 or 2, that the merger would
    go through. Indeed, if we thought it was just 50/50, we would
    have lowered the rating to properly reflect that.
        Senator Bunning. We need more people doing the ratings
    then, because obviously you three all agreed.
        Mr. Diaz. Senator, I think I've testified before that we
    also believed that the probability of the merger going through
    was high. We had a rating committee that included our senior
    management, and we came to the conclusion, given the changes in
    that agreement, there was a very high probability the merger
    would go through. So that's the key for holding the rating
    during that period.
        Just as another point, one of the comments that I've made
    is that we've been trying to figure out how can we improve the
    process, and one thing that we've done is talk to the major
    asset management firms to try to understand how they use
    ratings and how they would like us to, in effect, do the
    ratings.
        One of the things that they've said to us is that they like
    the stability of ratings, but the other point is that when
    things are going--when a company is under certain amount of
    distress, they would like for us to give the company the
    ability, if there's a probability of correcting the problem, to
    give them the opportunity to do so.
        Senator Bunning. Do you all realize that once you take a
    corporate bond and make it a junk bond, the potential of
    bankruptcy in that company is really high?
        Mr. Diaz. Senator, I think when we take--a company that
    wouldn't be an Enron----
        Senator Bunning. Any other company that might be listed, or
    not even listed, just private----
        Mr. Diaz. A Ba category, which is not investment grade, is
    still a viable category. A company can live as a Ba company for
    many years.
        Senator Bunning. How long?
        Mr. Diaz. The probability of default is in our studies, but
    I think the probability of default over a 10-year period for a
    Ba--and I may be wrong and would have to double-check, but it
    is in the neighborhood of 16 to 20 percent, which means that 80
    percent, roughly--and, again, don't hold me to the numbers, but
    it's a fairly high number--would actually survive for 10 years.
    So it's not a situation where it's Ba and death. In Enron's
    case it was because of the triggers, and it was because
    everybody was running away from it. But it's a different
    situation.
        Senator Bunning. They were running long before you ever
    downgraded.
        Mr. Diaz. No, because the----
        Senator Bunning. They were.
        Mr. Diaz. Well, the----
        Senator Bunning. The general public, the management of the
    company, and all others were running from that stock, and
    because you failed to act in downgrading it below investment
    grade, it held on a heck of a lot longer than it would have.
        Mr. Diaz. But we had good reasons for doing so. We were
    looking at a good probability of a merger with a bona fide
    partner, with Chevron-Texaco behind it, and with bank funding
    that would have made it work--if Enron itself--the real problem
    was that Enron itself was rotting from inside. The fact is that
    Dynegy--I don't think Dynegy knew, I don't think the banks knew
    how bad the situation was.
        Senator Bunning. And all the poor people that worked for it
    were the ones that took the big hit.
        Mr. Diaz. That's right, Senator, and that's a real tragedy.
        Senator Bunning. Yes, it is a tragedy. Thank you.
        Chairman Lieberman. Thanks, Senator Bunning, for some
    excellent questions.
        Thank you, gentlemen. Your testimony has been very
    important to this Committee as we try to learn the lessons of
    Enron as we follow the trail down to places that we didn't
    expect we would go. And I want to ask you to go back--maybe you
    are doing this already--and speak with the executives at your
    companies about how you can use, better use the real life-and-
    death power you have over corporations to protect us investors,
    individual and institutional, from the next Enron. We know it
    is the exception, but a lot of people, as you all just said,
    were hurt by it. And we think you are in a position to do more
    than was done in this case to try to protect the economy and a
    lot of people from the pain and suffering that they endured as
    a result of what happened. But for now, I thank you for your
    testimony this morning.
        Mr. Diaz. Thank you, Mr. Chairman.
        Mr. Barone. Thank you.
        Mr. Pellecchia. Thank you.
        Chairman Lieberman. We are now going to call panel two: The
    Hon. Isaac Hunt, Jonathan Macey, Glenn Reynolds, and Steven
    Schwarcz. And as you come to the table, I will just ask you to
    remain standing so I can administer the oath before you begin
    your testimony.
        I would ask the four witnesses to please raise your right
    hands, if you would. And do you solemnly swear that the
    testimony you are about to give this Committee today is the
    truth, the whole truth, and nothing but the truth, so help you,
    God?
        Mr. Hunt. I do.
        Mr. Macey. I do.
        Mr. Reynolds. I do.
        Mr. Schwarcz. I do.
        Chairman Lieberman. Thank you. Please be seated, and let
    the record show that each of the witnesses has answered the
    question in the affirmative.
        Thanks very much for being here. Some of you have come
    quite a distance, but thanks particularly for your patience as
    we heard the testimony of the first panel, and we now look
    forward to your helping us answer some of the questions that
    were both asked and we are left with by the first panel. First
    we are going to call on the Hon. Isaac C. Hunt, Jr.,
    Commissioner of the U.S. Securities and Exchange Commission.

      TESTIMONY OF HON. ISAAC C. HUNT, JR.,\1\ COMMISSIONER, U.S.
                   SECURITIES AND EXCHANGE COMMISSION

        Mr. Hunt. Good morning, Chairman Lieberman, Senator
    Thompson, and other Members of the Committee.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Hunt appears in the Appendix on
    page 131.
    ---------------------------------------------------------------------------
        Thank you for the opportunity to testify before you today
    on behalf of the SEC regarding credit rating agencies and the
    Commission's experience with the credit rating industry.
        The recent collapse of Enron has renewed questions as to
    whether rating agencies should be subject to increased
    regulation, particularly because all three nationally
    recognized statistical rating agencies rated Enron and/or its
    credit obligations as investment grade less than 1 week before
    Enron filed its bankruptcy petition.
        As you know, for almost a century, credit rating agencies
    have been providing opinions on the creditworthiness of issuers
    of securities and other financial obligations. During this
    time, the importance of these opinions to investors and other
    market participants and the influence of these opinions on the
    securities markets has increased significantly, particularly
    with the increase in the number of issuers and the advent of
    new and complex financial products, such as asset-backed
    securities and credit derivatives. The globalization of the
    financial markets also has served to expand the role of credit
    ratings to jurisdictions other than the United States. Today,
    credit ratings affect securities markets in a number of
    important ways, including an issuer's access to and cost of
    capital, the structure of financial transactions, and the
    ability of fiduciaries and others to invest in particular
    investments.
        During the past 30 years, regulators such as the Commission
    have increasingly used credit ratings as a surrogate for the
    measurement of risk in assessing investments held by regulated
    entities. Specifically, since 1975, the Commission has
    referenced the ratings of specified rating agencies in certain
    of its regulations, referring to these rating agencies as
    ``Nationally Recognized Statistical Rating Organizations.'' The
    term ``NRSRO'' was originally adopted by the Commission solely
    for the purpose of the Commission's net capital rule.
    Subsequently, the Commission used the ratings of NRSROs to
    distinguish ``investment grade'' securities from those that are
    ``non-investment grade,'' in regulations under the Securities
    Act of 1933, the Securities Exchange Act of 1934, and the
    Investment Company Act of 1940. Congress itself employed the
    term ``NRSRO'' when it defined the term ``mortgage-related
    security'' in Section 3(a)(41) of the Securities Exchange Act
    of 1934. Other Federal and State regulators also incorporated
    the NRSRO concept into their rules.
        Currently, to determine whether a rating organization is an
    NRSRO, the Commission staff reviews the rating organization's
    operations, position in the marketplace, and other criteria
    (which are elaborated on in my written testimony). If the
    Commission staff determines that the NRSRO designation is
    appropriate, the staff sends a no-action letter to the rating
    organization stating that the staff will not recommend
    enforcement action to the Commission against broker-dealers
    that are using ratings issued by the rating agency for purposes
    of the net capital rule.
        Chairman Lieberman. Sir, excuse me. Am I right that this
    only happens once in the life of a credit rating agency that it
    gets this no-action letter?
        Mr. Hunt. Yes, Senator, that's true, although we try to put
    the rating agencies on the same schedule for inspection as we
    do other investment advisers that are registered with us as
    investment advisers. Whether that is right or wrong is open to
    debate, but they are. And that is about every 5 years.
        Chairman Lieberman. That is interesting. So in that
    capacity--though presumably these no-action letters in some of
    the cases of these three agencies go back decades, correct?
        Mr. Hunt. Yes, sir. There were four others that we gave no-
    action letters to, but they were all subsequently merged into
    the existing three. So at one time there were seven.
        Chairman Lieberman. So that every 5 years, because they
    also have the status of investment advisers, you do go back----
        Mr. Hunt. Yes, sir.
        Chairman Lieberman [continuing]. And do an inspection. And
    what is that about? What does it constitute? What do you look
    at?
        Mr. Hunt. Well, we look at the books and records. We look
    at their operations. We look at their capacity. We do a much
    broader inspection when we give them the no-action letter. But
    when we go back and look at them every 5 years as investment
    advisers, we look at their books and records and their
    operations. I would not say it's as extensive as the first look
    we do when we give them the original no-action letter.
        Chairman Lieberman. OK. Understood. Thank you.
        Mr. Hunt. Over the course of its history, the Commission
    has considered a number of issues regarding credit rating
    agencies. Not surprisingly, many of the instances in which
    either the Commission or Congress reflected on the need for
    regulation coincided with a large-scale credit default such as
    the Orange County default and the default of the Washington
    Public Power Supply System bonds or, for example, Penn Central.
    Ten years ago the Commission seriously considered the need for
    oversight authority of credit rating agencies, given their
    increasing role in the financial and regulatory systems. The
    Commission at that time did not reach a consensus on the need
    for regulation.
        In 1994, the Commission did, however, issue a concept
    release soliciting public comment on the appropriate role of
    ratings in the Federal securities laws, and the need to
    establish formal procedures for designating and monitoring the
    activities of NRSROs. In 1997, the Commission published a rule
    proposal that would have adopted a definition of the term
    ``NRSRO'' that set forth the criteria a rating organization
    would have to satisfy to be acknowledged as an NRSRO.
    Generally, under the proposed amendments, the Commission would
    consider the same criteria currently used in the no-action
    letter process. To a large extent, the proposal was designed to
    bring greater transparency to the existing process and to
    provide for a formal appeal process to the Commission and, if
    necessary, to the Federal courts.
        Observers have criticized the national recognition
    requirement as creating a barrier to entry for new credit
    rating agencies. However, the Commission historically has not
    found that the requirement creates a substantial barrier to
    entry into the credit rating business. At this time, the
    Commission plans to examine the competitive impact of the NRSRO
    designation and will consider suggestions concerning other
    market-based alternatives that might address the competitive
    concerns association with the NRSRO framework. The Commission's
    examination, which may include hearings, will ascertain facts,
    conditions, practices, and other matters relating to the role
    of rating agencies in the U.S. securities market. We believe it
    is an appropriate time and in the public interest to re-examine
    the role of rating agencies in the U.S. securities markets.
        Thank you. I will be happy to try to answer your questions.
        Chairman Lieberman. Thanks, Commissioner Hunt, for that
    testimony and for what you indicated at the end. I gather you
    are going to commence your own inquiry here as a Commission.
        Mr. Hunt. Yes, sir.
        Chairman Lieberman. Motivated in part by the Enron episode?
        Mr. Hunt. Motivated in part by the Enron episode. Motivated
    in part by our concern that how people get this rating is not
    transparent to most of the investing public.
        Chairman Lieberman. Right.
        Mr. Hunt. Motivated in part because, as more and more
    entities use credit rating agencies, there may be more need for
    more than three, as there is now a need for more than four
    accounting firms. So for all those reasons, we think we are
    going to take a thorough look at what they do and whether we
    should have more authority over them and whether indeed we
    should even come to you and ask for more authority over them.
        Chairman Lieberman. Yes. Is it your judgment--well, maybe
    this is a preliminary question, but I will ask you: Is it your
    judgment now that if you chose to exercise more authority over
    the credit rating agencies, you would need legislative
    authorization or that it is within your legislative mandate
    now?
        Mr. Hunt. We could do a lot of it through rulemaking. Our
    hearings might show whether and to what extent we need more
    legislation.
        Chairman Lieberman. OK. I am greatly encouraged by that
    decision that the Commission has made. I appreciate it. And as
    I understand it, it goes not only to the question of whether
    there is sufficient competition within the credit rating agency
    sector, but also to the larger question of whether there is a
    public interest in having the SEC specifically do more
    oversight of the agencies.
        Mr. Hunt. They perform an ever more important role in our
    securities markets, as you understand.
        Chairman Lieberman. Yes.
        Mr. Hunt. They are involved in hundreds of millions, if not
    billions of dollars in our market, and so we thought it was
    time to take a look to see where we are and where we ought to
    go.
        Chairman Lieberman. Yes, excellent. Thank you.
        Next we are going to hear from Jonathan Macey, J. DuPratt
    White Professor of Law, John M. Olin Program in Law and
    Economics, Cornell Law School. Pretty extensive title there,
    Professor Macey. Thanks for being here.

     TESTIMONY OF JONATHAN R. MACEY,\1\ J. DUPRATT WHITE PROFESSOR
                       OF LAW, CORNELL LAW SCHOOL

        Mr. Macey. It's nice to be here. I am going to talk a
    little bit about the role of credit rating agencies in the
    economy.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Macey appears in the Appendix on
    page 138.
    ---------------------------------------------------------------------------
        The purpose of credit rating agencies is to inform
    investors of the credit quality of securities and warn
    investors when credit quality of securities deteriorates.
    Rating agencies are paid large fees by corporate clients in
    order to maintain ratings for the debt. For example, Enron paid
    Moody's between $1.5 and $2 million annually to maintain its
    ratings on its various public and private debt.
        Being a credit rating agency is a great business to be in.
    The industry is dominated by the two leading firms, Moody's and
    Standard & Poor's. Analysts have estimated that the profits of
    the big credit rating agencies have grown at the phenomenal
    compound annual rate of 15 percent for the past 20 years.
        Customer demand is strong because a host of regulations
    exists that forbid investors from purchasing securities that
    aren't rated. For example, money market mutual funds cannot
    hold securities unless they have one of the two highest ratings
    from rating agencies. Bank regulators long have required banks
    to write down bonds they hold in their portfolios unless they
    attain a certain rating. And they can't even own securities
    that aren't rated investment grade by one of the major rating
    agencies.
        These sorts of regulations have extended to securities
    firms where ratings are used to determine how much capital
    broker-dealer firms need to hold against the securities in
    their portfolios under the so-called net capital rules. There
    are quotas on the quantity of lower-graded bonds that pension
    funds and insurance companies can have in their portfolios. The
    higher the credit ratings assigned by the rating agencies, the
    greater the percentage of the securities value you can count
    towards meeting a firm's net capital requirements.
        Rating agencies have enormous power because government
    regulation creates an artificial demand for their services.
    Regulators have bestowed upon the big rating agencies the legal
    designation ``Nationally Recognized Statistical Rating
    Organization''--NRSRO--and have shielded rating agencies from
    competition, creating a comfortable oligopolistic environment.
    I would just add that this is the same problem, in my view,
    that plagues the accounting industry in this country as well.
        Of course, it's not just government regulation that gives
    rating agencies such immense power. They also get power from
    the extensive use of debt covenants and other financial
    instruments to create conditions of default. The downgrading of
    a rating by an NRSRO can throw a company into default under the
    terms of its debt covenants. But the artificial demand for the
    services of rating agencies that has been created by regulation
    should not be ignored.
        These massive regulatory subsidies, in my view, have given
    rating agencies a lack of accountability by removing market
    incentives from the work they perform. Rating agencies have few
    incentives in the current environment to do good work. Their
    incentives in today's regulatory environment are to reduce
    costs as much as possible, knowing that regulation guarantees a
    fixed stable demand for their services. This, in my view, may
    account for the agencies' lack of vigorous pursuit of the
    situation involving the Enron special purpose entities.
        The regulatory subsidies given to credit rating agencies
    would not be particularly troubling were it not for the fact
    that credit ratings, in my view, may not provide useful or
    timely information about the creditworthiness of companies in
    today's markets if the information is marginal because the
    information contained in credit ratings already has been
    incorporated into securities prices by the time a rating agency
    gets around to acting. For example, in Enron, the company's
    $250 million in senior secured debt retained its investment
    grade rating until November 28, 4 days before the energy firm
    filed for bankruptcy. But with respect to the market, in the 2
    weeks before the bonds lost their investment grade status,
    their price had plummeted from $85 to $35.
        Clearly, the financial markets were not waiting around for
    the credit rating agencies in the case of Enron, which is a
    good thing since the ratings providing by the rating agencies
    lagged the information contained in securities prices by a full
    year.
        We have heard and the rating agencies have responded to
    these sorts of criticism by point to the fact that very few
    companies with investment grade ratings default over a 5-year
    period. The rating agencies also can show that companies that
    have been rated AAA are less likely to default than companies
    with lower ratings, and bonds with high ratings are stable over
    time.
        Of course, this sort of track record isn't a big comfort to
    investors and companies like Enron when the rating agencies
    pull their investment grade ratings on the eve of default. The
    problem, in my view, is that there is little follow-through.
    The rating agencies rely too much on their corporate clients
    for information and don't ask tough questions of management
    that would permit them to deter future Enrons from occurring.
        For example, in the case of Enron, the rating agencies have
    excused their tardiness by saying that they kept their ratings
    high only because the rating was dependent on the merger with
    Dynegy. But nobody needed the rating agencies to tell them what
    would happen if the merger went through. They needed to know
    what would happen if the merger didn't go through.
        Poor credit ratings threaten to distort the process by
    which capital is allocated among businesses because in today's
    regulatory environment rating downgrades are self-fulfilling
    prophecies, triggering repayment of debt and bond covenants and
    causing those securities by virtue of the regulations to be
    worth less than identical securities that haven't been
    downgraded.
        In my view, I would make a few substantive recommendations
    with respect to the interactions between Commissioner Hunt's
    agency and the rating agencies. I think that the SEC should
    consider whether the rating agency should be obliged by
    regulation to disclose the public documents on which they
    relied as the basis for their rating determinations, and also
    to disclose whether the information contained in their ratings
    is based on anything other than publicly available documents
    like non-public interactions with the issuer or other entities.
        I also think it would be useful to have disclosure about
    whether ratings are being issued despite the fact that the
    rating agencies lack the information that a reasonable investor
    would consider relevant to the formulation of a rating and to
    disclose the extent to which the ratings that are being issued
    were based on credit spreads rather than financial reporting.
        Thank you very much.
        Chairman Lieberman. Thanks. Very constructive and helpful
    testimony.
        Next we are going to hear from Glenn L. Reynolds, chief
    executive officer of CreditSights, Inc. Thanks for being here.

      TESTIMONY OF GLENN L. REYNOLDS,\1\ CHIEF EXECUTIVE OFFICER,
                           CREDITSIGHTS, INC.

        Mr. Reynolds. Thank you, Mr. Chairman. It is my pleasure to
    get an opportunity to testify on a subject that I know is of
    grave concern to many of the institutional debt and equity
    investors that we deal with on a regular basis. The
    difficulties in navigating a very complex market are
    challenging enough without the added pressures of questioning
    the integrity of reported numbers, the adequacy of disclosure,
    or the ability of the rating agencies to get sufficient
    information to do their job effectively.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Reynolds appears in the Appendix
    on page 148.
    ---------------------------------------------------------------------------
        In the aftermath of Enron, there have also been some
    questions about the steps the rating agencies took in bringing
    many of these issues to a head and the depth and vigor of their
    due diligence. The response to date, which has been to speed up
    the pace of downgrades but not necessarily shed more light on
    the expectations built into a given rating, have not been
    satisfactory and will not allow us to deal with future Enron-
    type situations.
        Disclosure guidelines and accounting rules may be the
    responsibility of the SEC and the FASB, but the rating agencies
    can play a vital role in zeroing in on material risks and major
    shortcomings in the disclosure of those risks.
        Chairman Lieberman. Mr. Reynolds, would you excuse me a
    second? Under the arcane procedures and life that we lead here
    in the Senate, I have just been notified that a member of the
    Senate has lodged an objection to three committees proceeding
    with their business after noon, which is the right of the
    members, 2 hours after the Senate convenes. This Committee is
    one of those. This has nothing to do, as far as anybody would
    understand, with the subject of our inquiry. It probably has to
    do with something unrelated that the given Senator is trying to
    get attention for. One can only speculate that it might have
    something to do with the course of judicial nominations. I
    don't know.
        You have all come from some distance, and we are not
    transacting business as it were here, so I hope this is not
    considered an act of civil disobedience. I am going to say that
    the official hearing is over, though I would like to ask the
    record to continue to be kept, and that we are going to just
    continue this discussion, because you have come a long way, you
    have got something to offer, and I would hate not to hear it.
        So, with that caveat, please proceed.
        Mr. Reynolds. I can just defer to my written testimony, and
    we can go right to questions and answers.

                              INFORMAL DISCUSSION

                                  [12:04 p.m.]

        Chairman Lieberman. Well, go ahead and finish. But this is
    now not a formal hearing of the Governmental Affairs Committee.
    This is a discussion among a group of people interested in the
    credit rating agencies and what we have learned about them from
    the Enron episode.
        Mr. Reynolds. Let me cut to the chase. If a company fails
    to answer critical questions that are crucial to an assessment
    of the risks, it should either prompt a withdrawal of the
    rating or even potentially a downgrading in certain
    circumstances. The recurring refrain from the rating agencies
    that the issuer will not tell them just does not hold. It rings
    hollow when one considers that a rating has a requirement for
    access and that any conflicts with the rating agencies will be
    an incentive for the market and the SEC, to be somewhat
    unforgiving and, in particular, as we saw in the case of Enron,
    the market.
        With that I will just end my comments.
        Chairman Lieberman. Thanks.
        Professor Steven Schwarcz is a professor of law of Duke
    University, a shorter title than Professor Macey has, but we
    are, nonetheless, pleased that you are here.

      TESTIMONY OF STEVEN L. SCHWARCZ,\1\ PROFESSOR OF LAW, DUKE
                        UNIVERSITY SCHOOL OF LAW

        Mr. Schwarcz. Thank you. Anticipating this would be an
    informal hearing, I did not wear a suit today.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Schwarcz with an attachment
    appears in the Appendix on page 168.
    ---------------------------------------------------------------------------
        Chairman Lieberman. Well done. [Laughter.]
        Mr. Schwarcz. One of the things I should say is I will be
    speaking about the rating agencies, but I am an expert on
    structured finance. I actually would have answers to many of
    Senator Levin's questions, and the third edition of my treatise
    on structured finance came out in January, and I would be happy
    to answer any questions afterwards.
        Chairman Lieberman. Let me urge you to, if you haven't
    already, be in touch with Senator Levin after the hearing
    because this is a particular interest of his, and he has done a
    lot of--we have sent out a number of subpoenas through his
    Subcommittee, and one of the topics they are interested in is
    structured financial deals here. So you could be helpful to
    him.
        Mr. Schwarcz. I will do so. Thank you.
        Rating agencies are not substantively regulated by the
    United States. or any other major financial-center nation.
    Financial-center nations, nonetheless, impose a minimal form of
    governmental control by giving official recognition to rating
    agencies that meet certain criteria. This is exemplified in the
    United States by the NRSRO designation.
        Now, as you know, if a rating agency is designated a NRSRO,
    its ratings can be used to satisfy rating requirements
    established by governmental agencies like the SEC in certain
    Federal regulatory schemes.
        Today's hearing is being held because of a failure of the
    NRSRO-designated rating agencies to predict the Enron meltdown.
    In this context, I should note that rating agencies have always
    made their rating determinations based primarily on information
    provided by the issuer of securities. Thus, a rating is no more
    reliable than that information.
        Furthermore, ratings do not cover the risk of fraud. To the
    extent Enron provided the rating agencies with insufficient or
    fraudulent information, that would explain their failure to
    predict Enron's demise.
        I'll now turn to an analysis of the need for regulation,
    and I have submitted with my testimony--I don't know if you
    have copies or not--an article I wrote that is forthcoming, in
    fact, any day now, (in fact, it was published at 2002
    University of Illinois Law Review 1), entitled ``Private
    Ordering of Public Markets: The Rating Agency Paradox,'' \1\
    which focuses on whether rating agencies should remain
    unregulated.
    ---------------------------------------------------------------------------
        \1\ The article submitted by Mr. Schwarcz appears in the Appendix
    on page 175.
    ---------------------------------------------------------------------------
        The normative rationale for regulation in an economic
    context is improving efficiency. There are two ways that
    regulation could do this: By making rating agencies perform
    better the tasks they already do, or by limiting the negative
    consequences of their actions. I conclude in my article that
    regulation would neither improve such performance nor limit
    such negative consequences.
        Now, having said that, I understand that this Committee
    session is being held because of the Enron problem, but I
    believe Enron does not raise a systemic problem for rating
    agencies. They have, as has been acknowledged, a remarkable
    track record of success in their ratings and, indeed, recent
    experience is fairly reliable.
        However, most of the information in terms of reliability of
    ratings looks to see whether defaults have occurred at the time
    of an investment grade rating; and that can miss situations
    where default occurs, as happened with Enron, right after a
    company is downgraded below investment grade.
        Nonetheless, there is a recent internal analysis by
    Standard & Poor's that is publicly available which uses
    information extracted from its proprietary database on over
    9,000 companies with rated debt that confirms the stability of
    investment grade ratings, finding, for example, that all A-
    rated companies at the beginning of a given year would have an
    87.94 percent chance of maintaining that same rating by year-
    end.
        Now, I agree that Enron is a very visible and dramatic
    exception to these data. But statistically, the failure to
    predict Enron's demise does not materially change these data;
    and, as mentioned, to the extent that failure arose from
    Enron's providing the rating agencies with insufficient or
    fraudulent information, then the failure is truly an anomaly.
        Now, to get to the issue of NRSROs, there are many
    countries that make their applicability of laws turn on
    variants of the NRSRO-type designation. Whether the
    applicability of law should, as a normative matter, turn on a
    rating is beyond the scope of my testimony. I do note, as I
    said, that external credit ratings are being relied on in
    regulations worldwide. But so long as the applicability of law
    does turn on such ratings, some form of regulatory approval of
    rating agencies would appear appropriate. And in this context,
    I've examined the appropriateness of the NRSRO designation as a
    rating methodology.
        The central question is balancing the protection provided
    by the NRSRO designation with the goal of ensuring that a
    sufficient number of rating agencies receive such designation
    to ensure competition. In this context, it has been proposed by
    the Antitrust Division of the U.S. Department of Justice that
    NRSRO designation be awarded to some foreign recognized rating
    agencies as well as to arm's-length subsidiaries of domestic
    firms active in evaluating the business and securities of
    companies. There should be relatively little risk if these
    entities are well capitalized, have reputations for quality
    financial analysis in the investment community, and have
    acceptable business plans to rate securities. Consideration
    even might be given, for example, to firms that utilize
    alternative rating approaches such as, as Professor Macey
    mentioned, credit spreads and stock price volatility. The risk
    could be further minimized by making any de novo applicants for
    NRSRO status provisional for some period of time, such as, for
    example, 12 months.
        Now, in this way, the potential anticompetitive effect of
    NRSRO designation can, consistent with the integrity of that
    designation, be reduced. This seems to me like a very sensible
    approach.
        In closing, I should simply say that we all need to put
    these issues into perspective and not be as bent on placing
    blame as Enron's executives were to find profits.
        Thank you.
        Chairman Lieberman. Thank you, Professor Schwarcz.
        Mr. Reynolds, since that announcement cut you short a bit,
    let me go to you first to give you a chance to say a little bit
    more. In your testimony, you have indicated that the credit
    rating agencies are not using the power that they have to get
    all the information they need to make full and fair assessments
    of the companies, and you say--and I agree with you, and I
    would guess most Members of the Committee do, certainly after
    the first panel--that another Enron could be prevented if the
    rating agencies take advantage of that strength.
        Let me ask you first why you think they don't use the power
    they have now.
        Mr. Reynolds. It may be a practiced behavior. It may be a
    sense that there's a confidentiality that exists between the
    rated company and themselves that they're not supposed to step
    outside those boundaries. Maybe they need a mandate to have the
    willingness to do that. But one of my concerns--and a lot of
    the people I speak to regularly who are in the debt markets and
    default swap markets and equity markets--there is a very
    unlevel playing field in information flows. They will have
    access to material inside information, and they're exempted
    from Reg. FD. But if it's a material risk factor, we're
    supposed to have this information disclosed to begin with, so
    they are a very good set of eyes and ears to extract that
    information, and whether it be within a tighter regulatory
    framework or just by their own decision to voice conclusions
    that may not be clearly in the public domain, it would have
    benefit.
        Keep in mind that we are in markets now that are a lot more
    blurry than they used to be. We have banks actively
    participating in the tradable debt market. They have access day
    in and day out to inside information. They're transacting in
    the credit default swap market, which in turn sends signals to
    people who watch those markets to see what the banks are
    thinking, because they know everything the rating agencies
    know, and a lot more. And they are taking actions which are
    reflected in pricing.
        So there is a way to watch the system at work, but it seems
    that it's an unlevel playing field skewed towards those
    institutions which have access to information, and that is not,
    as we referred to earlier, the Mom and Pop investors.
        Chairman Lieberman. Let me ask this: What opportunities do
    you think, based on what you know of the Enron case, did the
    credit rating agencies miss that they should have found and
    pursued?
        Mr. Reynolds. Well, the existence of off-balance sheet
    transactions were discussed in some detail earlier, but there
    is one area that was not, which is the counterparty credit
    exposures which are generated in a trading operation.
        Chairman Lieberman. Describe that a little bit for the
    record.
        Mr. Reynolds. Basically, a trading operation enters into a
    tremendous amount of buy and sell transactions: Swaps,
    commodity swaps, interest rate swaps. These all give rise to
    theoretical lines of credit. It's off-the-shelf statistical
    modeling. Every Tom, Dick, and Harry in the derivatives world
    could model this for you. It is a line of credit that's
    generated with a counterparty.
        Now, when concerns started to arise in the marketplace with
    companies who were closest to Enron, there was a serious risk
    of them pulling in the credit lines and asking for collateral
    to be posted, and that is the run on the bank that people have
    been referring to in some of these hearings. The first thing
    they should have been looking at was that, finding out what
    those lines were----
        Chairman Lieberman. There was enough that they knew that it
    should have engaged their interest that they should have
    pursued it more.
        Mr. Reynolds. It's standard practice in risk management to
    know your counterparty exposure by every counterparty.
    Theoretical line of credit, you have either payables or
    receivables. Standard practice, any brokerage analyst deals
    with it regularly. It's just not as common with utilities.
        So it could have been pursued with some vigor because that
    at the end of the day is what killed the company. Debt hurts
    you. Lack of liquidity kills you.
        Chairman Lieberman. Right. Commissioner Hunt, let me ask
    this question about both the initial NRSRO determination made
    by the SEC and also the reviews that are done in their capacity
    of investment advisers every 5 years. I wonder, what do you
    look for in both of those stages? And, particularly, second, do
    you look at how diligently the credit agency is doing its work?
        Mr. Hunt. We look at their capacity to do their work, their
    internal controls. We do not second-guess their ratings, as we
    would not second-guess an asset manager's selection of equity
    securities. But we do look at their internal controls, their
    capacity to do the work, the kind of personnel they have, the
    number of personnel they have, and their books and records.
        Chairman Lieberman. Let me ask the two law professors here.
    I think each of you thinks there is a basis for further
    regulation of credit rating agencies, though I understand you
    come at it from a different point of view. If you were the SEC
    or Congress, ideally how would we regulate them better? What
    more would we ask of them?
        Mr. Macey. I guess the really quick thing, Senator, one, as
    I mentioned during my testimony, would be this disclosure
    point----
        Chairman Lieberman. Yes, I wanted you to talk a little more
    about that.
        Mr. Macey. Well, the idea is that, as I think several
    people have observed, what--the process by which credit rating
    agencies reach their results is a very opaque process, and it
    would be--I think it would be useful for investors to know
    exactly what it is they're relying on.
        For example, as I mentioned during my testimony, credit
    rating agency ratings tend to lag markets. It would be
    interesting to know the extent to which they look at the market
    prices, particularly in the securities they rate, to derive
    ratings, the extent to which they're using non-public
    information as they are able to do under--with the exemption
    they have under Regulation FD.
        Chairman Lieberman. What would be the best method or mode
    to make this disclosure?
        Mr. Macey. I think a filing with the SEC would make sense.
    As Commissioner Hunt mentioned, there are--the agencies are
    already regulated by the Commission, and I think it would be a
    natural follow-on to get some kind of exposure.
        Chairman Lieberman. What other ideas did you----
        Mr. Macey. The second is--a couple of people have touched
    on also. I think competition would be a good thing; to have a
    lot more of these rating agencies would be a good thing, and to
    have some easy entry and rivalrous competition. And, finally, I
    think that there should be a hard look taken at what I call the
    chicken-game problem; that is to say, if you look at the Enron
    situation, the credit rating agencies really were in a
    difficult position because pulling the rating, as was discussed
    in the previous panel, for certain of these private investment
    vehicles was the death knell for the company. And so you have
    this idea that these kinds of contractual arrangements allowed
    the company, in a case like Enron, which is run by some pretty
    aggressive folks, apparently, to play chicken with the credit
    rating agencies and say, Do you really want to be responsible
    for our death? Who's going to be the first to kind of swerve in
    this game?
        I don't think that's a particularly healthy situation, and
    I think that it puts the rating agencies in a very difficult
    situation. I'd have a look at those kinds of----
        Chairman Lieberman. It is a very interesting point. We keep
    pressing on this. We pressed them in the first panel.
        Mr. Macey. Right.
        Chairman Lieberman. That they have enormous power that they
    are not using to get more information, at least. But I suppose
    the other part of it is that with such enormous power, life and
    death, you are hesitant to drop the boom. Our hope is they use
    the power to get more information and report it to us. But how
    would you qualify that?
        Mr. Macey. Well, I think this problem is--happily, this
    particular aspect of the problem is rather rare; that is to
    say, it's my understanding, or at least the credit rating
    agencies tell us that in most of their rating situations,
    pulling the rating does not trigger these sort of covenants and
    is not going to be the death of the company. And so I would
    isolate those situations like Enron where it is, and I would
    urge the appropriate agency, obviously, in this case the SEC,
    to see whether or not there would be some better way of
    crafting these contractual provisions.
        Specifically, my own view is that a far superior way in
    this limited context would be credit spreads; that is, instead
    of looking at ratings, we can look at the spread between the
    yield to maturity on the Enron senior unsecured debt and some
    similarly structured government bond. And at the initial
    issuance, we would have a spread of, say, you know, 2 percent
    or 200 basis points, and if the spread goes to 9 percent or 900
    basis points, that should sort of be a clue that there's
    something going on in the company that maybe we should take a
    look at.
        Chairman Lieberman. Good. Interesting. Professor Schwarcz.
        Mr. Schwarcz. Yes, thank you. I agree with Jonathan Macey
    in terms of the fact that there probably should be additional
    entities designated as NRSROs, and as I mentioned in my
    testimony, those could include some foreign recognized rating
    agencies as well as arm's-length subsidiaries of domestic firms
    active in evaluating the business and securities of companies.
        The Law Review article I submitted goes into great detail
    on these possibilities, and I won't bore people now with those
    details.
        I disagree with Jonathan on two points, however.
        One is that he indicated that we need a lot more of these
    NRSROs, and I would be concerned that if we had too many of
    them, it would create almost a perverse incentive for issuers
    to shop around for the highest rating they could find. And so I
    would want to at least keep the number restricted to the very
    highest quality of these potential new rating agencies or
    NRSROs.
        Second, in terms of credit spreads, there are data that
    indicate that for a thick market of publicly traded bonds, that
    credit spreads may be, to some extent, more accurate than
    ratings. But there also are data that show the opposite, and in
    my testimony and in my article I cite at least an IMF study
    from 1999 that concludes that ratings are much more reliable
    than credit spreads.
        Beyond that, I should say that credit spreads are only
    effective where you have public trading of securities in a
    thick market. That means credit spreads have very little
    application, for example, to new issues of securities where
    there is no market at all and, therefore, no spreads. They have
    no application to structured finance deals or other structured
    deals where the rating depends as much on the legal structure
    as anything else, and the legal structure is not known to and
    certainly not fully understood by most market participants.
    And, third, they have little or no application to privately
    placed deals unless there's a very thick trading market. So
    most privately placed deals would not be eligible for the use
    of credit spreads.
        What I suggest, however, in my proposal is to have the
    foreign recognized rating agencies and other players
    potentially be appointed on a provisional basis as NRSROs; and
    that some of these players can be those that have considered
    credit spreads and stock price volatility as alternative ways
    to assess creditworthiness. And I think we can then all find
    out how accurate their ratings will be based on experience.
        Chairman Lieberman. Mr. Reynolds, do you have an opinion
    between the two we have heard on the question of competition,
    whether if we created a climate in which there were more credit
    rating agencies, that would encourage all of them to do more
    aggressive work or whether, as Professor Schwarcz said, there
    would be a certain amount of shopping around for a good rate?
        Mr. Reynolds. There historically has been a bit of shopping
    for higher rates going on among issuers. This has led to some
    ratings inflation, particularly in the money markets in past
    years. But a practical matter is that you're not going to see a
    lot of large-scale market entrants. You have fewer today rather
    than more. Everyone complains about the lack of new NRSRO
    designations, but if you look beyond the S&P's and Moody's big
    two, the other four rolled up into one. So there are
    significant barriers to entry away from the NRSRO designation
    scale: Specialized skill sets. It takes a lot to build a credit
    research company of that scale globally to be taken seriously.
    So you run the risk that where you get in is to be the
    proverbial professor in college, the other one that will give
    the A. And that's certainly not going to help the dialogue.
        I think the way we help the dialogue is for all of these
    agencies to be far more transparent in the information that is
    factored into their rating, because then the market economy can
    do an object gut test on the quality and depth of the
    understanding of the company as well as the industry and as
    well as what you have in the case of Enron, highly convoluted,
    financially engineered enterprises.
        One of the Senators earlier mentioned the fact that you're
    acting like analysts. Well, you have to be an analyst because
    ratings will have absolutely no credibility in the marketplace
    if you can't get on a conference call with an S&P's and Moody's
    analyst and grill him on his thought process.
        So I think that it's quality of information that is the
    biggest challenge right now and probably the easiest to solve.
    It will take 10 years to build another NRSRO unless Warren
    Buffet has a few billion to put to work. But he has it right
    now invested in Moody's.
        Chairman Lieberman. All right. Maybe that is a good note to
    end on. We have, of course, let me restate for the record,
    previously concluded the formal hearing. I thank you very much.
        Senator Levin. One question.
        Chairman Lieberman. I want to let you know, because there
    has been an objection to us proceeding.
        Senator Levin. Oh.
        Chairman Lieberman. No, no. I adjourned the hearing, but
    what I hope is not seen as a matter of civil disobedience, I am
    continuing an informal discussion, since we are not transacting
    business, among the group of us here who are interested in this
    subject. So if you would like to enter into that informal
    discussion----
        Senator Levin. I don't want to in any way contribute to the
    delinquency of a Chairman here. [Laughter.]
        Senator Levin. Being a Chairman myself.
        Let me just ask an informal question.
        Chairman Lieberman. Yes. I am sure you will get an informal
    answer.
        Senator Levin. If I could ask Mr. Hunt, I had a chance to
    just briefly ask you a question in the back room, and if you
    haven't been asked this question, perhaps I would do it now.
    That chart which----
        Mr. Hunt. Yes, I saw the chart. It's a wonderful chart.
    [Laughter.]
        Senator Levin. And if you haven't been asked----
        Mr. Hunt. I have a copy of it. You were kind enough to give
    me a copy.
        Senator Levin. Well, we thought we would get another
    opinion on this. Enron did a huge amount of structured
    financing deals from 1997 to 2001. Our estimate is $15 to $20
    billion a year. And this is one of the many that our subpoenas
    have uncovered, and this produced investments which were rated
    by Moody's in this case. What is your reaction, if you would,
    to that chart? Is that comprehensible?
        Mr. Hunt. I think my reaction to--I heard the first panel
    say that their structured analysts could understand this, and I
    take them at their word that they could. If you put this in a
    prospectus for Enron stock and sold it to the public, most of
    the public wouldn't have the slightest idea what this meant. I
    mean, it would not be useful to the average investor. It might
    be useful to somebody who is experienced in analyzing these
    kind of structures, but in my judgment, while Enron did need to
    make more disclosure, this kind of disclosure would not have
    been helpful.
        Senator Levin. Does that look like it is more intended to
    obfuscate and hide----
        Mr. Hunt. One could argue that, Senator, yes, sir. One
    could argue that it is needlessly complicated, but since I'm
    not an expert in structured financing, I don't know whether
    it's needlessly complicated or just complicated.
        Chairman Lieberman. We wanted you to know that, in your
    absence, Professor Schwarcz made a declaration which may be
    against his self-interest that he is an expert on structured
    finance.
        Senator Levin. Well, I don't know the answer to my
    question. Were you asked this question?
        Mr. Schwarcz. I was not asked this question----
        Senator Levin. If it is clear to you, I assume that it
    would be clear to any average investor.
        Mr. Schwarcz. Well, I think there are two issues, I would
    say. First of all, I have not had the chance to study this
    chart, nor do I frankly even know whether the chart is accurate
    in terms of all the players. I can generally guess from the
    chart, just quickly looking at it, who the players are, that
    you have the originator on the left and the SPVs or SPEs on the
    bottom and the investors on the right. But one would have to
    diagram this out and just double-check it and check the money
    flows.
        There is another part of the problem. I'm writing an
    article entitled ``The Use and Abuse of Special Purpose
    Entities in Corporate Structures,'' and one of the things that
    I'm considering is whether, in fact, some of these transactions
    are getting so complicated that, indeed, it's impossible to
    explain them to the ordinary investor. On the other hand, the
    question is what do you do about that? Do you restrict the
    structures and thereby really inhibit the flexibility and
    creativity of American business?
        And I have some solutions, some possible things that we can
    discuss. My thought process is still sufficiently incomplete
    that I don't want to discuss this in public, but I'd be happy
    to discuss it in private.
        Senator Levin. Thank you. Thank you so much.
        Chairman Lieberman. Thanks, Senator Levin. Again, thanks to
    all of you for a substantial contribution to this Committee's
    efforts.
        It is now my unique pleasure to adjourn this informal
    discussion. Thank you very much.
        [Whereupon, at 12:32 p.m., the Committee was adjourned.]

                                A P P E N D I X

                                  ----------

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