[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.
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    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.
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    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.
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    \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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