[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
79-888 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2002
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia PETE V. DOMENICI, New Mexico
THOMAS R. CARPER, Delaware THAD COCHRAN, Mississippi
JEAN CARNAHAN, Missouri ROBERT F. BENNETT, Utah
MARK DAYTON, Minnesota JIM BUNNING, Kentucky
Joyce A. Rechtschaffen, Staff Director and Counsel
Cynthia Gooen Lesser, Counsel
Beth M. Grossman, Counsel
Thomas J. Holloman III, Legislative Fellow
Richard A. Herlting, Minority Staff Director
William M. Outhier, Minority Chief Counsel
Jana A. Sinclair, Minority Counsel
Darla D. Cassell, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Lieberman............................................ 1
Senator Thompson............................................. 4
Senator Levin................................................ 5
Senator Bunning.............................................. 6
WITNESSES
Wednesday, March 20, 2002
Ronald M. Barone, Managing Director, Corporate and Government
Ratings Group, Standard & Poor's............................... 6
John C. Diaz, Managing Director, Moody's Investors Service....... 8
Ralph G. Pellecchia, Senior Director, Global Power Group, Fitch
Ratings........................................................ 9
Hon. Isaac C. Hunt, Jr., Commissioner, U.S. Securities and
Exchange Commission............................................ 40
Jonathan R. Macey, J. DuPratt White Professor of Law, Cornell Law
School......................................................... 43
Glenn L. Reynolds, Chief Executive Officer, CreditSights, Inc.... 45
Steven L. Schwarcz, Professor of Law, Duke University School of
Law............................................................ 46
Alphabetical List of Witnesses
Barone, Ronald M.:
Testimony.................................................... 6
Prepared statement with attachments.......................... 55
Diaz, John C.:
Testimony.................................................... 8
Prepared statement........................................... 116
Hunt, Hon. Isaac C., Jr.:
Testimony.................................................... 40
Prepared statement........................................... 131
Macey, Jonathan R.:
Testimony.................................................... 43
Prepared statement........................................... 138
Pellecchia, Ralph G.:
Testimony.................................................... 9
Prepared statement........................................... 129
Reynolds, Glenn:
Testimony.................................................... 45
Prepared statement........................................... 148
Schwarcz, Steven L.:
Testimony.................................................... 46
Prepared statement with an attachment........................ 168
Appendix
Article entitled ``Private Ordering of Public Markets: The Rating
Agency Paradox,'' submitted by Mr. Schwarcz.................... 175
Chart entitled ``Project Margaux: Whitewing Associates, L.P.
Financing Transaction, September 24, 1999'' (submitted by
Senator Levin)................................................. 207
Responses to Questions posed by Senator Levin during hearing
from:
Ralph G. Pellacchia.......................................... 208
Questions for the Record and responses from:
Hon. Hunt.................................................... 211
Mr. Macey.................................................... 212
Mr. Reynolds................................................. 213
Mr. Schwarcz..................................................... 215
RATING THE RATERS: ENRON AND THE CREDIT RATING AGENCIES
----------
WEDNESDAY, MARCH 20, 2002
U.S. Senate,
Committee on Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 9:35 a.m., in
room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, Levin, Thompson, Bennett, and
Bunning.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. Good morning, and welcome to this
fourth in a series of Governmental Affairs Committee hearings
on the collapse of Enron and the implications for Enron
employees, investors, and the American economy as a whole.
We are engaged in an ongoing investigation here into
whether the private and public watchdogs did all they could
have done to prevent or at least anticipate and warn the rest
of us of Enron's collapse.
Today, we are going to look at the private sector credit
rating agencies that wield immense power--to me, quasi-
governmental power--to determine which companies within the
corporate world are creditworthy and which are not. In pursuit
of our purpose here, which is to learn the lessons of Enron and
craft solutions to avoid future corporate calamities of this
sort, we will ask why the credit raters continued to rate Enron
as a good credit risk right up until 4 days before it declared
bankruptcy.
In this particular part of our investigation, I must say I
have learned a lot that I didn't know before about credit
rating agencies. A credit rating, I suppose self-evidently, is
an assessment of a company's creditworthiness or its likelihood
of repaying its debt. The entire corporate credit rating
industry consists of just three entities, three agencies--
Moody's Investors Service, Standard & Poor's, and Fitch
Ratings--three agencies that exercise significant power over
corporate America, the markets, and, therefore, our entire
economy. These are private companies, but the enormous scope of
their influence comes largely as a result of their government-
conferred power.
John Moody, the founder of what is now Moody's Investors
Service, is recognized, I have learned, for devising credit
ratings in 1908, and he did so for public debt issues, mostly
railroad bonds at that time. Moody's credit ratings, first
published in 1909, met a need for accurate, impartial, and
independent information on these bonds.
Now, almost a century later, an investment grade credit
rating has become an absolute necessity for any company that
wants to tap the resources of the capital markets. The credit
raters really do hold the key to capital and liquidity, which,
after all, are the lifeblood of corporate America and of our
capitalist economy. The ratings they give affect a company's
ability to borrow money. It affects whether a pension fund, for
instance, or a money market fund can invest in a company's
bonds, and it affects stock price. So the difference between a
good rating and a poor rating can be the difference literally
between success and failure, or more intensively stated,
prosperity and poverty.
The government, through hundreds of laws and regulations,
requires ratings. Corporate bonds, for instance, must be rated
if they are to be considered appropriate investments for
institutional investors. Most of the laws that require credit
ratings involve banks and securities, but their reach, actually
quite interestingly, also extends into education where schools
must be rated in order to participate in certain financial
assistance programs, and even into transportation where highway
projects must receive a rating to qualify for Federal funding,
and into telecommunications where companies must be rated in
order to receive Federal loan guarantees. These rating
requirements, quite understandably, have been placed by
lawmakers in a whole series of economic activities as a way to
give some independent assessment of the strength of the
company.
Along with this power that the credit rating agencies have,
comes special access and special protections. The credit
raters, for example, I learned, are allowed to look at a
company's inside information when making assessments, and they
are exempted from liability when they participate in securities
offerings, which are two benefits that give them more
information than other analysts have who work within our
system.
Someone once said that raters hold ``almost Biblical
authority.'' On a ``NewsHour with Jim Lehrer'' program in 1996,
New York Times columnist Tom Friedman went so far as to say,
``There are two superpowers in the world today: The United
States and Moody's bond rating service. And, believe me, it's
not clear,'' Friedman said, ``sometimes who is more powerful.''
With so much power, access, and protection, it's not
surprising that profitability also follows close behind. Not
all the agencies' books are open because some of them are
subsidiaries of larger corporations, but Moody's was spun off
into a separate company a few years ago, and by one calculation
my staff came across, it is worth $6.2 billion. So nothing
wrong with that, except it just indicates the scope of the
enterprise.
It seems reasonable that a power of this magnitude should
go hand in hand with some accountability, and yet once the SEC
anoints or accepts the status of a credit rating agency which
is now enjoyed by the three, the agencies are essentially left
alone. So I think it is appropriate, as we try to learn the
lessons of Enron, to ask whether these agencies should have
some more ongoing sense of accountability, some oversight from
the SEC, for instance, as we ask whether they are adequately
and as fully as possible performing a function as watchdogs or
gatekeepers.
In the Enron case, it seems to me that the credit raters
were no more knowledgeable about the company's problems than
anyone else who was following its fortunes, including those who
were following it in the newspapers. I just want to briefly go
over some of the events leading to the raters' decisions to
withdraw their assessment of Enron as a good credit risk.
Remember after a summer of last year during which Enron
stock steadily declined, it was reported in the third week in
October that the SEC had asked the company to disclose its ties
to outside investment partnerships set up by the company's
chief financial officer. Enron stock dropped 20 percent that
day, October 22, to a closing price of $20.65 per share. On
October 24, CFO Andrew Fastow resigned, and the stock went down
another $5 to $16.41. Five days later, on October 29, S&P's
credit rating analyst appeared on CNN. By this time, the
agencies had put Enron on a credit watch, but the company was
still literally investment rated as a good risk. The S&P's
analyst predicted that, ``Enron's ability to retain something
like the rating that they're at today is excellent in the long
term.'' When asked about the off-balance sheet partnerships
which had become public, as I mentioned, the analyst assured
investors that there would be no long-term implications.
``That's something that's really in the past,'' he said.
Now, I want to go back to the last hearing we held in this
series when a Wall Street analyst said to this Committee that
his ``buy'' recommendation was supported by the confidence
expressed by the credit rating agencies, which he specifically
pointed out had access to inside information about Enron's
liabilities that he didn't have. So S&P's confidence had an
effect on others, and I want to ask the witnesses about that
today.
We know that as time went on, the market was not convinced.
The stock price continued its descent, dropping to $8.41 on
November 8, when Enron disclosed it had overstated earnings by
over half a billion dollars since 1997. But, still, the rating
agencies kept Enron at investment grade. By November 28, the
day Moody's and Standard & Poor's downgraded Enron to junk bond
status, effectively, the company's stock was trading at just
over $1, and 4 days later, of course, it went into bankruptcy.
In other words, the credit raters, despite their unique
ability to obtain information unavailable to other analysts,
were no more astute and no quicker than the others to act in
warning and responding, and I want to ask about that today. The
agencies, I understand, defend their ratings as opinions
protected by the First Amendment. They refer to their
assessments as the world's shortest editorials. But the fact is
that their endorsement, if I can use the metaphor of the
editorials, is required by law unlike, fortunately, other
endorsements that newspapers give or don't give, which are not
required by law.
So the point here is that almost all the watchdogs who
should have barked before a lot of good people were hurt by
Enron's collapse didn't. Among them were the credit rating
agencies who had more access to Enron's books than most of the
other watchdogs, and the fundamental question we want to ask
today is: Why did that happen? And what can we do together,
hopefully, to make sure that the authority that credit rating
agencies have is used as actively as possible to protect and
defend the integrity of our capital markets, let alone the
confidence of the millions of average investors and not-so-
average investors who are institutional investors. So I look
forward to the hearing today, and I thank the witnesses who are
here for being here.
Senator Thompson.
OPENING STATEMENT OF SENATOR THOMPSON
Senator Thompson. Thank you, Mr. Chairman. I think you have
framed the issues very well, and I will just simply ask that my
full statement be made a part of the record.
I was given a summary here that I think accurately
summarizes the issues, and it says basically that these rating
organizations are delegated responsibility by the government
for certifying certain debt. They have the opportunity to
access information that other professionals and the public
cannot due to their exemption from Regulation FD. They are
protected from competition by the SEC as a result of their
status. They have the ability to effectively collect a tax from
companies issuing debt, and they operate virtually free from
liability. And yet some think that there is very little
accountability, so the issue here is whether or not that is a
good situation, and if not, what, if anything, should be done
about it.
I think there are First Amendment implications. I think it
is clear that people need to understand these organizations do
not recommend buy or sell. They deal in broad categories, and
perhaps, if nothing more, we can illuminate exactly what they
do and what they do not do for the benefits of investors and
the extent to which investors should or should not rely upon
what they are looking at.
So I think that very well frames the issues, and I look
forward to our witnesses today.
Chairman Lieberman. Thanks, Senator Thompson. Your full
statement, of course, will be printed in the record.
[The prepared statement of Senator Thompson follows:]
PREPARED STATEMENT OF SENATOR THOMPSON
Mr. Chairman, thank you for holding this hearing today. I
appreciate the way this series of hearings has focused on the
gatekeepers. Obviously, there is not much congress can do about
individuals who choose to skirt or violate the law. However, I think it
is appropriate for us to review the actions of regulatory agencies or,
as we are looking at today, private entities with special dispensations
from the government. That is the way I believe we can affect some
positive change.
During our first hearing which covered a number of topics,
Professor Frank Partnoy testified about problems he saw in the
structure of the credit rating agencies. Since that time, we have had
an opportunity to delve deeper into that topic.
The issues raised about credit rating agencies are not unlike those
raised during our hearing on Wall Street analysts. For example, the
Wall Street analysts maintained ``buy'' and ``strong buy'' ratings
until very late in the year last year. Similarly, each of the three
credit rating agencies on our first panel maintained investment grade
ratings until just four days before Enron declared bankruptcy. Like the
Wall Street analysts, some of the reasons given for the positive
ratings on Enron are that the credit rating agencies were misled, they
are not auditors and had to rely on Enron's financial statements and
the work of Arthur Andersen, and because of the anticipated merger with
Dynegy which never occurred.
The difference with the Wall Street analysts is that the credit
rating agencies do not have similar conflict of interest concerns
because they do not have the same investment banking relationships.
However, questions about conflicts and incentives to dig deep have been
raised as a result of the unique regulatory setup involved here.
My understanding of that setup is that three specific credit rating
agencies currently have Nationally Recognized Statistical Rating
Organization, or NRSRO, status. Several regulations and statutes
require issuers or debt holders to rely on NRSRO ratings. As a result,
issuers have little choice but to pay for ratings. Credit rating
agencies, by virtue of their exemption from Regulation FD, have the
opportunity to obtain information that others cannot. And they are
basically free from liability.
However, despite this special status, there appears to be little
accountability. Some writers have noted that the requirements for NRSRO
status appear to be ``inputs''--their reputation, access and
organization--but does not include ``outputs.'' that is, for example,
some method of following the agencies to see how timely and accurate
their ratings are.
A number of proposals have been floated from adding more NRSROs, to
eliminating the NRSRO status altogether, to maintaining the status quo
and providing more oversight. I look forward to hearing from the three
credit rating agencies today to hear their explanation for their
decisions. I would note that during the hearing on Wall Street
analysts, we had to pick and choose among a number of firms, but
because of the oligopoly associated with the NRSROs, we have all three
of those firms here today. I am also pleased that in these hearings on
government oversight we finally have a government official here today
and I look forward to the testimony of Commissioner Hunt. I also look
forward to hearing the experts discuss the current regulatory framework
and what, perhaps, should be done to provide stronger incentives and to
engender greater confidence.
Chairman Lieberman. Senator Levin.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you, Mr. Chairman, for your continuing
determination to get to the bottom not just of the Enron
disaster, but also as to whether or not the problems disclosed
are more endemic, more generic, and, therefore, require us to
take some very determined and specific actions to try to
restore confidence in our markets and in financial statements.
As the many failures of various players come to light and
as we dig deeper and deeper, the credit rating agencies clearly
have a role here that we have to investigate and, if necessary,
take action to see if we can't improve this situation so that
their ratings can be more reliable.
As our Chairman pointed out, one of the big questions that
we are looking at is why were the rating agencies so slow to
downgrade after the deceptions and the decline of Enron became
public. Even before the deceptions and decline became public,
the agencies were given access to information long before. Why
didn't they see early signs, for instance, of the extreme use
of structured finance deals, the use of undisclosed guarantees
not made public but which apparently were made available to the
rating agencies, which clearly affected the financial
circumstance and situation of Enron? Not just the undisclosed
guarantees here, which were not made public apparently, but
also items which were left off these financial statements--
liabilities which were omitted, which it would seem to me, with
an inside view that the credit rating agencies have, would have
shown that liabilities of Enron were omitted from the financial
statements, which should have been disclosed.
So there is a whole host of questions here. I am glad that
the agencies are represented this morning, all of them, and
that you, Mr. Chairman, are pursuing this investigation because
there are many, many layers that need yet to be uncovered, to
be disclosed, to be analyzed, and for corrective action to be
taken.
Thank you.
Chairman Lieberman. Thanks very much, Senator Levin.
Now we will go to the first panel: Ronald Barone, John----
Senator Bunning. Mr. Chairman.
Chairman Lieberman. Oh, I am sorry. How could I forget the
big man.
OPENING STATEMENT OF SENATOR BUNNING
Senator Bunning. That is all right, Mr. Chairman. I
understand you want to get to the witnesses, but I do have some
background that I would like to----
Chairman Lieberman. I apologize. Please.
Senator Bunning. Back in March 2001, Fortune Magazine
published an article by Bethany McLean titled, ``Is Enron
Overpriced?'' Now, this is March 5, 2001. In that article, she
asked several individuals to explain how Enron made its money.
The responses were not encouraging, according to the article.
An analyst from Standard & Poor's said, ``If you figure it out,
let me know.'' An analyst from Fitch, who I believe is also
testifying on our first panel today, said, ``Do you have a
year?''
While these may have been off-the-cuff statements, they are
very disturbing. Many of the people the public and the
investors depend on to give them independent, unbiased, and
accurate information dropped the ball. There is certainly
enough blame to go around from the accountants to the analysts.
Of course, most of the blame rests solely on the shoulders of
those Enron executives who apparently were not truthful to
their employees, investors, or analysts. But that doesn't let
the rest of you off the hook.
Last month, this Committee held a hearing on why Wall
Street analysts continued to recommend Enron stock even as the
company was collapsing. Those analysts told us that Enron
withheld information and that the company's financial documents
were not properly audited. This may be true. However, the one
independent financial analyst on the panel, Howard Schilit,
from the Center for Financial Research and Analysis, said that
there were clear warnings in Enron's public filings and that
just by reading over the statements the night before the
hearing, he was able to pick out multiple problems. He said,
``For any analyst to say there were no warning signs in the
public filings, they could not read the same public filings
that I did.''
The question that must be asked and answered is: How did
Enron get away with the questionable business practices for so
long? And what changes need to be made to ensure other
companies cannot follow in Enron's footsteps?
I appreciate the time the panelists testifying today have
set aside to be here, and I look forward to gaining their
perspective on this important issue.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Bunning.
Now we will go to the first panel: Ronald Barone, John C.
Diaz, and Ralph Pellecchia. Gentlemen, as is the custom of the
Committee, I would ask you all to stand at the table and raise
your right hands so I can administer the oath. Do you solemnly
swear that the testimony that you will give this Committee
today is the truth, the whole truth, and nothing but the truth,
so help you, God?
Mr. Barone. I do.
Mr. Diaz. I do.
Mr. Pellecchia. I do.
Chairman Lieberman. Thank you very much. Please be seated,
and let the record show that the witnesses have answered the
question in the affirmative.
Mr. Barone, Managing Director of Standard & Poor's, we
thank you for being here, and we look forward to your testimony
now.
TESTIMONY OF RONALD M. BARONE,\1\ MANAGING DIRECTOR, CORPORATE
AND GOVERNMENT RATINGS GROUP, STANDARD & POOR'S
Mr. Barone. Good morning, Mr. Chairman and Members of the
Committee. I am Ronald M. Barone, a Managing Director in the
Corporate and Government Ratings Group of Standard & Poor's.
From 1994 until Enron's bankruptcy in December 2001, one of my
roles was to serve as an analyst and then a manager with
respect to our ratings work for Enron. On behalf of Standard &
Poor's, I welcome this opportunity to appear at this hearing.
As a member of the financial community that relied on Enron for
complete, timely, and reliable information, and instead
received incomplete, deceptive, and, it now appears, fraudulent
representations, Standard & Poor's supports the Committee's
urgent sense of the need to investigate the circumstances
relating to Enron's collapse.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Barone with attachments appears
in the Appendix on page 55.
---------------------------------------------------------------------------
Standard & Poor's credit ratings have gained respect
because they are based on objective and credible analyses. Our
reputation ultimately depends on the credibility of our
opinions. In order to ensure maximum objectivity and in-depth
analysis, ratings are assigned by a Committee, not by an
individual, and no portion of an analyst's compensation is
dependent on the performance of the companies the analyst
rates. The record bears out our method, as there is a
longstanding and strong correlation between the ratings we
initially assign and the eventual default record.
At their core, our ratings opinions are based on the
issuer's public information, including audited financial
statements. We also may have access to certain confidential
information--we did with Enron--but only to the extent the
company is willing to provide such information. We expressly
rely on the companies we rate not only for current and timely
information at the time of the initial rating but for material
updates to that information.
From December 1995 until November 1, 2001, Standard &
Poor's rating of Enron was BBB-plus, which we define as
adequate ability to repay debt but subject to worsening
economic conditions. This placed Enron at the lower levels of
investment grade ratings, well below what Enron repeatedly, and
unsuccessfully, sought.
Standard & Poor's made continuous efforts to monitor
Enron's credit quality closely. When Enron's troubles began to
surface late last year, we changed Enron's outlook to negative
on October 25. Over roughly the next month, we downgraded Enron
three times, despite Enron's announced acquisition by
financially stronger Dynegy. Indeed, we stated publicly that
without the proposed merger, Enron's credit rating would likely
fall below investment grade.
On November 28, the day we determined that the merger was
unlikely to occur, yet still before Dynegy publicly called it
off, Standard & Poor's lowered Enron's rating to B-minus, a
non-investment grade rating.
We now know things we did not know when we were rating
Enron. Despite our repeated requests for all information
material to our analysis, Enron appears to have intentionally
concealed the true nature of its debt obligations by treating
almost $4 billion worth of in-substance loans as financial
hedges. Moreover, as documented in the report of Enron's
special committee, the company also failed to adequately
disclose its material dealings with the Chewco, LJM1, LJM2, and
Raptor partnerships.
In fact, beginning in October 1999, and prompted by
Standard & Poor's express request for full information
regarding Enron's off-balance sheet partnerships, Enron made a
series of formal presentations to us which they labeled as ``a
kitchen sink analysis'' of all the non-recourse debt for its
off-balance sheet affiliates. But in the presentations, two of
which I have included with my testimony, there is no mention of
any of these partnerships.
Had Enron told Standard & Poor's the truth about its
financial condition during the ratings process, as it was
required to do, the impact on Enron's rating would necessarily
have been significant. In addition to having a financial
impact, Enron's disclosure failures related directly to Enron's
honesty and, thus, to the validity of all its numbers. Enron's
deceptions about its true debt burdens and off-balance sheet
dealings not only hid many of its debt obligations from view,
but were done, the Powers Report concluded, to accomplish
favorable financial statement results, not to achieve bona fide
economic objectives.
Enron hid its true financial picture and, more
specifically, its true creditworthiness from Standard & Poor's.
Standard & Poor's publishes thousands of ratings that are
subject to market scrutiny every day. We welcome that scrutiny,
and I welcome the opportunity to testify here today.
Thank you, Mr. Chairman.
Chairman Lieberman. Thanks, Mr. Barone.
Now we are going to hear from John C. Diaz, who is the
Managing Director of Moody's Investors Service. Thanks, Mr.
Diaz. Please go forward with your testimony now.
TESTIMONY OF JOHN C. DIAZ,\1\ MANAGING DIRECTOR, MOODY'S
INVESTORS SERVICE
Mr. Diaz. Good morning, Mr. Chairman, Senator Thompson, and
Members of the Committee. My name is John Diaz, and I am a
Managing Director of Moody's Investors Service. I am pleased to
have the opportunity to appear before you today to discuss
Moody's, the role that rating agencies play in the markets, and
Moody's actions in rating the Enron Corporation and its debt
instruments.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Diaz appears in the Appendix on
page 116.
---------------------------------------------------------------------------
Moody's Investors Service is owned by Moody's Corporation,
a New York Stock Exchange-traded company. Moody's is the oldest
credit rating agency in the world. Our roots trace back to
1900, when John Moody & Company first published Moody's Manual
of Industrial and Miscellaneous Securities. From its beginning,
Moody's Investors Service has focused on rating debt
instruments, and as early as 1924, Moody's was rating nearly
every bond in the U.S. bond market.
Moody's and other rating agencies occupy a niche in the
investment information market. Ratings express relative
creditworthiness. The heart of our service lies in ratings on
long-term fixed-income debt instruments. We also provide, for
instance, short-term ratings, deposit ratings for banks, and
various rating services in foreign countries. Moody's has nine
primary long-term debt rating categories. Investment grade
ratings range from AAA at the high end down to a low of Baa.
Ratings below Baa are considered to be speculative grade, or
junk. Moody's supplies this long-term scale to ratings on other
types of financial obligations and to companies. We also assign
short-term ratings--mainly to issuers of commercial paper--on
an independent scale that ranks obligations Prime-1, Prime-2,
Prime-3, or Not Prime. In all, Moody's ratings are designed to
provide a relative measure of risk, with the probability of
default increasing with lower ratings.
As part of Moody's commitment to predictive ratings, we
review the relationship between defaults and our ratings. We
publish an annual study, which we call our default study, which
consistently shows that higher-rated bonds default less
frequently than lower-rated bonds, although the rates of
default may vary over time. Our default studies show the
predictive nature of our ratings. Put simply, as a forward-
looking opinion, ratings effectively distinguished bonds with
higher credit risk from bonds with lower credit risk.
Our strong record is due in large part to the availability
of reliable information. The combination of the financial
disclosure regime in the United States, audited accounts,
information that is provided directly to Moody's, and issuers'
good-faith dealings have normally been sufficient. Enron was an
anomaly, partly in the nature of its activities, and certainly
in the disclosure of its activities. As we have come to learn,
Enron's public disclosures and its responses to our specific
requests for information were misleading and incomplete.
Although we do not have investigative authority, our analysts
are encouraged to exercise skepticism with respect to an
issuer's claims and promises. That skepticism led us to assign
Enron a long-term rating that, at all times, was no better than
low investment grade and contained speculative elements.
Throughout Moody's rating history with Enron, we followed
processes and practices that conformed to our established
methods of credit analysis--methods that have been proven to
predict relative creditworthiness. In the case of Enron,
however, that methodology was undermined by the missing
information upon which our ratings should have been based and
the misleading information on which the ratings were, in fact,
based.
Having said that, my colleagues at Moody's and I wish we
had discovered the information that would have allowed us to
serve the market more effectively in this instance. We
acknowledge that the public bond markets look to us for our
opinion forecasts of long-term creditworthiness, and we
recognize that the market does not expect a very large issuer
of bonds, which we have rated investment grade, to default very
shortly after holding such a rating.
The integrity and reliability of our ratings and rating
processes are the essence of our business. We are constantly
striving to enhance rating processes and quality, and we have
examined the circumstances around the Enron bankruptcy to see
what lessons can be learned. For example, we are looking more
comprehensively at the role of so-called rating triggers, which
can cause payment obligations to accelerate or require the
posting of collateral based upon a rating downgrade. We have
enhanced our analysis of short-term corporate financial
capacity, that is to say, liquidity, and we are reviewing more
thoroughly the sufficiency and certainty of an issuer's near-
term sources of cash and credit under conditions of stress. We
have also contacted the large asset management firms in a
coordinated review of their use of ratings in the marketplace.
Finally, we commend this Committee, along with Congress in
general, for your efforts to ensure the continued health of our
financial markets.
I thank you for your time, and I look forward to your
questions.
Chairman Lieberman. Thanks, Mr. Diaz.
Finally, we are going to hear from Ralph Pellecchia, Senior
Director of the Global Power Group of Fitch Ratings. Good
morning.
TESTIMONY OF RALPH G. PELLECCHIA,\1\ SENIOR DIRECTOR, GLOBAL
POWER GROUP, FITCH RATINGS
Mr. Pellecchia. Thank you, Mr. Chairman and Members of the
Committee. My name is Ralph Pellecchia, and I am a Senior
Director in the Global Power Group of Fitch Ratings. I joined
Fitch in July 1989 as an analyst in the natural gas and power
sector. I have been the lead analyst following Enron at Fitch
since May 1997. At Fitch, I am the primary analyst for 14
companies in the Global Power Group and one of 15 Fitch
analysts covering the North American Global Power sector.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Pellecchia appears in the
Appendix on page 129.
---------------------------------------------------------------------------
Fitch is in the business of publishing independent ratings
and credit analysis of companies around the world. I am
responsible for coordinating this activity for the companies
assigned to me. My work includes regularly visiting companies I
cover, maintaining contacts with members of the finance staff
and other important personnel at those companies and staying
current on events affecting the companies and the industry that
I follow. I also conduct much of the quantitative and
qualitative analysis that Fitch uses to assess credit of the
companies we rate in my area.
Finally, my role as the primary analyst is to synthesize
the quantitative and qualitative analysis and to propose a
rating, with the final rating outcome to be determined by a
credit committee. The credit committee is comprised of a
minimum of five voting members typically specialists from the
industry/sector, but frequently includes members from other
groups within Fitch.
In my role as primary analyst, I am guided by procedures
and practices followed at Fitch. The ratings process related to
Enron was in all respects consistent with those procedures and
practices.
The assessment process itself is a blend of quantitative
and qualitative factors. The quantitative factors that are
parts of the rating process include an evaluation of published
financial information, supplemental financial information, and
peer financial performance. Qualitative factors include
business fundamentals, competitive position, growth
opportunities, the regulatory environment, and our view as to
the abilities of management.
Our analysis of Enron followed the rating process described
above. Over the past several years, because of a significant
shift in its business mix and a rapid revenue growth, Enron's
reported financial profile, in size alone, as presented in its
income statement and balance sheet, changed significantly. Yet
although the market capitalization of Enron increased
dramatically over the past several years, the various credit
ratios and other factors used by Fitch supported a constant
BBB-plus rating during the period from 1993 until the fourth
quarter of 2001. It should also be noted that of the more than
300 entities rated by our Global Power Group, the senior debt
rating of more than 60 percent of the companies in the sector
is above BBB-plus. BBB-plus is in the lowest investment grade
category.
In mid-October 2001, Enron released third quarter results
that reflected a $618 million third quarter loss and a $1.2
billion reduction in shareholder equity. Shortly thereafter,
adverse press reports appeared, an informal SEC investigation
was announced, and the CFO was replaced. Following these
events, on October 25, Fitch placed Enron's rating on Rating
Watch Negative warning that ``the loss of investor and
counterparty confidence, if it continues, would impair Enron's
financial flexibility and access to capital markets, therefore,
impacting its ability to conduct its business.'' Eleven days
later, on November 5, Enron's senior debt rating was downgraded
to BBB-minus, the lowest possible investment grade rating, and
left on Rating Watch Negative, an indication of the possibility
of future downgrades.
On November 8, Enron restated its earnings for a 5-year
period, and on November 9, 2001, Enron announced its merger
agreement with Dynegy. This announcement caused Fitch to revise
the rating watch status to ``evolving.'' It was Fitch's opinion
that Dynegy was a financially viable and knowledgeable
purchaser with a sound financial and business profile on a
stand-alone basis supplemented by a strong financial backer and
investor through its affiliation with Chevron-Texaco. The
merger agreement with Dynegy provided Enron with $1.5 billion
in cash, which supplied needed liquidity. We also held the
opinion that Dynegy, as a direct competitor, was quite familiar
with Enron's operations. The evolving status, however,
reflected a high level of execution risk compared with other
acquisitions by entities rated higher than the target company.
In those cases, Fitch would typically place the target's
ratings on Rating Watch Positive. Fitch warned in its
commentary accompanying the ratings action of November 9 that,
``If the merger were to terminate, Fitch believes Enron's
ability to manage its business would be severely impaired and
would expect to downgrade its securities to highly speculative
grade. Termination provisions to the merger agreement add an
element of uncertainty to completing the merger.''
In the 3-week period following the merger agreement, Enron
disclosed additional liabilities and incurred substantial cash
outflows that compromised its financial condition. Fitch
commented on these developments on November 21, stating that in
the absence of a merger agreement with Dynegy, Enron's
financial condition was ``untenable.'' At the time we published
that comment, based upon discussions with Enron and Dynegy
management, it was our understanding that the parties were
committed to the merger, but at revised terms that reduced the
value received by Enron shareholders. Based upon the inability
to execute a revised merger agreement, as well as obtain
additional secured bank financing, Enron's ratings were lowered
to CC on November 28, indicating probable default.
Thank you.
Chairman Lieberman. Thank you, Mr. Pellecchia. Interesting
opening statements by the three of you. We will do 7-minute
rounds of questions on the Committee.
As I listened to your statements and familiarize myself
with this whole Enron saga, one thing that struck me is,
although you have reported the different levels of concern that
each of you had about Enron as last year went on, the market in
some way was better reflecting increasing concerns about Enron
than the credit rating agencies were, because in some sense the
market during the year was going like that, whereas the
agencies were maybe going like that, [gesturing] and
notwithstanding the additional access that we know that you had
to information.
Let me go to some of the remarks, Mr. Barone, that I quoted
from you and Mr. Shipman--Mr. Shipman's were the quotes from
CNN in October, and then I didn't quote this in my opening
statement, on November 2 at S&P's public conference call
according to a transcript that was provided to my staff. You
said, ``We have a great deal of confidence that there are no
more surprises to come. We're confident we capture or are privy
to the obligations that Enron has. I think it's going to take a
little more time before everybody can get fully comfortable so
that there's not something else lurking out there, but at this
point we feel very confident that that's unlikely.''
So my question, obviously, is: What was the basis for your
confidence then that the off-balance sheet problems, which were
known, were in Enron's past or that nothing else would come out
soon?
Mr. Barone. Thank you, Senator. The confidence we had was
gained from discussions with Enron's management at that time,
the new president, Greg Whalley, and CFO Jeff McMahon. They
explained to us that, as much as they knew, from their
investigation, there were no further partnerships that had debt
obligations that they were unaware of. But that, indeed, and as
my comments stated, they had not fully completed all that the
investigation was to provide. The Powers Report was not yet
completed at that time. But for all that they saw, what they
knew, that was their assessment. And we gained confidence from
that discussion.
Chairman Lieberman. Let me ask the other two witnesses,
because my concern is that with your remarks, notwithstanding
the slight downgrade, although you still kept them at
investment grade at that point, in early November, a month
before Enron goes bankrupt, because of the way in which
information was conveyed through CNN and other newspapers,
etc., that you were still sending a message to the market that
everything would be OK at Enron.
Now, I understand what you have said about why. I want to
engage the other two of you in this conversation, which is--how
does the communication typically go between the rating agencies
and a company like Enron, particularly at moments like this
where there is alarm? Are you calling them or--and we know from
other indications all over the history of this company, they
were very aggressive--were they calling you to make the case
don't worry? Mr. Diaz.
Mr. Diaz. Mr. Chairman, thank you. Maybe I can go back a
little bit to the beginning of the crisis at Enron. On October
16, the company announced their earnings restatements and their
equity charges. On that day, we placed the company on review
for possible downgrade on our fundamental concerns about their
accounting and about a potential crisis of confidence.
Chairman Lieberman. You do that just based on the public
announcement of what has happened?
Mr. Diaz. No. We had talked to Enron a few days before that
and they had given us a heads-up on the writedowns that were to
come and began to explain to us the equity charge. And we were
very surprised at not only the asset writedowns they were
taking but also at the nature of the equity charge. And we were
questioning and scratching our heads about the type of
accounting that they were using for that charge and how did
that $1.2 billion of equity actually come about.
They made a rough attempt to explain to us the complexity
of the hedges, but we were not satisfied with their
explanations. So we told them that we would likely put them on
review for downgrade and then take a harder look at the
situation.
So throughout that crisis stage, we had become increasingly
concerned. At that time, Andrew Fastow was no longer involved
in the discussions, so we were talking primarily to Tim Despain
and then Jeff McMahon, who had joined as the new CFO.
Our discussions during that time were concentrated on
understanding the liquidity position of the company and how
that was impacting the trading business. When we became further
concerned on, I think, October 24--my recollection is not
exact--we had asked them about their availability of commercial
paper, and they told us they were still able to place
commercial paper, but that the price was getting much higher
for them. So as we got ready to go to committee to act on the
rating, they announced that they had drawn down their credit
lines.
So the bottom line at that point was that we were
increasingly concerned about the liquidity, and we downgraded
them on October 29, and then kept the rating on review for
further downgrade. We also put the commercial paper rating
review for downgrade.
Chairman Lieberman. Mr. Barone, I quoted you on the
November 2 conversation, so I should give you an opportunity to
say a little bit more about what Enron may have told you before
that.
Mr. Barone. Yes, generally going back to your question,
Senator, we were calling Enron, and----
Chairman Lieberman. They were not initiating calls with you
by and large?
Mr. Barone. There was an active dialogue back and forth,
Senator, as we do with many issuers. If they have news to tell
us, they would be active and do that, or respond to questions.
They would research our questions and they'd call us back with
answers.
Chairman Lieberman. Were they more active than most
companies, even at this point, in trying to convince you that
everything was OK?
Mr. Barone. Not unusually so. They've had a campaign for
years to try to be higher rated, as many firms try who have a
different opinion than we do.
Chairman Lieberman. How do you carry out such a campaign?
Mr. Barone. They try to show us, whether it be a financial
or qualitative assessment, that we take one view of the
information and they take a different view of it. They try to
get at the heart of our review, and we try to get at the heart
of their review. And often we have to agree to disagree.
Chairman Lieberman. Am I right that in conversations with
our staff leading up to the hearing, Mr. Barone, you told them
that Enron officials told you that they didn't know what else
was out there?
Mr. Barone. That is correct.
Chairman Lieberman. This was at the end of October, and
that they had a special committee investigating?
Mr. Barone. That's correct.
Chairman Lieberman. But, still, you felt confident enough
to make the statement you did on November 2?
Mr. Barone. That is correct. They explained to us that in
the investigation: (1) they found, I believe, the LJM1, LJM2,
Chewco, and Raptors; (2) they had started to scrub down
everything they could get their hands on; and (3) they would be
surprised if they would find anything further. And while they
said clearly that they did not have the full report, they
believed they had uncovered the majority of what there was to
uncover, and that this was what they expected.
Chairman Lieberman. I am over my time. Mr. Pellecchia, I
will come back to you in the next round. Senator Thompson.
Senator Thompson. Thank you very much.
In listening, it is surprising to me the extent to which
you seemingly rely on the management leadership for your
information. You know, Mom and Pop can read these public
documents, and it seems that what we are learning from all of
this is that there is really not much value-added for the
average investor in looking at either the--what the analysts
are saying or what the raters are doing; that when you have a
complex set of documents, that you don't really go behind the
documents, even though you have a right to; that when the
company officials refused to divulge certain information, they
can get away with that; and that you rely an awful lot--when
things pop up that seem troublesome, you rely an awful lot, if
not exclusively in some cases, on what the corporate management
tells you.
Is that an unfair assessment or is that about the way it
is?
Mr. Barone. Senator, we do rely on what senior management
tells us. It is in their best interest to tell us and be
forthright and not convey a different message, because if we
convey a message to the market that is different than what the
market perceives over the long term, then the credibility of
Standard & Poor's and then ultimately the credibility of the
company is at risk. And you saw what happened with Enron as to
what happened when the market loses confidence in their
credibility. And so it is in their best interest to tell us the
truth, and we rely on that.
Senator Thompson. That is kind of a chicken-and-egg deal.
Are you saying you don't think it is ever in--strictly from a
self-interested standpoint, it is never in the interest of a
corporate executive to minimize bad news and stretch the truth?
Clearly it is sometimes in their interest to play the short-
term game and hope things turn out better, right?
Mr. Barone. Yes. Many of the firms put forth their best
foot, but they don't put forth fraudulent information.
Senator Thompson. What is it exactly that Enron put out
that was most deceptive in retrospect, do you think? Did it
have to do with these related-party transactions?
Mr. Barone. I would say it had to do with the total amount
of their obligations, whether it be these related-party
transactions or other partnerships----
Senator Thompson. Mr. Diaz, briefly, could you pinpoint
anything?
Mr. Diaz. Senator, it's less what they put out. It's more
what they didn't put out. It's the fact that the off-balance
sheet partnerships were never disclosed anywhere. We've come to
learn about names like Braveheart, Raptor----
Senator Thompson. Is that what we now know was apparently
being referred to in footnote 16, related-party transactions?
Mr. Diaz. I believe that was related to LJM2, one of the
Fastow partnerships. There are a lot of other partnerships,
Senator, partnerships like Braveheart, Raptor, Southampton, and
Rawhide. The names just seem to be coming out.
Senator Thompson. In retrospect, is not footnote 16 also
referring to them? I mean, it is in the plural here.
Mr. Diaz. I believe that, having looked at it in some
detail and tying it back to the Powers Report, I believe that
it's talking about the LJM2 transactions, the Chewco
transactions, and the Raptors, which I think are embedded in
their LJM2. It's still difficult to understand exactly what
they were doing.
Senator Thompson. I think that makes the point, that we are
still here today trying to figure out what they are talking
about in footnote 16.
Mr. Diaz. That's right. It's a very obtuse footnote. You
know, there is some disclosure there, but it's extremely
difficult to understand what is going on.
Senator Thompson. The question becomes: What should the
rating agencies' obligations be? You can't audit every firm
that you deal with. On the other hand, some are bigger than
others. Some are more obtuse than others, I guess, in their
public documents. What should the rating--if you are just going
to look at this and say this is very confusing and obtuse and
call up the corporate executive and say is everything all
right, and he says everything is all right, if that is it, you
can see----
Mr. Diaz. I understand the point, Senator. I think in
looking at a footnote like 16, clearly what needs to be done in
those situations is try to get behind it and try to understand
a lot more of what's there.
Looking in hindsight at how that impacted the ultimate
confidence in the company, it's pretty clear that there were--
and from my point of view, we certainly look at it as a
situation where we could have dug more into and tried to get
behind that.
Senator Thompson. It would be fair to say that if you ran
across this same situation again, you would delve into it
deeper?
Mr. Diaz. Yes, sir.
Senator Thompson. I noticed here that on November 8, after
reviewing a copy of the merger terms, the merger with Dynegy,
you were concerned there were too many conditions that would
allow parties to walk away from the merger, and Moody's
informed Enron that it might drop its rating to below
investment grade. Subsequently, Moody's received a number of
telephone calls from interested parties, including Richard
Grasso, CEO of the New York Stock Exchange, Robert Rubin of
Citibank, Michael Carpenter of Salomon Smith Barney, and
William Harrison of J.P. Morgan Chase. The banks assured
Moody's that they were not planning on getting out of the
merger. Again, the next day, Moody's downgraded Enron, but not
below investment grade.
Clearly, Enron had called all these investment bankers up
to get them to call you, right?
Mr. Diaz. Senator----
Senator Thompson. And I am asking whether or not that is
correct. And, second, what are we to make of this? Here clearly
are interested parties trying to presumably have some impact on
what your rating was going to be. Is this normal in the
business?
Mr. Diaz. Senator, what I'd like to say is, first of all,
we were ready to downgrade Enron that morning. The first bit of
information was that there was a significant change in the
transaction. There was going to be up to $1 billion of new
equity put in, and they were going to be changing the terms of
the agreement. That was what we were led to understand--so that
we held off on the press release.
Throughout the course of the day, we had calls from
bankers, and we also had a meeting with bankers--and I can't
recall if Dynegy was actually in the room. But the bottom line
there was that the agreement was changed. There were
substantial changes made that made it more difficult for Dynegy
to walk away. They eliminated a material adverse change clause.
They eliminated rating triggers that were in the financing
agreement. And, also, they agreed to collapse the structure of
the combined entity so that the bonds of Enron and the bonds of
Dynegy were pari passu.
From our point of view, we were looking at the combined
entity as having an investment grade rating of Baa, at the low
end, so we gauged the probability that the deal would go
through to be high. We gauged the probability that Enron's
liquidity would be shored up enough for Enron to survive----
Senator Thompson. I understand what you are saying, but
without getting into the merits of the deal and the reason, I
understand you were concerned there were too many ways to walk
away and then they began to close that door somewhat.
Mr. Diaz. Right.
Senator Thompson. But in the meantime, these bankers were
calling you to tell you, I suppose, that they, according to
what I have got here, were not planning on getting out of the
merger. Of course, that is like a politician saying they are
not planning on running for office, I suppose. They are not
presently planning.
Senator Bunning. Except in your case. [Laughter.]
Senator Thompson. Of course, they did walk away from the
merger, what, 20 days later, I think, after I guess S&P's
downgraded them. I am just asking for information. Is this a
normal kind of interplay? I mean, do you get calls like this
telling you we know you are concerned about this deal that
would affect the welfare of the company, I am in on this deal,
and I want you to know here is our present intention?
Mr. Diaz. In general, we do get calls from banks and
companies when the company's rating is under pressure. That is
not an anomaly. Certainly, the intensity of that day was pretty
high given the situation of Enron, but that did not--was not an
influencing factor on our decision. The influencing factor on
the decision was the change in the merger--in the terms of the
merger agreement.
Senator Thompson. Well, I am not suggesting it was. All I
am suggesting is clearly they were--from their standpoint they
were making the call for some purpose. And if it wasn't to
influence your decision, I am not sure what it was.
Mr. Diaz. It was to get us to wait-- that is to say--listen
to the new terms of the deal, is really what they were trying
to do. They weren't saying please don't do this because Enron's
going to go bankrupt. They were saying we have a new deal on
the table.
Senator Thompson. Thank you, Mr. Chairman.
Chairman Lieberman. Thanks, Senator Thompson.
If I may, just following on the line of a question Senator
Thompson raised, I assume you allow for the, if I can call it
this, self-interest of the people calling and having Enron's
rating remain high.
Mr. Diaz. Sure, right.
Chairman Lieberman. In other words, various of people, of
the institutions that Senator Thompson has cited, we know from
public sources were either heavily--were creditors of Enron or
perhaps had fees which would be gained by the completion of the
Dynegy-Enron proposed merger. But I presume you allow for that
as you consider what they are saying.
Mr. Diaz. That's right. There were a lot of self-interested
parties in that situation. We certainly understand that. But,
we're still looking at whether or not the deal was going to go
through and what the impact on the combined companies was. That
was the bottom line for us.
Chairman Lieberman. OK. Senator Levin.
Senator Levin. Thank you, Mr. Chairman.
I want to pursue the line of Senator Thompson's questions
as to what was not disclosed to you that you now know should
have been disclosed to you, and what was deceptive and
fraudulent. Mr. Barone, you used the word ``fraudulent,'' which
means there was a representation of something which wasn't
true. Can you give us some examples of what was represented to
you that was not true?
Mr. Barone. Yes, Senator Levin. Enron had presented to us
something called its ``kitchen sink analysis,'' which purported
to show the full extent of all its obligations with
partnerships, third parties, related parties, and the like. And
we have come to learn that this representation of the kitchen
sink--and I think they wrote the words ``100 percent
disclosure''--did not include all of the so-called third-party
related transactions.
Senator Levin. Would you supply that document to the
Committee?
Mr. Barone. I believe, Senator, it's included with my full
testimony.
Senator Levin. That is fine. Thank you.
Can anyone else give examples of what was not disclosed to
you or what was disclosed to you and misrepresented in the
disclosure? Mr. Diaz.
Mr. Diaz. Yes, Senator. We also received the ``kitchen sink
analysis.''
Senator Levin. Is that the same analysis?
Mr. Diaz. I can't say it was exactly the same analysis, but
it was supposed to represent the complete picture of the
company's total obligations, and it clearly did not. As I've
said earlier, there have been quite a few names of partnerships
that have come out in the press and all the reports that we had
no knowledge of and were not included in that.
Senator Levin. Mr. Pellecchia.
Mr. Pellecchia. Well, I would add, in addition to the fact
that the company restated its financial statements back to
1997, the types of information they would supply us--and we
also got a ``kitchen sink analysis''--as far as the company's
off-balance sheet debt and guarantees was consistent with what
was provided the general public. So there wasn't any real
additional information that we had. And I would say to the
question of whether these presentations were fraudulent, what
we read in the Powers Report certainly seems to say that they
entered into transactions for a very different purpose than
what was represented to us, particularly with what was called
these LJM transactions, which were presented to us as a
technique to transfer risk to sophisticated investors.
Mr. Barone. Senator, may I----
Senator Levin. Please.
Mr. Barone. I want to add, too--and I noted this in my
opening remarks--that what was also hidden from us, not
disclosed fully--or at all, I should say, are those almost $4
billion of in-substance loans that Enron made with financial
institutions that were originally reported as financial hedges.
And that was not disclosed as well.
Senator Levin. Was it falsely disclosed or not disclosed?
Mr. Barone. I believe it was not disclosed as a loan, as it
worked.
Senator Levin. Was it disclosed as a hedge?
Mr. Barone. I don't know for sure, sir.
Senator Levin. What is the understanding that you have with
your clients as to what is disclosed? Do you have a written
agreement with them, a contract as to the amount of disclosure
and what your access will be, inside access that is not
publicly disclosed? Is that all set forth in a contract, Mr.
Barone?
Mr. Barone. We have an agreement--I don't know if it's
contractual or not, but it's an agreement that is included in
our rating letter, that they provide us full, timely, and
accurate disclosure of all material information relating to
their rating. I don't know the exact words, sir, but it is
quite broad and comprehensive.
Senator Levin. And they sign that, they agree to that?
Mr. Barone. Yes.
Senator Levin. Is that true with the other companies, too?
Mr. Pellecchia. We have a similar representation, but it's
not a signed agreement.
Mr. Barone. Senator, I don't know--excuse me, I apologize.
I'm not exactly sure they're signed or not. I don't want to
represent----
Senator Levin. All right. Mr. Diaz.
Mr. Diaz. We have applications for ratings in which the
maintenance of the rating is based on our satisfaction with the
information that's being provided, but there's no specific
agreement about the kind of or the type of information that has
to be given to us.
Senator Levin. All right. Let me go through one of the
transactions with you. Enron North America was trying to show
strong cash flow on its 1999 end-of-year statement. According
to the Powers Report, what Enron North America did or ENA did
was pool a group of loans that it held into a trust. The trust
then sold about $324 million of those notes and provided the
purchasers with certain rights to cash flow from repayments of
the loans. So these were collateralized loan obligations.
When they sold the loans, ENA was able to report an
increase in cash flow, and since the risk of default on the
loans was transferred to the trust, ENA didn't report or
account for the possibility of a default. They left that out
from their own reports.
Now, the trust that purchased those loans then sold
interests in those loans to investors, but the sales did not go
well. According to the Powers Report, the lowest-rated notes,
those with the last claim on repayments of the loans, were
extremely difficult to sell and no outside buyer could be
found. At the end of 1999, LJM2 purchased about $20 million of
those lowest-rated notes.
So LJM bought the notes that nobody else would buy, but
some credit rating agency would have had to have rated those
notes. And I think it was your agency, Mr. Pellecchia.
Mr. Pellecchia. We did.
Senator Levin. Is that correct?
Mr. Pellecchia. Yes.
Senator Levin. Now, how can your credit rating agency give
an investment grade to those notes when nobody else would buy
them? How does that work?
Mr. Pellecchia. Well, I'm a corporate analyst. This
transaction was one that was structured in a way that the
credit quality of the pool of loans--and I would say these
loans were on a stand-alone basis very weak companies, loans to
very weak companies--was structured in such a way so that there
were different tranches of ratings that apply to different
groups of securities that were sold, and they were able to
attain high ratings through this enhancement that is much
higher than you could individually for each of those individual
loans.
Senator Levin. So even though nobody else would buy them,
they were given investment grade rating because of the
guarantee?
Mr. Pellecchia. Well, I believe that this particular
transaction--again, I'm not a structured analyst--was one that
met all the qualifications that you would need for separateness
and other qualifications for doing a structured transaction,
and it was marketed and it was sold.
Senator Levin. Could you try to answer that, or get the
answer for the record on that question for us?
Mr. Pellecchia. As to----
Senator Levin. How is it possible that those specific notes
can be listed as investment grade if, in fact, nobody would buy
them? Can you talk to the person who did the analysis on that--
you said it wasn't you--and give us the answer?
Mr. Pellecchia. My answer was also I think they were sold,
and----
Senator Levin. They were sold to LJM. They were sold right
back to Enron.
Mr. Pellecchia. That might have been in the secondary
market, but I will provide that information.
Senator Levin. All right. Now, according to an Enron
employee who worked on the transaction, the head of ENA
finance, told one of the investors that if the note defaulted,
Enron would make the investors whole. Enron had agreed, in
other words, to repurchase the notes at face value, which
guaranteed the investment. Now my question to you is: Was it
publicly known that that guarantee existed?
Mr. Pellecchia. I do not know the answer to that. I would
say as far as a rating agency's obligation, we would have rated
the securities based upon the risk to the investors, and----
Senator Levin. Would the guarantee affect that risk?
Wouldn't it be less risky to buy it if there was an Enron
guarantee?
Mr. Pellecchia. It certainly would, yes.
Senator Levin. OK. Was it publicly known that there was an
Enron guarantee?
Mr. Pellecchia. I do not know if it was publicly known, and
I'm not sure there was an Enron guarantee.
Senator Levin. So you don't know yourself whether there was
an Enron guarantee?
Mr. Pellecchia. Apparently, LJM, as you explained--and I
didn't know the facts on that--stepped up and bought securities
which probably in effect would have done the same thing as
providing a guarantee.
Senator Levin. So my specific question is: Was it known to
your agency that there was such a purchase guarantee?
Mr. Pellecchia. I know that we had discussions with Enron
personnel as to the situation with the loans, and I'm not sure
exactly what agreements were struck, if anything, or what we
learned from that.
Senator Levin. Well, wouldn't that affect the
creditworthiness of the notes?
Mr. Pellecchia. It would have, certainly.
Senator Levin. And your rating?
Mr. Pellecchia. Yes.
Senator Levin. But you are not sure because of memory, or
you are not----
Mr. Pellecchia. Well, I'm not sure about exactly what was--
--
Senator Levin. Your ratings are affected by whether there
is a guarantee, but you are telling us you don't know whether
there was a guarantee.
Mr. Pellecchia. I do not know if there was a guarantee.
Senator Levin. But whether or not there was a guarantee
would have affected your rating?
Mr. Pellecchia. I would assume it would be considered, yes.
Senator Levin. OK. Can you find out for us whether anyone
in your company knew whether or not there was a guarantee?
Mr. Pellecchia. Yes.
Senator Levin. And can you also then answer this question:
If there had been a guarantee, assuming it went back to Enron,
would that have affected the value of Enron's stock?
Mr. Pellecchia. I would answer from the credit rating
standpoint. What we try to assess is the types of guarantees
and the amount of guarantees Enron has. So the fact that if
Enron had a guarantee, that would be a consideration in the
credit rating.
Senator Levin. OK. But also not on the credit rating----
Mr. Pellecchia. Of Enron Corp.
Senator Levin. Of the Enron Corporation, so that would
affect their stock.
Mr. Pellecchia. It would be considered in the credit
rating. They had approximately $2 billion of guarantees
outstanding to affiliated companies. Some of those guarantees
were supported by collateral, some weren't. So you would make
judgments, basically, upon what the effect of a guarantee would
have on Enron Corp.
Senator Levin. Would you say this: To the extent that those
guarantees were not known to the public, that they were,
therefore, telling the public that their company was in a lot
better shape than it really was, because guarantees which were
outstanding wouldn't have been disclosed? Is that a fair
statement?
Mr. Pellecchia. If Enron had a guarantee----
Senator Levin. If Enron had guarantees outstanding which
were not disclosed publicly, that, therefore, they would have
been--their financial statements would have looked better than,
in fact, they should have because it wouldn't have disclosed
outstanding potential obligations. Is that a fair statement?
Mr. Pellecchia. Yes, I do not believe Enron--and I'm not
aware that Enron guaranteed that debt.
Senator Levin. I am not talking about that debt. I am
talking about in general.
Mr. Pellecchia. In general, we would recognize guarantees
in the context of all its obligations, yes. That would be a
consideration.
Senator Levin. My question is: If the guarantees were not
disclosed publicly, would that----
Mr. Pellecchia. That--we should be aware--they should be
disclosed publicly, and as far as I know, every guarantee that
Enron had was--that we were aware of was consistent with the
guarantees that they published in their information, the public
information. As far as I know.
Senator Levin. I see my time is up, but the bottom line is
that you are not answering my question about failure to
disclose guarantees publicly. But what you are saying to us is
this: That you believe that every single guarantee that you
were aware of was disclosed publicly?
Mr. Pellecchia. Yes.
Senator Levin. Thank you.
Chairman Lieberman. Thanks, Senator Levin. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Just a little background for the average American and
average person who looks at credit ratings as a means of
investing. The SEC grants credit rating companies NRSRO status,
and currently only your three companies--S&P's, Moody's, and
Fitch--are those companies. You have special access to the
companies that you deal with. In that, you can have private
conversations with companies' management that analysts cannot
have. You can see financial information about companies that is
not public, and you are shielded from fraud under the security
laws. All that true?
Mr. Barone. That's true.
Senator Bunning. Well, you realize in 1997 the SEC looked
at this and said maybe there is a monopoly here, maybe you
three shouldn't be the only ones doing this because the only
three people that you could go to for a credit rating was
Standard & Poor's, Moody's, and Fitch. Is that correct? And
they tried to change the rules, and you fought them tooth and
nail. The Justice Department fought them tooth and nail also.
They criticized the new rules that pertained perpetuating the
anticompetitive environment of credit agencies. The Justice
Department was for changing the rules. The rule was never acted
upon.
Now, I think you have a major obligation to look beyond
what is given to you by any corporation. If the people rely on
your ratings, investment grade or non-investment grade,
particularly institutional investors, particularly anyone whose
stock is on a roller coaster in a down spiral, and your three
companies are still rating that as investment grade material.
Now, I don't even want to get to November. But I want to
get to March and the document that Fortune Magazine put out.
Someone said how can you rate these companies--how can you rate
Enron specifically investment grade, and people from your
companies made light of it. S&P's said, ``If you figure it out,
you let me know.'' Is that a quip or is that a serious
statement by S&P's? This is quoted in Fortune.
You, Mr. Pellecchia, said, ``Do you have a year?''
Mr. Pellecchia. Here's what I--could I answer that?
Senator Bunning. I mean, is that a correct quote or not?
Mr. Pellecchia. I believe what I was asked was exactly how
does Enron make its money, and my response was, ``Do you have a
year?'' That was----
Senator Bunning. In other words----
Mr. Pellecchia. That was a glib answer. But the spirit----
Senator Bunning. OK. I know it is a glib answer, but you
are responsible for the ability to grade that either investment
grade security or non-investment grade security.
Mr. Pellecchia. Yes.
Senator Bunning. And you are making light of the fact that
you are not sure how they are making their money?
Mr. Pellecchia. Well, I think the spirit of the answer was
Enron's a big company, it's a complex company----
Senator Bunning. Your duty was to get beyond the bigness
and just the words coming out of the corporate mouths. Is it
true or is it not true that the CFO and the chairman of the
board made calls to Mr. Diaz and Mr. Barone that they were
aggressively trying to get a higher grade credit rating for
their company? Is that true or false?
Mr. Barone. That's false. Mr. Lay did not call aggressively
seeking a higher rating for the company. Mr. Lay called to----
Senator Bunning. He didn't call you personally?
Mr. Barone. He called me personally, but not for that
reason, sir. He called me to let me know that he was committed
to the current credit quality of the company, that they would
take steps necessary to preserve what he thought was a very
important credit rating, and the similar steps to those that he
had taken in the past by issuing equity or selling assets----
Senator Bunning. Was there any pressure exerted by Enron to
get a similar upgrade or remain the same kind of credit rating
from your company?
Mr. Barone. During this period of time, sir, no.
Senator Bunning. Is it normal for the president and CEO of
a company to call you?
Mr. Barone. There are some that do, sir, and some that
don't. It depends. This was the first time I had heard from Mr.
Lay, but there are other firms that we follow under my purview,
and some of them call and some of them don't.
Senator Bunning. Don't you think there should be a
separation, a separation between the analyst making a credit
rating and the company executives? I mean, if somebody can
testify before this Committee, it was right in the filings
before the SEC that I could pick up that there were problems in
the company. You as experts in credit ratings couldn't see
that?
Mr. Diaz. Senator, I spoke with Mr. Lay one time only, and
that was just before putting them on review for downgrade, and
what he was trying to do is keep us from putting him on review
for downgrade.
Senator Bunning. Thank you.
Mr. Diaz. And we did not----
Senator Bunning. That doesn't answer my question.
Mr. Barone. Sir, we often speak with the senior management
of the firm----
Senator Bunning. I understand that----
Mr. Barone [continuing]. Because strategy is a very key
element to rating.
Senator Bunning. What about the filings that they filed
with the SEC as of all during this time that you were in charge
of their credit ratings? You couldn't pick anything out to give
you a heads-up or a red flag----
Mr. Barone. No, from the----
Senator Bunning [continuing]. And some other analyst could?
Why were you not able to pick up the red flags?
Mr. Diaz. Maybe I can address that. Senator, I mean,
hindsight is a great thing and----
Senator Bunning. We all know that.
Mr. Diaz [continuing]. People looking at this situation now
can go back and sort of look for flags and situations where----
Senator Bunning. It is your job.
Mr. Diaz. But what I'm trying to say, Senator, is
fundamentally we were looking at a company that on its face
looked like it had a very strong franchise in wholesale
trading. It looked like it was showing earnings, increasing
earnings, because of the mark-to-market accounting.
Senator Bunning. Then why was the stock plummeting? If all
of those things be true, why was the stock going straight down?
Mr. Diaz. The stock started to plummet in--I believe in the
spring of----
Senator Bunning. Inside traders were selling the devil out
of it.
Mr. Diaz. We're not equity analysts, so we don't focus
necessarily on stock.
Senator Bunning. I understand that, but there is a reason
for a stock to react.
Mr. Diaz. Sometimes, Senator, there are many reasons why
stocks go down. I mean, bear markets cause stocks to go down.
Enron stock had been hyped by the broadband euphoria, and it
had gone from the mid-40s to 90, and we didn't upgrade the
company then because we thought Enron is doing great. We kept
the same low investment grade rating that we had because of the
fundamental issues that we always looked for at the company.
Senator Bunning. But somehow, sir--and I beg to differ with
you--you have to be more responsible to the many people who
rely on your ratings. And if you are not more responsible, then
we have got to get more people rating.
Mr. Diaz. Senator, I guess----
Senator Bunning. My time has expired.
Chairman Lieberman. Go ahead.
Senator Bunning. Go ahead, Mr. Diaz.
Mr. Diaz. Could I answer? Thank you. Senator, we stand on
our record. We have a 100-year record that we publish every
year----
Senator Bunning. It just takes one.
Mr. Diaz. One company that misleads.
Senator Bunning. Billions and billions, and millions of
employees lost every penny they ever had.
Mr. Diaz. I understand that, Senator. But the reason was
because the company misled. Their executives have----
Senator Bunning. You have never had a company mislead you?
Mr. Diaz. Not to the extent of Enron. Not a company that,
in effect, has their executives refuse to testify, that have
had their accountants indicted for shredding documents. You
know, we're in a situation--we believe that Enron is an
anomaly, that Powers Report, a board-commissioned report, that
points out to the dealings of the CFO. In my experience----
Senator Bunning. I don't doubt that they are an anomaly,
but, in fact, Global Crossing could be another Enron.
Mr. Diaz. I'm not aware of--I don't rate Global Crossing,
so I don't know the details----
Senator Bunning. Well, OK. You don't grade it, but it is in
the same situation.
Mr. Barone. Senator, this was not a ratings problem. This
was a fraud problem.
Senator Bunning. It was also a rating problem. Your
reaction was way too late and too little.
Mr. Barone. The market expects us, with all due respect,
Senator, to take a tempered, deliberate approach. And as my
colleague----
Senator Bunning. No. The market expects you to anticipate
what happens and also warn people if something is red-flagging
you. You didn't----
Mr. Barone. And that's exactly what----
Senator Bunning [continuing]. Do it until after the fact.
Thank you.
Chairman Lieberman. Thank you, Senator Bunning. Senator
Bennett.
Senator Bennett. Thank you, Mr. Chairman, and I apologize
for having to slip out, but I appreciate the fact that the
panel is still here for my questions.
Now, follow me through this and see if I have it right, and
if I don't, set me right.
We, of course, start from the fact that is pretty well
established that the Enron management was engaged in fraud.
They were hiding things. They were lying. So you weren't used
to that. You weren't expecting that. And you were caught by
surprise by that.
However, would it be accurate to say that their accounting
gimmicks, the things they did to perpetuate that fraud, relied
heavily on the credit ratings? Whenever Enron credit ratings
dropped below investment grade levels or triggers, the special
purpose entities required that the Enron parent guarantee the
value of the SPE. That trigger was written into the deal, as I
understand it. So as long as the credit ratings were high, the
SPE does not demand the collateral, and Enron does not have to
pledge its stock. Is that an accurate description of the way
this was constructed?
Mr. Barone. In general, yes, sir.
Mr. Pellecchia. Yes.
Senator Bennett. OK. Now----
Mr. Diaz. Senator, that's an accurate description of two
SPEs that we rated. There are apparently many others out there
that we didn't know about.
Senator Bennett. OK. But as long as the credit rating is
above the trigger, the stock does not have to be pledged, does
not have to be delivered, and, therefore, Enron can say to the
analysts and everybody else, well, it is unencumbered because
this is a contingent liability, but it is a contingent that is
not going to come to pass because the credit rating is
sufficiently high.
So when the credit rating triggers the trigger, that is
when things begin to be really, really difficult. So the credit
rating does play a critical role in how this whole structure
operates. Am I all right so far?
Mr. Barone. In general, yes, sir.
Senator Bennett. OK. So when the credit rating hit the
trigger, and that is when former Secretary Rubin called the
Treasury, as I understand it, because he could clearly see that
this is where everything was going to go, the question is: Did
the credit rating firms understand how crucial the triggers
were as you were drawing up your credit rating? Did that enter
into your decision making? I am not just issuing a garden
variety rating here that some investor will say, ah, I don't
think I want to take a chance on this stock or, what the heck,
I made a lot of money in junk bonds, and if they are going to
say this is junk, why, I will jump in, I prospered during the
Michael Milken era, whatever.
It is not just that with an individual investor making that
kind of analysis and that kind of a decision. It is a trigger
that could bring the whole thing down. Were you aware of the
significance of the trigger? And did that enter into your
analysis as to where you were going to place it?
Mr. Barone. Yes, sir. We were well aware of the triggers'
existence in some of the partnerships that we knew about,
specifically Marlin, Osprey-1, Osprey-2. And we do take into
account the existence of those triggers in affecting Enron's
credit rating. And, indeed, the assets that are in those
entities as they began to lose value, we would then, because of
the likelihood of Enron having to pony up, as it were, this
contingent obligation, we put back to Enron some amount of that
obligation and utilized that information in determining its
credit rating.
On the sum, over the years we have placed roughly--and not
just for these two or three partnerships, but for the ones that
we did know--all the ones we knew about, placed roughly $2 to
$4 billion of additional liabilities back to Enron for these
contingent-like or related-party obligations, guarantees,
leases, and other things that appear off-balance sheet. So,
yes, Senator, we do take them into account.
But the other--going to your point, there's--as you get
closer to it, clearly there's a heightened awareness of the
impact that this could have. Again, Enron's stock trigger--
there was a stock trigger. There was a credit trigger. It was
an ``and'' situation. So when they blew through the stock
trigger, we were still at BBB-plus. I believe the other
agencies, because it was either of the agencies, if they
lowered it below investment grade, here still at BBB-plus
level, felt comfortable at that range that there was no--you
know, no reason for alarm, so to speak.
Mr. Diaz. Senator, can I follow up on that?
Senator Bennett. Sure.
Mr. Diaz. Certainly we were aware of the triggers. I'd just
like to point out one thing. When we held our rating
committee--I think it was November 7; it's in the record if I'm
incorrect--that evening, we concluded that we would downgrade
Enron to Ba2, non-investment grade, and we were ready to put
that press release out the next day. We were aware of the
consequences to Enron, yet we made that decision.
The reason that we ultimately did not bring it down to non-
investment grade had to do with the changes they made in the
merger agreement and the additional equity they were willing to
put in. And that's why we ended up with a Baa3 rating as
opposed to Ba2. But we were aware of the circumstances, and
that would not have stopped us from downgrading to below
investment grade because we felt that fundamentally the company
no longer merited that rating.
Senator Bennett. So the thing that saved your rating and
gave them a temporary reprieve from the harshest of all
triggers was your conviction that the merger was going to give
them sufficient capital to survive?
Mr. Diaz. Three things: That the merger would give them the
capital to survive; the probability that the merger would go
through based on the changes they had made; and that the
combined entity would be investment grade because of the
structural changes they made to the deal.
Senator Bennett. Well, those are all three if's. In order
for the thing to make it, all three have to fall in place. If
any one of them falls out of place, the whole thing collapses.
Now, we are here with the brilliance of hindsight, and I
recognize that and don't want to put myself in your position
when you are trying to look at it in foresight. But it does
seem to me, to just summarize it, in order for Enron to avoid
the disaster of the non-investment grade rating, three things
have to happen. There is no absolute assurance--of course, I
guess in this world there is no absolute assurance of anything.
It was your judgment that it was likely that all three would
happen.
Mr. Diaz. Right. Yes, Senator. We based a lot of that
judgment on probabilities. So we felt there was a high
probability that because of the equity infusion that was coming
into Enron, Enron would have sufficient capital to get through
the period and so forth.
Senator Bennett. Yes.
Mr. Diaz. And we felt that the outs in the agreement were
taken care of, and it had Chevron-Texaco behind it and
motivated banks to make the deal happen.
Senator Bennett. OK. Well, I have gone over my time, Mr.
Chairman, and we are mixing this panel with the previous
hearing. But the question obviously arises why an analyst faced
with this kind of circumstance--and you are not analysts like
the stock pickers that we had--wouldn't say, OK, they are on
the brink of disaster, and the only thing that can save them is
if the three following things all come to place simultaneously,
and life being what it is, if one of the three falls out, it
ain't going to work. And as an investor, I would really love to
have had that understanding of just how tenuous it was before I
make a decision. That is assuming I had any money to invest.
Thank you. This has been helpful.
Chairman Lieberman. Thanks, Senator Bennett. A very
interesting line of questions. You can feel the frustration, I
think, of the Members of the Committee as we look back, and
this is the basic question about whether you could have done
more. I don't think anybody is accusing you--I am certainly
not--of sort of malfeasance here. Nobody is accusing you of
conflicts of interest, which were rife in some of the other
cases that we have held investigations on. The question here is
whether you were aggressive enough and used the power that you
have. And these rating triggers, your ratings had enormous
impact on the companies.
Let me go back to this critical--and ask a few questions
about it--moment when the merger was being discussed, and you
had a decision to make as to whether to downgrade. You put
Enron on a credit watch, but you didn't lower them below
investment grade rating. Obviously this is a significant
decision. You have conversations. You receive a call, I believe
at that time, from Ken Lay, or certainly people from Enron. You
receive calls from people that Senator Thompson mentioned, from
the New York Stock Exchange, from various investment banks
involved, etc.
I have got to ask: Did you receive calls from anybody else?
For instance, did you receive calls from any government
officials which were aimed at urging you to not downgrade
Enron's rating?
Mr. Barone. Through the whole process, sir, the only folks
we were in conversation with were Enron and Dynegy about the
merger prospects. We were never called by the banks, investment
bankers, any government officials, or anyone else.
Chairman Lieberman. Mr. Diaz.
Mr. Diaz. No, we never received any calls from government
officials.
Chairman Lieberman. And as far as you know, no one else at
the company?
Mr. Diaz. As far as I know, no one else at the company.
Chairman Lieberman. Mr. Pellecchia.
Mr. Pellecchia. We received no calls from anyone either in
government, investment bankers, in any way to try to persuade
us to do anything with the rating. However, in the course of
our analysis and what we do as analysts is to get and receive
and respond to calls from all types of people who work for
financial institutions. So probably every major investment bank
and commercial bank called me one time or another between
October and December relative to Enron. But none of those calls
were in any way indicative of any pressure to do anything with
the rating.
Chairman Lieberman. And not at the level presumably that
Senator Thompson indicated. Did you agree that you had heard
from Mr. Grasso and Mr. Rubin?
Mr. Diaz. I believe we did get calls. I was not in those
calls, but I don't believe that any material discussions ensued
from those calls.
Chairman Lieberman. OK. But, in any case, none of you heard
from government officials.
Here is what is obviously agitating all of us, which is
that this--credit rating agencies have grown up in some ways
like Topsy, with an enormous power, with this sort of semi-
sanction of the SEC NRSRO designation, but not that much that
goes into them approving you for it. Then hundreds of statutes
come along, Federal, State, and local, I presume, that say you
have got to get the approval of these credit agencies to be out
in the markets. And yet you are exercising real quasi-
governmental authority, power, and yet there is--and I must say
in fairness that, by and large, your record is a very good one,
I mean, judged in the most objective way that the number of
defaults of companies that you have rated as investment grade
is quite low. I think on AAA it is at 1 percent, and maybe on
the others it is at 6 percent. Is that about right?
Mr. Barone. Less than 1 percent on AAA.
Chairman Lieberman. But this is our frustration. You have
got a big actor--Enron--comes along and its downfall has
disastrous consequences for its employees, for average--for
their retirement security, for investors, for the economy, in
fact. And we look and say, now, OK, you are the one that had--
you had more access to them, and yet I think our--if I can
summarize, I will say it for myself, I feel as if you weren't
as aggressive as you should have been in asking for more
information with the authority that you had.
Even some of the--I know it was a glib answer, but I know
that even some of the questions that have been--that your
answers have raised in my mind about the concern about their
accounting practices, about the partnerships--and let me ask
the baseline question. I assume each of you is saying that if
you knew then what you know now about Enron, you would have
downgraded Enron below investment grade. Is that correct?
Mr. Barone. Senator, if we knew then what we know now, we
would have withdrawn Enron's rating for failure to disclose
proper information.
Chairman Lieberman. Which would have had the effect of
basically putting them out of business, probably.
Mr. Barone. I don't want to speak for what the market's
reaction would be.
Mr. Diaz. We would have had a lower rating on Enron for--
probably for a few years before.
Chairman Lieberman. For a few years before.
Mr. Diaz. Yes, I mean, it looks like their partnerships
began to be put together back in at least 1999.
Chairman Lieberman. But you didn't know about them. Mr.
Pellecchia.
Mr. Pellecchia. I would say the same answer. We would have
had a lower rating well before 2001.
Chairman Lieberman. So looking back now at the confusion of
their accounting practices, which you, I think, knew about, you
had some sense that something--it was hard to understand
everything there. Don't you feel that you should have asked
more of them as you look back? Mr. Barone.
Mr. Barone. Senator, we rely on the audited financial
statements, and insofar as we read and understood fairly well
where they were making their money based on the representation
of those audited financial statements, we would ask questions,
and we would receive answers and use that information in our
ratings analysis.
Chairman Lieberman. But you are expert----
Mr. Barone. We are not forensic accountants, if that is the
question, and we don't have subpoena power, and so there's a
lot that----
Chairman Lieberman. You know, maybe--in some ways I have
been thinking, What is the analogy? You have authority here
over the markets and companies that is somewhat comparable--the
first thing that comes to mind is the FDA, Food and Drug
Administration. They don't let a drug go out on the market--
this is a controversy in itself--until they have gone over all
sorts of investigations to guarantee that it is safe, and then
doctors prescribe the drug, people use it in reliance on that.
To some extent, we have asked you to play--to a real
extent, we have asked you to play a similar role with regard to
corporations, and yet--and you do have power, but the power is
the threat that you will lower their rating or remove it. You
can put people out of business. And it just looks--again, I
want to be fair to you. Most of the cases people are leveling
with you, and your record is pretty good, a low percentage of
defaults. But here was one that as we look back, understanding
hindsight is always clearer, you want to say to yourself: Why
didn't you press harder for more information on accounting? Why
didn't you press harder on partnerships? Even in that ``kitchen
sink'' disclosure that they made, it just doesn't--it seems
like it left a lot of questions in your mind.
Actually, Mr. Diaz, let me ask you this question. I
appreciate the end of your opening statement because you said
Moody's has gone around and talked to a lot of people, held
interviews, and--let me read it--you are going to do some
things differently. ``Going forward, we are enhancing the
ratings process by putting increased focus in several areas. We
have substantially intensified our assessment of liquidity risk
for issuers with both investment grade and speculative grade
ratings.'' And Enron had a speculative grade rating, correct?
Mr. Diaz. They had a low investment grade rating at the
lowest level for pretty much their whole history, and then
became speculative grade at the end.
Chairman Lieberman. Right. ``We're also focusing''--it is
interesting to me--``on corporate governance and how aggressive
or conservative are accounting practices.''
Now, I am encouraged by that, but isn't that a way of
saying that you wish you had done that earlier as well?
Mr. Diaz. Senator, again I would hark back to our
fundamentally good record. But we didn't sit on it. We look all
the time at ways that we can improve. We've, over the years,
constantly put out comments on the rating process, on
securitization, on other issues. So certainly the Enron debacle
focuses our attention on certain areas that we would like to
get better understanding of, including rating triggers. But it
is our ongoing--that's not something that we just started
because of Enron. It's something we've had ongoing for a while,
and certain areas are going to be a focus of more intense
activity going forward.
Chairman Lieberman. OK. My time is up. I appreciate it.
Obviously in the next panel we are going to hear from some
people who have ideas about how to alter the status quo to give
you the authority or give you some sense of accountability for
the enormous authority that you do have that really matters in
a case like this. Senator Thompson and I were just talking
about it. He said to me, you know, the bridge only collapses
very rarely, but when it does, we wonder why the inspectors
hadn't noted the crack that led to the bridge falling and a lot
of people getting hurt. And that is essentially the tough, but
I think reasonable, question that we are asking of all of you
today.
Senator Thompson.
Senator Thompson. Yes, just one or two points, Mr.
Chairman. Studies indicate that for the most part credit rating
agencies do get it right, and companies rated in the AAA range
rarely default, companies rated in the BBB range default only
at slightly higher percentage. And I think it is important for
us to keep in mind that these companies do not recommend buy or
sell, that basically what they are dealing with is a broad,
general category with regard to the ability of a company to
fulfill its financial commitments; and that while there is a
relevance between the stock price and the rating, it is
certainly not directly tied. A company could see its stock go
down for any number of reasons, and it still may be practically
unaffected in terms of its ability to fulfill its financial
commitments. Is that correct?
Mr. Barone. Or vice versa.
Senator Thompson. Or vice versa. So I think we need to
understand that.
One of the things that interests me in looking at some of
this history here is the statements that representatives of
your companies make with regard to these stocks. I am
wondering--of course, we are in the age of constant television
coverage and cable and all of that, and some of the analysts
have become superstars, and maybe the raters are going in that
direction, and I guess it is strange for a politician to be
commenting on that. But it looks to me like you have got your
ratings, but then you have got your statements. And October 25,
S&P's changed Enron's rating to a negative, but retained its
BBB bond rating. Fitch also placed Enron on the watch for a
downgrade on October 29. Moody's downgraded Enron one notch to
B2A2, and kept it on review for another downgrade.
The same day S&P's primary Enron analyst Todd Shipman went
on CNN, even though S&P's had placed Enron on credit watch
negative, Shipman said, ``Enron's ability to retain something
like the rating they are at today, investment grade, is
excellent in the long term.''
When asked about the off-balance sheet partnerships,
Shipman remarked that S&P's was ``confident that there is not
any long-term implications to that situation, that that's
something that's really in the past.''
Then S&P's met with Enron on October 31 and was told that
Enron would sell off assets to shore up its access to capital.
The next day, November 1, S&P's downgraded Enron to BBB and
placed it on a negative credit watch.
Still, in its press release announcing the downgrade, S&P's
said it ``continues to believe that Enron's liquidity position
is adequate to see the company through the current period of
uncertainty.''
It looks to me like that you are making your ratings, which
are clearly broad category ratings--you are right, you are not
making recommendations of buy and sell, but then either through
your analysis on CNN or your press release you get into the
stuff that the analysts get into, and you really are getting
into painting a picture of long-term viability of the company.
I guess the question--I don't know how long your ratings are
supposed to apply. I mean, suppose you have questions long
term, but the current situation looks OK, that sort of thing. I
mean, should you really be getting into all of that? Is this a
recent phenomenon? Your ratings are one thing, but any analyst
that comes out of there under questioning and he doesn't know
what the questions are going to be, he clearly doesn't want to
say anything that is going to cause a lot of problems for the
company, then go back to headquarters and get this handed to
him. So he is put in a really awkward position, it looks to me
like, the same position that an analyst is in, really, to be
positive, and it looks like touting the stock, in effect.
Is this what you consider to be part of your obligation? Is
this a phenomenon that hasn't been around that long? Or have
you always had your people out there commenting on their
opinions as to various aspects of the company and not being
content simply on putting out the ratings?
Mr. Barone. I think it all depends on each market, sir, and
the energy market has had a lot of attention, say, the last 3
or so years. I think there has been a stepped-up media
interest, investor interest in the market. And so when we are
called upon to provide an opinion beyond what we have written,
whether it be in a news broadcast or an interview with a
publication of sorts, we comply when and where we can.
Senator Thompson. So you have an analyst function. You see
yourself as providing an analyst function as well as a rating
function.
Mr. Barone. Well, again, what we're providing, sir, is just
our opinion. It goes back to the credit analyses that we have
performed. Obviously we cannot convey anything greater in terms
of confidentiality or anything like that than what we may have
received. We just try to put forth what we may have written
already in various articles or rationales on the company's
credit. We are not recommending--we are not there recommending.
We are not there supporting. We are not a company's advocate.
We're not their dis-advocate. We really don't care. We're there
just to call it as we see it, as a third-party, objective,
credible opinion, as our default studies have proven.
Senator Thompson. What do you see your appropriate role as
in this?
Mr. Diaz. Our role is simply to gauge the company's
creditworthiness. It's an opinion of the company's ability to
repay its debt. And we do talk to the press and to other
interested investors and lay out the weaknesses and strengths
of a company. But it's not our role to recommend or to tout any
company, simply to lay out what goes into our analysis.
Senator Thompson. Here, Mr. Barone, the S&P's Enron analyst
says, after making your rating, your representative comments on
Enron's ability to retain that rating in the long run. It says
not only are we giving this rating today, but we are telling
you that it's our opinion that you're going to--they're going
to have this rating for a long time.
Mr. Barone. Ratings generally go from an intermediate to
long-term purview, the long-term rating.
Senator Thompson. Well, then does that really add anything
to the rating itself in this comment?
Mr. Barone. I am not sure I follow your question.
Senator Thompson. I get the impression you are saying that
he is saying nothing more than what the rating itself says.
Mr. Barone. Right, and I don't believe he was asked
anything further than that. Our view at that time was, given
the information we had to our avail, that there was a strong--
that we had an opinion----
Senator Thompson. Mr. Pellecchia, do you have any comment
on that?
Mr. Pellecchia. I think our commentary is particularly
important, specifically the commentary that is written that
goes along with the rating, for instance, the warnings that you
can give investors, such as what we said during the Dynegy-
Enron merger period, and we said if the merger goes away,
Enron's ratings will drop several notches to speculative grade.
So I think that that gives a warning to investors that this
is----
Senator Thompson. You give a balanced treatment background
as to how you came to that rating.
Mr. Pellecchia. Yes.
Senator Thompson. I venture to say that is something you
would never be able to do on CNN or any of the other cable
shows.
Mr. Pellecchia. To be honest, some of these conversations
that we have talked about involve an hour conversation with a
reporter.
Senator Thompson. Complicated situation.
Mr. Pellecchia. That picks up the most provocative----
Senator Thompson. And investors watching the show want to
know----
Mr. Pellecchia. But I think that's an important----
Senator Thompson [continuing]. If you guys say a stock is
going to be--this company is going to be in good shape.
Thank you, Mr. Chairman.
Senator Levin. Thank you. Let me just follow up with a few
questions. We have talked about a couple of trusts and about
some triggers. The trust names were referred to as Osprey and
Marlin, and you were aware that there were triggers that would
guarantee that investments in those trusts would, in fact, be
repaid, I believe, Mr. Barone, right? You knew about the
triggers. In fact, I think you testified that was relevant to
your assessment of Enron's credit rating because they
ultimately were the guarantor of that investment in those
trusts. Is that a fair----
Mr. Barone. That's correct, sir.
Senator Levin. Now, I just want to go through the timetable
on this and discuss what these triggers were and when the gun
went off. My understanding is that the stock price of Enron
fell below a certain level on May 5, so that was one of the
triggers at that point. Enron then was on the verge of having
to pay $2.4 billion back to investors in that Osprey trust.
What were the other criteria? Do you remember offhand?
Mr. Barone. That the ratings fall below investment grade
from either of the agencies.
Senator Levin. Now, when that happened, you were aware of
the trigger on the stock price.
Mr. Barone. Yes.
Senator Levin. And you also were aware that the other
criteria depended on your own rating, so that if you responded
to the gun going off on that date by changing your rating, that
would have certain massive consequences for Enron.
Did you on that day when that happened consider lowering
your rating?
Mr. Barone. No, sir, not at all.
Senator Levin. Did you know about it?
Mr. Barone. Yes.
Senator Levin. All right. If, in fact, that trigger was
relevant to the rating, why would the fact that the gun went
off not be relevant to a changed rating?
Mr. Barone. Again, the stock price dropping could be tied
to multiple reasons. Whereas, the credit rating, the thing that
I knew and knew best about, tied to the creditworthiness, is
something that we can manage and we can monitor. The stock
price dropped for many reasons. There was a general market
decline. Most stocks had dropped from the last 2 years from
general economic conditions. So it didn't cause us any alarm
because we were looking at the fundamentals of the company, its
business models, financial profile as we believed it to be, and
its qualitative assessment, and we were still at BBB-plus. We
had three notches to go before this trigger, the second part of
that, the ``and'' clause would have been tripped.
Senator Levin. You were the tripper?
Mr. Barone. We could have been, sure.
Senator Levin. It was in your hands as to whether it was
tripped or not.
Mr. Barone. Sure. Absolutely.
Senator Levin. But the first criteria had been met.
Mr. Barone. Right.
Senator Levin. Was that public?
Mr. Barone. Which part, sir?
Senator Levin. The triggers.
Mr. Barone. I think these were private--I believe these
partnerships were set up privately under 144(a) rules, so I do
not know whether they were disclosed, whether the general
market knew about them. Clearly, the investors who invested in
them knew, and many of those who decided not to invest in them
would have known because it was marketed to quite a few people
on Wall Street.
Senator Levin. But the people who invested in Enron would
not have known?
Mr. Barone. The common equity shareholders? I can't say,
but probably not, sir.
Senator Levin. It seems to me that this permeates this
problem, the fact that there were hidden guarantees here that
affected Enron's stock. This is a guarantee that could trigger
a $2.4 billion repayment from Enron or Enron stock, not known
to the public but known to you.
Mr. Barone. I would say, sir, the Mom and Pop investors
were not likely to know about it, but the institutional holders
of the common shares were probably aware of it. It's just
speculation on my part. I don't have firsthand knowledge.
Senator Levin. Well, this is one of the reasons that Mom
and Pop got the shaft. There were guarantees here that were not
disclosed to that average investor that you folks knew about.
You folks knew about those guarantees, right?
Mr. Barone. Right. Yes, sir.
Senator Levin. There is something wrong here. Something
very wrong, because we have advisers who know parts of the
investment banking--part of what an investment bank knows, you
folks know.
Mr. Barone. Right. This was a private deal, sir.
Senator Levin. I understand, and you are aware----
Mr. Barone. We would have breached confidentiality if we
had disclosed this.
Senator Levin. You are aware of it, though, and you are
rating Enron's credit. So you know something. You don't act on
it here even though you are aware of it. That bothers me, by
the way. It seems to me that it was relevant to your rating;
therefore, when it was triggered, it should be relevant to a
re-rating. I will state it that simply. OK? If it is relevant
to begin with, then the change in it makes it relevant to the
re-rating.
Mr. Barone. Are you asking a question----
Senator Levin. No, I will just make a statement on that.
Since you are the one who said that it was relevant to your
determination as to how to rate their debt, the fact that there
were these triggers, that was relevant; the fact that the
trigger went off, it seems to me would be relevant as well to
your rating of debt. I will make that as my statement.
Mr. Barone. It was specifically written, sir, with an
``and'' clause so that it wouldn't be subject to general market
condition, as I understand it. They purposely put both triggers
in, the slide of the common equity price as well as a decline
in credit, knowing fully if both occurred that that would
clearly indicate a significant impairment of their financial
profile.
Senator Levin. I will just repeat: The second part is in
your hands. That is the rating issue that is in your hands. So
it is not some outside objective factor. It is whether you rate
them below market grade.
Mr. Barone. Or my colleagues.
Senator Levin. Of course, your colleagues. I am looking at
you, but it is all three of you.
One other question here. I want to show you a typical
structured financing deal. Hundreds of these structured finance
deals were rated by you folks, or at least were entered into by
Enron. If you look hard enough, you will find Enron on that
chart. It is up somewhere in the top left bowl of the
spaghetti. There is a little piece of spaghetti way up there.
This is a diagram of the Whitewing part of the financing of
Project Margaux,\1\ which is a European energy deal. This is a
document which was produced from one of subpoenas issued by the
Permanent Subcommittee on Investigations.
---------------------------------------------------------------------------
\1\ Chart entitled ``Project Margaux'' appears in the Appendix on
page 207.
---------------------------------------------------------------------------
Now, wouldn't something as incomprehensible as this raise
some questions to you about the purpose and the viability of
this project? Because you are going to give a rating now to the
instruments which result from that project. When you look at
this and you realize there are hundreds of these things that
Enron is getting into, Enron had more structured financing
deals, I think, than any typical company, $15 to $20 billion a
year in structured financing deals from 1997 to 2001. Here is
one of them.
Two questions. Were your companies aware of the huge amount
of structured financing deals at Enron? Second, shouldn't this
have triggered some questions in your mind, this kind of a
haystack where you are supposed to find the needle of debt?
Shouldn't that have raised some questions in your mind as to
the purpose and viability of the project? Let me start with
you, Mr. Barone.
Mr. Barone. We were aware of many of their structured
finance deals, and Enron's aggressive use, if you will, of
structured finance deals was one of the many reasons we only
rated it BBB-plus, sir. If you looked at Enron's financial
profile on its face, you would have come to a conclusion that
this could have been a company with a much higher credit
rating, and yet we take into account the aggressive use of
financial structures and such.
Senator Levin. Would you agree this is a relatively
incomprehensible structure?
Mr. Barone. Not necessarily. I'm not a structured finance
analyst, but we have structured finance analysts at Standard &
Poor's, very capable ones, who make it their livelihood to
understand structures like----
Senator Levin. We would appreciate if one of them would
take a look at this and tell us whether that is a typical
structured deal and whether it is comprehensible. Let the
Committee know for the record, would you?
Do you have any comment, Mr. Diaz.
Mr. Diaz. I would, to a great extent, echo Mr. Barone's
comments. We were aware of a lot of their structured
transactions. We rated a couple of them. But we were not aware,
obviously, of a lot of the off-balance sheet partnerships. And,
also, I also am not a structured finance analyst, but this kind
of structure doesn't look dramatically different, all the
wiggly lines and all that, than a lot of the ones that are done
by our structured people.
Senator Levin. That looks to you like a typical structured
finance deal?
Mr. Diaz. It looks like the kinds of deals that I have seen
other companies put together, and again I wouldn't rate them
myself. I don't have the expertise to do structured financing.
But it's not, on the face of it, out of the ordinary.
Senator Levin. OK. Perhaps you could ask one of your
structured finance folks to tell us if that is typical, too, as
well.
Mr. Pellecchia.
Mr. Pellecchia. Well, my response would be certainly that
the complexity of the company and the types of transactions
that it entered into was a factor in keeping Enron's rating in
the BBB category. I don't think there's any question about
that.
Senator Levin. Thank you. Thank you, Mr. Chairman.
Chairman Lieberman. Senator Bunning.
Senator Bunning. Yes, sir. Thank you, Mr. Chairman.
Can I go back to March 2000? Both S&P's and Fitch rated
Enron as BBB-plus and Moody's rated Enron as Baaa-1, which is
in the slightly higher than ordinary but not at the top like a
AAA rating. It is somewhere between BBB-plus and----
Mr. Diaz. The Baa category is at the low end of the
investment grade spectrum. It has----
Senator Bunning. Baaa.
Mr. Diaz. Baa, we call it, B-a-a. So a Baa-1 rating would
be at the top of the low investment grade rating category.
Senator Bunning. But it is still an investment grade
rating?
Mr. Diaz. It is an investment grade rating, yes, sir.
Senator Bunning. OK. However, even as Enron's stock, common
stock, crumbled through most of 2001, the credit rating
agencies--that is you three--didn't downgrade Enron from
investment grade status until 4 days before it declared
bankruptcy--4 days.
Now, I know you are not security analysts as far as having
the ability to understand why a stock would be going down so
fast. But insider trading is published constantly on the
Internet. As Senator Levin said, you were part of a two-pronged
deal that said Enron was going to have to cough up $2.4
billion, their stock had hit $20 a share on the down side, but
as long as they held their investment grade rating, they didn't
have to do any of the $2.4 billion. The insider selling in that
stock was unbelievable. Everybody that knew anything about the
company was bailing out as fast as they could get their market
shares to the market.
Now we also have a lockdown on their 401(k) plan, so the
ordinary people in the company can't sell their stock.
Now, doesn't that ring a bell with you and say why in the
world are all these people bailing out if this is such a sound
corporation? And why in the world would I sell a share at $20
that was just $90 a few months prior if, in fact, I believed it
was going to turn around and go back up? That makes no sense to
me at all. And it should have triggered your investigation
because you were part of that two-pronged deal. As long as they
held an investment grade status, they didn't have to ante up
the $2.4 billion.
Didn't that set off any alarms in your financial rating of
those companies?
Mr. Barone. No, sir. We see insider trading from firms
quite frequently, and determining why a director or an officer
of the company is selling its shares of stock----
Senator Bunning. This was massive. This wasn't just one or
two or three people. This was anybody who knew anything about
the company. They were bailing. They had bad feelings about the
company. And all you had to do was trigger the other half of
that and make them come up with $2.4 billion if their stock is
under $20, and that would have done it completely in, the $2.4
billion, because you know darn well they couldn't pay it off.
They had no means of paying $2.4 billion off.
I would like to know why you held that rating to 4 days
before they filed bankruptcy.
Mr. Barone. For us, Senator, we were aware of the Dynegy
merger on----
Senator Bunning. Well, the Dynegy merger is an if. If they
are successful in merging with Dynegy, then maybe they would be
able to survive.
Mr. Barone. It is our practice and the practice that the
market has come to recognize, when mergers occur, to take into
account the probability of the merger. We deal in
probabilities, as my colleagues said. And our assessment was
that there was a strong probability at the time that it would
succeed. And when we lost confidence in that probability,
that's when we decided to act prior to the merger being dis-
consummated, so to speak.
Senator Bunning. That is a pile-on, as far as I am
concerned. That is after the fact. You are depending on
something that the potential of it happening is not going to be
50/50 maybe.
Now, you are supposed to have inside information that we
don't have, that the average investor doesn't have, and yet you
didn't flag it.
Mr. Barone. I'd say, sir, our assessment was that there was
a greater, much greater, chance than 50/50 at the time when we
made that assessment on November 1 or 2, that the merger would
go through. Indeed, if we thought it was just 50/50, we would
have lowered the rating to properly reflect that.
Senator Bunning. We need more people doing the ratings
then, because obviously you three all agreed.
Mr. Diaz. Senator, I think I've testified before that we
also believed that the probability of the merger going through
was high. We had a rating committee that included our senior
management, and we came to the conclusion, given the changes in
that agreement, there was a very high probability the merger
would go through. So that's the key for holding the rating
during that period.
Just as another point, one of the comments that I've made
is that we've been trying to figure out how can we improve the
process, and one thing that we've done is talk to the major
asset management firms to try to understand how they use
ratings and how they would like us to, in effect, do the
ratings.
One of the things that they've said to us is that they like
the stability of ratings, but the other point is that when
things are going--when a company is under certain amount of
distress, they would like for us to give the company the
ability, if there's a probability of correcting the problem, to
give them the opportunity to do so.
Senator Bunning. Do you all realize that once you take a
corporate bond and make it a junk bond, the potential of
bankruptcy in that company is really high?
Mr. Diaz. Senator, I think when we take--a company that
wouldn't be an Enron----
Senator Bunning. Any other company that might be listed, or
not even listed, just private----
Mr. Diaz. A Ba category, which is not investment grade, is
still a viable category. A company can live as a Ba company for
many years.
Senator Bunning. How long?
Mr. Diaz. The probability of default is in our studies, but
I think the probability of default over a 10-year period for a
Ba--and I may be wrong and would have to double-check, but it
is in the neighborhood of 16 to 20 percent, which means that 80
percent, roughly--and, again, don't hold me to the numbers, but
it's a fairly high number--would actually survive for 10 years.
So it's not a situation where it's Ba and death. In Enron's
case it was because of the triggers, and it was because
everybody was running away from it. But it's a different
situation.
Senator Bunning. They were running long before you ever
downgraded.
Mr. Diaz. No, because the----
Senator Bunning. They were.
Mr. Diaz. Well, the----
Senator Bunning. The general public, the management of the
company, and all others were running from that stock, and
because you failed to act in downgrading it below investment
grade, it held on a heck of a lot longer than it would have.
Mr. Diaz. But we had good reasons for doing so. We were
looking at a good probability of a merger with a bona fide
partner, with Chevron-Texaco behind it, and with bank funding
that would have made it work--if Enron itself--the real problem
was that Enron itself was rotting from inside. The fact is that
Dynegy--I don't think Dynegy knew, I don't think the banks knew
how bad the situation was.
Senator Bunning. And all the poor people that worked for it
were the ones that took the big hit.
Mr. Diaz. That's right, Senator, and that's a real tragedy.
Senator Bunning. Yes, it is a tragedy. Thank you.
Chairman Lieberman. Thanks, Senator Bunning, for some
excellent questions.
Thank you, gentlemen. Your testimony has been very
important to this Committee as we try to learn the lessons of
Enron as we follow the trail down to places that we didn't
expect we would go. And I want to ask you to go back--maybe you
are doing this already--and speak with the executives at your
companies about how you can use, better use the real life-and-
death power you have over corporations to protect us investors,
individual and institutional, from the next Enron. We know it
is the exception, but a lot of people, as you all just said,
were hurt by it. And we think you are in a position to do more
than was done in this case to try to protect the economy and a
lot of people from the pain and suffering that they endured as
a result of what happened. But for now, I thank you for your
testimony this morning.
Mr. Diaz. Thank you, Mr. Chairman.
Mr. Barone. Thank you.
Mr. Pellecchia. Thank you.
Chairman Lieberman. We are now going to call panel two: The
Hon. Isaac Hunt, Jonathan Macey, Glenn Reynolds, and Steven
Schwarcz. And as you come to the table, I will just ask you to
remain standing so I can administer the oath before you begin
your testimony.
I would ask the four witnesses to please raise your right
hands, if you would. And do you solemnly swear that the
testimony you are about to give this Committee today is the
truth, the whole truth, and nothing but the truth, so help you,
God?
Mr. Hunt. I do.
Mr. Macey. I do.
Mr. Reynolds. I do.
Mr. Schwarcz. I do.
Chairman Lieberman. Thank you. Please be seated, and let
the record show that each of the witnesses has answered the
question in the affirmative.
Thanks very much for being here. Some of you have come
quite a distance, but thanks particularly for your patience as
we heard the testimony of the first panel, and we now look
forward to your helping us answer some of the questions that
were both asked and we are left with by the first panel. First
we are going to call on the Hon. Isaac C. Hunt, Jr.,
Commissioner of the U.S. Securities and Exchange Commission.
TESTIMONY OF HON. ISAAC C. HUNT, JR.,\1\ COMMISSIONER, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Hunt. Good morning, Chairman Lieberman, Senator
Thompson, and other Members of the Committee.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Hunt appears in the Appendix on
page 131.
---------------------------------------------------------------------------
Thank you for the opportunity to testify before you today
on behalf of the SEC regarding credit rating agencies and the
Commission's experience with the credit rating industry.
The recent collapse of Enron has renewed questions as to
whether rating agencies should be subject to increased
regulation, particularly because all three nationally
recognized statistical rating agencies rated Enron and/or its
credit obligations as investment grade less than 1 week before
Enron filed its bankruptcy petition.
As you know, for almost a century, credit rating agencies
have been providing opinions on the creditworthiness of issuers
of securities and other financial obligations. During this
time, the importance of these opinions to investors and other
market participants and the influence of these opinions on the
securities markets has increased significantly, particularly
with the increase in the number of issuers and the advent of
new and complex financial products, such as asset-backed
securities and credit derivatives. The globalization of the
financial markets also has served to expand the role of credit
ratings to jurisdictions other than the United States. Today,
credit ratings affect securities markets in a number of
important ways, including an issuer's access to and cost of
capital, the structure of financial transactions, and the
ability of fiduciaries and others to invest in particular
investments.
During the past 30 years, regulators such as the Commission
have increasingly used credit ratings as a surrogate for the
measurement of risk in assessing investments held by regulated
entities. Specifically, since 1975, the Commission has
referenced the ratings of specified rating agencies in certain
of its regulations, referring to these rating agencies as
``Nationally Recognized Statistical Rating Organizations.'' The
term ``NRSRO'' was originally adopted by the Commission solely
for the purpose of the Commission's net capital rule.
Subsequently, the Commission used the ratings of NRSROs to
distinguish ``investment grade'' securities from those that are
``non-investment grade,'' in regulations under the Securities
Act of 1933, the Securities Exchange Act of 1934, and the
Investment Company Act of 1940. Congress itself employed the
term ``NRSRO'' when it defined the term ``mortgage-related
security'' in Section 3(a)(41) of the Securities Exchange Act
of 1934. Other Federal and State regulators also incorporated
the NRSRO concept into their rules.
Currently, to determine whether a rating organization is an
NRSRO, the Commission staff reviews the rating organization's
operations, position in the marketplace, and other criteria
(which are elaborated on in my written testimony). If the
Commission staff determines that the NRSRO designation is
appropriate, the staff sends a no-action letter to the rating
organization stating that the staff will not recommend
enforcement action to the Commission against broker-dealers
that are using ratings issued by the rating agency for purposes
of the net capital rule.
Chairman Lieberman. Sir, excuse me. Am I right that this
only happens once in the life of a credit rating agency that it
gets this no-action letter?
Mr. Hunt. Yes, Senator, that's true, although we try to put
the rating agencies on the same schedule for inspection as we
do other investment advisers that are registered with us as
investment advisers. Whether that is right or wrong is open to
debate, but they are. And that is about every 5 years.
Chairman Lieberman. That is interesting. So in that
capacity--though presumably these no-action letters in some of
the cases of these three agencies go back decades, correct?
Mr. Hunt. Yes, sir. There were four others that we gave no-
action letters to, but they were all subsequently merged into
the existing three. So at one time there were seven.
Chairman Lieberman. So that every 5 years, because they
also have the status of investment advisers, you do go back----
Mr. Hunt. Yes, sir.
Chairman Lieberman [continuing]. And do an inspection. And
what is that about? What does it constitute? What do you look
at?
Mr. Hunt. Well, we look at the books and records. We look
at their operations. We look at their capacity. We do a much
broader inspection when we give them the no-action letter. But
when we go back and look at them every 5 years as investment
advisers, we look at their books and records and their
operations. I would not say it's as extensive as the first look
we do when we give them the original no-action letter.
Chairman Lieberman. OK. Understood. Thank you.
Mr. Hunt. Over the course of its history, the Commission
has considered a number of issues regarding credit rating
agencies. Not surprisingly, many of the instances in which
either the Commission or Congress reflected on the need for
regulation coincided with a large-scale credit default such as
the Orange County default and the default of the Washington
Public Power Supply System bonds or, for example, Penn Central.
Ten years ago the Commission seriously considered the need for
oversight authority of credit rating agencies, given their
increasing role in the financial and regulatory systems. The
Commission at that time did not reach a consensus on the need
for regulation.
In 1994, the Commission did, however, issue a concept
release soliciting public comment on the appropriate role of
ratings in the Federal securities laws, and the need to
establish formal procedures for designating and monitoring the
activities of NRSROs. In 1997, the Commission published a rule
proposal that would have adopted a definition of the term
``NRSRO'' that set forth the criteria a rating organization
would have to satisfy to be acknowledged as an NRSRO.
Generally, under the proposed amendments, the Commission would
consider the same criteria currently used in the no-action
letter process. To a large extent, the proposal was designed to
bring greater transparency to the existing process and to
provide for a formal appeal process to the Commission and, if
necessary, to the Federal courts.
Observers have criticized the national recognition
requirement as creating a barrier to entry for new credit
rating agencies. However, the Commission historically has not
found that the requirement creates a substantial barrier to
entry into the credit rating business. At this time, the
Commission plans to examine the competitive impact of the NRSRO
designation and will consider suggestions concerning other
market-based alternatives that might address the competitive
concerns association with the NRSRO framework. The Commission's
examination, which may include hearings, will ascertain facts,
conditions, practices, and other matters relating to the role
of rating agencies in the U.S. securities market. We believe it
is an appropriate time and in the public interest to re-examine
the role of rating agencies in the U.S. securities markets.
Thank you. I will be happy to try to answer your questions.
Chairman Lieberman. Thanks, Commissioner Hunt, for that
testimony and for what you indicated at the end. I gather you
are going to commence your own inquiry here as a Commission.
Mr. Hunt. Yes, sir.
Chairman Lieberman. Motivated in part by the Enron episode?
Mr. Hunt. Motivated in part by the Enron episode. Motivated
in part by our concern that how people get this rating is not
transparent to most of the investing public.
Chairman Lieberman. Right.
Mr. Hunt. Motivated in part because, as more and more
entities use credit rating agencies, there may be more need for
more than three, as there is now a need for more than four
accounting firms. So for all those reasons, we think we are
going to take a thorough look at what they do and whether we
should have more authority over them and whether indeed we
should even come to you and ask for more authority over them.
Chairman Lieberman. Yes. Is it your judgment--well, maybe
this is a preliminary question, but I will ask you: Is it your
judgment now that if you chose to exercise more authority over
the credit rating agencies, you would need legislative
authorization or that it is within your legislative mandate
now?
Mr. Hunt. We could do a lot of it through rulemaking. Our
hearings might show whether and to what extent we need more
legislation.
Chairman Lieberman. OK. I am greatly encouraged by that
decision that the Commission has made. I appreciate it. And as
I understand it, it goes not only to the question of whether
there is sufficient competition within the credit rating agency
sector, but also to the larger question of whether there is a
public interest in having the SEC specifically do more
oversight of the agencies.
Mr. Hunt. They perform an ever more important role in our
securities markets, as you understand.
Chairman Lieberman. Yes.
Mr. Hunt. They are involved in hundreds of millions, if not
billions of dollars in our market, and so we thought it was
time to take a look to see where we are and where we ought to
go.
Chairman Lieberman. Yes, excellent. Thank you.
Next we are going to hear from Jonathan Macey, J. DuPratt
White Professor of Law, John M. Olin Program in Law and
Economics, Cornell Law School. Pretty extensive title there,
Professor Macey. Thanks for being here.
TESTIMONY OF JONATHAN R. MACEY,\1\ J. DUPRATT WHITE PROFESSOR
OF LAW, CORNELL LAW SCHOOL
Mr. Macey. It's nice to be here. I am going to talk a
little bit about the role of credit rating agencies in the
economy.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Macey appears in the Appendix on
page 138.
---------------------------------------------------------------------------
The purpose of credit rating agencies is to inform
investors of the credit quality of securities and warn
investors when credit quality of securities deteriorates.
Rating agencies are paid large fees by corporate clients in
order to maintain ratings for the debt. For example, Enron paid
Moody's between $1.5 and $2 million annually to maintain its
ratings on its various public and private debt.
Being a credit rating agency is a great business to be in.
The industry is dominated by the two leading firms, Moody's and
Standard & Poor's. Analysts have estimated that the profits of
the big credit rating agencies have grown at the phenomenal
compound annual rate of 15 percent for the past 20 years.
Customer demand is strong because a host of regulations
exists that forbid investors from purchasing securities that
aren't rated. For example, money market mutual funds cannot
hold securities unless they have one of the two highest ratings
from rating agencies. Bank regulators long have required banks
to write down bonds they hold in their portfolios unless they
attain a certain rating. And they can't even own securities
that aren't rated investment grade by one of the major rating
agencies.
These sorts of regulations have extended to securities
firms where ratings are used to determine how much capital
broker-dealer firms need to hold against the securities in
their portfolios under the so-called net capital rules. There
are quotas on the quantity of lower-graded bonds that pension
funds and insurance companies can have in their portfolios. The
higher the credit ratings assigned by the rating agencies, the
greater the percentage of the securities value you can count
towards meeting a firm's net capital requirements.
Rating agencies have enormous power because government
regulation creates an artificial demand for their services.
Regulators have bestowed upon the big rating agencies the legal
designation ``Nationally Recognized Statistical Rating
Organization''--NRSRO--and have shielded rating agencies from
competition, creating a comfortable oligopolistic environment.
I would just add that this is the same problem, in my view,
that plagues the accounting industry in this country as well.
Of course, it's not just government regulation that gives
rating agencies such immense power. They also get power from
the extensive use of debt covenants and other financial
instruments to create conditions of default. The downgrading of
a rating by an NRSRO can throw a company into default under the
terms of its debt covenants. But the artificial demand for the
services of rating agencies that has been created by regulation
should not be ignored.
These massive regulatory subsidies, in my view, have given
rating agencies a lack of accountability by removing market
incentives from the work they perform. Rating agencies have few
incentives in the current environment to do good work. Their
incentives in today's regulatory environment are to reduce
costs as much as possible, knowing that regulation guarantees a
fixed stable demand for their services. This, in my view, may
account for the agencies' lack of vigorous pursuit of the
situation involving the Enron special purpose entities.
The regulatory subsidies given to credit rating agencies
would not be particularly troubling were it not for the fact
that credit ratings, in my view, may not provide useful or
timely information about the creditworthiness of companies in
today's markets if the information is marginal because the
information contained in credit ratings already has been
incorporated into securities prices by the time a rating agency
gets around to acting. For example, in Enron, the company's
$250 million in senior secured debt retained its investment
grade rating until November 28, 4 days before the energy firm
filed for bankruptcy. But with respect to the market, in the 2
weeks before the bonds lost their investment grade status,
their price had plummeted from $85 to $35.
Clearly, the financial markets were not waiting around for
the credit rating agencies in the case of Enron, which is a
good thing since the ratings providing by the rating agencies
lagged the information contained in securities prices by a full
year.
We have heard and the rating agencies have responded to
these sorts of criticism by point to the fact that very few
companies with investment grade ratings default over a 5-year
period. The rating agencies also can show that companies that
have been rated AAA are less likely to default than companies
with lower ratings, and bonds with high ratings are stable over
time.
Of course, this sort of track record isn't a big comfort to
investors and companies like Enron when the rating agencies
pull their investment grade ratings on the eve of default. The
problem, in my view, is that there is little follow-through.
The rating agencies rely too much on their corporate clients
for information and don't ask tough questions of management
that would permit them to deter future Enrons from occurring.
For example, in the case of Enron, the rating agencies have
excused their tardiness by saying that they kept their ratings
high only because the rating was dependent on the merger with
Dynegy. But nobody needed the rating agencies to tell them what
would happen if the merger went through. They needed to know
what would happen if the merger didn't go through.
Poor credit ratings threaten to distort the process by
which capital is allocated among businesses because in today's
regulatory environment rating downgrades are self-fulfilling
prophecies, triggering repayment of debt and bond covenants and
causing those securities by virtue of the regulations to be
worth less than identical securities that haven't been
downgraded.
In my view, I would make a few substantive recommendations
with respect to the interactions between Commissioner Hunt's
agency and the rating agencies. I think that the SEC should
consider whether the rating agency should be obliged by
regulation to disclose the public documents on which they
relied as the basis for their rating determinations, and also
to disclose whether the information contained in their ratings
is based on anything other than publicly available documents
like non-public interactions with the issuer or other entities.
I also think it would be useful to have disclosure about
whether ratings are being issued despite the fact that the
rating agencies lack the information that a reasonable investor
would consider relevant to the formulation of a rating and to
disclose the extent to which the ratings that are being issued
were based on credit spreads rather than financial reporting.
Thank you very much.
Chairman Lieberman. Thanks. Very constructive and helpful
testimony.
Next we are going to hear from Glenn L. Reynolds, chief
executive officer of CreditSights, Inc. Thanks for being here.
TESTIMONY OF GLENN L. REYNOLDS,\1\ CHIEF EXECUTIVE OFFICER,
CREDITSIGHTS, INC.
Mr. Reynolds. Thank you, Mr. Chairman. It is my pleasure to
get an opportunity to testify on a subject that I know is of
grave concern to many of the institutional debt and equity
investors that we deal with on a regular basis. The
difficulties in navigating a very complex market are
challenging enough without the added pressures of questioning
the integrity of reported numbers, the adequacy of disclosure,
or the ability of the rating agencies to get sufficient
information to do their job effectively.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Reynolds appears in the Appendix
on page 148.
---------------------------------------------------------------------------
In the aftermath of Enron, there have also been some
questions about the steps the rating agencies took in bringing
many of these issues to a head and the depth and vigor of their
due diligence. The response to date, which has been to speed up
the pace of downgrades but not necessarily shed more light on
the expectations built into a given rating, have not been
satisfactory and will not allow us to deal with future Enron-
type situations.
Disclosure guidelines and accounting rules may be the
responsibility of the SEC and the FASB, but the rating agencies
can play a vital role in zeroing in on material risks and major
shortcomings in the disclosure of those risks.
Chairman Lieberman. Mr. Reynolds, would you excuse me a
second? Under the arcane procedures and life that we lead here
in the Senate, I have just been notified that a member of the
Senate has lodged an objection to three committees proceeding
with their business after noon, which is the right of the
members, 2 hours after the Senate convenes. This Committee is
one of those. This has nothing to do, as far as anybody would
understand, with the subject of our inquiry. It probably has to
do with something unrelated that the given Senator is trying to
get attention for. One can only speculate that it might have
something to do with the course of judicial nominations. I
don't know.
You have all come from some distance, and we are not
transacting business as it were here, so I hope this is not
considered an act of civil disobedience. I am going to say that
the official hearing is over, though I would like to ask the
record to continue to be kept, and that we are going to just
continue this discussion, because you have come a long way, you
have got something to offer, and I would hate not to hear it.
So, with that caveat, please proceed.
Mr. Reynolds. I can just defer to my written testimony, and
we can go right to questions and answers.
INFORMAL DISCUSSION
[12:04 p.m.]
Chairman Lieberman. Well, go ahead and finish. But this is
now not a formal hearing of the Governmental Affairs Committee.
This is a discussion among a group of people interested in the
credit rating agencies and what we have learned about them from
the Enron episode.
Mr. Reynolds. Let me cut to the chase. If a company fails
to answer critical questions that are crucial to an assessment
of the risks, it should either prompt a withdrawal of the
rating or even potentially a downgrading in certain
circumstances. The recurring refrain from the rating agencies
that the issuer will not tell them just does not hold. It rings
hollow when one considers that a rating has a requirement for
access and that any conflicts with the rating agencies will be
an incentive for the market and the SEC, to be somewhat
unforgiving and, in particular, as we saw in the case of Enron,
the market.
With that I will just end my comments.
Chairman Lieberman. Thanks.
Professor Steven Schwarcz is a professor of law of Duke
University, a shorter title than Professor Macey has, but we
are, nonetheless, pleased that you are here.
TESTIMONY OF STEVEN L. SCHWARCZ,\1\ PROFESSOR OF LAW, DUKE
UNIVERSITY SCHOOL OF LAW
Mr. Schwarcz. Thank you. Anticipating this would be an
informal hearing, I did not wear a suit today.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Schwarcz with an attachment
appears in the Appendix on page 168.
---------------------------------------------------------------------------
Chairman Lieberman. Well done. [Laughter.]
Mr. Schwarcz. One of the things I should say is I will be
speaking about the rating agencies, but I am an expert on
structured finance. I actually would have answers to many of
Senator Levin's questions, and the third edition of my treatise
on structured finance came out in January, and I would be happy
to answer any questions afterwards.
Chairman Lieberman. Let me urge you to, if you haven't
already, be in touch with Senator Levin after the hearing
because this is a particular interest of his, and he has done a
lot of--we have sent out a number of subpoenas through his
Subcommittee, and one of the topics they are interested in is
structured financial deals here. So you could be helpful to
him.
Mr. Schwarcz. I will do so. Thank you.
Rating agencies are not substantively regulated by the
United States. or any other major financial-center nation.
Financial-center nations, nonetheless, impose a minimal form of
governmental control by giving official recognition to rating
agencies that meet certain criteria. This is exemplified in the
United States by the NRSRO designation.
Now, as you know, if a rating agency is designated a NRSRO,
its ratings can be used to satisfy rating requirements
established by governmental agencies like the SEC in certain
Federal regulatory schemes.
Today's hearing is being held because of a failure of the
NRSRO-designated rating agencies to predict the Enron meltdown.
In this context, I should note that rating agencies have always
made their rating determinations based primarily on information
provided by the issuer of securities. Thus, a rating is no more
reliable than that information.
Furthermore, ratings do not cover the risk of fraud. To the
extent Enron provided the rating agencies with insufficient or
fraudulent information, that would explain their failure to
predict Enron's demise.
I'll now turn to an analysis of the need for regulation,
and I have submitted with my testimony--I don't know if you
have copies or not--an article I wrote that is forthcoming, in
fact, any day now, (in fact, it was published at 2002
University of Illinois Law Review 1), entitled ``Private
Ordering of Public Markets: The Rating Agency Paradox,'' \1\
which focuses on whether rating agencies should remain
unregulated.
---------------------------------------------------------------------------
\1\ The article submitted by Mr. Schwarcz appears in the Appendix
on page 175.
---------------------------------------------------------------------------
The normative rationale for regulation in an economic
context is improving efficiency. There are two ways that
regulation could do this: By making rating agencies perform
better the tasks they already do, or by limiting the negative
consequences of their actions. I conclude in my article that
regulation would neither improve such performance nor limit
such negative consequences.
Now, having said that, I understand that this Committee
session is being held because of the Enron problem, but I
believe Enron does not raise a systemic problem for rating
agencies. They have, as has been acknowledged, a remarkable
track record of success in their ratings and, indeed, recent
experience is fairly reliable.
However, most of the information in terms of reliability of
ratings looks to see whether defaults have occurred at the time
of an investment grade rating; and that can miss situations
where default occurs, as happened with Enron, right after a
company is downgraded below investment grade.
Nonetheless, there is a recent internal analysis by
Standard & Poor's that is publicly available which uses
information extracted from its proprietary database on over
9,000 companies with rated debt that confirms the stability of
investment grade ratings, finding, for example, that all A-
rated companies at the beginning of a given year would have an
87.94 percent chance of maintaining that same rating by year-
end.
Now, I agree that Enron is a very visible and dramatic
exception to these data. But statistically, the failure to
predict Enron's demise does not materially change these data;
and, as mentioned, to the extent that failure arose from
Enron's providing the rating agencies with insufficient or
fraudulent information, then the failure is truly an anomaly.
Now, to get to the issue of NRSROs, there are many
countries that make their applicability of laws turn on
variants of the NRSRO-type designation. Whether the
applicability of law should, as a normative matter, turn on a
rating is beyond the scope of my testimony. I do note, as I
said, that external credit ratings are being relied on in
regulations worldwide. But so long as the applicability of law
does turn on such ratings, some form of regulatory approval of
rating agencies would appear appropriate. And in this context,
I've examined the appropriateness of the NRSRO designation as a
rating methodology.
The central question is balancing the protection provided
by the NRSRO designation with the goal of ensuring that a
sufficient number of rating agencies receive such designation
to ensure competition. In this context, it has been proposed by
the Antitrust Division of the U.S. Department of Justice that
NRSRO designation be awarded to some foreign recognized rating
agencies as well as to arm's-length subsidiaries of domestic
firms active in evaluating the business and securities of
companies. There should be relatively little risk if these
entities are well capitalized, have reputations for quality
financial analysis in the investment community, and have
acceptable business plans to rate securities. Consideration
even might be given, for example, to firms that utilize
alternative rating approaches such as, as Professor Macey
mentioned, credit spreads and stock price volatility. The risk
could be further minimized by making any de novo applicants for
NRSRO status provisional for some period of time, such as, for
example, 12 months.
Now, in this way, the potential anticompetitive effect of
NRSRO designation can, consistent with the integrity of that
designation, be reduced. This seems to me like a very sensible
approach.
In closing, I should simply say that we all need to put
these issues into perspective and not be as bent on placing
blame as Enron's executives were to find profits.
Thank you.
Chairman Lieberman. Thank you, Professor Schwarcz.
Mr. Reynolds, since that announcement cut you short a bit,
let me go to you first to give you a chance to say a little bit
more. In your testimony, you have indicated that the credit
rating agencies are not using the power that they have to get
all the information they need to make full and fair assessments
of the companies, and you say--and I agree with you, and I
would guess most Members of the Committee do, certainly after
the first panel--that another Enron could be prevented if the
rating agencies take advantage of that strength.
Let me ask you first why you think they don't use the power
they have now.
Mr. Reynolds. It may be a practiced behavior. It may be a
sense that there's a confidentiality that exists between the
rated company and themselves that they're not supposed to step
outside those boundaries. Maybe they need a mandate to have the
willingness to do that. But one of my concerns--and a lot of
the people I speak to regularly who are in the debt markets and
default swap markets and equity markets--there is a very
unlevel playing field in information flows. They will have
access to material inside information, and they're exempted
from Reg. FD. But if it's a material risk factor, we're
supposed to have this information disclosed to begin with, so
they are a very good set of eyes and ears to extract that
information, and whether it be within a tighter regulatory
framework or just by their own decision to voice conclusions
that may not be clearly in the public domain, it would have
benefit.
Keep in mind that we are in markets now that are a lot more
blurry than they used to be. We have banks actively
participating in the tradable debt market. They have access day
in and day out to inside information. They're transacting in
the credit default swap market, which in turn sends signals to
people who watch those markets to see what the banks are
thinking, because they know everything the rating agencies
know, and a lot more. And they are taking actions which are
reflected in pricing.
So there is a way to watch the system at work, but it seems
that it's an unlevel playing field skewed towards those
institutions which have access to information, and that is not,
as we referred to earlier, the Mom and Pop investors.
Chairman Lieberman. Let me ask this: What opportunities do
you think, based on what you know of the Enron case, did the
credit rating agencies miss that they should have found and
pursued?
Mr. Reynolds. Well, the existence of off-balance sheet
transactions were discussed in some detail earlier, but there
is one area that was not, which is the counterparty credit
exposures which are generated in a trading operation.
Chairman Lieberman. Describe that a little bit for the
record.
Mr. Reynolds. Basically, a trading operation enters into a
tremendous amount of buy and sell transactions: Swaps,
commodity swaps, interest rate swaps. These all give rise to
theoretical lines of credit. It's off-the-shelf statistical
modeling. Every Tom, Dick, and Harry in the derivatives world
could model this for you. It is a line of credit that's
generated with a counterparty.
Now, when concerns started to arise in the marketplace with
companies who were closest to Enron, there was a serious risk
of them pulling in the credit lines and asking for collateral
to be posted, and that is the run on the bank that people have
been referring to in some of these hearings. The first thing
they should have been looking at was that, finding out what
those lines were----
Chairman Lieberman. There was enough that they knew that it
should have engaged their interest that they should have
pursued it more.
Mr. Reynolds. It's standard practice in risk management to
know your counterparty exposure by every counterparty.
Theoretical line of credit, you have either payables or
receivables. Standard practice, any brokerage analyst deals
with it regularly. It's just not as common with utilities.
So it could have been pursued with some vigor because that
at the end of the day is what killed the company. Debt hurts
you. Lack of liquidity kills you.
Chairman Lieberman. Right. Commissioner Hunt, let me ask
this question about both the initial NRSRO determination made
by the SEC and also the reviews that are done in their capacity
of investment advisers every 5 years. I wonder, what do you
look for in both of those stages? And, particularly, second, do
you look at how diligently the credit agency is doing its work?
Mr. Hunt. We look at their capacity to do their work, their
internal controls. We do not second-guess their ratings, as we
would not second-guess an asset manager's selection of equity
securities. But we do look at their internal controls, their
capacity to do the work, the kind of personnel they have, the
number of personnel they have, and their books and records.
Chairman Lieberman. Let me ask the two law professors here.
I think each of you thinks there is a basis for further
regulation of credit rating agencies, though I understand you
come at it from a different point of view. If you were the SEC
or Congress, ideally how would we regulate them better? What
more would we ask of them?
Mr. Macey. I guess the really quick thing, Senator, one, as
I mentioned during my testimony, would be this disclosure
point----
Chairman Lieberman. Yes, I wanted you to talk a little more
about that.
Mr. Macey. Well, the idea is that, as I think several
people have observed, what--the process by which credit rating
agencies reach their results is a very opaque process, and it
would be--I think it would be useful for investors to know
exactly what it is they're relying on.
For example, as I mentioned during my testimony, credit
rating agency ratings tend to lag markets. It would be
interesting to know the extent to which they look at the market
prices, particularly in the securities they rate, to derive
ratings, the extent to which they're using non-public
information as they are able to do under--with the exemption
they have under Regulation FD.
Chairman Lieberman. What would be the best method or mode
to make this disclosure?
Mr. Macey. I think a filing with the SEC would make sense.
As Commissioner Hunt mentioned, there are--the agencies are
already regulated by the Commission, and I think it would be a
natural follow-on to get some kind of exposure.
Chairman Lieberman. What other ideas did you----
Mr. Macey. The second is--a couple of people have touched
on also. I think competition would be a good thing; to have a
lot more of these rating agencies would be a good thing, and to
have some easy entry and rivalrous competition. And, finally, I
think that there should be a hard look taken at what I call the
chicken-game problem; that is to say, if you look at the Enron
situation, the credit rating agencies really were in a
difficult position because pulling the rating, as was discussed
in the previous panel, for certain of these private investment
vehicles was the death knell for the company. And so you have
this idea that these kinds of contractual arrangements allowed
the company, in a case like Enron, which is run by some pretty
aggressive folks, apparently, to play chicken with the credit
rating agencies and say, Do you really want to be responsible
for our death? Who's going to be the first to kind of swerve in
this game?
I don't think that's a particularly healthy situation, and
I think that it puts the rating agencies in a very difficult
situation. I'd have a look at those kinds of----
Chairman Lieberman. It is a very interesting point. We keep
pressing on this. We pressed them in the first panel.
Mr. Macey. Right.
Chairman Lieberman. That they have enormous power that they
are not using to get more information, at least. But I suppose
the other part of it is that with such enormous power, life and
death, you are hesitant to drop the boom. Our hope is they use
the power to get more information and report it to us. But how
would you qualify that?
Mr. Macey. Well, I think this problem is--happily, this
particular aspect of the problem is rather rare; that is to
say, it's my understanding, or at least the credit rating
agencies tell us that in most of their rating situations,
pulling the rating does not trigger these sort of covenants and
is not going to be the death of the company. And so I would
isolate those situations like Enron where it is, and I would
urge the appropriate agency, obviously, in this case the SEC,
to see whether or not there would be some better way of
crafting these contractual provisions.
Specifically, my own view is that a far superior way in
this limited context would be credit spreads; that is, instead
of looking at ratings, we can look at the spread between the
yield to maturity on the Enron senior unsecured debt and some
similarly structured government bond. And at the initial
issuance, we would have a spread of, say, you know, 2 percent
or 200 basis points, and if the spread goes to 9 percent or 900
basis points, that should sort of be a clue that there's
something going on in the company that maybe we should take a
look at.
Chairman Lieberman. Good. Interesting. Professor Schwarcz.
Mr. Schwarcz. Yes, thank you. I agree with Jonathan Macey
in terms of the fact that there probably should be additional
entities designated as NRSROs, and as I mentioned in my
testimony, those could include some foreign recognized rating
agencies as well as arm's-length subsidiaries of domestic firms
active in evaluating the business and securities of companies.
The Law Review article I submitted goes into great detail
on these possibilities, and I won't bore people now with those
details.
I disagree with Jonathan on two points, however.
One is that he indicated that we need a lot more of these
NRSROs, and I would be concerned that if we had too many of
them, it would create almost a perverse incentive for issuers
to shop around for the highest rating they could find. And so I
would want to at least keep the number restricted to the very
highest quality of these potential new rating agencies or
NRSROs.
Second, in terms of credit spreads, there are data that
indicate that for a thick market of publicly traded bonds, that
credit spreads may be, to some extent, more accurate than
ratings. But there also are data that show the opposite, and in
my testimony and in my article I cite at least an IMF study
from 1999 that concludes that ratings are much more reliable
than credit spreads.
Beyond that, I should say that credit spreads are only
effective where you have public trading of securities in a
thick market. That means credit spreads have very little
application, for example, to new issues of securities where
there is no market at all and, therefore, no spreads. They have
no application to structured finance deals or other structured
deals where the rating depends as much on the legal structure
as anything else, and the legal structure is not known to and
certainly not fully understood by most market participants.
And, third, they have little or no application to privately
placed deals unless there's a very thick trading market. So
most privately placed deals would not be eligible for the use
of credit spreads.
What I suggest, however, in my proposal is to have the
foreign recognized rating agencies and other players
potentially be appointed on a provisional basis as NRSROs; and
that some of these players can be those that have considered
credit spreads and stock price volatility as alternative ways
to assess creditworthiness. And I think we can then all find
out how accurate their ratings will be based on experience.
Chairman Lieberman. Mr. Reynolds, do you have an opinion
between the two we have heard on the question of competition,
whether if we created a climate in which there were more credit
rating agencies, that would encourage all of them to do more
aggressive work or whether, as Professor Schwarcz said, there
would be a certain amount of shopping around for a good rate?
Mr. Reynolds. There historically has been a bit of shopping
for higher rates going on among issuers. This has led to some
ratings inflation, particularly in the money markets in past
years. But a practical matter is that you're not going to see a
lot of large-scale market entrants. You have fewer today rather
than more. Everyone complains about the lack of new NRSRO
designations, but if you look beyond the S&P's and Moody's big
two, the other four rolled up into one. So there are
significant barriers to entry away from the NRSRO designation
scale: Specialized skill sets. It takes a lot to build a credit
research company of that scale globally to be taken seriously.
So you run the risk that where you get in is to be the
proverbial professor in college, the other one that will give
the A. And that's certainly not going to help the dialogue.
I think the way we help the dialogue is for all of these
agencies to be far more transparent in the information that is
factored into their rating, because then the market economy can
do an object gut test on the quality and depth of the
understanding of the company as well as the industry and as
well as what you have in the case of Enron, highly convoluted,
financially engineered enterprises.
One of the Senators earlier mentioned the fact that you're
acting like analysts. Well, you have to be an analyst because
ratings will have absolutely no credibility in the marketplace
if you can't get on a conference call with an S&P's and Moody's
analyst and grill him on his thought process.
So I think that it's quality of information that is the
biggest challenge right now and probably the easiest to solve.
It will take 10 years to build another NRSRO unless Warren
Buffet has a few billion to put to work. But he has it right
now invested in Moody's.
Chairman Lieberman. All right. Maybe that is a good note to
end on. We have, of course, let me restate for the record,
previously concluded the formal hearing. I thank you very much.
Senator Levin. One question.
Chairman Lieberman. I want to let you know, because there
has been an objection to us proceeding.
Senator Levin. Oh.
Chairman Lieberman. No, no. I adjourned the hearing, but
what I hope is not seen as a matter of civil disobedience, I am
continuing an informal discussion, since we are not transacting
business, among the group of us here who are interested in this
subject. So if you would like to enter into that informal
discussion----
Senator Levin. I don't want to in any way contribute to the
delinquency of a Chairman here. [Laughter.]
Senator Levin. Being a Chairman myself.
Let me just ask an informal question.
Chairman Lieberman. Yes. I am sure you will get an informal
answer.
Senator Levin. If I could ask Mr. Hunt, I had a chance to
just briefly ask you a question in the back room, and if you
haven't been asked this question, perhaps I would do it now.
That chart which----
Mr. Hunt. Yes, I saw the chart. It's a wonderful chart.
[Laughter.]
Senator Levin. And if you haven't been asked----
Mr. Hunt. I have a copy of it. You were kind enough to give
me a copy.
Senator Levin. Well, we thought we would get another
opinion on this. Enron did a huge amount of structured
financing deals from 1997 to 2001. Our estimate is $15 to $20
billion a year. And this is one of the many that our subpoenas
have uncovered, and this produced investments which were rated
by Moody's in this case. What is your reaction, if you would,
to that chart? Is that comprehensible?
Mr. Hunt. I think my reaction to--I heard the first panel
say that their structured analysts could understand this, and I
take them at their word that they could. If you put this in a
prospectus for Enron stock and sold it to the public, most of
the public wouldn't have the slightest idea what this meant. I
mean, it would not be useful to the average investor. It might
be useful to somebody who is experienced in analyzing these
kind of structures, but in my judgment, while Enron did need to
make more disclosure, this kind of disclosure would not have
been helpful.
Senator Levin. Does that look like it is more intended to
obfuscate and hide----
Mr. Hunt. One could argue that, Senator, yes, sir. One
could argue that it is needlessly complicated, but since I'm
not an expert in structured financing, I don't know whether
it's needlessly complicated or just complicated.
Chairman Lieberman. We wanted you to know that, in your
absence, Professor Schwarcz made a declaration which may be
against his self-interest that he is an expert on structured
finance.
Senator Levin. Well, I don't know the answer to my
question. Were you asked this question?
Mr. Schwarcz. I was not asked this question----
Senator Levin. If it is clear to you, I assume that it
would be clear to any average investor.
Mr. Schwarcz. Well, I think there are two issues, I would
say. First of all, I have not had the chance to study this
chart, nor do I frankly even know whether the chart is accurate
in terms of all the players. I can generally guess from the
chart, just quickly looking at it, who the players are, that
you have the originator on the left and the SPVs or SPEs on the
bottom and the investors on the right. But one would have to
diagram this out and just double-check it and check the money
flows.
There is another part of the problem. I'm writing an
article entitled ``The Use and Abuse of Special Purpose
Entities in Corporate Structures,'' and one of the things that
I'm considering is whether, in fact, some of these transactions
are getting so complicated that, indeed, it's impossible to
explain them to the ordinary investor. On the other hand, the
question is what do you do about that? Do you restrict the
structures and thereby really inhibit the flexibility and
creativity of American business?
And I have some solutions, some possible things that we can
discuss. My thought process is still sufficiently incomplete
that I don't want to discuss this in public, but I'd be happy
to discuss it in private.
Senator Levin. Thank you. Thank you so much.
Chairman Lieberman. Thanks, Senator Levin. Again, thanks to
all of you for a substantial contribution to this Committee's
efforts.
It is now my unique pleasure to adjourn this informal
discussion. Thank you very much.
[Whereupon, at 12:32 p.m., the Committee was adjourned.]
A P P E N D I X
----------
[GRAPHIC] [TIFF OMITTED] T9888.001
[GRAPHIC] [TIFF OMITTED] T9888.002
[GRAPHIC] [TIFF OMITTED] T9888.003
[GRAPHIC] [TIFF OMITTED] T9888.004
[GRAPHIC] [TIFF OMITTED] T9888.005
[GRAPHIC] [TIFF OMITTED] T9888.006
[GRAPHIC] [TIFF OMITTED] T9888.007
[GRAPHIC] [TIFF OMITTED] T9888.008
[GRAPHIC] [TIFF OMITTED] T9888.009
[GRAPHIC] [TIFF OMITTED] T9888.010
[GRAPHIC] [TIFF OMITTED] T9888.011
[GRAPHIC] [TIFF OMITTED] T9888.012
[GRAPHIC] [TIFF OMITTED] T9888.013
[GRAPHIC] [TIFF OMITTED] T9888.014
[GRAPHIC] [TIFF OMITTED] T9888.015
[GRAPHIC] [TIFF OMITTED] T9888.016
[GRAPHIC] [TIFF OMITTED] T9888.017
[GRAPHIC] [TIFF OMITTED] T9888.018
[GRAPHIC] [TIFF OMITTED] T9888.019
[GRAPHIC] [TIFF OMITTED] T9888.020
[GRAPHIC] [TIFF OMITTED] T9888.021
[GRAPHIC] [TIFF OMITTED] T9888.022
[GRAPHIC] [TIFF OMITTED] T9888.023
[GRAPHIC] [TIFF OMITTED] T9888.024
[GRAPHIC] [TIFF OMITTED] T9888.025
[GRAPHIC] [TIFF OMITTED] T9888.026
[GRAPHIC] [TIFF OMITTED] T9888.027
[GRAPHIC] [TIFF OMITTED] T9888.028
[GRAPHIC] [TIFF OMITTED] T9888.029
[GRAPHIC] [TIFF OMITTED] T9888.030
[GRAPHIC] [TIFF OMITTED] T9888.031
[GRAPHIC] [TIFF OMITTED] T9888.032
[GRAPHIC] [TIFF OMITTED] T9888.033
[GRAPHIC] [TIFF OMITTED] T9888.034
[GRAPHIC] [TIFF OMITTED] T9888.035
[GRAPHIC] [TIFF OMITTED] T9888.036
[GRAPHIC] [TIFF OMITTED] T9888.037
[GRAPHIC] [TIFF OMITTED] T9888.038
[GRAPHIC] [TIFF OMITTED] T9888.039
[GRAPHIC] [TIFF OMITTED] T9888.040
[GRAPHIC] [TIFF OMITTED] T9888.041
[GRAPHIC] [TIFF OMITTED] T9888.042
[GRAPHIC] [TIFF OMITTED] T9888.043
[GRAPHIC] [TIFF OMITTED] T9888.044
[GRAPHIC] [TIFF OMITTED] T9888.045
[GRAPHIC] [TIFF OMITTED] T9888.046
[GRAPHIC] [TIFF OMITTED] T9888.047
[GRAPHIC] [TIFF OMITTED] T9888.048
[GRAPHIC] [TIFF OMITTED] T9888.049
[GRAPHIC] [TIFF OMITTED] T9888.050
[GRAPHIC] [TIFF OMITTED] T9888.051
[GRAPHIC] [TIFF OMITTED] T9888.052
[GRAPHIC] [TIFF OMITTED] T9888.053
[GRAPHIC] [TIFF OMITTED] T9888.054
[GRAPHIC] [TIFF OMITTED] T9888.055
[GRAPHIC] [TIFF OMITTED] T9888.056
[GRAPHIC] [TIFF OMITTED] T9888.057
[GRAPHIC] [TIFF OMITTED] T9888.058
[GRAPHIC] [TIFF OMITTED] T9888.059
[GRAPHIC] [TIFF OMITTED] T9888.060
[GRAPHIC] [TIFF OMITTED] T9888.061
[GRAPHIC] [TIFF OMITTED] T9888.062
[GRAPHIC] [TIFF OMITTED] T9888.063
[GRAPHIC] [TIFF OMITTED] T9888.064
[GRAPHIC] [TIFF OMITTED] T9888.065
[GRAPHIC] [TIFF OMITTED] T9888.066
[GRAPHIC] [TIFF OMITTED] T9888.067
[GRAPHIC] [TIFF OMITTED] T9888.068
[GRAPHIC] [TIFF OMITTED] T9888.069
[GRAPHIC] [TIFF OMITTED] T9888.070
[GRAPHIC] [TIFF OMITTED] T9888.071
[GRAPHIC] [TIFF OMITTED] T9888.072
[GRAPHIC] [TIFF OMITTED] T9888.073
[GRAPHIC] [TIFF OMITTED] T9888.074
[GRAPHIC] [TIFF OMITTED] T9888.075
[GRAPHIC] [TIFF OMITTED] T9888.076
[GRAPHIC] [TIFF OMITTED] T9888.077
[GRAPHIC] [TIFF OMITTED] T9888.078
[GRAPHIC] [TIFF OMITTED] T9888.079
[GRAPHIC] [TIFF OMITTED] T9888.080
[GRAPHIC] [TIFF OMITTED] T9888.081
[GRAPHIC] [TIFF OMITTED] T9888.082
[GRAPHIC] [TIFF OMITTED] T9888.083
[GRAPHIC] [TIFF OMITTED] T9888.084
[GRAPHIC] [TIFF OMITTED] T9888.085
[GRAPHIC] [TIFF OMITTED] T9888.086
[GRAPHIC] [TIFF OMITTED] T9888.087
[GRAPHIC] [TIFF OMITTED] T9888.088
[GRAPHIC] [TIFF OMITTED] T9888.089
[GRAPHIC] [TIFF OMITTED] T9888.090
[GRAPHIC] [TIFF OMITTED] T9888.091
[GRAPHIC] [TIFF OMITTED] T9888.092
[GRAPHIC] [TIFF OMITTED] T9888.093
[GRAPHIC] [TIFF OMITTED] T9888.094
[GRAPHIC] [TIFF OMITTED] T9888.095
[GRAPHIC] [TIFF OMITTED] T9888.096
[GRAPHIC] [TIFF OMITTED] T9888.097
[GRAPHIC] [TIFF OMITTED] T9888.098
[GRAPHIC] [TIFF OMITTED] T9888.099
[GRAPHIC] [TIFF OMITTED] T9888.100
[GRAPHIC] [TIFF OMITTED] T9888.101
[GRAPHIC] [TIFF OMITTED] T9888.102
[GRAPHIC] [TIFF OMITTED] T9888.103
[GRAPHIC] [TIFF OMITTED] T9888.104
[GRAPHIC] [TIFF OMITTED] T9888.105
[GRAPHIC] [TIFF OMITTED] T9888.106
[GRAPHIC] [TIFF OMITTED] T9888.107
[GRAPHIC] [TIFF OMITTED] T9888.108
[GRAPHIC] [TIFF OMITTED] T9888.109
[GRAPHIC] [TIFF OMITTED] T9888.110
[GRAPHIC] [TIFF OMITTED] T9888.111
[GRAPHIC] [TIFF OMITTED] T9888.112
[GRAPHIC] [TIFF OMITTED] T9888.113
[GRAPHIC] [TIFF OMITTED] T9888.114
[GRAPHIC] [TIFF OMITTED] T9888.115
[GRAPHIC] [TIFF OMITTED] T9888.116
[GRAPHIC] [TIFF OMITTED] T9888.117
[GRAPHIC] [TIFF OMITTED] T9888.118
[GRAPHIC] [TIFF OMITTED] T9888.119
[GRAPHIC] [TIFF OMITTED] T9888.120
[GRAPHIC] [TIFF OMITTED] T9888.121
[GRAPHIC] [TIFF OMITTED] T9888.122
[GRAPHIC] [TIFF OMITTED] T9888.123
[GRAPHIC] [TIFF OMITTED] T9888.124
[GRAPHIC] [TIFF OMITTED] T9888.125
[GRAPHIC] [TIFF OMITTED] T9888.126
[GRAPHIC] [TIFF OMITTED] T9888.127
[GRAPHIC] [TIFF OMITTED] T9888.128
[GRAPHIC] [TIFF OMITTED] T9888.129
[GRAPHIC] [TIFF OMITTED] T9888.130
[GRAPHIC] [TIFF OMITTED] T9888.131
[GRAPHIC] [TIFF OMITTED] T9888.132
[GRAPHIC] [TIFF OMITTED] T9888.133
[GRAPHIC] [TIFF OMITTED] T9888.134
[GRAPHIC] [TIFF OMITTED] T9888.135
[GRAPHIC] [TIFF OMITTED] T9888.136
[GRAPHIC] [TIFF OMITTED] T9888.137
[GRAPHIC] [TIFF OMITTED] T9888.138
[GRAPHIC] [TIFF OMITTED] T9888.139
[GRAPHIC] [TIFF OMITTED] T9888.140
[GRAPHIC] [TIFF OMITTED] T9888.141
[GRAPHIC] [TIFF OMITTED] T9888.142
[GRAPHIC] [TIFF OMITTED] T9888.143
[GRAPHIC] [TIFF OMITTED] T9888.144
[GRAPHIC] [TIFF OMITTED] T9888.145
[GRAPHIC] [TIFF OMITTED] T9888.146
[GRAPHIC] [TIFF OMITTED] T9888.147
[GRAPHIC] [TIFF OMITTED] T9888.148
[GRAPHIC] [TIFF OMITTED] T9888.149
[GRAPHIC] [TIFF OMITTED] T9888.150
[GRAPHIC] [TIFF OMITTED] T9888.151
[GRAPHIC] [TIFF OMITTED] T9888.152
[GRAPHIC] [TIFF OMITTED] T9888.153
[GRAPHIC] [TIFF OMITTED] T9888.154
[GRAPHIC] [TIFF OMITTED] T9888.155
[GRAPHIC] [TIFF OMITTED] T9888.156
[GRAPHIC] [TIFF OMITTED] T9888.157
[GRAPHIC] [TIFF OMITTED] T9888.158
[GRAPHIC] [TIFF OMITTED] T9888.159
[GRAPHIC] [TIFF OMITTED] T9888.160
[GRAPHIC] [TIFF OMITTED] T9888.161