[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




 
                 RATING THE RATING AGENCIES: THE STATE
                    OF TRANSPARENCY AND COMPETITION

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                    CAPITAL MARKETS, INSURANCE, AND 
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                              COMMITTEE ON
                           FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                             APRIL 2, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-18



                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003
89-083 PDF

For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov  Phone: toll free (866) 512-1800; (202) 512-1800  
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001



                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice         JULIA CARSON, Indiana
    Chairman                         BRAD SHERMAN, California
RON PAUL, Texas                      GREGORY W. MEEKS, New York
PAUL E. GILLMOR, Ohio                BARBARA LEE, California
JIM RYUN, Kansas                     JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         CHARLES A. GONZALEZ, Texas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSELLA, New York               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey             
TIM MURPHY, Pennsylvania             BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director
            Subcommittee on Capital Markets, Insurance, and 
                    Government Sponsored Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York               HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio                  RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona             KEN LUCAS, Kentucky
JIM RYUN, Kansas                     JOSEPH CROWLEY, New York
VITO FOSSELLA, New York              STEVE ISRAEL, New York
JUDY BIGGERT, Illinois               MIKE ROSS, Arkansas
MARK GREEN, Wisconsin                WM. LACY CLAY, Missouri
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania      JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania        STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio              RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona



                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    April 2, 2003................................................     1
Appendix:
    April 2, 2003................................................    63

                               WITNESSES
                        Wednesday, April 2, 2003

Cunningham, Deborah A., Senior Vice President, Federated 
  Investors......................................................    30
Egan, Sean J., Managing Director, Egan-Jones Ratings Co..........    28
Joynt, Stephen W., President and Chief Executive Officer, Fitch, 
  Inc............................................................    36
Kaitz, James A., President and Chief Executive Officer, 
  Association for Financial Professionals........................    38
McDaniel, Raymond W., President, Moody's Investors Service, Inc..    39
Nazareth, Annette, Director, Division of Market Regulation, 
  Securities and Exchange Commission.............................     7
Root, Greg, Executive Vice President, Dominion Bond Rating 
  Service........................................................    32
White, Lawrence J., Professor of Economics, Stern School of 
  Business, New York University..................................    34

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    64
    Clay, Hon. Wm. Lacy..........................................    65
    Emanuel, Hon. Rahm...........................................    66
    Gillmor, Hon. Paul E.........................................    67
    Kanjorski, Hon. Paul E.......................................    69
    Cunningham, Deborah A........................................    71
    Egan, Sean J.................................................    75
    Joynt, Stephen W.............................................    87
    Kaitz, James A...............................................    95
    McDaniel, Raymond W..........................................   123
    Nazareth, Annette............................................   128
    Root, Greg...................................................   137
    White, Lawrence J............................................   144

              Additional Material Submitted for the Record

Egan, Sean:
    Written response to questions from Hon. Michael G. Oxley.....   161
McDaniel, Raymond W.:
    Default and Recovery Rates of Corporate Bond Issuers.........   164
Fidelity Investments, prepared statement.........................   214
Standard & Poor's Credit Market Services, prepared statement.....   219


                 RATING THE RATING AGENCIES: THE STATE
                    OF TRANSPARENCY AND COMPETITION

                              ----------                              


                        Wednesday, April 2, 2003

             U.S. House of Representatives,
        Subcommittee on Capital Markets, Insurance,
               And Government Sponsored Enterprises
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:02 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Ose, Shays, Oxley (ex-officio), 
Ney, Ryun, Capito, Hart, Tiberi, Brown-Waite, Feeney, 
Kanjorski, Hooley, Sherman, Inslee, Capuano, Hinojosa, Lucas, 
Clay, McCarthy, Baca, Matheson, Miller, Emanuel and Scott.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Subcommittee on Capital Markets to order this 
morning.
    We are here today to celebrate the birthday of my ranking 
member, Mr. Paul Kanjorski.
    [Laughter.]
    And secondarily, to take up another small matter relating 
to the performance of our rating agencies, the regulation and 
oversight of those agencies by the SEC.
    The hearing today actually represents the next logical step 
in the committee's work and in examining all sectors in the 
performance of our capital markets.
    Most recently the committee received comment concerning 
mutual fund performance and are awaiting the response from the 
SEC on matters of particular interest before our next hearing. 
But today, it is the issue of the nationally recognized 
statistical rating organization known as the NRSROs. And there 
are only at this moment four such organizations currently 
recognized in that capacity.
    It is my hope that we can examine in some detail the manner 
by which these organizations are designated, the adequacy of 
our current regulatory oversight methodologies and the basis 
for which such organization is either to be given approval or 
the methodology for revocation of such authority.
    It is also important, I think, to understand how the system 
works. As committee members will recall, in our examination of 
the analyst investment banking world, many were surprised to 
learn of the relationships and the revenues generated between 
the various parties in transactions relating to analytical 
opinions. It appears that the NRSROs do receive a significant 
amount of revenue from the parties they are assigned for public 
purposes to rate.
    Then there is the real issue of bottom line performance. 
NRSROs do have access to more information than any other market 
participant other than the officials or the corporation which 
they are examining. Shouldn't we expect as a result their 
performance to exceed that of any other analyst or observer of 
corporate conduct?
    These are all questions of great significance and concern. 
It has been sometime since the Congress has reviewed the NRSRO 
system in any detail. And it is my expectation that today's 
hearing will provide us with a broad scope of information, very 
helpful in understanding whether any further actions may be 
warranted or not.
    And I certainly welcome all of those who have agreed to 
participate here this morning.
    Mr. Birthday Boy?
    [Laughter.]
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    Mr. Chairman, for nearly a century, rating agencies like 
Moody's, Standard & Poor's and Fitch have published their views 
about the creditworthiness of issuers of debt securities. The 
importance of these opinions has grown significantly in recent 
decades as a result of increases in the number of issues and 
issuers, the globalization of our financial markets, and the 
introduction of complex financial products like asset-backed 
securities and credit derivatives.
    I believe that strong regulation helps to protect the 
interests of American investors, but regulation in itself may 
fail to accomplish this goal, and the private market may not 
necessarily be responsible for the burdens. So somewhere in 
there, we have to ascertain whether there is a responsibility 
of the SEC and the Congress to reexamine the need for 
regulatory activity on behalf of or regarding the credit-rating 
agencies.
    Accordingly, I am pleased we have worked diligently over 
the last year to augment the resources available to the 
Securities and Exchange Commission and enacted sweeping reforms 
of auditing and accounting practices, restored accountability 
to investment backing and analyst research, and improved the 
conduct of business executives and corporate boards.
    Although rating agencies received some scrutiny after the 
recent spate of corporate scandals, we have not yet mandated 
any substantive change in their practices.
    At hearings before our committee last year, however, one 
witness noted that rating agencies played a significant role in 
Enron's failure. Additionally, a recent Senate investigative 
report found that the monitoring and review of Enron's 
finances, quote, fell far below the careful efforts one would 
have expected from organizations whose ratings hold so much 
importance, unquote.
    I wholeheartedly agree. Outside of Arthur Andersen, the 
rating agencies probably had the greatest access to 
comprehensive non-public information about Enron's complicated 
financial arrangements, and they exhibited a disappointing lack 
of diligence in their coverage of the company.
    Furthermore, the rating agencies have missed a number of 
other large-scale financial debacles over the last several 
decades. They failed to sound appropriate alarms before New 
York City's debt crisis in 1975 and the Washington Public Power 
Supply System's default in 1983. They have also floundered 
before when First Executive Life collapsed in early 1990s and 
during Orange County's bankruptcy of 1994. The failure of 
rating agencies to lower the ratings in these cases ultimately 
resulted in the loss of billions of dollars of American 
investors who little understood the true credit risks.
    As a result of the concerns about the role that the rating 
agencies played in recent downfalls of Enron, WorldCom and 
other companies, we called upon the Securities and Exchange 
Commission to study these issues and report back to us. In 
reviewing this report, it has become clear to me that while our 
capital markets and the rating agencies have evolved 
considerably in recent decades, the Commission's oversight and 
regulations in this area have changed little.
    Moreover, it disturbs me that the Commission has studied 
these issues for more than a decade without reaching any firm 
conclusion. In 1992, for example, then SEC Commissioner Richard 
Roberts first noted that rating agencies, despite their 
importance and influence, remained the only participants in the 
securities markets without any real regulation.
    In 1994, the Commission also solicited public comment on 
the appropriate role of ratings in our federal securities laws 
and the need to establish formal procedures for recognizing and 
monitoring the activities of the nationally recognized 
statistical rating organizations.
    This release led in 1997 to a rule proposal that the 
Commission never finalized. In releasing its latest rating 
agency report to the Congress, the Commission stated that it 
would issue within 60 days a concept paper asking questions 
about rating agency regulation. Sixty days have now passed.
    It is therefore my expectation that the SEC will publish 
its concept release as quickly as possible and that it will 
move with due diligence to finally resolve this issue and 
publish regulations regarding agencies.
    As we proceed today, it is also my hope that we will 
carefully examine the many issues raised in the recent SEC 
report on rating agencies. We must discern how the Commission 
should oversee rating agencies in a systematic way. We should 
also explore the conflicts of interest that rating agencies 
encounter like their reliance on payment by issuers, and their 
provision of consulting services to issuers. Last year, 
accountants came under fire for similar problems. We should 
additionally discuss the competitiveness of the credit rating 
industry. In particular, many critics have raised concerns 
about the ability of participants to enter the market.
    Furthermore, I think that we should evaluate the ability of 
investors to understand credit ratings. In studying the 
recommendations of investment analysts two years ago, we heard 
stories about ``buy'' meaning ``hold'' and ``hold'' meaning 
``sell.'' With respect to credit ratings, investors may well 
understand that triple A is an excellent credit risk with 
little probability of default and that triple B+ means an 
acceptable credit risk with some chance of default. But they 
may not know that B-, a passing grade on their child's report 
card, signifies junk bond status. Average American investors 
need help in deciphering this convoluted code.
    In closing, Mr. Chairman, I expect the Commission to take 
prompt and prudent action on rating-agency regulatory issues. I 
also look forward to working with you on these matters as we 
move forward deliberatively.
    Chairman Baker. I thank the gentleman.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 69 in the appendix.]
    Chairman Baker. Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    And I want to thank you and commend you and thank you for 
holding this important hearing to study the role and function 
of credit rating agencies in the securities markets.
    Over the past two years, this committee has lead the way on 
investor protection beginning with an examination of Wall 
Street analysts and continuing with a review of accountants, 
corporate officers and boards, investment banks, mutual funds 
and corporate governance practices generally.
    Our inquiries resulted in the Sarbanes-Oxley Act and other 
regulatory reforms and now we turn to credit rating agencies.
    Sarbanes-Oxley required the SEC to submit to the committee 
report on rating agencies and that report was issued in 
January. I am pleased that the SEC's top market regulator is 
here this morning to discuss its content.
    Ms. Nazareth, welcome to the committee. We are glad to have 
you back with your valued experience at the SEC.
    I know that members of this committee have questions about 
the Commission's oversight for this industry. Some commentators 
have called for greater transparency in the rating process and 
have raised questions about potential conflicts of interest 
that arise because agencies collect fees from and sell other 
services to the companies that they rate.
    We have seen to many instance where greater transparency 
has led to better functioning markets and more informed 
investors.
    The similarities between the potential conflicts of 
interest presented in this area and those that were addressed 
in the area of accounting firms in Sarbanes-Oxley are 
impossible to ignore. I look forward to our panel's views on 
the need for more disclosure and clarity in the rating process. 
Beyond the potential conflicts and the lack of transparency, 
some of questioned the real liability of the ratings 
themselves, particularly in light of the rating agencies 
failure to warn investors about the impending bankruptcies at 
Enron, WorldCom, Global Crossing and other major companies.
    There are also concerns regarding the openness of the 
industry and whether anti-competitive barriers to entry exist 
for ratings firms seeking recognition by the SEC. We are all 
familiar with the accounting scandals which turned the big five 
into the final four and resulting concerns that have been 
raised.
    Somehow the fact that until very recently, there were only 
three SEC-recognized credit ratings agencies does not seem to 
garner the same level of scrutiny. The Commission has 
recognized only one new firm in well over a decade.
    I am concerned that the Commission may have allowed an 
oligopoly to exist. And I hope and expect to hear from the SEC 
on how they plan to clarify and improve the application for 
firms striving to qualify as recognized rating agencies.
    Thank you, Chairman Baker, for holding this hearing. 
Focusing attention on the role of rating agencies and examining 
the current levels of disclosure, competition, accuracy and 
regulatory oversight in the industry will surely benefit 
investors and the market.
    And I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 64 in the appendix.]
    Chairman Baker. Thank you, Mr. Chairman.
    Mr. Miller? No opening statement?
    Mr. Emanuel?
    Mr. Emanuel. Thank you very much.
    Obviously a number of questions, Mr. Chairman, that we need 
to hear have already been raised. So rather than repeat them, I 
think like every member of this body and of this committee and 
subcommittee, we have state funds, teachers' funds, police 
funds, all who lost money in WorldCom and Enron.
    And although the Sarbanes-Oxley bill correctly started to 
realign the walls that exist in the accounting industry, the 
investment banking, commercial banking, the credit agencies to 
date have been immune from that oversight. And we need to 
obviously take a look at what those agencies do, whether there 
is a conflict of interest that exists, whether there is in fact 
more of the debt market they should cover rather than limit it.
    So I submit my full remarks to the committee. And then look 
forward to the testimony and the question and answer period.
    Thank you.
    [The prepared statement of Hon. Rahm Emanuel can be found 
on page 66 in the appendix.]
    Chairman Baker. Mr. Shays?
    Mr. Shays. Thank you, Mr. Chairman.
    I thank you for conducting this hearing. And just to say to 
you that when we had the hearing on Enron there was not one 
profession that looked good. The managers did not manage. The 
directors did not direct. The employees did not speak out, not 
withstanding Ms. Watkins who spoke out internally. The lawyers 
were on a gravy train. The accountants did not do their job of 
auditing. But what to me was most alarming was how the rating 
agencies just broke down.
    And it seemed very clear to me that they broke down in 
measure because they also were part of the renumeration this 
incredible amount of opportunity to make money at the public's, 
I think, unfortunate expense.
    So delighted we are having this hearing, and I hope that we 
hear some very convincing information from the regulators as to 
how we are dealing with this issue.
    Chairman Baker. Thank you, sir.
    Other Members wanting opening statements?
    Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman. I too want to 
thank you Chairman Baker and Ranking Member Kanjorski for 
holding this important hearing today regarding the Securities 
and Exchange Commission's oversight of the credit rating 
agencies. I certainly want to thank the distinguished panel of 
witnesses today for your testimony.
    This is indeed a very, very important hearing. As we know 
last year the Senate Governmental Affairs Committee held a 
hearing on Enron's scandal and questioned why Enron's credit 
rating was high until just before the company filed for 
bankruptcy.
    Due to the development of complex financial products and 
the globalization of the financial markets, credit ratings have 
been given increased importance. The credit ratings effect the 
security markets in many ways. But the SEC has not performed 
any significant oversight over rating agencies.
    And perhaps this lack of oversight has led to what the 
Senate Governmental Affairs Committee in their hearing, to be 
incredulous that they had that good credit risk until just 
before the bankruptcy.
    I think there are several areas we certainly need to focus 
on--information flow, potential conflicts of interest, alleged 
anti-competitive or unfair practices, reducing potential 
regulatory barriers to entry and ongoing oversight.
    And there are some questions that I certainly would want to 
get some answers to. For example, I would like to know whether 
there is general agreement about whether greater regulatory 
oversight of credit agencies is indeed warranted.
    The Senate Governmental Affairs Committee staff report 
recommended that the SEC monitor credit agency compliance with 
performance and training standards. I mean, is it time for that 
change?
    Again, a very important hearing. I look forward to hearing 
from the panel and the recommendations for the SEC review of 
the credit agencies.
    Thank you Mr. Chairman.
    Chairman Baker. Thank you, Mr. Scott.
    Mr. Tiberi? No opening statement?
    Mr. Ryun? Mr. Ryun has excused himself.
    Mr. Matheson?
    Mr. Sherman?
    Mr. Sherman. As we explore the financial world, we find a 
world where the referees are paid by one of the teams. We find 
this among auditors and around credit creating agencies or bond 
rating agencies.
    What insulated bond rating agencies from the same pressures 
that accountants faced was first an absence of competition. The 
vast majority of bonds being rated by the two major agencies. 
So even if you call them as you see them, they still have to 
hire you for the next game.
    But the absence of competition is not an enshrined value of 
American free enterprise. And it probably is a good thing that 
we are going to get some more competition in this area.
    If the competition is to serve investors either by reducing 
the fees charged to corporations or to provide better insight 
that is good. My fear is that competition will be best 
expressed in the sense of who will give you a better a grade.
    If you were to--if a rating agency were to cut its fees by 
half, it would be nothing in terms of value to the corporation 
as if it were increase its grade by the slightest denomination 
available.
    I will look forward to learning in these hearings what we 
are doing to providing a disclosure of all of the relationships 
between the rating agencies and the issuer in terms of is there 
consulting services being provided? What services and what 
cost? And what are the fees being charged for the basic rating 
services?
    The thing that would concern me the most as a bond buyer is 
if I ever saw that a corporation was paying more than the 
standard fee to the entity providing its grade.
    One advantage we have in bonds is that most of the 
decisions are being made by highly sophisticated bond 
purchasers and that the individual investor plays a smaller 
role. But even there often it is a fund that invests in bonds 
and then competes for the highest rate of return saying, ``All 
of our bonds are at least single A or double A.
    And so even bond managers should they fear that a rating 
agency's results may not be strong, the pressure on them is to 
buy the highest yield with the best grade whether they like 
that grade or not.
    So I look forward to seeing what we can do to prevent the 
increase in competition from being a competition for who will 
provide the best grade and to provide investors with the best 
way for them to decide whether it is a grade they can trust.
    Thank you.
    Chairman Baker. Thank you, Mr. Sherman.
    If there are no members seeking recognition, then at this 
time I would like to welcome our first panelist this morning, 
Ms. Annette Nazareth, who appears here in her capacity as the 
Director of the Division of Market Regulation for the 
Securities and Exchange Commission.
    Welcome, Ms. Nazareth. And I do not know if your mike is 
on. Try that little button.
    Ms. Nazareth. Can you hear me now?
    Chairman Baker. Very well.

  STATEMENT OF ANNETTE NAZARETH, DIRECTOR, DIVISION OF MARKET 
         REGULATION, SECURITIES AND EXCHANGE COMMISSION

    Ms. Nazareth. Thank you, Chairman Baker, Ranking Member 
Kanjorski and Members of the Subcommittee.
    On behalf of the Securities and Exchange Commission, I 
appreciate the opportunity to testify today before you 
regarding credit rating agencies and their role and function in 
the operation of the securities markets.
    As you know, this past January, the Commission submitted to 
Congress a detailed report on credit rating agencies in 
response to the congressional directive contained in the 
Sarbanes-Oxley Act of 2002.
    In my testimony this morning, I would like to highlight for 
you some of the key points in the Commission's report and give 
you a sense of some of the areas we intend to explore in more 
depth.
    During the past 30 years, regulators, including the 
Commission, have increasingly used credit ratings to help 
monitor the risk of investments held by regulated entities and 
to provide an appropriate disclosure framework for securities 
of differing risks.
    Since 1975, the Commission has relied on ratings by market-
recognized credible rating agencies for distinguishing among 
grades of creditworthiness in various regulations under the 
federal securities laws.
    These nationally recognized statistical rating 
organizations or NRSROs, are recognized as such by Commission 
staff through a no-action letter process.
    Recently, the Commission has pursued several approaches, 
both formal and informal to conduct a thorough and meaningful 
study of the use of credit ratings in the federal securities 
laws, the process of determining which credit ratings should be 
used for regulatory purposes, and the level of oversight to 
apply to recognized rating agencies.
    Commission efforts included informal discussions with 
credit rating agencies and market participants, formal 
examinations of each of the NRSROs, and public hearings that 
offered a broad cross-section of market participants the 
opportunity to communicate their views on credit rating 
agencies and their role in the capital markets.
    These Commission initiatives coincided with the requirement 
of the Sarbanes-Oxley Act that the Commission conduct a study 
of credit rating agencies and submit a report of that study to 
Congress.
    Our report identified a number of important substantive 
issues relating to credit rating agencies that the Commission 
would be exploring in more depth. And the Commission plans to 
issue a concept release that would seek public comment on these 
matters in the very near future.
    Among other things, the concept release would ask a wide 
range of questions regarding possible approaches the Commission 
could develop to address various concerns regarding credit 
rating agencies.
    I will devote the remainder of my testimony to a synopsis 
of some of these complex issues.
    One important group of issues the Commission staff has been 
reviewing relates to the information flow surrounding the 
credit rating process.
    First, we are exploring the current amount of disclosure 
that rating agencies provide regarding their ratings decisions. 
At the Commission's credit rating agency hearings 
representatives of the users of securities ratings, 
particularly the buy side firms, stressed the importance of 
transparency in the rating process.
    In their view the marketplace needs to more fully 
understand the reasoning behind the ratings decision and the 
types of information relied upon by the rating agencies in 
their analysis.
    Better information about ratings decisions they assert 
would reduce the uncertainty and accompanying market volatility 
that frequently surrounds a ratings change.
    Second, the Commission staff is reviewing the implications 
of direct contacts between rating analysts and subscribers. 
Some have expressed concern regarding the special access 
subscribers have to rating agency information and personnel. 
And questions have been raised as to whether this direct access 
creates the potential for inappropriate selective disclosure of 
information.
    Finally, the Commission staff is assessing the extent and 
quality of disclosure by issuers. At the Commission's credit 
rating agency hearings several specific areas for improved 
issuer disclosure were mentioned, including the need for 
additional detail regarding an issuer's short term credit 
facilities and, particularly in light of the Enron experience, 
better disclosure of the existence and nature of ratings 
triggers in contracts that are material to an issuer.
    Another set of issues the Commission staff has been 
examining is the potential conflicts of interest faced by 
credit rating agencies.
    First, the Commission staff is reviewing potential 
conflicts of interest that could arise when issuers pay for 
ratings. Arguably, the dependence of rating agencies on 
revenues from the companies they rate could induce them to rate 
issues more liberally and temper their diligence in probing for 
negative information.
    Rating agencies on the other hand assert that their 
processes, procedures and market competition sufficiently 
address these concerns.
    Second, the Commission staff is assessing the potential for 
conflicts of interest to arise when rating agencies develop 
ancillary fee-based businesses. The large credit rating 
agencies recently have begun to develop ancillary businesses 
such as ratings assessment services and risk management and 
consulting services to compliment their core ratings business.
    Concerns have been expressed, for example, that credit 
rating decisions might be impacted by whether or not the issuer 
purchases additional services offered by the credit rating 
agency.
    The Commission staff also has been exploring the extent to 
which allegations of anti-competitive or unfair practices by 
large credit rating agencies have merit.
    In the course of the Commission's study, there were a few 
allegations that the largest credit rating agencies have abused 
their dominant position by engaging in certain aggressive 
competitive practices.
    Some allege, for example, that rating agencies may have 
used what critics term strong-arm tactics to induce payment for 
a rating that an issuer did not request.
    A fourth set of issues under review by the Commission staff 
is whether the Commission's historical approach to the NRSRO 
designation has created potential regulatory barriers to entry 
into the credit rating business.
    For many years, market participants have voiced concerns 
about the concentration of credit rating agencies in the U.S. 
securities markets and whether inordinate barriers to entry 
exist.
    Most agree that significant natural barriers exist, 
particularly given the long standing dominance of the credit 
rating business by a few firms, essentially the NRSROs, as well 
as the fact that the marketplace may not demand ratings from 
more than two or three rating agencies.
    There also has been substantial debate regarding the extent 
to which any natural barriers to entry are augmented by the 
regulatory use of the NRSRO concept and the process of 
Commission recognition of NRSROs.
    One obvious way to avoid potential regulatory barriers to 
entry is to eliminate the regulatory use of the NRSRO concept. 
And the Commission staff is exploring this possibility.
    The Commission staff also is reviewing steps short of 
eliminating the NRSRO concept that would reduce potential 
regulatory barriers including possible clarifications of the 
current process and criteria for regulatory recognition of 
rating agencies. Instituting timing goals for the evaluation of 
applications for regulatory recognition, and considering 
whether rating agencies that cover a limited sector of the debt 
market or confine their activity to a limited geographical area 
could be recognized for regulatory purposes.
    Finally, the Commission staff is assessing whether more 
direct ongoing oversight of rating agencies is warranted and 
possible and if so, the appropriate means of doing so.
    This oversight could include, among other things, record 
keeping requirements designed for the credit rating business 
and a program of regular Commission inspections and 
examinations.
    As part of this analysis, we are examining the scope of the 
Commission's present oversight as well as the potential impact 
on the credit rating market of any action the Commission may 
take.
    In addition, I should note that the rating agencies have 
asserted that their ratings activities are at least to some 
extent protected by the First Amendment.
    Another aspect of possible ongoing Commission oversight is 
whether rating agencies should and can be required to 
incorporate general standards of diligence in performing their 
rating analysis and develop standards for training and 
qualification of credit rating analysts.
    In the aftermath of the Enron situation and the recent 
corporate failures, some have criticized the performance of the 
credit rating agencies and questioned whether they are 
conducting sufficiently thorough analysis of issuers, 
particularly given their special position in the marketplace.
    Concerns have also been raised regarding the training and 
qualifications of credit rating agency analysts. Whether and 
how such standards might be incorporated into the Commission's 
oversight of credit rating agencies likely will be explored 
more deeply in the forthcoming concept release.
    As you can see, credit rating agencies raise a wide range 
of complex regulatory and policy issues. I expect you will get 
a sense of some of the diverse perspectives on these matters 
from the witnesses who will be testifying later this morning.
    The Commission has made substantial progress in its review 
of credit rating agencies as I hope is evident from our recent 
report to Congress. And I expect our analysis to be focused 
further based on comments received in response to the planned 
concept release.
    Thank you for the opportunity to testify.
    [The prepared statement of Annette Nazareth can be found on 
page 128 in the appendix.]
    Chairman Baker. Thank you very much. I do appreciate, Ms. 
Nazareth, not only your work but the apparent openness having 
read your written testimony, of the SEC to consider a number of 
alternative directions to take with regard to current market 
performance.
    Is there at the current time a written set of standards if 
one complies with, would lead to a designation as an NRSRO that 
could be printed in a form and handed to someone? And if you 
meet these guidelines, you can be assured of approval?
    Ms. Nazareth. The process is not that formal at this time. 
I believe that in general the standards for national 
recognition are understood to the extent that the 1997 proposal 
basically talked about codifying what was the staff's approach 
to national recognition.
    But certainly what the Commission has been talking about 
more recently is taking those general standards and were it to 
decide to continue to use the NRSRO designation to apply more 
objective criteria and further list criteria to obtain the 
NRSRO designation.
    Chairman Baker. In response to the 1997 rule proposal, in 
which the SEC had a considerable number of suggestions, the 
response from the NRSRO group was that the SEC concerns were 
addressed by their existing policies, meaning the SEC's, 
procedures and competition.
    Now if there are only four of them, and there were three at 
the time, doesn't it seem that the competitive argument was at 
best a little disingenuous? How does one allege that a 
government granted authority to do a public function and you 
only have three of you in the country, leads one to conclude 
that that is a competitive environment? But yet they were 
saying this strong competition is what keeps us on our toes.
    Ms. Nazareth. I understand the position that you are 
taking. You know, there is a question as to whether or not 
there really is sort of a natural oligopoly in this business. 
And----
    Chairman Baker. I think that is a great answer.
    Ms. Nazareth. Yes, I think our concern is we certainly do 
not want to be in a position where we are adding to any 
impediments to entry into the business through the regulatory 
process.
    Chairman Baker. Let me jump to the next level because my 
time is going to expire here. And we do have members with a lot 
of interest.
    Let's assume for the moment that I have been designated. 
What is the normal regulatory oversight process that exists 
today from your perspectives to my conduct? What is it that I 
could expect? Do I have an SEC audit? Are there analysts coming 
through and looking at how I perform my day-to-day? Do you have 
to present a business plan? What is the formal relationship 
between this public regulatory authority and the SEC?
    Ms. Nazareth. The SEC's oversight on an ongoing basis is 
very limited. These entities are registered as investment 
advisers, but the Adviser's Act does not really specifically 
contemplate much of this type of business.
    So there is not sort of a regular examination process or--
--
    Chairman Baker. Well, let's assume for the moment that 
tomorrow we read where one of the four is engaging in their 
inappropriate conduct, there is a capital adequacy question, 
whatever the reason. But it is a national in scope issue.
    Is there a process by which the designation can be 
withdrawn?
    Ms. Nazareth. The designation has never been withdrawn, but 
certainly it could be withdrawn. I mean, there is not a formal 
process, but there is a process in general for no action 
letters that they could be withdrawn.
    Chairman Baker. Well, you can hopefully understand that the 
concern is that we do not have clinical standards by which 
someone gets approved. There is not a formal set of standards 
for continual oversight, and there is not a published 
methodology for withdrawing the designation once granted.
    Would it at least be advisable to consider having this 
process subject to the Administration Procedures Act where that 
requires certain printed notices to the public, public hearings 
where interested parties could come and make comment?
    At least opening it up to that extent where market 
participants at the very least and the general public on a 
large scope would have an ability to express the views of the 
market to the SEC because one of the principles on which the 
SEC basis its judgment is national recognition and market 
acceptance of whoever it is that is to be designated.
    It seems to be difficult to obtain without a formally 
structured process to get that information. Is that something 
would or would not be advisable?
    Ms. Nazareth. It is certainly something that is along the 
lines of what a number of participants at the credit rating 
agency hearings that we had, had raised as well. Greater 
transparency with respect to the process as well as 
solicitation of more data from the public at large about the 
national recognition. So that is certainly something that the 
Commission could consider.
    Chairman Baker. And let me again, I do not want to end on a 
negative note. I appreciate your appearance and recognize that 
this is not a circumstance that has occurred in the last six 
months. This is an environment, which frankly has existed the 
first designation. And this is just the appropriate for a 
review of all aspects of market conduct. And I certainly have 
more questions, but my time has long expired.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Ms. Nazareth, your testimony raises some questions about 
the rating agencies. I am more interested in what is your 
personal valuation or opinion of the rating agencies? Because 
you know, there is no reason to go along to set standards and 
an awful lot of paperwork and a lot of hoops and things to jump 
through just to make us look like we are closing the door after 
the horse got out of the barn.
    The question really should go: In your opinion, do the 
agencies open up the door to allow the horse to get out of the 
barn?
    Ms. Nazareth. Well, I do not know who much weight my 
personal opinion should have on this particularly since I am 
not familiar with all of the factors, you know, surrounding 
this. But I can say that, in general what makes this area so 
difficult and the reason that we never seem to come to closure 
on how to address these issues is that, fundamentally what is 
occurring here is financial analysis.
    Mr. Kanjorski. Yes.
    Ms. Nazareth. Which is why we certainly need to be sure it 
is being done in a manner that has integrity and that is free 
to the fullest extent of conflicts----
    Mr. Kanjorski. Well, are there any questions concerning----
    Ms. Nazareth. ----but you do not know whether or in general 
it is an opinion.
    Mr. Kanjorski. Well, you mean after all of this time of 
studying it and the requests that we made under the Sarbanes-
Oxley Act, the Commission still has not made a judgment?
    I think it is about time somebody steps up to resolve the 
problem, rather than spending a lot of time studying it. Look, 
we have had some startling failures--Enron, WorldCom--and all 
of us are trying to prove that we did not have anything to do 
with it. Certainly the Congress is not responsible for it.
    And the Commission probably is saying, ``Well, we are not 
responsible for it.'' And the rating agencies I would assume 
are saying, ``Well, we are not responsible for it either.''
    I do not think that we should concentrate necessarily on 
finding fault. Those are days gone by. But, do you see any way 
that we are going to improve analysis, limit conflicts of 
interest, or restore integrity if we do put into effect some 
regulatory control over these rating agencies?
    Ms. Nazareth. Well, what the Commission is going to examine 
in the concept release is whether or not additional regulatory 
oversight would be appropriate and whether, you know, it might 
help in this area. I think----
    Mr. Kanjorski. I thought that was what the concept release 
that we are waiting to receive would do.
    Ms. Nazareth. That is right, in the concept release. That 
is----
    Mr. Kanjorski. When is that going to happen? I mean, maybe 
we should have postponed this hearing until we obtain the 
concept release.
    Ms. Nazareth. Well, we suggested that. No, the concept 
release will be coming out shortly. There are drafts 
circulating internally now.
    Mr. Kanjorski. Can you give us a peek preview as to what 
you are talking about?
    Ms. Nazareth. Well, I think where it currently stands, and 
again I cannot say where the Commission will come out, but it 
could potentially be very broad in its scope in raising as 
Chairman Baker had mentioned, you know, all manner of issues--
--
    Mr. Kanjorski. I understand all of that, and you know, I 
think we do not get to that level unless we find that rating 
agencies have either failed or scored very poorly.
    I guess what I am simply asking you is as a teacher, grade 
them, A, B, C, D, or F.
    Ms. Nazareth. You know, I think in general the credit 
rating agencies have done remarkably well. I think the problem 
is that you have some colossal failures, and we can--and it is 
interesting what you have----
    Mr. Kanjorski. Would you attribute any of these failures of 
Enron, WorldCom or any of these other organizations to either 
the conflict of interest that the agencies may or may not have 
been in, or their failure of analysis, or their failure of due 
diligence?
    Do you see a problem? I mean, there was not any question 
when we examined the accountants. There was a very definite 
link between the accountants who were getting involved in 
carrying out the fraud. I mean that was very clear as far as 
testimony.
    Are these people directly involved in any of this or is it 
a failure of one out what 17,000 publicly traded corporations 
and they have missed three or four of them. Is that all?
    Ms. Nazareth. You know, I am personally not aware of all of 
the facts. I can tell you that the rating agencies certainly 
take the view that they were defrauded in the same manner as 
the rest of the investing public was.
    Mr. Kanjorski. Well, then, shouldn't we----
    Ms. Nazareth. On the other hand, they may have been privy 
to more information than others were. So I really do not know.
    Mr. Kanjorski. Well, I am wondering, rather than 
concentrate a lot of our time on process and particularly new 
regulations of an existing business that is doing fairly well, 
I mean, until preparing for this hearing, over the years, I 
have always had a great deal of respect for the rating 
agencies. I have always thought that they have done a pretty 
good job. The failures also are minute when you really look at 
them over the scheme of how many papers they are rating.
    Should we have more transparency on the corporate side? Is 
it that? There was some mention here on Enron--that they could 
not pierce the veil of some of these off-shore things because 
they just did not know about it. Should we be up here arguing 
for total disclosure of everything a corporation does and then 
put some rule into effect that the agencies have to be an arm 
of the government in some way directly or indirectly, to 
examine that?
    Should the SEC be out there even examining that? I mean, it 
sort of seems unfair for me to suggest that we are all up here 
trying to burden this system all over again. Boy, as a Democrat 
I should not be talking this way.
    [Laughter.]
    Democrats are supposed to be for more regulation, but you 
know, I do not want to be a party to adding expense to the 
securities market, driving the credit situations into a 
jeopardized position because of actions we take that are not 
really going to accomplish the one thing I am interested in.
    Maybe I should say it: How many unsophisticated investors 
are the ones that are reading these ratings or is it a fact 
that the people that read these ratings and understand these 
ratings are because they are expert in the field? And what we 
are trying to do is prepare something that mom and pop can 
decide over a kitchen table discussion, but when it in fact 
they do not decide on bond ratings or other ratings made by 
these agencies?
    Ms. Nazareth. Well, the ratings are used primarily by the 
sophisticated financial users. And the reason that we consider 
it important is because it does have great influence on the 
financial markets and people's ability to raise funds and the 
like. It is important to----
    Mr. Kanjorski. Let me come to a conclusion----
    Ms. Nazareth. ----the----
    Mr. Kanjorski. ----I know my time is almost gone. Can you 
attribute any of the financial failures that have occurred over 
the last year in the American economy to a large extent, not a 
total extent, but to a large extent or as to the extent of the 
accountant problem that we have to the rating agencies?
    Do see them as the----
    Ms. Nazareth. I personally do not see that level of----
    Mr. Kanjorski. So we are at a much lower position and----
    Ms. Nazareth. I would assume so.
    Mr. Kanjorski. ----therefore our regulations or statutory 
authority for regulations should be more constricted? Is that--
--
    Ms. Nazareth. Again, what we have to analyze is what will 
additional regulation bring to the process? The Commission is 
not only going to have to decide if it engages in more 
regulation, but what additional benefits would that regulation 
bring? And two, are there limits to the Commission's current 
authority? And would the Commission need----
    Mr. Kanjorski. Now----
    Ms. Nazareth. ----additional authority from Congress to do 
that?
    Mr. Kanjorski. In some of our opening statements, we 
referred to this conflict of interest problem. It is 
potentially an alleged conflict of interest because we do not 
know whether there is one where payments are coming from the 
issuers and/or paying to the rating agencies that may cloud 
their judgment.
    Have you ever seen anything like that happen? I mean, are 
we dealing here with conflicts of interest that are rampant or 
even evident in some of these failures? Or is that just a 
misstatement of fact and we should apologize to the rating 
companies.
    Ms. Nazareth. I think there are always potential conflicts 
of interest----
    Mr. Kanjorski. Have you seen any? I know there is a 
potential conflict of interest in every step we take in life.
    Ms. Nazareth. That is right.
    Mr. Kanjorski. But have we seen any conflict problem or do 
we know of any or have any evidence that they have had any 
impact on any of these failures?
    Ms. Nazareth. I am not aware of their being systemic 
conflict problems.
    Mr. Kanjorski. Thank you.
    Chairman Baker. Mr. Oxley?
    Mr. Oxley. Thank you.
    Mr. Chairman, in the absence of marketplace competition, 
the SEC really is the only agency that determines the 
qualifications of a ratings agency in place of the normal 
checks and balances a marketplace has. And in the case of other 
oligopoly or monopolies regulated by the SEC, there are 
regulations, public interest obligations and the like that tend 
to provide some balance. But in the case of the rates charged 
by the agencies, the SEC really has no authority over those 
rates. Is that correct?
    Ms. Nazareth. That is right.
    Mr. Oxley. And what would prevent the--any of the agencies 
from exercising monopoly power or pricing for their services?
    Ms. Nazareth. Well, there are a few of them obviously, and 
I would think that market forces have, you know, prevented that 
from happening because there is some limited competition there. 
And I would also assume that were there inappropriate tactics 
being exercised by these agencies, we would have heard about 
it.
    But----
    Mr. Oxley. So you think there is some marketplace----
    Ms. Nazareth. I think there is some marketplace 
competition. Usually the number of ratings required for an 
issue is one or two ratings. And they do have some choice here.
    Mr. Oxley. I know that there are--at least I have been told 
that there is one agency that is considering tripling its price 
even though they apparently are adding no value, extra value.
    If that were the case and they were indeed to triple their 
price, what would be the--what would be the outcome? What would 
be the view of the SEC in that situation?
    Ms. Nazareth. Normally we would not exercise authority over 
the prices that these entities would charge. We do not do that 
with the broker dealers either.
    Mr. Oxley. Well, and I am not here to advocate the 
government regulation of pricing. Far be it for a conservative 
Republican to advocate that. But obviously our goal is to--our 
goal is to try to get more competition, more entries into the 
market. And you have obviously heard from Chairman Baker, 
Ranking Member Kanjorski and myself, that that clearly is I 
think what we are aiming at.
    And so to that extent we want to work with the SEC to 
encourage market entry. It may very well be potential growth 
industry given the past history of ratings agencies and some of 
the problems that developed with failure to recognize some of 
the major business failures that we had over the last several 
months. And clearly that is what we are aiming at.
    We appreciate your constant efforts in that--and I know you 
have been at the Commission for a number of years and have 
always had the best interests of the public at heart. And this 
is no exception. And we are looking forward to your leadership, 
working with us to provide a more competitive marketplace in 
this area.
    And I thank you and I yield back.
    Ms. Nazareth. Thank you.
    Chairman Baker. Thank you, Mr. Chairman.
    Mr. Miller, do you have a question?
    Mr. Miller. I do, a few. They are along the lines of Mr. 
Sherman's opening statement. We have heard both concerns for 
conflicts of interest and a lack of competition. And I know 
that reliability has to be one basis of competition for these 
agencies, at least sequentially because no issuer is going to 
want any agent--if every issuer is going to want a rating that 
is accepted in the marketplace as reliable.
    But what will be the basis of the competition? Is it going 
to be price only to the issuer, what the agency would charge if 
there were more agencies? And are we going to have to worry 
about the more of what we saw with the accounting firms 
becoming willing partners in Enron, WorldCom, et cetera?
    Ms. Nazareth. What our focus has been all along is that the 
marketplace ultimately would decide through their use of these 
rating that the issuers of these ratings were credible and were 
issuing the ratings in an appropriate way without conflict and 
side agreements with the issuers.
    So basically, we have used that process to try to recognize 
or mimic how the marketplace viewed what these agencies were 
doing.
    Mr. Miller. What we want these agencies to be is detached. 
We want detachment from the agencies. That is--isn't that 
right?
    Ms. Nazareth. Yes.
    Mr. Miller. Is it--if there is a proliferation of these 
agencies, and I know that there are natural barriers to entry, 
there is not going to be 400 agencies. But is--is there not 
going to be some push for more favorable ratings as Mr. Sherman 
suggested in his opening remarks? Is that not a concern?
    Ms. Nazareth. Well, certainly from our limited 
perspective--you know, originally we started using this 
national recognition process because we wanted to ensure that 
our regulated entities that were using these ratings for 
regulatory purposes were not in fact doing what you are 
suggesting, which is sort of buying a rating, you know.
    Because the ratings were used to determine things like 
capital requirements for the broker dealers and the like. And 
you did not want to have a situation where there was any issue 
that the credibility of the rating was called into question.
    And so there is a concern there if we are going to continue 
to use this designation because we have become somewhat 
attached to it for regulatory purposes, we really do have to 
ensure that all of the appropriate procedures are in place so 
that you do not have what you are suggesting which is a race to 
the bottom based on people coming in and competing on basis 
other than the credibility of their ratings.
    Mr. Miller. The suggestion is that having essentially three 
firms is oligolistic.
    Ms. Nazareth. Yes.
    Mr. Miller. What would be the appropriate size of the 
market?
    Ms. Nazareth. I do not know what the perfect size of the 
market would be but I do note that in Europe where they do not 
have this designation process, they likewise have a somewhat 
limited number of major firms that are operating in the 
marketplace.
    I think we had a staff person from the Financial Services 
Authority in London testify at our hearing, who said that they 
generally have I think south of 10. So I do not think we are 
talking about a situation here where there are hundreds of new 
entrants trying to come into this marketplace.
    Mr. Miller. Okay. Has Europe had any of the kind of 
problems that we have had or that we fear or agencies missing 
it?
    Ms. Nazareth. Well, I think that they feel that they have 
had a very comparable experience. And they are very much 
looking to what we are doing in this area. There is a lot of 
interest in Europe as there has been here to looking into 
further regulation of the credit rating agencies. So they are 
very much looking to us for the analysis that we undertake in 
this regard.
    Mr. Miller. Okay. Thank you.
    Chairman Baker. I thank the gentleman.
    Mr. Shays?
    Mr. Shays. I would like to ask you what your reaction was 
when the whole debacle of Enron unfolded. I would like you to 
tell me what you thought and why you thought what you thought.
    Ms. Nazareth. I cannot really speak for the agency in that 
regard. So I am not sure it is appropriate or how helpful it 
would be to just say what my own personal views are. I do not 
think in this regard I am necessarily----
    Mr. Shays. Well, you were in office at the time, correct?
    Ms. Nazareth. Yes.
    Mr. Shays. Well, then describe----
    Ms. Nazareth. Well, we----
    Mr. Shays. Describe to me what you felt as a Commissioner.
    Ms. Nazareth. And----
    Mr. Shays. And what that, you know, made you think you 
might need to do.
    Ms. Nazareth. I think----
    Mr. Shays. I do not think it is a difficult question.
    Ms. Nazareth. We do not oversee the activities of these 
credit rating agencies. There may be people in other areas of 
the Commission involved in Enron enforcement action who have be 
privy to more detailed information.
    But in the Division of Market Regulation, we are not privy 
to the specific information that the credit rating agencies 
reviewed with respect to the Enron situation.
    I think--there is no question that looking at the 
situation, there are two distinct possibilities. One is that, 
as I said earlier, the fraud that was perpetrated on the public 
was likewise perpetrated on the credit rating agencies, and 
that they were given answers that were not truthful with 
respect to questions that they raised.
    The other possibility is that because of their unique role 
there may have been information that had they probed further 
might have caused them to realize that things basically did not 
add up.
    What would be my personal question is--on which side of the 
line did it fall? But I personally am not aware of which was 
the case.
    Mr. Shays. The--you know, all of us when we had to examine 
that, I do not think that--since I do not believe there was a 
professional that did their job or looked good, any one of us 
in any profession would--I would think have instinctively have 
said, ``My gosh, what role should or could we have played?''
    And so we as legislators had to look at, you know, whether 
our oversight was proper and whether we needed to take action.
    I do not think it would be surprising for me to expect that 
your agency ultimately while you do not regulate a rating 
agency, you are the that has given them authenticity, correct?
    Ms. Nazareth. Certainly we have some involvement because of 
this designation process.
    Mr. Shays. So if you believe that maybe the rating agencies 
did not do their job, do not you have the ability to--in other 
words, de-designate them?
    Ms. Nazareth. Well, that is one issue. I do not think that 
we have considered in this instance that they were subject to 
designation but I think that----
    Mr. Shays. Why not, why not?
    Ms. Nazareth. Because in general, I think, as we said 
earlier, ultimately--if we believed that there was a systemic 
issue, clearly that is something that the Commission or the 
staff should consider. I think if you look--there have been 
some, there is no question about it, colossal failures.
    And we have discussed many of them here today, WHOPPS, 
Orange County, New York City, but you know the track record in 
general. It is public--they publish it. It is quite admiral in 
terms of the track record and in terms of predicting the 
repayments on debt securities. And I think nobody is a 
guarantor in this area. This is an area of you know, financial 
analysis and opinion.
    So----
    Mr. Shays. Do you believe that the rating agencies 
adequately serve the public in continuing to rate Enron's 
investment grade four days before bankruptcy rating the 
California utilities A-2 weeks before it default, in rating 
WorldCom investment grades three months before bankruptcy and 
rating Global Crossing investment grade four months before 
defaulting on loans?
    Ms. Nazareth. What was your question--did they serve the 
pubic?
    Mr. Shays. Yes.
    Ms. Nazareth. I do not think it was their finest hour.
    Mr. Shays. Would you say that is an understatement?
    Ms. Nazareth. In this case, I said I am not sure the 
reasons for their inability to detect the problems, but 
certainly the result was extremely problematic. And we all know 
what the affects of that were.
    Mr. Shays. I would just say Mr. Chairman, that the 
challenge I am having is that I think you wrote a very thorough 
statement of all the things you are reviewing, but I do not 
feel any passion in your voice. I do not feel any sense of 
responsibility in your position. And it makes me tremendously 
concerned.
    I thought I was giving you a softball that you could have 
knocked out of the park. I thought I was basically giving you 
the opportunity to say, ``I was horrified. It caused us to look 
at what we are doing and how we might make a better 
contribution. It got us thinking of recommendations we might 
make to the legislative body on ways that we could protect the 
public interest to make sure things were done better.''
    I get the feeling that basically you all are pretty much 
asleep. That is the feeling I get from the way you responded to 
me.
    Chairman Baker. Your question is, ``Did you know that all 
of those things?'' That is your question. I was just framing it 
for you as a question instead of a statement.
    Mr. Shays. I would like you to do it. That is your 
question.
    [Laughter.]
    Chairman Baker. Thank you, Mr. Shays.
    If I may, Mr. Scott, you are next.
    Mr. Scott. Thank you very much. Ms. Nazareth let me ask you 
this, could you explain to me why three credit rating agencies 
are exempt from the SEC rules on corporate disclosure?
    Ms. Nazareth. I am glad you asked that question, because 
there is some misunderstanding about how reg FD works. All 
credit rating agencies that publicly disseminate their views, 
whether or not they are NRSROs--have an exemption from reg FD.
    At the time that reg FD was promulgated I think the belief 
was and continues to be that you want credit ratings to be as 
knowing and be based on as much information as possible. And to 
the extent that there is some information that issuers might 
feel free to share with the rating agency, that could be 
factored into the rating and therefore, have the rating be to 
some extent more accurate and timely, that that was an 
appropriate exception, particularly since the rating then is 
widely disseminated.
    So it was within keeping of the spirit of reg FD whether or 
not the full basis on which the rating was promulgated was 
known. The fact of the matter is that there would be wide 
dissemination of a rating that included this information. And 
that therefore you would have a better more fulsome rating than 
you would have had without it.
    That was the logic.
    Mr. Scott. But as you look at it, do not you think that 
this lack of disclosure has a harmful effect on the decision 
making process?
    Ms. Nazareth. It's not a lack of--it is a question of 
whether or not something is not required to be disclosed at the 
time. If you recall, reg FD said if the issuer were determined 
to disclose something you had that was material that you had to 
widely disseminate to every one. It could not be selective 
discloser.
    In this case again, if it is something that the issuer is 
not obligated at that moment in time to publicly disseminate, 
but feels that it would be important for the credit rating 
agency to know, reg FD would not be an impediment to sharing 
that information.
    It does not require that he share it. If he does share it, 
it is not a violation of the regulation.
    Mr. Scott. These credit rating agencies are sort of like an 
exclusive club. I mean, they cannot get a foothold in the 
industry, in the business without the SEC's approval. Is that 
right?
    Ms. Nazareth. Well, I think credit rating agencies in 
general, you know, there are many of them and they can--and 
many of them are quite successful. I think the issue is the 
designation as a nationally recognized statistical rating 
organization which is more selective.
    Mr. Scott. Can't get that without the SEC approval?
    Ms. Nazareth. Yes.
    Mr. Scott. Well, why have there not been any new rating 
agencies designed in the last 10 years? Do you see that as a 
problem?
    Ms. Nazareth. I guess I have to put it in the context of 
how many have applied as well.
    Again, we think there are some natural barriers to entry 
here. There have not been that many applications. As you may 
know, at one point we were up to seven and because of 
consolidation in the industry, those seven who had been 
designated went down to three.
    And I would say in the last ten years we probably had about 
four or five additional rating agencies who had applied who did 
not receive the designation. We have currently three or four 
that are pending.
    So we are not talking about scores of people who have come 
in who we have turned down. There has been a limited number, 
obviously some of them have received the designation and I 
think we took action in 1999, on Thompson Bank Watch, which had 
had a limited designation. And so we expanded their NRSRO 
designation to cover a wider variety or products in 1999. And 
then as you know, recently we had Dominion approved. So we are 
now up to four.
    Mr. Scott. Are there artificial barriers?
    Ms. Nazareth. Well, that is what we want to be sure that we 
are not creating. I think we are trying to ensure that there is 
some discipline on this process because we use the designation 
for regulatory purposes. But I think the Commission is very 
interested in ensuring that they are not creating artificial 
barriers that exacerbate any competitive issues.
    Mr. Scott. So there are barriers, but you would say they 
are more natural market forces?
    Ms. Nazareth. Well, there certainly are a lot of natural 
market barriers.
    The question is, are there things that the Commission could 
do to ensure that their regulatory process does not make it 
worse.
    Chairman Baker. Mr. Scott, your time is winding up. If you 
could make this your last one, sir.
    Mr. Scott. Well, I just would like to say that I think that 
there is a challenge here for the SEC to move forthrightly to 
make for better competitiveness as an--just--is there--is there 
general agreement on whether greater regulatory oversight of 
these credit agencies is warranted? Is it pretty much agreed?
    Ms. Nazareth. No. I think that the Commission has an open 
mind about it and is seeking comment on that through the 
concept release--which explains my lack of passion in my 
testimony. I think that the Commission is truly open minded 
about what inputs it gets back in the context of the concept 
release.
    And I think we will also carefully look at the authority 
issues and determine if additional regulation is warranted, in 
which case we may also seek further authority from Congress.
    Mr. Scott. Thank you Ms. Nazareth.
    Chairman Baker. Thank you Mr. Scott.
    Mr. Capuano?
    Mr. Capuano. Thank you, Mr. Chairman.
    Ms. Nazareth, do not confuse me with Mr. Shays. I have no 
softballs to throw at you.
    Ms. Nazareth. Oh, great.
    Mr. Capuano. I have to tell you that I came to this hearing 
today because I wanted to make sure that I was on record as 
telling the SEC that think you have done a minimal job at best 
in reaction to this crisis that has been facing us now for 
almost two years. If it was not for the state attorney general 
in New York, I think that you would have done even less than 
you have done.
    So I am not a happy camper. I do not that the investing 
confidence has come back. I do think that today's situation or 
today's hearing relative to rating agencies is just another 
part of it.
    But it amazes me, absolutely amazes me that average people 
can see the potential conflict in the private end in what the 
agencies do. Every single one of them, just like auditors, are 
afraid that the people they are rating are going to go to 
another rating agency if they rate them too harshly. How is 
that not seeable? How is that not clearly understood?
    And when you have that situation, I think there is no 
answer other than relatively strict regulation or at least 
oversight from somebody. And the only somebody is the SEC.
    That is who the public looks to. They look to the SEC.
    And for the SEC to sit back and say, ``Well, we are not 
sure. We have been thinking about this for--well, since 1994. 
We are going to continue to think about it. We have a lot of 
questions.''
    To me is, well, why bother. Why bother? Forget your concern 
or anybody's concerns for the general public's faith in the 
system. The credit rating agencies, just like the auditors, 
have a financial push to not anger their clients.
    Very simple. Having been involved with credit rating 
agencies in the past, their desire to delve deeply into the 
numbers underwhelmed me every time I ever dealt with them.
    Cookie cutter stuff, did not fit into the cookie cutter, 
fine if it did, fine. Very little--very few questions. And here 
is the rating.
    And you know as well as I do that the average investor, 
that includes the small investor who might just wonder what 
their mutual fund is doing, they may not read the credit report 
but they certainly will know that it is an A or double AA or a 
triple BBB or whatever it is going to be. They know that.
    And the individual companies themselves use those ratings 
as advertising. You know that. ``Oh, we got an A. We got a B.''
    That is what it is all about. And to worry about or to 
take, I do not know, I think I read somewhere since 1994, if 
you want to certify a group, do it and make it count. If you do 
not, then do not.''
    These people are walking around and that does not mean that 
everybody is doing a bad job. I do not mean to imply that. But 
the ones who do not do their job, clearly there have been many, 
but the ones who do not do their job are walking around with 
their CC certification which tells the investing public, ``It 
is fine.''
    How is it that you do not see a problem with that? How is 
that there is still debate in the SEC to do something? How is 
that possible at this point in time after the crisis that we 
continue to suffer from?
    Ms. Nazareth. I do not think that there is any question 
that the Commission considers it a very important issue. I 
think--you actually stated it quite clearly. I think where we 
are is that given that we do give this NRSRO designation--we 
either have to be in or out.
    We either have to stop giving the designation and basically 
say we have no oversight responsibility over these entities. 
And clearly the statute does not specifically say that we are 
supposed to be overseeing credit rating agencies, or if we are 
going to continue to designate these entities, there has to be 
certainly more transparency to the process. And it will raise 
further issues of what additional oversight is necessary.
    I think we are in a difficult position right now because 
once you designate an entity, I think it does leave the 
impression that there is more being done on any ongoing basis. 
And I think that is the challenge that the Commission has and 
we are hoping that in the next few months once they basically 
analyze more current feedback that they get from the soon-to-
be-released concept release, that they will make a 
determination.
    Mr. Capuano. The last time they asked for feedback and they 
analyzed it, they basically decided to do nothing. Do I have 
any faith whatsoever--should I have any faith that something 
will be done, anything will be done?
    Ms. Nazareth. I would think so. I also think that the 
concept release of the time was probably somewhat more limited 
than the issues that we are looking at now.
    So, I think there is much more focus on the issue how.
    But suffice it to say, as others have said here, that it is 
a very complicated issue. But----
    Mr. Capuano. I understand that it is a complicated issue. 
Everything is complicated in life. I understand that, but at 
the same time for me, I do not care. The SEC gets paid and now 
hopefully gets paid more than they used to----
    Ms. Nazareth. We thank you for that.
    Mr. Capuano. Well, happy to do that. I think it was 
worthwhile. But it gets paid to deal with complicated issues.
    Ms. Nazareth. Uh, huh.
    Mr. Capuano. My mother relies on your goodwill and your 
positive action to do your best within reason obviously, to 
make sure that her investment is reasonably safe. We need some 
speed here.
    I need some speed here.
    Ms. Nazareth. Right.
    Chairman Baker. Speaking of speed, Mr. Capuano, your time 
has expired but----
    Mr. Capuano. Thank you.
    Chairman Baker. Thank you, Mr. Capuano.
    I would like to suggest for members, because everybody has 
a sincere interest in this, as opposed to going to a second 
round with five minutes for everybody, that everybody who 
chooses can ask--well, we have members who have not yet--do you 
have questions?
    Okay. Mr. Ney?
    Let me recognize Mr. Ney for his five minutes, and then we 
will go to a second round with each member having the option to 
ask two more questions just to make sure we have vetted 
everything.
    Mr. Ney?
    Mr. Ney. Thank you, Mr. Chairman. One question I wanted to 
ask is about the rating firms. You know, the rating firms are 
essentially private research firms. They have been granted a 
government benefit in the form of a monopoly power they enjoy 
as a result of receiving an NRSRO status from the Commission's 
staff.
    Why should they also get special access to information that 
reg full disclosure restricts from the public?
    Ms. Nazareth. They do not have a unique benefit under 
regulation FD. All credit rating agencies whether or not they 
are designed as an NRSRO have an exception under reg FD.
    Mr. Ney. So they do not have special access to information?
    Ms. Nazareth. They do not. They do not. NRSROs alone do not 
have special access.
    Mr. Ney. Okay. The other question, Mr. Chairman, I had is 
Standard & Poor and Moody's control about 80 percent of the 
credit ratings market. In light of the fact that a rating from 
two different firms is typically needed for issuing new debt, 
the two firms do not actually compete against each other.
    Even though S&P and Moody'ss have failed repeatedly to warn 
investors, their revenues have not suffered because there are 
few alternatives.
    What do you think could be done to counter what I consider 
unhealthy conditions?
    Ms. Nazareth. Well, I think there is some issue as to 
whether or not there are natural barriers to entry, but one of 
the things that the Commission is interested in ensuring is 
that it is not sort of adding to the competitive problems 
through its regulations. So that is something that is the 
subject of great Commission focus right now and will be 
hopefully addressed through the concept release, the questions.
    Mr. Ney. So this subject is under internal discussion----
    Ms. Nazareth. It is under internal discussion, yes.
    Mr. Ney. Is there a timeframe or guesstimate or----
    Ms. Nazareth. Well, we are hoping that the concept release 
will be issued within the next few weeks and then from there, 
we will take the data and the Commission will determine what 
further steps it wishes to take.
    Mr. Ney. Thank you.
    Thank you.
    Chairman Baker. Thank you, Mr. Ney. And starting our second 
round now, we would recognize any member for a couple of 
additional questions. I just want again reiterate my 
appreciation for your appearance.
    I have two questions that are not troubling, but of 
interest. S&P for example, is a publicly owned corporation that 
has its stock traded in the public market.
    Who rates them?
    Ms. Nazareth. Who rates S&P? I do not know.
    [Laughter.]
    Chairman Baker. Because it would seem that if--if we have 
only four them and they are all publicly traded stock----
    Ms. Nazareth. Right.
    Chairman Baker. And you in normal conduct of business, you 
have to get access to capital, if you are going to get access 
to capital, you have to have a rating. It has to be by a 
nationally recognized rating organization.
    Secondly, it is I think generally known that there are 
officials of the credit rating corporations, to make it clear, 
there are businesses making business judgments for their own 
shareholders who serve in either a board or administrative or 
executive capacity who also serve on the boards of the 
companies they rate.
    Now that to me is an extraordinary--a difficult matter.
    Has the SEC looked at that relationship or an executive in 
a rating agency serving on a--as a board member of a company 
which they are not rating?
    Ms. Nazareth. No, we have not. If that is the case, I think 
that is a good area of pursuit. We have more to suggest but we 
will get to those later.
    That is my two questions.
    Mr. Miller?
    Mr. Miller. A quick couple of questions. All of our 
concerns about conflict of interest, about the lack of 
detachment by these agencies does seem to date from the 
agencies from being paid principally by investors being paid 
principally by issuers.
    Is it possible to go back? Can the market work? Can we get 
that genie back in the bottle?
    Ms. Nazareth. You know, the rating agencies themselves may 
be able to speak more directly to that. I think the reason it 
switched originally was because it is very difficult in a world 
where information is sort of freely disseminated through 
technology to be able to make their money through subscriptions 
because these ratings become widely known, and you know, there 
is sort of a free-rider effect.
    So this was really their alternative to that problem. And 
certainly the rating agencies can address, how they think the 
potential conflicts are mitigated. Largely it is done, I think, 
both through their view that their franchise value is based 
substantially on the integrity of their ratings.
    That is certainly one thing they argue. But also they rate 
so many issuers that their income is not reliant to any 
significant extent on any one issuer so that they do not feel 
that they are unduly influenced by an issuer leaving because 
there is no concentration.
    Mr. Miller. Second question. Mr. Shays pointed out the 
number of times that changes in ratings did not appear until 
immediately before bankruptcy. That also may be because the 
change of rating precipitated bankruptcy.
    One of the things that seems to be most troubling about the 
amount of power that these agencies have and the lack of--and 
relative lack of regulation either by the marketplace or by 
government or anybody is those triggers. Do you think that 
those are a necessary part of the marketplace having 
accelerated payments on debt because of changes in ratings?
    Ms. Nazareth. I think that is a great question. I think 
certainly one of the lessons learned from some of these 
situations is that we need a greater understanding of the 
ratings triggers. I think from what I understand the credit 
rating agencies themselves do a more rigorous job now of 
understanding where all of the ratings triggers are and what 
impact the change in rating would have.
    And I also think that it is something the Commission will 
consider in terms of adding more disclosure information as 
well, because it obviously has a material effect. There is in 
some sense a spiraling effect when things go bad if you have 
these triggers that as you say, precipitates a bigger crisis.
    Chairman Baker. Thank you, Mr. Miller.
    Mr. Shays?
    Thank you Mr. Chairman.
    Mr. Chairman, I am going to make two observations. One is 
that when I have an employee, I want an employee who is 
anticipating problems and looking for solutions.
    And so Ms. Nazareth, I understand you are not a 
Commissioner, but this is your area. And I want to go on record 
as saying that I believe your lack of energy points out that a 
fire needs to be lit underneath you.
    Tell me why I should take more comfort in the four rating 
agencies that basically have your ``no action'' stamp of 
approval than I should on the ones that do not?
    In other words, it strikes me that there are some rating 
agencies that do not have the status of your stamp of approval 
that really have done a better job. Why should I be comfortable 
when I look at what two of these firms have done, they have 80 
percent of the business and they do not compete with each 
other.
    Why should I take comfort in what they have done?
    Ms. Nazareth. We are not by virtue of designating these 
entities saying that any of these other ratings services cannot 
be used. What we are saying is that we had tried very narrowly 
for purposes of our regulations to determine that we had 
agencies that were nationally recognized and as Mr. Miller 
suggested, who were significant enough and whose ratings 
presumably would not be influenced by other factors, like other 
competitive factors, to have credible ratings.
    Obviously, you have raised a number of important issues 
that the Commission will consider. I take issue with your 
characterization unfortunately of a lack of zeal. I think that 
you are perhaps misinterpreting a cautiousness on my part 
because I am in fact representing the views of a number who may 
not at this moment in time have completly formulated their 
views on what the Commission is going to do.
    But I can assure you that the Commission is examining this 
issue with a tremendous passion and that there is a huge amount 
of effort going on at the Commission to come to the right 
answer on this.
    And again, if we feel that more is needed to be done, we 
may in fact be back here asking Congress for additional 
authority to do more in this area.
    Mr. Shays. Well, the fact that you would ``if I feel more 
that needs to be done,'' we all know that more needs to be 
done. It is the question of what needs to be done.
    My second question, living with the format of the question, 
is to ask why should I draw comfort that there are no formal 
requirements to have your stamp of approval and it is not 
transparent?
    Why should I draw any comfort from that at all?
    Ms. Nazareth. I am not suggesting that you draw comfort 
from that. It is quite clear that if the Commission continues 
to use this designation, there will be much greater 
transparency around that process. I have no doubt about that at 
all.
    Mr. Shays. And so the proposed rule of 97, maybe we will 
finally be acted on?
    Ms. Nazareth. Or some other form of it, yes.
    Mr. Shays. Interesting that it is a proposed rule in 1997, 
isn't it?
    Ms. Nazareth. Yes.
    Chairman Baker. Thank you, Mr. Shays.
    Mr. Kanjorski?
    Mr. Kanjorski. Who is going to win the World Series?
    [Laughter.]
    Thank you very much, Mr. Chairman.
    Ms. Nazareth. Happy birthday.
    Mr. Kanjorski. Thank you.
    Chairman Baker. Thank you, Mr. Kanjorski.
    Ms. Capito?
    Mr. Shays. Can I make an observation?
    I like Mr. Kanjorski, when it is not his birthday. He is 
just too nice today.
    [Laughter.]
    Totally out of character for the record.
    [Laughter.]
    Mr. Kanjorski. One day here----
    Chairman Baker. Officially no comment?
    Ms. Capito?
    Mr. Ney?
    Ms. Hart?
    Mr. Scott?
    Mr. Scott. Yes, I would like to--let me ask you in terms of 
regulatory oversight, do you think that the Securities and 
Exchange Commission should monitor credit agency compliance 
with performance and training standards?
    Ms. Nazareth. That is something that is under very serious 
consideration by the Commission. I know that was something that 
was recommended in one of the congressional reports. And it is 
one of the items that is going to be explored in the concept 
release.
    Mr. Scott. What about you? What do you think? Do you think 
this should be done?
    Ms. Nazareth. I think if we continue to use this 
designation we cannot be sort of half in. If we are going to do 
that, then we are going to have to do more rigorous oversight. 
Exactly what form that will take I do not know and whether or 
not we need to come for additional authority is also an open 
question.
    Mr. Scott. Okay.
    Ms. Nazareth. But it is for the Commission to decide. I do 
not have a vote.
    Mr. Scott. Let me ask you this question about conflict of 
interest.
    Chairman Baker. And that will have to be your last, Mr. 
Scott so we can wrap up. Thank you Mr. Scott.
    Mr. Scott. What do you think should be done about potential 
conflicts of interest that arise when insurers pay for ratings 
and when rating agencies develop additional fee based services?
    Ms. Nazareth. That definitely raises questions for us. As 
you may know, at this point, the additional fee-based services 
that the credit rating agencies, that those businesses are 
involved in, are rather small. But certainly, intellectually, 
it raises all the same issues that we saw with the accounting 
industry. So that is another issue that the Commission is 
looking at very closely.
    Mr. Scott. Thank you, Ms. Nazareth.
    Chairman Baker. Thank you Mr. Scott.
    Let me express my appreciation on behalf of the committee 
for your willingness to participate at such length. Your 
appearance here has been a great help to the committee, and we 
look forward to working with you on the results of the concept 
study. And appreciate the efforts of the agency .
    Thank you very much.
    Ms. Nazareth. Thank you.
    Chairman Baker. At this time I would like to call up our--
members of our second panel, please. I want to welcome each of 
you here this morning to participate in this informational 
hearing for the subcommittee.
    To the extent possible, I would ask that each witness try 
to summarize their testimony. All of your formal statements 
will be made part of the official record. It is my observation, 
given the interest of members, that the follow-on discussion 
between the committee members and each of you will probably be 
of great interest to us. And given the number of folks we have 
to hear from this morning, please try to constrain your remarks 
to no longer than five minutes.
    To that end, I would like to begin by calling on the 
managing director of Egan-Jones Ratings Company, Mr. Sean J. 
Egan.
    Welcome, sir.

   STATEMENT OF SEAN J. EGAN, MANAGING DIRECTOR, EGAN-JONES 
                          RATINGS CO.

    Mr. Egan. Thank you.
    My name is Sean Egan. I am managing director of Egan-Jones 
Ratings, a credit ratings firm. By way of background, I am the 
co-founder, and we were established for providing timely, 
accurate ratings to institutional investors.
    We are dissimilar to the rating firms that are currently 
recognized by the SEC, the NRSROs, in that we are not paid by 
the issuers of ratings. We think there is a fundamental 
conflict of interest, and we do not think that it is 
surmountable.
    We are paid by approximately 300 institutional investors 
and broker-dealers. Unlike the current NRSROs, we provided 
warning to investors on the major debacles, such as Enron, 
WorldCom, Global Crossing, Genuity.
    We are based in the Philadelphia, Pennsylvania, area, but 
we have employees that are in other offices.
    We believe that the rating industry is flawed in a couple 
of fundamental ways. One is that there is little competition. 
This is not an oligopoly. People refer to it as an oligopoly; 
it is not. What it is is a partner monopoly. That is, that you 
have two firms, S&P and Moody's, having between 80 and 85 
percent of the revenues in this business, and neither of them 
compete against each other because you need two ratings, 
typically, for a bond underwriting.
    So, if S&P is awarded a designation for rating a particular 
issue, Moody's is soon to follow. It is not as if they are 
competing against each other, unlike the accounting firms. In 
fact, they are side by side.
    The second problem, of course, is that there is a conflict 
of interest. The major rating firms, S&P and Moody's, used to 
be paid by the users of credit ratings, but that changed 
approximately in the mid-1970s, whereby they received the bulk 
of their rating, their fees, now from the issuers.
    Some people refer to this as a natural oligopoly. We 
disagree. It is not a natural oligopoly in any other way than, 
let's say, the financial analysis industry, or the money 
management industry; you do not have two firms controlling 80 
to 85 percent of the industry. Likewise, in the equity research 
area you do not have two firms controlling 80 to 85 percent. It 
is simply not a natural oligopoly. There have been barriers 
that have been set up for getting this NRSRO designation.
    Because of the unhealthy state of the credit rating 
industry, investors have lost hundreds of billions of dollars, 
pensioners have lost their pensions, and workers have lost 
their futures.
    Now, the current NRSROs will put up what we call five 
defenses for why they should be the only NRSROs recognized, and 
I will run through these very quickly. I have four in my 
written testimony, but we added a fifth.
    One is issuer misdeeds. That is that the issuers did not 
tell us that they had fraudulent financial statements. Our 
feeling is that any decent credit rating firm should be able to 
figure it out. There is always fraud. It always happens. When 
Bernie Ebbers has a $400 million loan from the company, that 
should be a fairly good signal that something is wrong.
    The second defense that the S&P and Moody's put up for why 
they missed it is that they have little incentive. We call that 
the Jack Grubman defense, and you heard a little bit about that 
this morning from Annette.
    Our feeling is that, just like Jack Grubman and Henry 
Blodget of Merrill Lynch constitute a small part of their 
respective firms' revenue base, they still misled investors, to 
their benefit. So we do not believe that the little incentive 
argument holds much water.
    A third comment you will hear for the defense of the 
current situation is that ``our reputation is key.'' We refer 
to this as the Arthur Andersen defense, that, ``There is no way 
we would let a rating company be misrated''--this is what they 
will say--``because our reputation is too important.'' Well, we 
think that is trumped by the compensation issue.
    This fourth defense that they will use is the committee 
approach. That is, that, ``We rate things via committee and 
that way no one particular person can affect things.'' We refer 
to this as the lemming defense, that it is very clear that 
there is just one analyst that is looking at the company, it is 
very clear what the hierarchy is, and it is very difficult to 
buck that.
    The last defense that will be used for not changing this 
industry is what we call the ``great, great grandfather 
defense,'' and that is that a firm needs to be established 
around World War I, which is when S&P and Moody's were 
established, to have any sort of presence in this industry. We 
disagree with this.
    We have a number of recommendations. I do not want to get 
into them now. What we would encourage the SEC to do is to 
broaden their definition of what is appropriate for an NRSRO. 
They list national recognition in the United States as being 
the primary criterion for recognition.
    We commissioned a survey. We contacted the SEC before that 
survey, during that survey and afterwards, and that survey 
basically indicated that we had more than four times the 
recognition of any other non-NRSRO firm. We provided that to 
the SEC, we asked for a meeting, they refused to have a meeting 
with us.
    We were somewhat surprised when DBRS was given the 
designation. We had more than four times the recognition of 
them. We asked the SEC what exactly we needed to get this 
designation and they said they simply could not tell us and 
they are still studying it.
    So if you have any additional questions, I will be happy to 
answer them later.
    [The prepared statement of Sean J. Egan can be found on 
page 75 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Egan.
    Our next witness is the Senior Vice President of Federated 
Investors, Ms. Deborah A. Cunningham.
    Welcome, Ms. Cunningham.

  STATEMENT OF DEBORAH A. CUNNINGHAM, SENIOR VICE PRESIDENT, 
                      FEDERATED INVESTORS

    Ms. Cunningham. Thank you, Chairman Baker.
    I am in charge of the taxable money market group at 
Federated investors, which is a mutual fund company based in 
Pennsylvania, and it is in that context that I offer my remarks 
to you here today.
    The group that I am in charge of at Federated is required 
from a regulatory standard to utilize the ratings from the 
various NRSROs, and this is set forth by Rule 297 from the 
Investment Company Act of 1940, which requires money market 
funds to utilize NRSROs as information in the minimal credit 
risk determination that we make. It is one piece of the puzzle 
that is used in the determination of creditworthiness that our 
analysts use, but we are required to do so.
    The securities that the funds that I manage purchase are 
generally corporate notes from either financial-or industrial-
type corporations, as well as asset-backed securities. The 
asset-backed securities that I purchase are required, again 
from a regulatory standpoint, to have NRSRO ratings, while that 
requirement is not mandatory for the corporate securities that 
we purchase. On average, however, though, 99 percent of the 
securities that I purchase in the funds that I manage are 
indeed rated by at least one NRSRO.
    On the positive side, I think that the content of the NRSRO 
writeups that have been disseminated has improved drastically 
over the last several years. The qualitative information, as 
well the timeliness of those writeups is very good.
    On the negative side, there have been instances in recent 
times when I have reviewed information that shows data that is 
more than 18 months out of date. So it is obviously not a 
perfect scenario yet in this context.
    The NRSRO reports are helpful from my analysts standpoint 
because they are concise, they offer peer-group information, 
show industry averages, industry comparisons. They also show a 
large array of historical information, so you are able to look 
at some trend analysis from this information that is 
disseminated by the rating agencies.
    In general, then, they have a summary that has positives 
and negatives that effectively is the justification for the 
rating that in fact that rating agency is giving to that 
particular company.
    The NRSROs are also providing clues for future financial 
health of the particular entities that we are using by way of 
their outlook and by way of their watch lists. The watch list 
companies are basically those who are closer to having their 
ratings change, either upward or downward, in the near future.
    Occasionally, however, an issuer will be downgraded without 
first having a negative outlook or first being listed on a 
watch list as a potential downgrade, and this causes a lot of 
havoc in the marketplace. It is a very disruptive procedure.
    The reason for those sort of sudden surprise changes can be 
necessarily a sudden surprise change in the information that is 
being disseminated by the company or it can be 
misrepresentation or a misunderstanding of the information that 
had been previously disseminated.
    Whichever the case is, I think an improvement that we would 
like to see would be for any type of sudden, unexpected changes 
by the NRSROs to be accompanied by a more detailed, transparent 
statement as to why those changes occurred and what the future 
outlook will be for other such changes.
    Switching to asset-backed securities for a second, these 
issuers are special purpose entities, they are not publicly 
traded, publicly held companies, so the information that is 
available in the marketplace for them is much, much lower than 
it is for publicly traded corporates and financials.
    The NRSROs do require a great amount of information to be 
submitted in order for them to rate these special purpose 
entity, asset-backed securities and they require that 
information on a regular basis to monitor and upkeep that 
rating.
    Another suggestion that I would have for the NRSROs for 
improvement would be to better disseminate a lot of this 
information to the investing community so that we are not 
always at odds trying to get that information directly from the 
issuers.
    Now let me address for a second the issue of fees. The fees 
that are paid by fund companies, such as Federated Investors, 
who manage money market funds and other types of bond funds, 
are a substantial portion of the advisory fees that we charge 
our customers for those funds.
    Although these fees may indeed pale to what the issuers are 
actually paying those NRSROs, I guess I believe that it is 
incremental enough that the rating agencies are in fact looked 
upon by us as being unbiased third-party experts.
    In order to ensure this unbiased quality, I think all of 
the contract negotiations that take place for fees from the 
issuers to the rating agencies should be done away from the 
analysts and the committee members that are actually 
responsible for designating ratings for that particular 
company. And I am not sure if that is the case today or not.
    With regard to additional fee-based businesses, I guess I 
take a different tack, and it is one that we are familiar with, 
in that I have many of the funds that I manage rated by the 
rating agencies themselves.
    And in those instances some of the rating agencies dictate 
that the securities that are held within those funds are also 
rated by that same NRSRO. So this seems to be a little bit of a 
bad business practice that I think could be amended in that, as 
long as there is any rating on those securities within those 
rated funds, this should suffice.
    Let me recap by looking at the current NRSRO status. The 
SEC most recently designated Dominion Bond Ratings as the 
fourth NRSRO. At one point there was a high of seven NRSROs and 
through consolidation that shrunk down to three.
    I think this recognition of DBRS as the fourth agency is 
one that is welcome. Investors are always looking for 
additional information and additional opinions, and we are in 
the process right now of negotiating with DBRS as to how we are 
going to utilize their information.
    I think that the addition, though, of these NRSROs should 
be deliberate and it should be detailed by the Commission. 
However, more transparency in that process is probably a good 
idea.
    [The prepared statement of Deborah A. Cunningham can be 
found on page 71 in the appendix.]
    Chairman Baker. Thank you very much, Ms. Cunningham.
    Out next witness is the Executive Vice President of 
Dominion Bond Rating Service, Mr. Greg Root.
    Welcome, sir.

STATEMENT OF GREG ROOT, EXECUTIVE VICE PRESIDENT, DOMINION BOND 
                         RATING SERVICE

    Mr. Root. Thank you very much. I would like to thank you 
and the subcommittee for giving us the opportunity to address 
such an important issue today.
    As we all know, ratings have become a key, integral part of 
the financial markets, and therefore I think it is imperative 
that there be a clear understanding of the role of rating 
agencies, how they operate and how they compete.
    Let me begin with just a brief overview of Dominion Bond 
Rating. We are based in Toronto, founded in 1976 by Walter 
Schroeder, who remains the company's president. And DBRS is 
employee owned. We do not have public shareholders, we are not 
affiliated with any other organization and we limit our 
business to providing credit ratings and research.
    DBRS is what we call a general rating agency in that we 
analyze and rate a wide variety of institutions and provide 
credit research on these as well.
    We currently rate about 700 different entities, and we have 
about another 250 companies, most of which are based here in 
the U.S., that we are providing credit research on without 
ratings.
    DBRS has 65 employees and we have 45 analysts at this time.
    Since our inception, DBRS has been widely recognized as a 
provider of timely, in-depth, impartial credit analysis. Our 
opinions are conveyed to the marketplace using a familiar, 
easy-to-use letter grade rating scale. These ratings are 
supported by extensive research, which include detailed reports 
on individual companies, as well as comprehensive industry 
studies.
    This information is disseminated through various means, 
including a proprietary subscription service, which is used by 
more than 300 institutional investors, financial institutions 
and government bodies.
    DBRS credit ratings reflect the company's opinion as to the 
likelihood of timely payment in full of principal and interest. 
In arriving at these decisions, our team of analysts consider a 
wide range of quantitative and qualitative factors that could 
affect the future creditworthiness of the issuer or specific 
instrument in question.
    As part of the process, we maintain an ongoing dialogue 
with the managements of the companies we rate. All ratings are 
processed through a committee system and are reviewed 
constantly. Ratings are changed whenever we are of the opinion 
the relative creditworthiness has changed positively or 
negatively.
    Next I would like to say a few words about the role of 
rating agencies in the capital markets. Again, over the past 30 
years the SEC, other federal and state regulators and even 
Congress have increasingly relied on credit ratings as a way to 
monitor the risk of investments held by regulated entities. In 
addition to these legislative and regulatory uses, NRSRO credit 
ratings are widely used extensively in debt covenants and other 
financial instruments between private parties.
    I am pleased to say that the confidence the regulators and 
the markets have shown in the rating agencies is not misplaced. 
While ratings are certainly not guarantees of future 
performance, studies show that there is a strong positive 
correlation between ratings and default rates.
    However, although DBRS is proud of the role rating agencies 
play in the global securities markets, we are aware that there 
are certain concerns that have been raised regarding our 
industry, and I would like to touch on a few of these at this 
time.
    First is transparency. At the SEC's rating agency hearings 
last fall we heard institutional investors express a desire for 
a clear understanding of the reasoning behind rating decisions. 
DBRS makes every effort to satisfy this desire by issuing full 
detailed reports on the companies we rate. These reports openly 
convey our views on both current ratings and on the direction 
of ratings. We believe everyones' interests are best served 
when the reasons behind ratings are widely known.
    The second involves conflict of interest. DBRS has worked 
diligently to minimize the potential for conflicts of interest 
in the rating process. My written testimony goes into this 
topic in my detail, but let me just say here that the success 
of our business is primarily based on one key factor: our 
reputation. If at any point investors doubted the independence 
of our judgment, the demand for our services would decline. We 
have no intention of letting that happen.
    And the third is the competition and barriers to entry. As 
the rating that has been most recently granted the NRSRO 
designation, DBRS has somewhat of a unique perspective on this 
issue. Because credit ratings play such an important role in 
the capital markets, we believe that barriers to entry in this 
field should be high.
    That said, the real concern, as we see it, is not so much 
that the barriers make it difficult for new competitors to 
enter the field, but rather that there is no well-defined 
process for designating NRSROs.
    The no action letter process that the SEC currently use is, 
in our opinion, ill suited for this task because the criteria 
for designation are not sufficiently defined, the application 
process is not standardized and adverse decisions on requests 
for designation are not subject to appeal.
    Based on our recent experience, DBRS believes that there 
should be a clear definition of what constitutes an NRSRO and a 
transparent process to enable qualified companies to apply for 
this designation.
    In conclusion, I believe that the credit rating system as 
it exists today works quite well and has helped foster the 
growth of the financial markets globally. In light of recent 
events, it is appropriate that the issues being raised by the 
subcommittee be thoroughly reviewed, and we very much 
appreciate having the opportunity to be part of this process.
    Thank you.
    [The prepared statement of Greg Root can be found on page 
137 in the appendix.]
    Chairman Baker. Thank you, Mr. Root.
    It would be my intent, we have announcement of two votes on 
the floor that are now pending, we have about 10, 12 minutes 
left before the first vote closes, so we could proceed with Dr. 
White's testimony. The committee would then stay in recess for 
15 minutes to go over and come back for the two votes and 
hopefully not inconvenience you too greatly.
    Dr. White is a Professor of Economies at Stern School of 
Business, New York University.
    Welcome, Doctor.

 STATEMENT OF LAWRENCE J. WHITE, PROFESSOR OF ECONOMICS, STERN 
            SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

    Mr. White. Thank you, Mr. Chairman. I am very pleased to be 
here and to have this opportunity to testify before the 
subcommittee. My written testimony states my position in 
greater depth.
    The problem of the regulation of the NRSROs is what I have 
described as ``the SEC's other problem.'' Of course the SEC's 
efforts with respect to corporate governance and public 
accounting is at center stage, but the NRSRO issues could well 
be as important for the efficient operation of the U.S. capital 
markets.
    The SEC's current regulatory barriers to entry into the 
NRSRO category are highly unsatisfactory, and the two potential 
paths out of these difficulties are clear. Unfortunately, the 
SEC's recent report was a great disappointment. It simply 
raised the same old questions instead of pointing toward the 
solutions.
    The basic problem is as follows: Since 1931, financial 
regulators have required their regulated institutions to pay 
attention to the credit ratings of the bonds and obligations 
that they hold. That regulation has grown greatly, especially 
in the past three decades.
    The issue of whose ratings should be paid attention to was 
addressed only in 1975, when the SEC created the NRSRO 
category. It immediately grandfathered into the category the 
three major incumbents, and it then allowed only four 
additional entrants over the next 17 years. But mergers and 
consolidation among those entrants and between those entrants 
and Fitch then reduced the total number back to the original 
three by the end of the year 2000.
    From 1992 until the end of February of this year, the SEC 
allowed no new entrants. Only at the end of February, as we 
have just heard, did DBRS enter this category.
    So that is where we are: greatly expanded regulatory demand 
that financial institutions use ratings, and limited supply of 
SEC-designated approved rating firms, the NRSROs. It is no 
wonder that we are here today discussing the problems of this 
industry.
    Now, it is important to remember: So long as regulators 
delegate their safety judgments to ratings firms, there is 
going to be a need to designate whose ratings should be heeded 
by the regulated financial institutions. So long as we have 
that process set up, this designation is unavoidable. But that 
process forces the capital markets to pay attention primarily 
to the designated entities, and there are unfortunate 
consequences to this whole limitation process. One has to worry 
whether new ideas, new innovations are going to enter the 
marketplace in this kind of framework.
    There are two basic paths that could be followed to get us 
out of these difficulties. The first and best is to have the 
financial regulators withdraw those safety delegations and to 
make the safety judgments themselves. I say this as a former 
bank regulator myself. For almost three years I served on the 
Federal Home Loan Bank Board. I had a number of sessions in 
just this hearing room, Mr. Chairman, some of them enjoyable, 
some of them less so, but I know what it is like. And those 
delegations can be withdrawn, those judgments can be made by 
the financial regulators themselves.
    Once that is done, the SEC could eliminate the NRSRO 
category, and the capital markets would then be free to make up 
their own minds: ``Whose judgments do we follow? Whose 
predictions of default do we pay attention to? What new ideas 
should we be paying attention to?''
    Indeed, they might even ask, ``Do we even need rating firms 
in the 2003, 94 years after John Moody's first started issuing 
ratings?''
    This is the best, the clearest, the cleanest and the most 
market-oriented approach to dealing with these problems.
    But if this route is considered infeasible, then there is 
Plan B: The SEC must cease being a barrier to entry, it must 
actively certify qualified firms as NRSROs and inevitably it 
must periodically assess the suitability of incumbents to 
continue to be NRSROs.
    The SEC in this process must focus on performance: How well 
does the firm, entrant or incumbent, predict defaults?
    In this light, the criteria that the SEC proposed in 1997 
must be scrapped. Those criteria focused on inputs, not on 
performance. An innovative firm that could predict defaults 
well could nevertheless fail the input criteria. Also, the 
criteria create a Catch-22 that could exclude entrants.
    If this expanded regulatory task is considered to be beyond 
the capabilities of the SEC, then there is always Plan A: 
Withdraw those regulatory delegations, then eliminate the NRSRO 
category and let the markets make their own choices and 
decisions.
    The paths are clear, and I disagree with Ms. Nazareth's 
comment this morning. This is not a complicated issue. The time 
for action is now.
    Thank you very much, Mr. Chairman.
    [The prepared statement of Lawrence J. White can be found 
on page 144 in the appendix.]
    Chairman Baker. Thank you very much.
    Time for action has also occurred for me. I have to go vote 
and I will be right back. We stand in recess.
    [Recess.]
    Chairman Baker. If I may ask folks to resume the seats at 
table, we will reconvene. Members will be on their way back as 
they conclude the vote.
    At this time I would like to call on the President and 
Chief Executive Officer of Fitch, Inc., Mr. Stephen W. Joynt.
    Welcome, sir.

  STATEMENT OF STEPHEN W. JOYNT, PRESIDENT AND CEO, FITCH INC.

    Mr. Joynt. Thank you, Mr. Chairman. Thank you for inviting 
me to come participate today.
    My name is Steve Joynt, and I am President and CEO of Fitch 
Ratings.
    Ratings are used by a broad mix of investors as a common 
benchmark to grade the credit risk of various securities. In 
addition to their ease of use, efficiency and widespread 
availability, credit ratings are most useful to investors 
because they allow for reliable comparisons across many diverse 
investment opportunities.
    Credit ratings assess credit accurately in the overwhelming 
majority of cases. Credit ratings have proven to be a reliable 
indicator for assessing the likelihood of a securities default 
possibilities.
    I think it is important to note that while the current 
inquiry into the role of rating agencies has been focused on 
issues surrounding the ratings of corporate issuers, corporate 
ratings only represent approximately 10 percent of the total 
rated universe. Fifty percent or more of Fitch's activities and 
revenues and ratings come from mortgage-backed and asset-backed 
securities analysis. New criteria development, original 
analysis, published research and follow-up surveillance 
information have support transparency in development of these 
markets.
    Fitch is also very active in rating other markets, such as 
global financial institutions and the 1.8 trillion U.S. 
municipal market. Any changes for the rating industry need to 
consider the impact on these markets as well.
    We believe the SEC's review of the rating agencies is a 
constructive process. As a result of this review, the SEC has 
already recommended some improvements to our policies and 
procedures and we are voluntarily implementing them.
    Today's hearings may probe several areas regarding the 
business of rating agencies: regulatory barriers to entry, 
potential conflicts of interest with issuers and information 
disclosure. And I would like to briefly comment on each of 
these.
    At Fitch we firmly believe in the power of competition. 
Fitch's emergence as a global, full-service rating agency 
capable of competing against Moody's and S&P across all 
products and market segments has created meaningful competition 
in the ratings market for the first time in a decade.
    Fitch's challenge to the Moody's-S&P monopoly has enhanced 
innovation, forced transparency in the ratings process, 
improved service to investors and created much needed price 
competition.
    We also believe that there is a demand for insightful, 
independent credit research. The NRSRO system is designed 
appropriately, in our view, to assure that recognized 
organizations possess the competence to develop accurate and 
reliable ratings. Without a system to recognize rating 
organizations for their competence, many important capital 
adequacy and eligibility investment rules used in financial 
institutions regulations would be ineffective.
    To address concerns regarding potential conflicts of 
interest and issuer fees, Fitch goes to great efforts to assure 
that our receipt of fees from issuers does not affect or impair 
the objectivity of our ratings. Fitch culture emphasizes the 
importance of integrity and independence as critical 
foundations of our most important asset, our reputation. Fitch 
has separate sales and marketing teams that work independently 
of the analysts that cover the issuers.
    Our analyst compensation philosophy reflects quality of 
effort and individual accomplishment in research and ratings. 
Individual company fees, revenue production and individual 
department profitability do not factor in analyst compensation.
    Analysts may not own securities in companies that they 
rate. Fitch does not have an advisory relationships with 
companies it rates.
    Another issue that merits discussion is better disclosure 
of information. We believe for the most part the credit rating 
agencies have adequate access to the information they need to 
form an independent and objective opinion about the 
creditworthiness of an issuer. Non-public information is 
provided to the rating agencies as part of the rating process. 
The nature and level of that information varies widely, by 
company, industry and even country.
    Typically, it is not the value of any particular piece of 
non-public information that is important to the rating process, 
but that access to such information and senior management can 
assist us in forming a qualitative judgment about a company's 
management and its prospects.
    At Fitch, we are working to encourage transparency 
throughout all sectors of the capital markets. As we found in 
our recently published study on credit derivatives in the 
global market, financial reporting and disclosure with respect 
to areas such as credit derivatives. off-balance-sheet 
financing and other forms of contingencies varies greatly by 
sector. Comparability is further obscured by differences in 
international reporting and accounting standards.
    If this type of information is difficult for us to obtain, 
it is almost impossible for the typical investor. Better 
disclosure not only leads to more accurate ratings, it creates 
a more informed investor.
    Fitch is an independent global rating agency valued by the 
credit markets, and we are here today open to all suggestions 
on how to improve our industry's performance and our 
performance.
    Thank you.
    [The prepared statement of Stephen W. Joynt can be found on 
page 87 in the appendix.]
    Chairman Baker. Thank you, sir.
    Our next witness is Mr. James A. Kaitz, President and Chief 
Executive Officer, Association for Financial Professionals.
    Welcome, sir.

STATEMENT OF JAMES A. KAITZ, PRESIDENT AND CEO, ASSOCIATION FOR 
                    FINANCIAL PROFESSIONALS

    Mr. Kaitz. Thank you, Mr. Chairman.
    I am Jim Kaitz, President and CEO of the Association for 
Financial Professionals, and we thank you for the invitation 
today.
    Chairman Baker. And I took my best guess on the name. I am 
sorry. Mr. Kaitz.
    Mr. Kaitz. You did a great job. Thank you.
    AFP represents 14,000 finance and treasury professionals 
from over 5,000 organizations throughout the United States. Our 
members are drawn generally from the Fortune 1000 and the 
largest of the middle market companies in a wide variety of 
industries.
    Our members are responsible for issuing short-term and 
long-term debt and investing corporate cash and pension funds 
for their organizations. They rely on the rating agencies when 
their companies issue debt and when they make investment 
decisions. As such, their experience with the rating agencies 
provides them with an opportunity to form opinions on both the 
strengths and weaknesses of the agencies.
    AFP's members recognize the important role that the SEC and 
the rating agencies play in ensuring the efficient operation of 
the capital markets.
    In September 2002, we surveyed senior-level corporate 
practitioners, such as chief financial officers, vice 
presidents of finance and corporate treasurers, regarding the 
accuracy and timeliness of credit ratings, the role the SEC 
should take in regulating the rating agencies, and the impact 
additional competition may have on the marketplace for ratings 
information.
    In summary, survey respondents expressed concerns about the 
accuracy and timeliness of credit ratings. Twenty-nine percent 
of corporate treasury and finance professionals who work for 
companies with rated debt indicate that their companies' 
ratings are inaccurate. This is true for companies that have 
recently been upgraded, as well as for those that have been 
downgraded.
    Respondents from companies that have seen their debt 
upgraded indicate that the change took place more than six 
months after the improvement in the company's financials.
    Additionally, some respondents from companies that were 
downgraded report that it took more than six months for their 
ratings to reflect a deterioration in the company's financial 
condition.
    The survey also found that rating agencies are primarily 
serving the interests of parties other than investors. Less 
than one-quarter of treasury and finance professionals believe 
that ratings most favored the interests of investors. Rather, 
they believe ratings favored debt issuers, investment banks and 
commercial banks.
    Our members believe that the SEC plays an important role in 
overseeing the rating agencies. The overwhelming majority of 
respondents indicate that the SEC should take additional steps 
in the oversight of the rating agencies.
    Currently, there is no clearly defined process for credit 
agencies to achieve nationally recognized statistical rating 
organization status. Most respondents believed that the SEC 
should clarify the procedures it follows to determine whether 
it will recognize a rating agency as an NRSRO. Granting NRSRO 
status to other credit-rating agencies would provide additional 
competition that could result in improved accuracy and 
timeliness of ratings. Respondents believed that additional 
competition could increase both the accuracy and timeliness of 
credit ratings and lead to greater certainty in the assessment 
of corporate credit risk.
    Once the SEC recognizes a rating agency as an NRSRO, there 
is currently no ongoing process to ensure that the agency's 
methodologies and procedures continued to be appropriate. Our 
survey respondents believe that periodic review of the rating 
agencies is necessary.
    In conclusion, AFP believes that our survey results clearly 
show that the time has come to reexamine the role, function and 
regulation of credit-rating agencies. We are encouraged by the 
SEC report delivered to Congress in January and the issues it 
identified for further examination. Many of those issues are 
consistent with the findings of our survey. We look forward to 
reviewing and commenting on the SEC's concept release when it 
is published.
    We are also encouraged by the SEC's recognition of Dominion 
Bond Rating Service as a fourth nationally recognized 
statistical rating organization. As I mentioned, our members 
expect additional competition to improve the accuracy and 
timeliness of the information provided by rating agencies, 
providing them with a greater certainty in assessing corporate 
credit risk.
    AFP believes that the credit-rating agencies are vital to 
the efficient operation of capital markets and is pleased that 
you have taken the lead in examining these issues. We hope that 
this hearing will bring to light opportunities to increase 
competition in the market for credit ratings and improve the 
quality of the information provided by credit-rating agencies 
for the benefit of issuers and investors in the securities 
markets.
    Thank you, Mr. Chairman, and I would be pleased to answer 
any questions you might have.
    [The prepared statement of James A. Kaitz can be found on 
page 95 in the appendix.]
    Chairman Baker. Thank you, Mr. Kaitz.
    Our final witness is Mr. Raymond W. McDaniel, President, 
Moody's Investors Service, Inc.
    Welcome, sir.

STATEMENT OF RAYMOND W. MCDANIEL, PRESIDENT, MOODY'S INVESTORS 
                         SERVICE, INC.

    Mr. McDaniel. Thank you, Chairman Baker.
    My name is Ray McDaniel. I am the President of Moody's 
Investors Service. On behalf of my colleagues, I appreciate the 
opportunity to be here today.
    As you know, a large number of companies over the past two 
years have experienced serious financial difficulties, causing 
suffering for their employees and sometimes significant losses 
for the investors in their stocks and bonds.
    Attempting to understand, and where appropriate redress the 
underlying reasons associated with these failings, has been 
both necessary and beneficial.
    Yet it is also important to keep in mind that the economy 
and financial markets of the United States remain the envy of 
most of the world.
    Moody's is proud of our role as a supporting participant in 
these markets. Credit ratings help level the playing field for 
information between borrowers and investors. Ratings improve 
both transparency and efficiency in debt markets by promoting 
investor confidence, which in turn allows creditworthy 
borrowers greater access to capital.
    With that perspective in mind, I would like to offer a few 
comments about our industry and Moody's in particular.
    Founded at the beginning of the last century, Moody's is 
the oldest credit-rating agency in the world. From the start, 
Moody's has focused on rating debt instruments.
    Our long-term debt rating system for public bonds is the 
heart of our business. We have 21 long-term debt rating 
categories which provide a relative measure of risk. The 
probability of default increases with each step down our 
ratings scale.
    Our ratings are reliable predictors of relative 
creditworthiness. Their predictive content has been 
demonstrated and consistently confirmed through Moody's 
publication of annual corporate bond default studies and by 
third-party academic analysis.
    What this means is that, as forward-looking opinions, our 
ratings have effectively distinguished bonds with higher credit 
risk from bonds with lower credit risk.
    At Moody's, we are committed to providing the highest 
quality credit assessments available in the global markets. We 
are committed to continuous learning, both from our successes 
and our mistakes.
    In this spirit, we have undertaken substantial internal 
initiatives to learn from recent difficulties in the credit 
markets, as well as in response to potential shortcomings in 
our own analytical approach and in the broader system of market 
checks and balances.
    Our business model is based primarily on receipt of fees 
from debt issuers. Issuers are the natural source of rating 
agency fees for several related reasons, but most importantly 
for one key attribute demanded of our ratings: that they be 
freely and widely disseminated to the investing public.
    Ratings are critical because they condense and transmit a 
great deal of credit information about issuers and because they 
do so for the equal benefit of all investors, publicly and 
promptly.
    We recognize that being paid by issuers creates potential 
conflict of interest. Moody's has taken strict measures to 
avoid conflicts. As a corporation, for example, Moody's does 
not offer investment products, nor do we buy, sell or recommend 
securities. Within our ratings practice, committees, rather 
than individual analysts, assign Moody's ratings. Analysts are 
neither compensated based upon the revenues associated with the 
companies that they analyze, nor are they permitted to hold or 
trade the securities in their areas of primary analytical 
responsibility.
    Over time, the use of our ratings has been adopted by 
numerous capital market participants for multiple and sometimes 
conflicting objectives. For example, issuers use our ratings 
because many investors demand ratings on debt issues.
    Not surprisingly, issuers would like the highest possible 
plausible ratings and greater control over the rating process. 
Large institutional investors often use our ratings in their 
portfolio composition and governance guidelines. Generally, 
these investors prefer stability in the ratings on securities 
that they own.
    Finally, global governmental authorities have incorporated 
ratings into banking, insurance, securities and other 
regulations to limit risk in financial institutions for the 
dual purposes of promoting investor protection and improving 
financial market stability.
    Because each group has different objectives in using 
ratings, the performance or quality of ratings has been 
subjected to multiple assessment processes. In some cases, 
those assessments are incompatible with Moody's goal of 
leveling the information playing field.
    Let me briefly turn to the degree of competition within the 
industry. We are confident of our ability to compete in diverse 
competitive environments, if competing successfully is driven 
by who offers the most reliably predictive credit opinions.
    That form of competition requires diverse, independent 
opinions. As such, we urge that any new framework not 
inadvertently encourage competition based on forced 
harmonization or reduced standards.
    Lastly, we believe that in examining ratings quality and 
rating-agency performance, two essential principles must be 
kept in mind.
    First, ratings at their core must be independently formed 
opinions. They must capably predict bond issuers' future 
creditworthiness, which means that the rating agencies must be 
motivated to act independently of each other, of governments 
and of issuers and their agents to reach the highest standards, 
not the most popular or most convenient standards.
    And second, rating agencies must disseminate ratings 
broadly and promptly to all of the investing public. Without 
this attribute, ratings would cease to be a public good. They 
would become a tool for the few and would further tilt the 
playing field for information.
    Only by preserving these principles can ratings continue to 
fulfill the larger public values of transparency and investment 
protection that the marketplace, regulatory authorities and 
lawmakers expect of us.
    Moody's greatly appreciates the subcommittee's invitation 
to participate in this important panel discussion, and I look 
forward to answering any questions that you might have.
    Thank you.
    [The prepared statement of Raymond W. McDaniel can be found 
on page 123 in the appendix.]
    Chairman Baker. Thank you, Mr. McDaniel.
    To Moody's, especially, Mr. McDaniel, I want to express the 
view that the committee's work is not about any particular 
company's performance in light of the past 36 months of market 
disappointments. But rather an obligation to examine the 
structure and question on periodic basis, whether there are 
alterations that are warranted or significant structures that 
would be justified in light of the past pass performance.
    There have been issues raised, for example, not with 
Moody's, that a rating agency might perform for as much as a 
$150,000 fee, a corporate governance examination to tell the 
corporate management how they can better improve their methods 
of operations in order to presumably enhance their ratings. It 
would be difficult to see someone pay such a fee, and then not 
have a subsequent enhancement in the rating result, otherwise 
the recommendations seem to be without merit. Just that one is 
an example.
    We could go to other issues where a rating agency executive 
could serve on a broad of a company which they might be rating.
    When we went through the Sarbanes-Oxley debate, much was 
made to do about the relationship of analysts with investment 
bankers with clients and that there needed to be more 
separation or at least disclosure where separation was not 
deemed advisable of those relationships; transparency.
    It may be okay to do business with someone for a fee 
outside your principle public responsibility, as long as the 
individuals who rely on that information are made aware of the 
relationship and make their own judgments about the quality of 
that review. I think that is fine.
    And I am not suggesting that we need to have dramatic new 
regulatory structures, but given where we are today, in light 
of some of the comments made by those here on the panel and 
other information brought to the committee's attention, it 
would seem some modifications.
    For example, a clear-cut guideline by the SEC as what 
constitutes the approval process within a fixed period of time 
in which you would either get approval or not get approval as a 
designated rating organization.
    A clear-cut set of standards for the SEC in oversight of 
your activities to ensure that Moody's high standards of 
conduct are being attained by all others. Finally, a clear-cut 
process by which, if one fails to perform to that standard, one 
could be de-designated or undesignated. Would those kinds of 
principle constructs present any operational concern to an 
organization, such as Moody's?
    Mr. McDaniel. With respect to the general nature of your 
question and transparency and disclosure, Moody's could not 
agree more strongly that disclosure and transparency of 
information is critical to the sound operation of our financial 
markets.
    We are a consumer of good information, as much as we are a 
provider of good information. And in that respect, we 
absolutely would support any efforts to improve transparency 
not only in the markets, but in our own industry. That is 
something that is very easy for us as a firm to get behind.
    With respect to two of your specific comments, I should 
just say that Moody's does not offer any corporate governance 
fee-based service, nor do we have any of our executives sit on 
the boards of any rated companies.
    Chairman Baker. To that end, let's assume for the moment 
that members of the committee would find some generalized 
package not to be necessarily advisable, in light of the rating 
agency's performance over past years, what about the flip side? 
What would be the negative to a company with the stature and 
market share of Moody's in simply not having an SEC impromptu 
on the front bumper of the corporate automobile.
    I do not believe neither S&P nor Moody's needs that 
designation to maintain its market position and may, then, 
obviate the need for all these standards relative to entry, 
oversight and decommissioning because the market would do that 
between the two. Or is there a third position that you proffer 
as being more appropriate?
    Mr. McDaniel. Moody's had a very strong position in the 
market prior to 1975 and prior to the introduction of what was 
the more rapid acceleration of the use of the NRSRO designation 
in regulations and legislation. And we would certainly expect 
that we would be able to compete effectively if that 
designation were removed. In fact, we have a similar position 
elsewhere around the world where the NRSRO designation does not 
play a role in----
    Chairman Baker. In your opinion, would such a determination 
be to the public's disinterest in any way?
    Mr. McDaniel. For a number of years, Moody's observed that 
there were risks of incorporating ratings and regulation. More 
recently, however, I think we have taken a pragmatic view that 
the concept of or the interaction of regulation with the rating 
agency industry as a practical matter, has become very broad 
and deep and it would be difficult to reverse that process. We 
feel that we can perform a valuable public service and compete 
effectively regardless of the existence or nonexistence of this 
designation.
    Chairman Baker. Thank you.
    My time has expired.
    Mr. Kanjorski?
    Mr. Kanjorski. I just want to correct something. Mr. 
Alexander is the Chairman of Moody's?
    Mr. McDaniel. Mr. Alexander, Cliff Alexander is the 
Chairman of the Board of Moody's Corporation currently, that is 
Moody's Investors Service parent company, yes.
    Mr. Kanjorski. Well, didn't he serve as a director of MCI 
from 1981 to 1998 and on WorldCom from 1998 until June of 2001?
    Mr. McDaniel. I do not know the dates specifically, but he 
did serve on the board of MCI, and then of WorldCom.
    Mr. Kanjorski. Well, didn't you rate those two 
corporations?
    Mr. McDaniel. Yes, we did.
    Mr. Kanjorski. Well, isn't that in conflict to what you 
just testified that your officials and officers are not allowed 
to serve on boards?
    Mr. McDaniel. He is nonexecutive Chairman of our Board----
    Mr. Kanjorski. So Board of Directors Chairman----
    Mr. McDaniel. Yes. I am sorry. If I either misspoke or----
    Mr. Kanjorski. Well, he has sort of an interest, so----
    Mr. McDaniel. He is the nonexecutive Chairman of----
    Mr. Kanjorski. Chairman?
    Mr. McDaniel. ----Moody's corporation. Yes. Absolutely.
    Mr. Kanjorski. I would imagine that he is a major 
stockholder of Moody's.
    Mr. McDaniel. I do not know that.
    Mr. Kanjorski. Okay. So you are giving a very limited 
qualification. Those in direct line authority are not allowed 
to serve on boards of corporations that are rated.
    Mr. McDaniel. The management and executives of Moody's 
Investor Service and Moody's Corporation did not serve on the 
boards of any rated companies. We do have members of the board 
of----
    Mr. Kanjorski. But Directors and Chairman of the Board of 
Directors are allowed to.
    Mr. McDaniel. Yes.
    Mr. Kanjorski. And you make a distinction.
    Mr. McDaniel. Yes.
    Mr. Kanjorski. Okay.
    Mr. Egan, did you rate Enron or WorldCom or any of the 
failed corporations in your organization?
    Mr. Egan. Yes, we did.
    Mr. Kanjorski. Okay. Do you think that some of the 
questions should have been asked by Moody's and other rating 
organizations of these corporations? Should they have known the 
answers that would have indicated that they should not have had 
the ratings that they had immediately prior to bankruptcy? What 
did your organization rate Enron and WorldCom, et cetera? At 
what time did you change your ratings relative to when Moody's 
changed their ratings?
    Mr. Egan. It is a part of the written testimony that I 
provided. Let me just refer to it.
    We started downgrading Enron in January 27th of 2001. Okay?
    Mr. Kanjorski. About six months before bankruptcy.
    Mr. Egan. That is correct, yes.
    And then, you can see in the testimony our other negative 
actions on Enron.
    Mr. Kanjorski. Okay.
    Mr. Egan. WorldCom is the same sort of thing.
    Mr. Kanjorski. Was that based on the fact that your 
examiners or raters asked certain questions that indicated 
there were offshore transactions that you felt were risky 
toward the viability of the organization?
    Mr. Egan. We rely on information in the public domain. In 
fact, we encourage companies not to give us any information 
that is not public.
    Mr. Kanjorski. You mean without asking the questions of the 
company you came to this conclusion?
    Mr. Egan. That is correct. There is enough information out 
there to perform the analysis.
    Mr. Kanjorski. Because Mr. Egan did not attack Moody's 
directly because you are on the same panel, let me throw out 
the question: Why did you operate only within a week of 
bankruptcy to find out what they found out six months before?
    Mr. McDaniel. The actions that Moody's took with respect to 
Enron were based on all the information that we were able to 
gather both publicly and privately on Enron.
    Mr. Kanjorski. So you had the information of the offshore 
transaction?
    Mr. McDaniel. I am sorry?
    Mr. Kanjorski. You knew about all the offshore 
transactions, the off-balance sheet transactions?
    Mr. McDaniel. No, absolutely not. We did not know about all 
of those. We knew about a very small handful of them.
    Mr. Kanjorski. So Mr. Egan's people, assuming they only 
knew what you knew, made a six-month perception that there was 
a problem here, six months ahead of when you were able to do 
it.
    But the question that we are faced with is we are trying to 
protect investors. How is he did not ask these questions. You 
were not aware that they were offshore transactions? Some of 
them were actually disclosed, if I recall, in the statements' 
footnotes.
    Mr. McDaniel. Yes, we did have information on a handful of 
offshore transactions, that is correct.
    Mr. Kanjorski. Well, didn't you follow through what they 
were, what was the nature of them, how large were they, why 
were they there? Didn't that send up any signal that they were 
putting debt off the books?
    Mr. McDaniel. The scope of fraud with Enron was 
unprecedented. And we asked many questions over the course of 
the rating relationship with Enron to try and have the best 
possible understanding of that company's credit worthiness.
    However, there were multi-billion dollars worth of 
transactions and assets off the balance sheet which were not 
revealed.
    Mr. Kanjorski. I understand all that. But what we are 
trying to find is a mechanism here of how to find out, get 
transparency of those things, so that the information is 
related to the investor.
    It seems to me you are telling us that, under the existing 
ways of what rating agencies are doing, they are not going to 
find this fraud, and they are not going to find this 
misinformation that is being given to the investor and the 
public and everyone else in the marketplace. So then you seem 
to be telling me that we have a very serious problem here that 
we do not have a functioning credit-rating system.
    Mr. McDaniel. In hindsight, Congressman, we could have done 
a better job----
    Mr. Kanjorski. I know, but that is what the accountants 
said. What do we have to fix?
    You heard my opening statement. I do not want to clutter up 
the marketplace with anymore regulations that are absolutely 
necessary to get to positive ends. I mean, we can have the SEC 
come in here with books of regulations that by the time--as a 
matter of fact--that will limit the business because nobody 
will be able to compete cause they will not be able to spend 
the money to conform to the regulations, and then we will 
really have a monopoly.
    Forgetting all of that--and we do not want to do that--how 
do we advise the public and the marketplace of scurrilous 
activity like this? For example, let's forget Enron for a 
moment. Did you rate HealthSouth?
    Mr. McDaniel. Yes, we did.
    Mr. Kanjorski. What was it rated at?
    Mr. McDaniel. It has been a junk bond rated credit for 
three years.
    Mr. Kanjorski. Okay. Now why was it rated that way?
    Mr. McDaniel. Because our analysis of the fundamentals of 
that company indicated that it was a relatively weak company.
    Mr. Kanjorski. Right. And one of the things would have 
been, maybe, the CEO's income and residence and yachts and 
airplanes may exceed what he should be getting, and then maybe 
the board is not really a board.
    All of these things are what analysts should be looking at 
in making the ratings. Obviously, you got the bell to ring over 
there. You saw something was wrong and you notified the 
investor. It would be interesting to see how many people listen 
to your rating and got out in time to save their money.
    Chairman Baker. Will the gentleman yield on that point?
    Mr. Kanjorski. Sure.
    Chairman Baker. I would just help in the cause here.
    What troubles me is that we were very upset with the 
conduct of the analysts who were supposed to be advising the 
broader market. But in this case, rating agencies have a level 
of access to data which even the analysts do not have. From my 
uninformed position, it would appear that the rating agencies 
should be out ahead of the professional analysts. Did the 
gentleman know that?
    Mr. McDaniel. Yes.
    Mr. Kanjorski. You are in the same position, as I see it, 
as the auditor. You can ask any question. They must have the 
fear of God of you, and the CEO is not going to give you 
misinformation that is going to kick his bond ratings and other 
ratings down significantly. So it would seem to me he is going 
to respond or else the response is going to indicate that there 
is some fraud going on, something is being misstated here. It 
should become apparent.
    All I would like to correct is to fill that vacuum. I 
probably would like the industry to make a self-analysis. What 
happened? Why? Where did the vacuums occur? What responsible 
actions should the Congress or the SEC also take to make sure 
it does not happen again in the future so that we have a better 
market?
    I say that because, quite frankly, I am so impressed with 
the fact that we are making so much out of 10 or 15 major 
failures. A lot of money was lost. But, there are the thousands 
and thousands of good companies, good executives, and good 
people that are out there. I cannot over emphasize that point.
    We are just talking about problems in the margins, more 
than two standard deviations from the norm. We are way out 
here. But still we cannot allow hundreds of billions of dollars 
to be lost fraudulently or by misrepresentation that either the 
accountants, the rating agencies, the analysts, or somebody 
else has to be out there picking up.
    I come to the question Dr. White proposed. He said that we 
had two alternatives: We can do it in-house or we can enlarge 
the number of recognized entities that can perform this 
function and try and agitate some competition out in the field. 
Are you suggesting a government-sponsored enterprise to perform 
ratings?
    Mr. White. Absolutely not, Congressman. The basic choices I 
laid out were essentially the position that Moody's held until 
a few years ago. If you look at their comments to the SEC back 
at the 1997----
    Mr. Kanjorski. What did they do a few years ago that 
changed them? In your estimation, what made them lose the 
right----
    Mr. White. I do not know. And I must confess, I was 
distressed to hear Mr. McDaniel's statement. I fear that this 
is a bargain with the devil and that you [Mr. McDaniel] are 
going to regret it when you find SEC regulations coming down on 
top of you. I think that this is a mistake.
    I think the clean market-oriented result is to get the 
regulators out of delegating, have them do their jobs, make 
their own judgments about the safety of, for example, corporate 
bonds in bank portfolios----
    Mr. Kanjorski. But when you were talking about the 
regulators----
    Mr. White. ----and then the capital markets can make their 
own decisions.
    Mr. Kanjorski. But when you were talking about the 
regulators, Dr. White, you are talking about the SEC as being 
one major regulator?
    Mr. White. That is right.
    Mr. Kanjorski. And this Congress refused to appropriate 
sufficient funds for them to hire the personnel to do the job. 
I say in the last three years since the peak of the bubble, 
thank God we had the private market to self regulate. I mean, 
those people at the SEC were inundated. What were they doing, 
one audit every five years of major corporations?
    When we have the political swings and the philosophical 
swings in this country there is a tendency if you want to avoid 
regulations you can repeal them. But if it is not politically 
acceptable or if you do not want to do it, just starve the 
agency that has the responsibility and you have accomplished 
the same thing. And we did starve the SEC.
    Mr. White. Congressman, I could not agree with you more and 
I think that was a big mistake. Where regulation is needed, the 
regulators should have the funds and the resources to do the 
job.
    Here is one area, though, where I think we could pull back 
and let the financial markets make their own decisions. We 
would get more innovation, more new ideas, and we would not 
have to worry about, ``Is the SEC doing the right thing or the 
wrong thing with respect to the NRSRO.''
    Mr. Kanjorski. Accomplishing that by taken a designation 
away as a nationally recognized statistical rating 
organization.
    Mr. White. That is right, get rid of the category. But it 
does mean you have to get the other regulators, including the 
SEC to make their own judgments----
    Mr. Kanjorski. But then we would have to back up and change 
a lot of prior legislation that used that standard.
    Mr. White. It is really worth doing. You would not be 
holding this hearing today in that kind of world.
    Mr. Kanjorski. How about if we have a Texas cowboy--and I 
hate to use that expression----
    [Laughter.]
    But what if we have a Texas cowboy rating agency that comes 
along and says, you know, ``You hire us for $1 million, and you 
just may get the best rating you have ever heard of.''
    Mr. White. And very quickly the markets--if you do not have 
that regulatory overlay, the markets will figure out, ``This 
guy's ratings ain't worth the paper they are written on. We 
will pay no attention to this guy's ratings.'' And very quickly 
other companies will realize they do not get anything by paying 
this guy whatever he is asking.
    Mr. Kanjorski. After several years. But up until that time, 
what would happen?
    Mr. White. Oh, I think it will be quicker than that.
    Chairman Baker. If I can, recognize Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Mr. Joynt, in your prepared testimony you talk about 
addressing concerns raised about conflicts of interest posed 
when rating agencies offer ratings advisory services. And 
according to your testimony, I understand that you have already 
decided to stop providing this service to some issuers and are 
contemplating doing away with it altogether. Is that correct?
    Mr. Joynt. It is. But it is sort of an easy concession 
because we just started doing rating assessments last June, and 
we had only completed three. So we did not have an extensive 
practice at all. And so what we have decided to do for now, 
while it is being looked into, is not accept any new proposals 
in the U.S., at least for any rating assessment services, and 
consider whether they should be done by separate analysts, 
nothing to do with our rating analysts.
    Mr. Oxley. And after three examples, what changed your 
mind?
    Mr. Joynt. Only the outside spotlight on that practice 
coming from the SEC's review and thinking about it; not a 
concern of our own internally.
    Mr. Oxley. I see.
    Mr. Root and Mr. McDaniel, what is the status in that 
particular issue with Dominion and Moody's? Do you offer 
similar services, and have you determined whether you wish to 
continue those?
    Mr. Root. At Dominion, we do not offer those services. Our 
revenue stream is strictly from the rating of institutions and 
the research that we provide.
    Mr. McDaniel. We do offer the service called the rating 
assessment service. It constitutes less than 1 percent of our 
annual revenues. I would expect, even if we continue it, that 
it would continue to represent 1 percent or less of our total 
revenues. And we do it as an accommodation for companies that 
are contemplating major transactions, acquisitions or mergers 
or something of that sort. And are looking for some idea of 
what the consequences of those activities might be on the 
credit rating.
    We frankly would prefer to provide informal feedback. It is 
less time consuming. It is a process that does not carry some 
of the issues that, I think, concern the SEC and other 
authorities that have looked into the business, and we do 
encourage that.
    Mr. Oxley. Informal meaning, noncompensated?
    Mr. McDaniel. Yes, exactly, noncompensated.
    Mr. Oxley. Do other members of the panel have any opinions 
on the conflict of potential conflict of interest in this 
particular service.
    Mr. White. Congressman, it cannot be a completely black 
box. Suppose a company needs to know, ``Now, if I do X, what 
are the consequences going to be?'' The answer just cannot be, 
``Well, we cannot tell you, just go ahead and do it, and then 
we will tell you.'' That is just not a feasible way to proceed. 
I am very sympathetic to this process. But you know, I am not 
sympathetic to the whole, larger structure.
    Mr. Oxley. So you like what Mr. McDaniel's said in terms of 
the informal aspect to it?
    Mr. White. Whether it is formal or informal is not 
important. It cannot be a black box.
    Mr. Oxley. Now, Mr. Chairman, I could raise a question, and 
I apologize for this because Ms. Nazareth, our first panelist, 
in her testimony this morning talked about some issues 
regarding the potential changes in regulation and how this 
whole concept is treated at the SEC. And she made the comment--
and I made a note at the time, and then we had to go vote and I 
did not get a chance to ask her.
    I am kind of paraphrasing this, but she indicated that 
there were some First Amendment issues raised by the ratings 
agencies--and I see the professor shaking his head--could you 
help me on that? What First Amendment issues are out there and 
how are they raised.
    Mr. White. Sorry, I am not a lawyer. I do not practice law 
without a license, especially in this August body----
    Mr. Oxley. We give you a dispensation here.
    Mr. White. Well, thank you.
    I think the representatives of the agencies would be in a 
better position to be able to explain.
    My understanding is that they have described themselves as 
publishers. They are publishing opinions and are thereby 
covered by the First Amendment, in terms of commercial speech.
    Mr. McDaniel. Chairman Oxley, I would be happy to add. I 
agree with Professor White. The basis for the First Amendment 
comments that Ms. Nazareth made, I believe relate to the fact 
that we are publishers of opinions, and our opinions are 
released to the general public in the form of ratings and press 
releases explaining the ratings. And it is not just simply an 
assertion on our part, there is case law history that supports 
that.
    Mr. Oxley. Yes?
    Mr. Egan. In our view, the First Amendment has provided an 
ideal cover for the major rating firms to take anti-competitive 
behavior. They were sued by two municipal issuers in the early 
1990s when in Moody's case, they were not retained by the 
issuer and they issued a punishment rating. The issuers sued 
Moody's. And Moody's said: ``This is our opinion. I am sorry we 
did not have enough information, we had to issue a very low 
rating.'' The fact is, they were protecting the monopoly.
    Mr. Oxley. And that defense was a First Amendment defense?
    Mr. Egan. Exactly.
    Mr. Oxley. And that was the case that you referred to.
    Mr. Egan. That is what I was referring to, yes.
    Mr. Oxley. Was that the case--I am sorry--Mr.--was that the 
case you referred to?
    Mr. McDaniel. Well, I am not sure if I am talking about the 
same case as Mr. Egan. We have never issued a punishment 
rating. We would never put anything into market other than our 
best possible opinion. It may be right, it may be wrong, but it 
is our best possible opinion.
    And we have had cases where issuers have not wanted us to 
publish opinions. And in a particular case, one in Colorado is 
one I would be referring to, an issuer did sue us for assigning 
a rating on an unsolicited basis. And we had a successful First 
Amendment defense to that suit.
    Mr. Oxley. Mr. Egan, is it your understanding that that 
case is a controlling authority in that area?
    Mr. Egan. I think it was--well, I do not know.
    Mr. Oxley. Mr. Chairman, I would ask unanimous consent, 
perhaps, that Mr. Egan could supply us with some of that 
information in writing.
    Mr. Egan. Yes. There are some articles in Wall Street 
Journal in the mid-90s about the two municipal issuers that did 
sue Moody's for the punishment ratings----
    Mr. Oxley. And for balance in if I may suggest we ask Mr. 
McDaniel for the same information to have their--that would be 
helpful, I think, for staff and the members to better 
understand that whole First Amendment issue.
    Mr. Egan. Yes.
    Mr. Oxley. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Shays?
    Mr. Shays. Thank you, Mr. Chairman, again, for holding this 
hearing.
    And thank you to the witnesses.
    When bad things happen it is easy to, with hindsight, 
obviously to cast dispersions, and I do not want to do that, 
but I am interested, with hindsight, how people reacted. And I 
found Ms. Nazareth's response is frankly, you know, not 
alarming, but very disappointing.
    And I also want to say, you know, since I have been in 
college, Moody's and Standards & Poors, you know, I just put 
them way up there, but I have to say, I also put Enron up 
pretty high, too. And for me, what happened in Enron, was a 
wake-up call. I want to know if we are waking up.
    So let me ask you, first, Mr. McDaniel, what was your 
reaction when you learned about what happened at Enron?
    Mr. McDaniel. The Enron situation was, I would agree, 
indeed a wake-up call not just for Moody's, but for the market 
generally. And we took a number of steps in response to the 
collapse of Enron, as well as some of the other corporate 
collapses that have followed over the last 18 months or so.
    We began publishing liquidity risks assessments which 
focused on the short-term liquidity position of the firms that 
we rate. We conducted a comprehensive rating trigger survey, 
both in the United States and in Europe asking companies 
specifically whether they had elements in financial contracts 
that would cause posting of collateral or cash calls in the 
event that rating fell below a certain level. And we found that 
there were a large number of those and a large number of those 
that were not otherwise disclosed.
    We created two regional chief credit officer positions for 
our corporate ratings; one in the United States and one in 
Europe. Most importantly, though, we began what we call a 
specialist initiative or an enhanced analysis initiative where 
we have been hiring accountants, off-balance sheet risk 
transfer specialists and corporate governance specialists to 
both broaden and deepen the scope of our rating analysis.
    Mr. Shays. Let me ask you, though, in terms of your own 
state of mind, was this a shock to you?
    Mr. McDaniel. Yes.
    Mr. Shays. Were you embarrassed that Moody's was so high on 
this company for, you know, until death do us part?
    Mr. McDaniel. I want to be careful in answering because we 
were not high on the company. We had rated it in our lowest 
investment grade category.
    Mr. Shays. Yes, but your lowest investment rating is 
still--I mean, was it that in the standard of one to 20-
something, it is still pretty high up there, right?
    Mr. McDaniel. Yes. Well, it is in the middle.
    Mr. Shays. But it clearly--you mean it is like a 10 or is 
it more like a four? I mean, in terms of your rating scale.
    Mr. McDaniel. It is in the middle. A BAA rating is--there 
are three rating categories above it and three rating 
categories below it. So it is a rating indicating that we do 
believe it is investment grade and, as we publish in our 
definitions, contains----
    Mr. Shays. Do you have people that are totally focused on 
Enron or is your business so big that you just--I mean, do you 
have people dedicated to just looking at Enron?
    Mr. McDaniel. We never had a single individual dedicated to 
Enron.
    Mr. Shays. When VIVA, a Germany company, wanted to unite 
with Enron, and another accounting firm was called in, like two 
years before Enron took a nose dive, I think, the U.S. 
accounting firm said there is $2 billion of undisclosed 
liability. Why didn't that impact Moody's determination of this 
company?
    Mr. McDaniel. I apologize, Congressman, but I do not have 
those specific facts at hand. I would be happy to, you know, 
provide them for you afterward.
    Mr. Shays. Help me out, Mr. White. I would also say I do 
not often get someone from the Stern's school, where I 
graduated in economics, but never had you, sir, only cause I 
was there 30 years ago.
    I am intrigued by the fact that evidently there are no 
standards, no formal requirements in which to joint this select 
group of nationally recognized statistical rating 
organizations--and it is done in private--how someone--to know 
how they qualify.
    Mr. White. Congressman, I think that is an excellent 
question. I do not have a good answer for you, and I was not 
happy with Ms. Nazareth's answers either. Basically it is body 
language. If you look at the 1997 proposed criteria, the SEC 
said, ``We have been sort of using this criteria for our no-
action letters. We might as well put them out and see what the 
reaction is.'' So----
    Mr. Shays. But it strikes me, how are you able to determine 
if you do not have--I mean, it is almost like what you would be 
taught in ninth grade or earlier that you got to have some kind 
of standards and people have to meet these standards and then 
you know. I mean, it is like I have an impression that the 
business community is pretty smart. And that when people 
criticize politicians, you know, we sometimes take hits. But I 
am begging to think the business community almost makes 
politicians look brilliant.
    Because, seriously, I mean--I am almost sounding very self-
righteous here--but someone on this panel tell me why you do 
not need, first, if you disagree and you think there are 
standards, and then tell me why we do not need standards. One 
person here tell me why.
    Mr. White. Again, Congressman, if we are going to have the 
NRSRO category, then we need standards. They need to be 
transparent. And they need to be applied equally to incumbents, 
as well as to entrants. They should be performance standards, 
not input standards the way the 1997 criteria were stated.
    Mr. Shays. Does anyone on this panel disagree with that, 
with what Mr. White said? Anybody? I am going to infer that all 
of you agree with that.
    Chairman Baker. Mr. Shays, if I can seize upon that moment? 
We are going to come back for another round. And Mr. Inslee's 
arrived, and since he has not had an opportunity to ask, I 
would like--Mr. Inslee do you have questions at this time?
    Well, that makes it easy. Well, we will start a second 
round here. Just briefly; following on Mr. Shays' point, I may 
suggest in writing, to each of you, just to respond to us on 
some points that were raised during the course of the hearing 
today, one of which will be the Shays' observation about no 
objection to the generalized points he made.
    Mr. Kanjorski had a few points he wanted to get on that 
record that, I think, we would include in that document.
    And I want to find out, basically, two generalized 
approaches. If we maintain the current system, from each of 
you, what do you see as the minimal steps necessary to have a 
functioning system treating all participants equally that is 
transparent and understood by the market without getting into 
day-to-day regulation of your business, whether you engage in 
rating and consulting with the same client or not? I am not 
prejudging any activity. But if you do it, how do you disclose 
that?
    Whether officers and officials of the rating agency serve 
in a board capacity of a rate enterprise? Fine. But if you do 
it, how do you disclose that in a broad context, not as 
narrowly defined today?
    And further, the comment as to whether or not you deem it 
advisable to maintain the current system, meaning the bumper 
sticker on the front of the corporate vehicle, as a necessity 
for the flow of information to the capital markets and to the 
public? And it will be cleaned up where it makes more sense 
than that.
    But just indicate to you that I hope we have several 
members of the committee sign on and we may very well send the 
same letter to the appropriate SEC officials for comments, 
which will enable us to kind of get to closure on this. I do 
not want to have this hearing raise a bunch of issues, and then 
not subsequently take some steps to bring us to resolution. So 
I think Mr. Shays' question is a good starting point. And Mr. 
Kanjorski and others who are interested will engage in that 
activity and get it out forthwith.
    Mr. Kanjorski, I believe you had some more questions.
    Mr. Kanjorski. Yes. I am going to take advantage of my 
position and the quality of our panel. I direct this question 
to everybody on the panel, but primarily the representatives of 
the major rating agencies, including Mr. Egan.
    A number of months ago, probably less than six, probably 
more than three--I cannot quite yet place it in, I had an 
extensive meeting with a very highly appointed official of the 
present Administration who has a great deal to do with 
economics, financial markets, et cetera. I will leave it at 
that.
    In the course of that meeting, in analyzing the 
macroeconomic condition of the United States and the world, he 
indicated to me that he had great worries that there were 
perhaps more than 200 corporations that had difficulties yet 
undisclosed and unknown that he saw coming down the road. Most 
recently, HealthSouth fell into that category.
    Now, those of you who are in the rating agencies, are you 
giving the investors a macroeconomic picture of that possible 
future? Are you giving the public any awareness that could help 
us out? Do we have to go through every company that is on all 
the exchanges to try and come up with the identification of who 
those companies may be?
    The thing that worries me, since I do not either have the 
time nor the inclination to examine every publicly traded 
corporation to try and identify those 200, is would they, the 
problem companies clearly, in your ratings, show up so that a 
simpleton, such as myself, could look at those ratings and say, 
``Here are the 200 of them that are in trouble, and that we can 
anticipate problems that will have a definite impact on the 
economy.''
    Mr. Egan. Yes. We maintain a list where we compare our 
ratings against Standard & Poors ratings, and there are a 
number of companies where we are significantly lower. And by 
the way, we are in the business of protecting investors, 
period. So we want to get to the truth quickly.
    We measure ourselves on what is called hits and misses. 
That is, if there is convergence where S&P or Moody's move 
toward our ratings, that is considered a hit. If they move 
away, it is a miss. Last year, there were 440 hits and about 19 
misses; year before, about the same. So we constantly keep 
track of it.
    And we do see a number of huge problems out there. Probably 
the biggest one that has not been dealt with is the pension 
fund and health care liabilities. A lot of corporations are not 
treating it as real liabilities. They are hoping that the 
market is going to zip up 100 percent over the next two years. 
We tell our clients or identify where there are huge problems. 
Many times we get into difficulty because our ratings are so 
far apart from the majors. And the Enron, the WorldCom, the 
Global Crossing has given us the leeway with our clients to 
maintain that huge discrepancy.
    Chairman Baker. Would the gentleman yield?
    How many companies do you rate?
    Mr. Egan. Approximately 800.
    Chairman Baker. And how many does S&P rate?
    Mr. Egan. In the corporate area, significantly more----
    Chairman Baker. Including bond market and everything. The 
scope of their full authority, what do they do in an annual 
period of time?
    Or if I can, I will jump Mr. McDaniel. What is your rating 
responsibility? I am trying to get some sense of scale here.
    Mr. McDaniel. Almost 6,000 corporate and structured 
finance--corporate entities and structured financed vehicles, 
about 16,000 public finance issuers.
    Chairman Baker. So a total of 22,000 obligations versus----
    Mr. Egan. Eight hundred, maybe 900. But we focus on the 
corporate.
    Chairman Baker. I understand.
    I thank the gentleman for yielding.
    Mr. Kanjorski. Mr. McDaniel, do you have any macro picture 
that you could make available? In other words, I am trying to 
determine whether this remark was off the top of his head or is 
this really a serious matter where we have 200 major 
corporations that may be in significant difficulty out there 
that the public is not aware of?
    Mr. McDaniel. Well, we rate slightly over 1,000 
corporations in the junk category, speculative grade, below 
investment grade. I think your question is going more to, ``Are 
we providing a macroeconomic framing around that?'' And we do 
do that through our economics department, and that is published 
both on our Web site and through major media outlets, and that 
includes economic analysis and default probability analysis and 
forecasting.
    Mr. Kanjorski. Is this information readily made available? 
It was rather shocking to me when he told me that statement, 
but maybe it just means I am under read.
    Mr. McDaniel. It is available on our Web site. Our 
economists would speak to the major news outlets. I do not know 
how broadly it might be consumed. I have not looked at the Web 
sites hits on that in some time.
    Mr. Kanjorski. Mr. Joynt, do you have a comment on that?
    Mr. Joynt. I have a couple of comments. One, I think, also 
Fitch does industry surveys describing whole industries and how 
they would be affected by economic development. So if we expect 
in the next several years deteriorating economic conditions 
globally or in the U.S., then you could first look at those 
industry pieces to try to identify companies that might be 
problematic; the airlines industry today. So I could not have 
maybe told you the amount of problems they would have had a 
year ago, but in light of what has happened in the world today 
and with the war, then they are having significant problems and 
they are quickly deteriorating.
    Also, by looking at industry studies you can look at groups 
of companies that are competing against each and how they are 
leveraged. And so there are a significant number of companies, 
as Mr. McDaniel has pointed out, that Moody's rates 1,000 that 
are non-investment grade, many of which would be highly 
leveraged, and so those would be candidates for a more rapid 
deterioration.
    Is that helpful?
    Mr. Kanjorski. Yes, it is helpful.
    I am sitting back here and listening to a lot of analysis 
coming out of government, coming out of industry, coming out of 
academia, and it does not seem to me that there are many people 
out there discussing real potential economic risks.
    Some people call it meltdown, others have termed it 
something else. Everybody can use their own imagination to 
describe it. But it is something that we must explore. For 
example, about two or three months ago, the Japanese Government 
went to the bond market and they wanted to sell Japanese bonds 
and there were no buyers. Is that correct?
    And I do not know how they were rated.
    Now, just around two weeks ago, the Deutsche Bank formally 
notified the German government that under present conditions, 
if they continue as they might, the German banking system might 
become insolvent.
    So now we have the second-largest economy in the world 
unable to sell its bonds; we have the third-largest economy in 
the world talking about bank insolvency; and we are the first 
economy in the world and I do not know whether we are in the 
stage of prosperity or recession. We do not know. I would say, 
however, we are probably in stagnation, and in the midst of a 
war.
    Additionally, I am hearing hue and cry out there indicating 
that not only the United States but the world may have some 
very, very, very serious economic situations. We seem to be 
only talking about the economic situation of the United States 
vis-a-vis the 2004 presidential and congressional elections at 
this point. You know, as long as we can do anything to not 
address this issue between now and then, we do not want to 
shake the population up.
    And yet, let me go further with this analysis, this 
discussion, because it did disturb me and does continue to 
disturb me. It is something I want to take up with my chairman 
in the not too distant future. The unnamed official then 
indicated that the problematic period would be 12 to 18 months. 
We subsequently did talk about an economic meltdown.
    We did not just talk about an industry meltdown, such as 
the airlines, but a global meltdown. I said I was always 
worried about that problem and I had always wanted to look at 
that problem. I also estimated at best there would be maybe a 
one-in-ten chance of that meltdown happening, but he shook his 
head knowingly. He then said that he thought it was more like a 
one-in-three chance of that meltdown happening.
    Is there any reasonable truth to that analysis?
    Mr. Egan. We would not disagree with that. The problem that 
we face is when we sound the alarm, and we did on some of the 
auto companies recently, that we have run into a lot of 
difficulty. We have sounded the alarm on some major government-
sponsored entities and some major bond insurers who have Triple 
A ratings by our competitors; we think they are far from it.
    There are a number of things that can happen that can 
trigger it and we are very concerned. So we are balancing that 
high level of concern with protecting investors and really 
trying to steer them to the safe harbors.
    Mr. McDaniel. The issues that you are identifying that are 
macroeconomic level, Congressman, particularly in the situation 
of Japan and Germany, I think might be more fairly 
characterized as longer term, chronic problems, rather than 
acute problems that are likely to have significant 
deterioration over the next 12 to 18 months. We have a Single A 
rating on Japanese government bonds, those are the Yen 
denominated bonds----
    Mr. Kanjorski. Those are the ones they could not sell?
    Mr. McDaniel. The ones that they sold several months ago, 
yes, we rate them A-2.
    Mr. Kanjorski. But there were some that they had no buyers?
    Mr. McDaniel. And the Bank of Japan and governmental 
authorities may step in and buy the paper.
    Mr. Kanjorski. The real market did not buy those bonds, 
though you had an ``A'' rating?
    Mr. McDaniel. I read the papers, in terms of what the 
market appetite was for those bonds. You know, we did not have 
conversations with the Japanese government about what the 
appetite was for those bonds. But we do hold a Single A rating 
on the government of Japan for the yen-denominated bonds. That 
is down from a number of years ago, from Triple A. So we have 
been moving down on the rating scale for the yen-denominated 
securities. And, in fact, they are substantially below their 
dollar-denominated securities.
    Chairman Baker. If I can, Mr. Kanjorski, can I jump to Mr. 
Shays.
    Mr. Shays?
    Mr. Shays. Mr. Chairman, I want to say, this is an 
excellent panel. We have just kind of scratched at the surface, 
though. For instance, Ms. Cummingham, I would like to ask you, 
the rating agencies are important to you because of law, but do 
they provide a valuable service to you if the law was not 
requiring that you use them?
    Ms. Cunningham. They are one of many inputs that go into 
our decision-making process for the securities that we purchase 
in the institutional marketplace with funds that we manage. I 
think that by and large the fixed income marketplace is an 
institutional marketplace; it is really not a retail 
marketplace.
    If you are going to buy bonds as a retail investor, you 
would probably buy Treasury securities. So it is not 
necessarily something you would be utilizing rating agencies 
for.
    On the assessment of the other types of fixed-income 
securities that are in the marketplace, I think by and large 
the retail investor is looking to independent adviser services, 
such as Federated, that utilize the rating agencies as one of 
the inputs, but certainly not entirety.
    Mr. Shays. Do you have to use the nationally recognized 
statistical rating organizations or can you use Mr. Egan's 
organization?
    Ms. Cunningham. We can use any input that we would like. We 
are required by law to recognize if a rating is designated from 
one of the NRSROs.
    Mr. Shays. So it becomes pretty important that it be from 
one of the four?
    Ms. Cunningham. It is a hurdle level that is mandated on a 
regulatory basis if it exists. If it does not exists, we do not 
have to use them.
    Mr. Shays. Mr. Egan, would you explain to me why you have 
worked so hard to be one of these four, now five. What 
difference does it make to you? You have how many employees?
    Mr. Egan. I think we are up to about 13 right now. We have 
about 300 institutional clients, mostly institutional 
investors, some broker dealers. A number of institutions simply 
will not look at our ratings since we are not an NRSRO. The 
thought is that if you are any good, you would have the 
designation.
    It is interesting, but I just heard yesterday from a client 
when they heard about this hearing, they said, ``Please, 
please, do not become an NRSRO because their ratings are no 
good.'' In other words, they did not want us to be compensated 
by the issuers, who--they think that is a fundamental conflict, 
and we said, ``We could not agree with you more.'' And we are 
not going to change our business practice. We are going to 
continue to refuse compensation from the issuers, and just get 
it from the investors.
    So to answer your question, it will broaden our voice in 
the market.
    Chairman Baker. If the gentleman will yield on a point you 
asked Ms. Cummingham about, just to make sure that I got it 
correct. In your earlier testimony you did indicate that the 
Investment Company Act does require you by law to utilize the 
NRSROs with regard to money market funds and asset-backed 
securities.
    Is that correct?
    Ms. Cunningham. That is correct.
    Chairman Baker. Okay, thanks. I thank the gentleman for----
    Mr. Shays. So you only have, basically, four companies to 
turn to?
    Ms. Cunningham. That is correct, if those ratings exist. If 
those ratings do not exist for those particular issuers that we 
are purchasing we can buy non-rated securities.
    Mr. Shays. Mr. Kaitz observes in his testimony that 29 
percent of corporate treasury and finance professionals who 
work for companies with rated debt, indicated that their 
companies ratings are inaccurate.
    He also states that only 65 percent of the corporate 
respondents that use credit ratings to make investment 
decisions believe that the ratings of the companies in which 
they invest are accurate.
    Doesn't this lack of confidence in the accuracy of firms 
ratings raise concerns about their ability to perform their 
jobs. And, Mr. Kaitz, would you start and then I want to ask 
each of you to answer.
    Mr. Kaitz. The premise of the survey really was a result 
of, to your point earlier, Mr. Shays, the debacle with Enron. 
So this was an outgrowth of our membership, which is a 
professional organization.
    And I think that it was expressed in some of our membership 
that this was a broader issue, which is why we did this survey. 
Obviously, the results speak for themselves in terms of the 
accuracy and the timeliness of those ratings. And interestingly 
enough, as I pointed out, members revealed that not only with 
upgrades, but also with downgrades that there was a significant 
time lag.
    So I think the survey speaks for itself that our membership 
does believe that there are some issues, both in accuracy and 
timeliness of the rating agencies.
    Mr. Shays. Before I go to the other panelists, to answer 
who rates the rating agencies?
    Mr. Kaitz. From a----
    Mr. Shays. From a standpoint of how accurate they are in 
comparing them? Does Fortune Magazine look at the others?
    Mr. Kaitz. To my knowledge there is no one that currently 
does that.
    Mr. Shays. I would think that would be a great business to 
go into.
    Mr. Egan. In fact, the----
    Mr. Shays. No, I am serious, it would seem to me that if 
you could start to develop a standard on how accurate these 
folks are, that you would basically provide a tremendous public 
service.
    I would think an entrepreneur like you, Mr. Egan, would 
jump on that.
    Mr. Egan. In fact, the Federal Reserve Board of Kansas City 
just came out with a study, it was published yesterday, and it 
indicated that there is a lot of stickiness in the investment 
grade ratings of S&P and Moody's----
    Mr. Shays. There are a lot of what?
    Mr. Egan. What they call stickiness. In other words, like 
the Enron case, where the rating was kept too high for too 
long--same with WorldCom.
    And that the other rating agencies, S&P and Moody's moved 
in, down to our ratings afterwards, an average of about three 
months or something like that.
    But, yes, you are absolutely right. And they went through 
all of our ratings from when we started in December of 1995. I 
think I sent to your staff, it just became available yesterday, 
a copy of that survey.
    Mr. Shays. I guess that I could kind of change the design 
of the question that I asked Mr. Kaitz and ask, the four rating 
agencies, three that have the designation, how are you held 
accountable?
    Mr. McDaniel. At Moody's we publish annual default 
studies----
    Mr. Shays. Annual what?
    Mr. McDaniel. Annual default studies. It looks at all of 
the ratings that we have out in the corporate bond market, and 
it looks at the defaults that have occurred over the previous 
year.
    I think we have just published our 16th annual default 
study. That shows whether or not our ratings are predictive. It 
shows whether or not companies that receive higher ratings 
default less frequently that companies that receive lower 
ratings.
    Mr. Shays. Would that be the standard or should there be 
some levels in between? A default means bankruptcy, basically?
    Mr. McDaniel. A failure to pay on an obligation.
    Mr. Shays. But what, would there be anything that would be 
in between that that you could also--I mean, I think that is 
good that you do that, obviously.
    So, but that is the extreme, correct?
    Mr. McDaniel. Well, it is an aggregate measure of whether 
as you move down the rating scale defaults become more frequent 
or whether there is not a relationship between a lower rating, 
in increasing degrees, with higher default probability.
    Mr. Shays. How about, I am sorry, thank you.
    Mr. Joynt. I might just add to that, actually, to address 
your question, there is also transition studies that are 
published by Moody's, Standard & Poor's and Fitch, of the 
movement of ratings among categories, A to A minus, so in 
addition to the ultimate default probability there is the 
movements that are studied.
    Mr. Shays. Okay.
    Mr. Joynt. And Fitch also----
    Mr. Shays. And the study of the movement suggests what? 
That you are describing the movement or you are saying we could 
have called it better here or here?
    Mr. Joynt. No, it is actually looked at in the many ways 
one would want to look. Does it look like the ratings are 
moving too quickly--overreactions? Are they moving too slowly? 
Have they jumped categories? Do they move by one notch at a 
time?
    So, and to come back to your more basic question, which is, 
who rates the rating agencies? Investors do, all the time.
    I think the effectiveness of rating agencies comes from 
investor scrutiny and the improvements in rating agencies come 
from investor demands for more research and more background 
information, not just the published rating alone.
    And I think that is who is rating the rating agencies. And 
I think that is a separate matter from just the NRSRO 
designation, which I would acknowledge has some bearing and 
merit on people's usage of ratings, as well.
    But not the sole----
    Mr. Shays. Just to put it on the record.
    Mr. Root. Yes, I am going to add, you know, our core 
business is in Canada, and there is no such thing as NRSRO; so, 
you know, kind of following up on what Steve just said that, 
you know, who is rating us, who is grading us? It is the 
marketplace.
    Because there is no regulatory designation that gives us 
the similar type of status, if you will, as we have here. So to 
the extent----
    Mr. Shays. So you would argue that you do not need that 
status?
    Mr. Root. As long as everybody else did not have it, 
correct.
    Mr. Shays. Right.
    No, but that is interesting. I think that is a summation 
for me. I mean, if the others do not have it then let the 
marketplace--I mean, S&P and Moody's would be way up there, it 
is just, they are both great companies, they are big, they are 
large, and it is not like the ratings are enabling the new 
folks with just 13 employees to jump in and be given that 
status.
    Would you agree with Mr. Egan that maybe you just get rid 
of it all?
    Mr. Egan. I believe so. What has happened to this point is 
that there has become a whole infrastructure that has supported 
the two majors. For example, if an issuer decided not to hire 
S&P and Moody's, and they hired somebody else, the investment 
bankers could very well make it difficult for that issuer and 
discourage the issuer from using those other sources.
    It is very--the system has already been set up, it does not 
work and there are a lot of parties supporting the current 
system. So maybe--it probably would be better than what is 
currently, but I do not know if that is the ultimate answer.
    Mr. Shays. Okay, Mr. White, I am going to just let you 
finish, I am sorry.
    Mr. White. Thank you. I want to give you my reaction to 
what you have just heard.
    Mr. Shays. Okay.
    Mr. White. First, I did not before and I was derelict as a 
professor at the NYU Stern School of Business in not commending 
you for having made a good choice of institutions.
    Mr. Shays. Yes, you made a good choice in the past.
    Mr. White. I have been there for 27 years, so I think we 
just----
    Mr. Shays. 1974 is when I graduated.
    Mr. White. And I arrived in 1976. But I will make sure our 
alumni office has you----
    Mr. Shays. Trust me, they do.
    Mr. White. Okay.
    As I stated earlier, I believe in a markets-oriented 
approach; I think that this is the best way to ensure that we 
get new ideas, innovations, in the whole assessment of 
corporate health and viability. That is the direction we need 
to go. But if we going to go in that direction, then we have to 
realize that this does require a number of financial regulators 
to cease delegating their judgments to the rating companies. 
They must make those judgments themselves.
    For example, since 1931, bank regulators have been telling 
banks that the banks must pay attention to the ratings on the 
bonds that the banks hold in their portfolios. Since 1936, 
banks have not been permitted to hold bonds that were below 
investment grade in their portfolios.
    The immediate question is: Whose judgment----
    Mr. Shays. Right.
    Mr. White. ----as to investment grade? And that was in 
limbo until 1975 when the SEC stepped up, to its credit, and 
said, NRSRO, that will be the category whose judgments should 
be adhered to.
    If you are going to get rid of the NRSRO category, then you 
have to somehow deal with this issue of what is to prevent the 
XYZ rating company from coming along, giving out AAA ratings to 
anybody----
    Mr. Shays. Very good point.
    Mr. White. ----willing to line their pockets?
    And the bank regulators can do it. They need to deal with 
bonds the way they deal with loans: Bonds are just another form 
of loans. When the bank regulators sent their examiners into a 
bank, on day one the examiner says, ``tell me about your 
loans.'' And on day two the examiner should say, ``tell me 
about your bonds.''
    Moody's, back in 1997, offered similar types of suggestions 
to the SEC as to how the SEC could substitute its own judgments 
for its use of NRSRO status. That could be done across the 
board.
    Mr. Shays. You took about four minutes to give me a one-
second answer, but I got it.
    Well, I get the point. In other words, you made your point.
    Mr. White. Okay. Thank you, Congressman.
    Mr. Egan. I question whether bank regulators would be able 
to catch Enron or Worldcom or Genuity. I do not think they have 
the training, the incentive, the tools to do it. I think to 
reform the system you need rating firms not to be paid by the 
issuers, get rid of some of these basic conflicts of interest, 
that is the first step to reforming it.
    Encourage young firms, like ourselves, to have a vibrant, 
healthy credit analysis industry, as opposed to what we have--
this basic partner monopoly, with people sitting on boards and 
all the other unhealthy aspects.
    Chairman Baker. Okay. Thank you, Mr. Shays.
    Mr. Shays. Thank you.
    Chairman Baker. I want to thank all of you for your 
participation in a what was not expected--if anybody had told 
me that a hearing on transparency in credit reporting agencies 
would last until 1:30 in the afternoon, I would have had them--
well, in any event, I am surprised by the events of the day.
    And I do find it very helpful to the committee's work. We 
will followup with our letter of inquiry. And we look forward 
to your responses, as timely as possible. We thank you for your 
participation. And this meeting is adjourned.
    [Whereupon, at 1:32 p.m., the subcommittee was adjourned.]


                            A P P E N D I X


                             April 2, 2003


[GRAPHIC] [TIFF OMITTED] T9083.001

[GRAPHIC] [TIFF OMITTED] T9083.002

[GRAPHIC] [TIFF OMITTED] T9083.003

[GRAPHIC] [TIFF OMITTED] T9083.004

[GRAPHIC] [TIFF OMITTED] T9083.005

[GRAPHIC] [TIFF OMITTED] T9083.006

[GRAPHIC] [TIFF OMITTED] T9083.007

[GRAPHIC] [TIFF OMITTED] T9083.008

[GRAPHIC] [TIFF OMITTED] T9083.009

[GRAPHIC] [TIFF OMITTED] T9083.010

[GRAPHIC] [TIFF OMITTED] T9083.011

[GRAPHIC] [TIFF OMITTED] T9083.012

[GRAPHIC] [TIFF OMITTED] T9083.013

[GRAPHIC] [TIFF OMITTED] T9083.014

[GRAPHIC] [TIFF OMITTED] T9083.015

[GRAPHIC] [TIFF OMITTED] T9083.016

[GRAPHIC] [TIFF OMITTED] T9083.017

[GRAPHIC] [TIFF OMITTED] T9083.018

[GRAPHIC] [TIFF OMITTED] T9083.019

[GRAPHIC] [TIFF OMITTED] T9083.020

[GRAPHIC] [TIFF OMITTED] T9083.021

[GRAPHIC] [TIFF OMITTED] T9083.022

[GRAPHIC] [TIFF OMITTED] T9083.023

[GRAPHIC] [TIFF OMITTED] T9083.024

[GRAPHIC] [TIFF OMITTED] T9083.025

[GRAPHIC] [TIFF OMITTED] T9083.026

[GRAPHIC] [TIFF OMITTED] T9083.027

[GRAPHIC] [TIFF OMITTED] T9083.028

[GRAPHIC] [TIFF OMITTED] T9083.029

[GRAPHIC] [TIFF OMITTED] T9083.030

[GRAPHIC] [TIFF OMITTED] T9083.031

[GRAPHIC] [TIFF OMITTED] T9083.032

[GRAPHIC] [TIFF OMITTED] T9083.033

[GRAPHIC] [TIFF OMITTED] T9083.034

[GRAPHIC] [TIFF OMITTED] T9083.035

[GRAPHIC] [TIFF OMITTED] T9083.036

[GRAPHIC] [TIFF OMITTED] T9083.037

[GRAPHIC] [TIFF OMITTED] T9083.038

[GRAPHIC] [TIFF OMITTED] T9083.039

[GRAPHIC] [TIFF OMITTED] T9083.040

[GRAPHIC] [TIFF OMITTED] T9083.041

[GRAPHIC] [TIFF OMITTED] T9083.042

[GRAPHIC] [TIFF OMITTED] T9083.043

[GRAPHIC] [TIFF OMITTED] T9083.044

[GRAPHIC] [TIFF OMITTED] T9083.045

[GRAPHIC] [TIFF OMITTED] T9083.046

[GRAPHIC] [TIFF OMITTED] T9083.047

[GRAPHIC] [TIFF OMITTED] T9083.048

[GRAPHIC] [TIFF OMITTED] T9083.049

[GRAPHIC] [TIFF OMITTED] T9083.050

[GRAPHIC] [TIFF OMITTED] T9083.051

[GRAPHIC] [TIFF OMITTED] T9083.052

[GRAPHIC] [TIFF OMITTED] T9083.053

[GRAPHIC] [TIFF OMITTED] T9083.054

[GRAPHIC] [TIFF OMITTED] T9083.055

[GRAPHIC] [TIFF OMITTED] T9083.056

[GRAPHIC] [TIFF OMITTED] T9083.057

[GRAPHIC] [TIFF OMITTED] T9083.058

[GRAPHIC] [TIFF OMITTED] T9083.059

[GRAPHIC] [TIFF OMITTED] T9083.060

[GRAPHIC] [TIFF OMITTED] T9083.061

[GRAPHIC] [TIFF OMITTED] T9083.062

[GRAPHIC] [TIFF OMITTED] T9083.063

[GRAPHIC] [TIFF OMITTED] T9083.064

[GRAPHIC] [TIFF OMITTED] T9083.065

[GRAPHIC] [TIFF OMITTED] T9083.066

[GRAPHIC] [TIFF OMITTED] T9083.067

[GRAPHIC] [TIFF OMITTED] T9083.068

[GRAPHIC] [TIFF OMITTED] T9083.069

[GRAPHIC] [TIFF OMITTED] T9083.070

[GRAPHIC] [TIFF OMITTED] T9083.071

[GRAPHIC] [TIFF OMITTED] T9083.072

[GRAPHIC] [TIFF OMITTED] T9083.073

[GRAPHIC] [TIFF OMITTED] T9083.074

[GRAPHIC] [TIFF OMITTED] T9083.075

[GRAPHIC] [TIFF OMITTED] T9083.076

[GRAPHIC] [TIFF OMITTED] T9083.077

[GRAPHIC] [TIFF OMITTED] T9083.078

[GRAPHIC] [TIFF OMITTED] T9083.079

[GRAPHIC] [TIFF OMITTED] T9083.080

[GRAPHIC] [TIFF OMITTED] T9083.081

[GRAPHIC] [TIFF OMITTED] T9083.082

[GRAPHIC] [TIFF OMITTED] T9083.083

[GRAPHIC] [TIFF OMITTED] T9083.084

[GRAPHIC] [TIFF OMITTED] T9083.085

[GRAPHIC] [TIFF OMITTED] T9083.086

[GRAPHIC] [TIFF OMITTED] T9083.087

[GRAPHIC] [TIFF OMITTED] T9083.088

[GRAPHIC] [TIFF OMITTED] T9083.089

[GRAPHIC] [TIFF OMITTED] T9083.090

[GRAPHIC] [TIFF OMITTED] T9083.091

[GRAPHIC] [TIFF OMITTED] T9083.092

[GRAPHIC] [TIFF OMITTED] T9083.093

[GRAPHIC] [TIFF OMITTED] T9083.094

[GRAPHIC] [TIFF OMITTED] T9083.095

[GRAPHIC] [TIFF OMITTED] T9083.096

[GRAPHIC] [TIFF OMITTED] T9083.097

[GRAPHIC] [TIFF OMITTED] T9083.098

[GRAPHIC] [TIFF OMITTED] T9083.099

[GRAPHIC] [TIFF OMITTED] T9083.100

[GRAPHIC] [TIFF OMITTED] T9083.101

[GRAPHIC] [TIFF OMITTED] T9083.102

[GRAPHIC] [TIFF OMITTED] T9083.103

[GRAPHIC] [TIFF OMITTED] T9083.104

[GRAPHIC] [TIFF OMITTED] T9083.105

[GRAPHIC] [TIFF OMITTED] T9083.106

[GRAPHIC] [TIFF OMITTED] T9083.107

[GRAPHIC] [TIFF OMITTED] T9083.108

[GRAPHIC] [TIFF OMITTED] T9083.109

[GRAPHIC] [TIFF OMITTED] T9083.110

[GRAPHIC] [TIFF OMITTED] T9083.111

[GRAPHIC] [TIFF OMITTED] T9083.112

[GRAPHIC] [TIFF OMITTED] T9083.113

[GRAPHIC] [TIFF OMITTED] T9083.114

[GRAPHIC] [TIFF OMITTED] T9083.115

[GRAPHIC] [TIFF OMITTED] T9083.116

[GRAPHIC] [TIFF OMITTED] T9083.117

[GRAPHIC] [TIFF OMITTED] T9083.118

[GRAPHIC] [TIFF OMITTED] T9083.119

[GRAPHIC] [TIFF OMITTED] T9083.120

[GRAPHIC] [TIFF OMITTED] T9083.121

[GRAPHIC] [TIFF OMITTED] T9083.122

[GRAPHIC] [TIFF OMITTED] T9083.123

[GRAPHIC] [TIFF OMITTED] T9083.124

[GRAPHIC] [TIFF OMITTED] T9083.125

[GRAPHIC] [TIFF OMITTED] T9083.126

[GRAPHIC] [TIFF OMITTED] T9083.127

[GRAPHIC] [TIFF OMITTED] T9083.128

[GRAPHIC] [TIFF OMITTED] T9083.129

[GRAPHIC] [TIFF OMITTED] T9083.130

[GRAPHIC] [TIFF OMITTED] T9083.131

[GRAPHIC] [TIFF OMITTED] T9083.132

[GRAPHIC] [TIFF OMITTED] T9083.133

[GRAPHIC] [TIFF OMITTED] T9083.134

[GRAPHIC] [TIFF OMITTED] T9083.135

[GRAPHIC] [TIFF OMITTED] T9083.136

[GRAPHIC] [TIFF OMITTED] T9083.137

[GRAPHIC] [TIFF OMITTED] T9083.138

[GRAPHIC] [TIFF OMITTED] T9083.139

[GRAPHIC] [TIFF OMITTED] T9083.140

[GRAPHIC] [TIFF OMITTED] T9083.141

[GRAPHIC] [TIFF OMITTED] T9083.142

[GRAPHIC] [TIFF OMITTED] T9083.143

[GRAPHIC] [TIFF OMITTED] T9083.144

[GRAPHIC] [TIFF OMITTED] T9083.145

[GRAPHIC] [TIFF OMITTED] T9083.146

[GRAPHIC] [TIFF OMITTED] T9083.147

[GRAPHIC] [TIFF OMITTED] T9083.148

[GRAPHIC] [TIFF OMITTED] T9083.149

[GRAPHIC] [TIFF OMITTED] T9083.150

[GRAPHIC] [TIFF OMITTED] T9083.151

[GRAPHIC] [TIFF OMITTED] T9083.152

[GRAPHIC] [TIFF OMITTED] T9083.153

[GRAPHIC] [TIFF OMITTED] T9083.154

[GRAPHIC] [TIFF OMITTED] T9083.155

[GRAPHIC] [TIFF OMITTED] T9083.156

[GRAPHIC] [TIFF OMITTED] T9083.157

[GRAPHIC] [TIFF OMITTED] T9083.158

[GRAPHIC] [TIFF OMITTED] T9083.159

[GRAPHIC] [TIFF OMITTED] T9083.160

[GRAPHIC] [TIFF OMITTED] T9083.161

[GRAPHIC] [TIFF OMITTED] T9083.162

[GRAPHIC] [TIFF OMITTED] T9083.163

[GRAPHIC] [TIFF OMITTED] T9083.164

[GRAPHIC] [TIFF OMITTED] T9083.165

[GRAPHIC] [TIFF OMITTED] T9083.166

[GRAPHIC] [TIFF OMITTED] T9083.167

