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



 
                      THE RATINGS GAME: IMPROVING 
                     TRANSPARENCY AND COMPETITION 
                    AMONG THE CREDIT RATING AGENCIES 

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                           SEPTEMBER 14, 2004

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-110






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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

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














                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    September 14, 2004...........................................     1
Appendix:
    September 14, 2004...........................................    23

                               WITNESSES
                      Tuesday, September 14, 2004

Egan, Sean, Managing Director, Egan-Jones Ratings Co.............    10
Kaitz, James A., President and CEO, Association for Financial 
  Professionals..................................................     4
Pollock, Alex J., Resident Fellow, American Enterprise Institute.     9
Putnam, Barron H., President and Chief Economist, LACE Financial 
  Corporation....................................................     6

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    24
    Gillmor, Hon. Paul E.........................................    26
    Kanjorski, Hon. Paul E.......................................    27
    Egan, Sean...................................................    29
    Kaitz, James A...............................................    31
    Pollock, Alex J..............................................    52
    Putnam, Barron H.............................................    55













                      THE RATINGS GAME: IMPROVING
                      TRANSPARENCY AND COMPETITION
                    AMONG THE CREDIT RATING AGENCIES

                              ----------                              


                      Tuesday, September 14, 2004

             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 10:04 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Gillmor, Biggert, Capito, 
Brown-Waite, Kanjorski, Moore, Ford, Lucas of Kentucky, 
McCarthy, and Scott.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order.
    The purpose of this morning's hearing is to again review 
the performance and regulatory authority for the conduct of 
what are commonly known as the credit rating agencies. On April 
2, 2003, this committee convened a hearing in the course of its 
normal review of market sector performance to hear from a 
representative of the SEC and others concerning the status of 
and performance of the rating agency community.
    To date, there is not clearly established a methodology by 
which a corporate entity may become recognized as a rating 
agency. There is no ongoing supervision as to the methodologies 
utilized in performing their duty, and there is not a method to 
formally decommission an agency once having been designated.
    The purpose of today's hearing is to receive additional 
comment as to the advisability of either SEC rule or 
legislative action to provide additional transparency, to 
provide sufficient disclosure as to methodologies, and to 
evaluate the very manner by which these agencies engage in 
their rating practices.
    The Investment Company Act requires the maintenance of at 
least two rating agency analyses before issuance of public 
debt, and therefore there is a statutory requirement that 
public corporations utilize the services of these rating 
agencies. That makes it all the more important for us to make 
sure that market participants fully understand their function 
and the methodologies by which these ratings are issued. It is 
clear, at least to me, that we are a long way from that type of 
functioning system.
    Secondarily, it is extraordinarily important that the 
agencies engage in and conduct arms-length evaluations to 
ensure the ratings which are used by many in the market for 
various purposes are reliable and professional. It is troubling 
to realize the superficial nature by which many of the ratings 
have been issued and the reliance that many have placed upon 
that data. We only have to return to the bursting bubble a few 
months back and painfully look at the ratings issue just prior 
to many prominent corporations' announced bankruptcies.
    How is it that these events came to pass? What is it that 
needs to be changed to ensure that it does not occur again in 
the future? And are there other options available to us to 
obtain the necessary financial data without perhaps mandatory 
reliance on the rating agency system as it is structured today?
    For all these reasons, the committee meets. We will be 
pleased to hear the comments of those who have agreed to 
testify, and would point out that Standard & Poor's, which was 
invited to participate, notified the committee as of yesterday 
they would be unable to attend here today. We look forward to 
hearing from them on another occasion.
    With that, I yield to the gentleman from Pennsylvania.
    Mr. Kanjorski. Mr. Chairman, we meet for the second time in 
the 108th Congress to examine the issue of credit rating 
agencies.
    Entities like Moody's, Standard & Poor's and Fitch have 
long published their views on the creditworthiness of the 
issuers of debt securities. The importance of these opinions 
has grown significantly in recent years as a result of the 
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.
    As you know, Mr. Chairman, I have made investor protection 
one of my top priorities. I believe that strong regulation 
helps to protect the interests of America's investors.
    Accordingly, I am pleased that we have worked diligently 
during the last several years to augment the resources 
available to the Securities and Exchange Commission, enacted 
sweeping reforms of auditing and accounting practices, restored 
accountability to investment banking and analyst research, and 
improved the conduct of business executives and corporate 
boards. Although credit rating agencies received some scrutiny 
after the recent tidal wave of corporate scandals, we have not 
yet mandated any substantive changes in their practices.
    Nevertheless, this issue is ripe for examination and 
action. At hearings before our committee last year, the 
commission's Director of Market Regulation noted that while 
credit rating agencies have generally performed their work well 
for nearly a century, they have also missed some colossal 
failures in recent years. A Senate investigative report also 
found that the monitoring and review of Enron's finances ``fell 
far below the careful efforts one would have expected from 
organizations whose ratings hold so much importance.''
    After last year's hearing, I was hopeful that the 
commission would take swift action regarding these matters. It 
did belatedly issue a concept release to examine the issues 
surrounding rating organizations in June of 2003. Since that 
time, the commission has continued to study these matters 
without reaching any conclusion. The commission, I should note, 
has been examining these matters for more than a decade.
    Although a formal proposal for improved oversight of credit 
rating agencies has yet to emerge, a top official at the 
commission did suggest in a recent speech that additional 
legislative authority may be needed I this area.
    I have previously urged the commission to act promptly and 
prudently in these matters. It is therefore my expectation that 
it will move expeditiously in the coming months to finalize its 
opinions on credit rating agencies and advise us about the most 
appropriate steps to take in these matters during the 109th 
Congress.
    When we revisit these matters next year, it is also my hope 
that we will be able to put together a more inclusive and 
comprehensive hearing. We are fortunate today to have with us 
two rating professionals. We will also hear from the 
Association for Financial Professionals, which has taken a 
leading role in examining the need and identifying ways to 
improve the oversight of credit rating agencies.
    Rather than rushing to hold a hearing, our proceedings 
would have greatly benefited if we had waited and been able to 
receive the testimony of the commission, major credit rating 
agencies, and other interested parties.
    In closing, Mr. Chairman, we are at a crucial moment in the 
evolution of our capital markets. We must act to ensure the 
continued integrity of the rating agencies and the credit 
rating process. I also look forward to continuing to work with 
you as we move forward deliberately on these important matters.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 27 in the appendix.]
    Chairman Baker. I thank the gentleman.
    Mr. Scott?
    Mr. Scott. Thank you, Mr. Chairman.
    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 affect the 
securities markets in many ways, but the Securities and 
Exchange Commission has not performed any significant oversight 
over rating agencies. Several of the large corporate scandals 
at Enron, WorldCom and other companies were not brought to the 
attention of regulators by the rating agencies.
    Since 1994, the SEC has developed proposed rulemaking to 
provide better oversight of rating agencies. I believe that it 
is time for the SEC to try to provide a better standard for 
oversight of rating agencies. In that regard, Mr. Chairman, I 
look forward to hearing from our distinguished panel about 
recommendations for the SEC review of the credit agencies.
    Chairman Baker. Thank you, Mr. Scott.
    Ms. McCarthy, did you have a statement?
    Mrs. McCarthy. Thank you, Mr. Chairman. I will hand in my 
opening statement. I would rather hear the testimony.
    Chairman Baker. Thank you, Ms. McCarthy.
    If we could please have our witnesses come forward, we 
would like to recognize you at this time. This morning, we are 
pleased to have Mr. Sean Egan, managing director of Egan-Jones 
Rating Company; Mr. James A. Kaitz, President and CEO, 
Association for Financial Professionals; Dr. Barron H. Putnam, 
President and chief economist, LACE Financial Corporation; and 
Mr. Alex J. Pollock, resident fellow, American Enterprise 
Institute.
    Since Mr. Egan is a little behind this morning, we are 
going to start first with Mr. Kaitz.
    Welcome, sir.

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

    Mr. Kaitz. Thank you, Congressman.
    Good morning, Chairman Baker, Ranking Member Kanjorski, and 
members of the committee. I am Jim Kaitz, President and CEO of 
the Association for Financial Professionals.
    AFP welcomes the opportunity to participate in today's 
hearing on improving competition and transparency among the 
credit rating agencies. As we have continually noted, AFP 
believes that the credit rating agencies and investor 
confidence in the ratings they issue are vital to the efficient 
operation of global capital markets.
    AFP represents more than 14,000 finance and treasury 
professionals representing more than 5,000 organizations. 
Organizations represented by our members are drawn generally 
from the Fortune 1000 and the largest of the middle-market 
companies from a very wide variety of industries. Many of our 
members are responsible for issuing short-and long-term debt 
and managing corporate cash and pension assets for their 
organizations.
    In these capacities, our members are significant users of 
the information provided by credit rating agencies. Acting as 
both issuers of debt and investors, our members have a balanced 
view of the credit rating process and a significant stake in 
the outcome of the examination of rating agency practices and 
their regulation.
    When I appeared before this committee more than 17 months 
ago, I shared the results of a survey conducted by AFP in 
September 2002. In summary, that survey found that many of our 
members believe that the information provided by credit rating 
agencies is neither timely nor accurate and that the Securities 
and Exchange Commission should take steps to foster greater 
competition in the market for credit ratings and improve its 
oversight of rating agencies.
    AFP is currently conducting an update to the 2002 survey 
and preliminary results indicate that confidence in the credit 
rating agencies has not improved. We will be releasing the 
results of the updated survey later in the fall.
    In June of 2003, the SEC issued a concept release on rating 
agencies and the use of credit ratings under the federal 
securities laws. That concept release asked 56 questions about 
the nationally recognized statistical rating organization, 
designation, recognition criteria, the examination and 
oversight of NRSROs, conflicts of interest, and 
anticompetitive, unfair and abusive practices.
    The concept release asked market participants to provide 
answers in less than 60 days. Yet more than 15 months after 
this concept release and more than a decade after a similar 
concept release in 1994, the SEC has yet to provide a single 
answer of its own.
    To address many of the questions raised by the SEC and 
market participants, the Association for Financial 
Professionals in April of this year, along with treasury 
associations from the United Kingdom and France, took the 
initiative and developed an exposure draft of a Code of 
Standard Practices for Participants in the Credit Rating 
Process.
    We are currently reviewing comments we received on the 
exposure draft and intend to release our final recommendations 
later this year. We developed the draft code in an effort to 
improve investor and issuer confidence in the credit rating 
agencies and the ratings they promulgate. This is particularly 
important in light of the SEC's continued inaction.
    I have submitted a copy of the code, along with my 
testimony. However, I would like to take a minute to summarize 
the key themes. The code contains recommendations for 
regulators, as well as rating agencies and issuers. To be 
clear, the code is a private-sector response intended to 
complement rather than replace regulation.
    Regulatory recommendations in the code of standard 
practices focus on establishing transparent recognition 
criteria based on whether a credit rating agency can 
consistently produce credible and reliable ratings over the 
long term. Establishing clearly defined recognition criteria is 
a crucial step to removing barriers to entry and enhancing 
competition in the credit ratings market.
    The regulatory recommendations also include improving 
ongoing oversight of approved rating agencies to ensure that 
NRSROs continue to meet the recognition criteria. The code also 
urges regulators to require that rating agencies document 
internal controls that protect against conflicts of interest 
and anticompetitive and abusive practices that may arise from 
ancillary services such as corporate governance reviews and 
ratings advisory services.
    For rating agencies, the code includes suggestions to 
improve the transparency of the rating process, protect non-
public information provided by issuers, protect against 
conflicts of interest, address the issue of unsolicited 
ratings, and improve communication with issuers and other 
market participants.
    Finally, recognizing that the credibility and reliability 
of credit ratings is heavily dependent on issuers' providing 
accurate and adequate information to the rating agencies, the 
code of standard practice outlines issuer obligations in the 
credit rating process. These obligations are intended to 
improve the quality of the information available to the rating 
agencies during the initial rating process and on an ongoing 
basis, and to ensure that issuers respond appropriately to 
communications received from rating agencies.
    Other organizations have also taken steps to address this 
critical issue. The International Organization of Securities 
Commissions, IOSCO, in September 2003 issued a statement of 
principles regarding the manner in which rating agency 
activities are conducted. In February of this year, IOSCO also 
announced the formation of a special task force chaired by SEC 
Commissioner Campos to develop a code of conduct for credit 
rating agencies. We expect IOSCO to issue that code shortly.
    In July, the Committee of European Securities Regulators, 
at the request of the European Commission, issued a call for 
evidence on possible measures concerning credit rating 
agencies. The committee intends to review comments, develop a 
consultation paper, hold an open hearing, and approve and 
publish its final advice to the European Commission in March 
2005, I would note, less than 8 months after the commencement 
of its activities.
    Despite all this activity, the SEC remains silent on the 
appropriate regulation of credit rating agencies. At hearings 
before the Bond Market Association in January, a senior SEC 
official admitted that the commission needs to come up with an 
approach or ``cede the area'' to other rulemakers. By its 
continuing inaction on this issue, the SEC is abdicating its 
responsibility to capital market participants and potentially 
subjecting issuers, investors and rating agencies to a 
fragmented, duplicative and overly prescriptive regulatory 
regime.
    A reasonable regulatory framework that minimizes barriers 
to entry and is flexible enough to allow innovation and 
creativity will foster competition among existing NRSROs and 
those that may later be recognized and restore investor 
confidence in the rating agencies and global capital markets. 
Rather than excessively prescriptive regulatory regimes, 
innovation and private-sector solutions, such as AFP's Code of 
Standard Practices, are the appropriate responses to many of 
the questions that have been raised about credit ratings.
    Restoring issuer and investor confidence in the credit 
ratings process is critical to global capital markets. We 
commend you, Mr. Chairman and the committee, for recognizing 
the importance of this issue and its impact on all 
institutional and individual participants in global capital 
markets. We hope this hearing will motivate the SEC to action.
    In addition, regulators should require rating agencies to 
develop policies to insure against the inappropriate use of 
nonpublic information to which the rating industries are privy 
because of their exemption from regulation FD. Recently, the 
SEC took action against a former credit rating agency employee 
who used nonpublic information regarding pending mergers for 
personal enrichment. While we cannot comment on the specifics 
of this case, this again highlights the need for the SEC to 
take an active role in the oversight of credit rating agencies.
    Thank you.
    [The prepared statement of James A. Kaitz can be found on 
page 31 in the appendix.]
    Chairman Baker. Thank you very much, sir. We appreciate 
your comments.
    Dr. Putnam, please proceed.

 STATEMENT OF BARRON H. PUTNAM, PRESIDENT AND CHIEF ECONOMIST, 
                   LACE FINANCIAL CORPORATION

    Mr. Putnam. Thank you, Mr. Chairman and other distinguished 
members of the committee. My name is Barron Putnam and I am 
President of LACE Financial Corporation. I am a former staff 
member of the Federal Reserve Board here in Washington. While I 
was at the Fed, I chaired the committees that put together--
this is a three-interagency bank committee that put together 
the off-site rating system for the Fed. I also set up the Bank 
Holding Company Analysis Program for the Fed and I directed for 
the Fed the surveillance of all banks and bank holding 
companies for a period of 10 years.
    I left the Fed in 1984 and established LACE Financial 
Corporation. LACE Financial rates approximately 20,000 
institutions. We have issued over a period of 20 years about 
1.2 million credit ratings. We have never received a complaint 
from a regulator, be it state or federal or any regulator, nor 
have we ever had a serious threat of a lawsuit. We have 
actually rated banks and other financial institutions prior to 
Moody's and Standard & Poor's entering the market.
    I have been in the banking business for more than 25 years. 
I would like to say that it is an honor for me to sit here 
today before your committee.
    I would like to address two areas of concern to your 
committee, the NRSRO designation process and the 
anticompetitive effects that the SEC net capital rules and the 
NRSRO designation have on a rating company like ours.
    First, we submitted our application for NRSRO status back 
in 1992. Eight years later, we received a phone call from a 
lawyer at the SEC stating that our application was denied. I 
asked him what the reason was, and he could not give that to me 
over the phone. So I said, well, would you put it in writing. 
He was a little surprised that I asked for that, but they sent 
it to me and the denial was based on the fact that we only had 
three financial analysts. I wrote back to them saying this was 
an error; that in fact we had 10 financial analysts and that 
eight were involved in the ratings process.
    We received another letter, which stated the NRSRO 
criteria, which I am sure most of you are familiar with. It is 
very detailed and lengthy. And then they stated at the bottom 
of the letter that our application had been denied because you 
did not meet the criteria above. They did not say what part of 
the criteria. When we saw that Congress was interested in this 
issue as well as the press we appealed our application. We sent 
our appeal in and it has been now 2 years and 3 months and we 
have not heard anything from the SEC.
    To me, this is deja vu. I think that given what we have 
gone through, I do not feel that any person or corporation 
should go through something in this manner. It is just that an 
agency of the government should not act in this way. Obviously, 
there needs to be transparency in this process and the 
application process needs to be expedited.
    I also would like to say that I feel that the SEC staff, 
and I think it is the policies, not necessarily the staff 
members, have more of an adversary view towards companies like 
ours. It should be the other way around. They should be 
proactive. If a company does not meet the criteria, they should 
state why and let the company come back and show that in fact 
what it is that they need so that they can go on and eventually 
become an NRSRO company.
    Now, the other point I would like to speak to the committee 
on is the effects of both the net capital rules and the NRSRO 
designation on the ability of a company like ours, a small 
company, to effectively compete with other NRSRO companies. 
First, Moody's, Standard & Poor's and Fitch have tremendous 
name recognition and market share. That is a tough act to 
compete against. However, from the very beginning, all we 
wanted was to be on a level playing field with these companies. 
The problem is, and people at this table know this well, that 
we are prohibited by law, federal law, the SEC regulations, to 
compete with these existing NRSRO companies.
    The designation and the use in the bylaws of large 
corporations prohibit companies like ourselves from being able 
to use these companies as clients. To put it in other words, if 
the company does not have an investment-grade rating from an 
NRSRO company, those are the only ratings they can use, either 
credit ratings or buy securities of those companies. That keeps 
us, we cannot compete with a very large portion of the AFP 
members. Although we do have several clients in that 
organization, many of them are prohibited from using us. I used 
to get, and finally the gentleman gave up, from GE Capital, an 
e-mail asking me when we were going to get that status because 
they want to use us. Finally, he just gave up because I sent 
him back I was not sure.
    But it is a very tough problem. In 1992, about the time we 
submitted our application, Thompson Bank Watch received NRSRO 
status. Our revenues prior to that time were growing about 25 
or 30 percent a year. For 10 years, they just stopped growing. 
They stagnated. Only until recently have our revenues starting 
picking up and growing about 20 percent because we have entered 
into new security issues. We have kind of broken into that 
market, but it has taken us 20 years to do so. It is a very 
tough game for a non-NRSRO company to basically stay in this 
business.
    If you want to bring competition into this industry, you 
not only have to recognize companies like ours, Sean's company, 
also there are several others out there that are very credible 
companies, but they have to aid these companies in becoming 
larger and better competitors. The NRSRO status is a double-
edged sword. It keeps you from competing, but if you receive 
the designation it will help you a great deal in growing 
because clients will come your way if you are good and 
credible. Companies like ourselves have to grow about 40 
percent a year to become effective competitors to the NRSRO 
companies.
    Moody's and Standard & Poor's, I do not know exactly, but 
they are growing about 20 percent a year, about what we are, 
but our size is so small relative to theirs that we will not 
become effective competitors unless we grow faster. We cannot 
do it unless we have the NRSRO status.
    Thank you, sir.
    [The prepared statement of Barron H. Putnam can be found on 
page 55 in the appendix.]
    Chairman Baker. Thank you very much.
    Welcome back, Mr. Pollock. I think this is your first 
appearance in your new capacity.

    STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. Pollock. It is, Mr. Chairman, and thank you very much. 
Mr. Chairman, Ranking Member Kanjorski, and members of the 
committee. It is a pleasure to be here to present my views, 
which focus on the unintended cartel-like effects of the SEC's 
regulation of rating agencies through its NRSRO designation.
    I must say I find Dr. Putnam's comments very convincing. He 
expresses in a specific case many of the same things I am going 
to say in a somewhat more abstract way. I then want to talk 
about what steps might be taken to reduce these barriers to 
competition.
    The theme of my work at the American Enterprise Institute 
is to examine ways to inject greater economic efficiency and 
market choice into situations in which the government in one 
way or another has created noncompetitive structures.
    What do we find in the rating agency sector? As Professor 
Larry White of New York University has written, ``The problem 
concerns the SEC's regulation of the bond rating industry. 
Incumbent bond rating firms are protected; potential entrants 
are excluded, and new ideas and technologies for assessing the 
riskiness of debt, and therefore the allocation of capital, may 
well be stifled. This entry regulation is a perfect example of 
good intentions gone awry.''
    The fundamental source of the problem is that the 
designation ``nationally recognized statistical rating 
organization'' or NRSRO has become embedded in numerous rules 
of numerous regulators. The only way to get to be an NRSRO is 
to be designated as one by the SEC, and this involves, as many 
commentators have pointed out, a practically insuperable Catch-
22.
    The SEC's own concept release, which was referred to 
earlier by the ranking member, on the subject states that in 
order to become a recognized NRSRO, ``The single most important 
criterion is that the rating agency is widely accepted in the 
U.S. as an issuer of credible and reliable ratings by the 
predominant users of securities ratings.''
    To summarize their position, you cannot be widely accepted 
by the predominant users unless you are an NRSRO, but you 
cannot become an NRSRO unless you are already widely accepted. 
That is the Catch-22. The same SEC release says, ``Some 
commenters believe that the NRSRO designation acts as a barrier 
to entry into the credit rating business.'' There seems to be 
no doubt that these commenters, which include the Department to 
Justice, are correct.
    It seems to me that we should simply consider that when 
John Moody published his first ratings in 1909, or when Poor's 
Publishing Company published its first ratings in 1916, or the 
Fitch Publishing Company published its first ratings in 1924, 
they were not yet ``widely accepted by the predominant users.'' 
They all had to discover a market need, and compete their way 
into becoming nationally recognized in time.
    Dr. Putnam also touched on the natural barriers to entry in 
the credit rating business, which seem to be pretty 
substantial, including the need to establish reputation, 
reliability and integrity; a definite prestige factor involved 
in the purchase of opinions and judgments; and natural 
conservatism of the users of ratings. To add to this a 
``distortionary entry restriction regime,'' to use Professor 
White's phrase, ensures a noncompetitive outcome.
    What could be done to make this business more competitive? 
I suggest four possible actions. First, it is clear that what 
NSRSO really means is ``SEC approved rating agency.'' The term 
``NRSRO'' with its implication that is represents some sort of 
a market test, which 30 or 40 years ago it did, but it no 
longer does, should be dropped altogether. If the SEC continues 
to require its own approval of raging agencies for regulatory 
purposes, at least we could get the designation accurate and 
just make it ``SEC approved.''
    Second, if the SEC continues to require its approval of 
rating agencies, the Catch-22 criterion of having to be 
``nationally recognized'' in advance should be simply 
eliminated.
    Third, the approval of rating agencies for specialized 
purposes, as the SEC has sometimes done in the past, should be 
encouraged. Such specialization might be an industry, for 
example, financial institutions; a country, for example, Japan; 
or any other logical domain defined by competence and 
knowledge. This would allow new entrants to create competition 
based on their skills and where they are best able to compete, 
to demonstrate in those specialized domains their value, and if 
they succeed, then to grow organically.
    Fourth, in my opinion, in the best case, not only the term 
``NRSRO'' but also the requirement of designation by the SEC 
would be dropped. Instead, the responsibility to choose among 
rating agency alternatives should belong to investors, 
financial firms, securities issuers and other users, in short, 
the market. Every firm should have among its financial and risk 
management policies its approved policies for how it uses 
credit ratings and whose ratings can be used for what.
    These policies should be appropriately disclosed, and could 
be examined by any relevant regulators. Under these 
circumstances, which rating agencies turn out to be nationally 
recognized would reflect a true competitive market test, and 
that competition would provide its normal benefits of 
innovation, improved services, lower cost, choice and 
efficiency.
    Thank you very much for the opportunity to testify, Mr. 
Chairman.
    [The prepared statement of Alex J. Pollock can be found on 
page 52 in the appendix.]
    Chairman Baker. Thank you, Mr. Pollock.
    I wish to welcome Mr. Sean Egan, managing director, Egan-
Jones Rating Company.
    Welcome.

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

    Mr. Egan. Thank you. I apologize for being late.
    Chairman Baker, members of the subcommittee, good morning. 
I am Sean Egan, managing director of Egan-Jones Ratings 
Company, a credit ratings firm. By way of background, I am a 
co-founder of Egan-Jones Ratings, which was established to 
provide timely, accurate credit ratings to institutional 
investors.
    Our firm differs significantly from other rating agencies 
in that we have distinguished ourselves by providing timely, 
accurate ratings and we are not paid by issuers of debt, which 
we view as a fundamental conflict of interest. Instead, we are 
paid by approximately 400 firms consisting mainly of 
institutional investors and broker-dealers. We are based in a 
suburb of Philadelphia, although we do have employees that 
operate from other offices.
    The rating industry currently is suffering from a severe 
lack of competition. S&P and Moody's dominate the industry, 
which has caused the following problems. One, issuers pay too 
much for capital because they are underrated; and two, 
investors are not provided with sufficient warning about 
failing firms such as Enron, WorldCom, and Parmalat.
    By way of interest, we receive a lot of publicity for our 
identifying problem companies. That is because reporters like 
to report on that. But in reality, we have pointed out many 
more cases where companies are underrated, that is they are 
paying too much for capital.
    There are few industries where the two major firms do not 
directly compete, and yet control over 90 percent of the 
revenues. Since two ratings are needed to issue debt, the two 
major firms do not compete and therefore are not subjected to 
the normal checks and balances. Even after the recent credit 
rating debacles, S&P and Moody's revenues have continued to 
grow because of their lock on the market.
    To put the industry structure in perspective, it is as 
though there are only two major broker-dealers for corporate 
securities and the approval of both were required before any 
transactions could be completed. Some other manifestations of 
the limited competition include abuses in the use of 
unsolicited ratings and heavy-handed marketing of related 
corporate services such as issuer governance ratings.
    Regarding Egan-Jones, we have provided warning for the 
Enron, Genuity, Global Crossing and WorldCom failures. We did 
not rate Parmalat. Furthermore, we regularly identify improving 
credits. Most of our ratings have been above S&P's and Moody's 
over the past 2 years, thereby providing issuers with more 
competitive capital. Our success has been recognized by the 
Federal Reserve Bank of Kansas City, which compared all our 
ratings since inception in December 1995 to those of S&P and 
Moody's. You can read the quote from that study. It is 
available online.
    Stanford University and the University of Michigan drew 
similar conclusions. That also is available online. In August 
1998, we applied for recognition by the SEC as a ratings firm, 
i.e. NRSRO status. We continue to provide information to the 
SEC and hope to eventually be recognized.
    To reform the ratings industry, we recommend the following 
changes. One, recognize some rating firms which have succeeded 
in providing timely, accurate ratings. Two, wean rating firms 
from issuer compensation. We think that is a fundamental 
conflict, just like the equity analyst problem. Three, adopt a 
code of standard practices for participants in the credit 
rating process issued by the ACT, AFP, and AFTE. And four, 
encourage SEC action. This area has been under review since the 
early 1990s and is in dire need of reform. The costs of 
delaying the recognition of additional rating firms is far 
greater than the benefit of additional study.
    There are two additional points that I would like to make. 
That is, one of my colleagues brought up the issue of national 
recognition criteria being dropped. We disagree with that. We 
believe that the successful firms can achieve national 
recognition. We have national recognition. A recent firm that 
was admitted by the SEC, DBRS, according to outside studies did 
not have that recognition in the United States. We take issue 
with the application of those criteria.
    The second problem is that it may be worth finding out why 
it is that there has been such a delay in taking action. We 
tend to believe that it is because the SEC has bought into the 
notion offered by S&P and Moody's that more competition in this 
area would lead to problems. That is, there would be rate 
shopping. We think in those cases where the rating firm is not 
paid by the issuers, that is not a problem. But there has to be 
some fundamental cause for the huge delay in action in this 
area, and this may be one of them.
    Thank you very much.
    [The prepared statement of Sean Egan can be found on page 
29 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Egan.
    I appreciate each of your perspectives on this important 
issue. It is clear to me there is not an objective standard by 
which a corporation may comply and be assured it will achieve a 
NRSRO status. There really is no oversight of an entity once it 
has received a designation, and there is not an official 
decommissioning process by which such an award may be removed.
    Secondly, it is not very clear as to what standards of 
review the rating agencies utilize in determining a public 
corporation's rating; that prior to the rating being made 
public, the agency can meet with a subscriber and go over the 
information or release it previously prior to public 
disclosure; that an agency can send a bill to a public company 
without having solicited the rating, which creates an 
interesting problem for the company, I am sure; and that at the 
end of the day the rating agency performance in the midst of 
the corporate crisis we faced was frankly marginally, if better 
at all, than the broader market controls that seem to have 
failed us generally.
    It leads me to the question or the observation, this may be 
one area where the Congress can actually act and not make 
matters worse. There is no room for us to go downhill from 
here. In light of that, we have had a concept release as early 
as 1994 by the SEC, subsequent concept release, and to date 
still no recommendation for action either for the SEC or for 
the Congress.
    I am very troubled by this because of the Public Company 
Investment Act requires the maintenance of at least two ratings 
prior to issuance of public debt, and there appears to be great 
reliance on these ratings by many stakeholders without 
understanding fully the mechanisms by which these ratings are 
issued.
    I even have read of late where Basel is considering 
utilizing the rating agency determinations for determination of 
capital adequacy for financial institutions, which is a 
shocking turn of events given what I think I know about the 
agency's performance to date.
    I know that each of you has suggested that enhanced 
competition may be the ultimate reform that is most beneficial. 
But I am very concerned that that potential could have been 
exercised over the last decade, where resources could have been 
brought to bear, and as Dr. Putnam's case indicates, the 
languishing in response from the SEC to be told no for 2 years 
is not the most professional standard of conduct.
    Is there anything short of incentivizing additional 
competitors? For example, some have suggested that utilization 
of credit spreads might be more beneficial in getting real 
critical examination of financials than looking with a 
retrospective view that apparently the rating agencies use.
    What other rating alternatives might there be available to 
us? Are there any? And is the only hope SEC action and 
competition? I just make that observation and question to the 
panel.
    Mr. Egan. Regarding credit spreads, we have a variety of 
clients including a number of hedge funds. I think if there is 
a turning to credit spreads as being the rating proxy, it would 
be fairly easy for sophisticated traders to manipulate it.
    Basically what they would do is buy up the company's 
securities and sometimes the float is not that great so it does 
not take much time to control the float; move down the spread, 
which would imply a higher rating; let other institutions get 
into that security and then move out. You can do that multiple 
times. It is very, very easy to manipulate a system like that.
    Also, there is some suggestion for pure quantitative 
systems. We started out, probably about 12 or 13 years ago when 
the firm was founded, as purely a quantitative shop. We found 
that it did not get us where our clients wanted to go. That is, 
we were maintaining 95 percent-plus accuracy. With a pure 
quantitative system, it would be between 85 and 90 percent. 
Typically, these quantitative systems rely on equity prices, 
and again you have mixed signals. For example, if a company 
announces a share buy-back, its share price will go up, but 
that would be a negative for credit quality.
    Chairman Baker. But in the current circumstance, though, 
the rating agency to a great extent relies on representations 
made by management. They do not appear at least to rely on 
audit or underlying financial examination to a great degree. 
How assured can we be that the manipulative effects you are 
concerned about are not already in the market?
    Mr. Egan. Sometimes they are and sometimes they are not. I 
think that the best safeguard is to have a viable competitive 
market, which we do not have.
    Chairman Baker. My time has just about expired, and I do 
have other members, but just one other question that concerns 
me about the way these markets function. Wouldn't it seem 
likely, given the way in which the review is now done, that the 
bigger the corporation the less scrutiny one might receive, and 
the further down the food chain you go the more likely the 
rating agency is to actually get involved into the real 
financials to make their determination?
    Mr. Egan. Sometimes there is greater scrutiny of the larger 
companies, but they are given the benefit of the doubt.
    Chairman Baker. Thank you.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Egan, you have been here so often you are starting to 
get the demeanor of a member of Congress.
    Mr. Egan. My wife is wondering about my multiple trips to 
Washington.
    [Laughter.]
    Mr. Kanjorski. Welcome.
    I do not know, if I were sitting at the table I sense a 
great deal of frustration. Am I correct?
    Mr. Egan. Yes.
    Mr. Kaitz. Yes.
    Mr. Putnam. Yes.
    Mr. Pollock. Yes.
    Mr. Kanjorski. We obviously can give the authority for the 
SEC to regulate a particular industry or activity, but after 
that it is in their hands.
    Dr. Putnam, you indicated 8 years your application was 
pending?
    Mr. Putnam. Yes, sir.
    Mr. Kanjorski. And, Mr. Egan, yours is 6 years?
    Mr. Egan. Ours is since 1998, so yes.
    Mr. Kanjorski. Six years.
    Do you think it is time that we throw up our hands and say 
that obviously the SEC does not want to be the regulatory body 
and we take the proposals of the professionals and craft 
authorization and assign it to the Federal Reserve and see if 
we have a better activity there and maybe you can create 
competition between the regulators.
    If a regulator does not seem to want to assert its 
authority in a field, let us find another regulator. What is 
your thought to that?
    Mr. Putnam. I am from the Fed, so I would look in that 
direction. But no, I think that the SEC should do it right.
    Mr. Kanjorski. What if we cannot make them? Obviously, 10 
years, Doctor.
    Mr. Putnam. Then it is time for change. There are obviously 
very serious problems, but it seems so simple, to be able to 
expedite an application and be more positive.
    Mr. Kanjorski. What do you think the underlying proposition 
for the delay is?
    Mr. Putnam. I think it is to maintain the status quo.
    Mr. Kanjorski. I mean, is there restriction of competition? 
Do they just want the majors in the field and nobody else?
    Mr. Egan. Our feeling is that if the area is not cleaned 
up; if the SEC cannot take action in the near future, that they 
should step away from regulating the area. Our relationship 
with the SEC has gone through different stages. At one point, 
they would not return our phone calls and simply ignored our 
requests. At this point, it appears as though we are making 
progress, but it is very easy to sidetrack that progress.
    It is very easy for them to compare us to S&P and Moody's 
and say you are significantly smaller, and therefore even 
though you have all these ratings correct, you warned investors 
about Enron, WorldCom and Global Crossing and Genuity, you 
still do not look big enough compared to them. At which point, 
we think that we would be fairly upset, because neither the 
investors nor the corporations are being served by the current 
arrangement.
    Mr. Kanjorski. What do you want? To hang in for another 6 
years?
    Mr. Egan. No, I do not have that patience.
    Mr. Kanjorski. What do you want us to do? Myself, I am 
convinced after the second year of hearings that we will be 
back next year in the 109th, and we will just have to have 
larger handkerchiefs.
    [Laughter.]
    Mr. Egan. If there is not significant progress in the next 
6 months, consider withdrawing their ability to regulate this 
area.
    Mr. Kanjorski. As I say, why don't we prepare a model 
statute with the criteria set out of what the regulation should 
be and what the standards should be, and give them a year to 
promulgate rules and regulations and act to regulate, or 
automatic action that the authority transfers to the Federal 
Reserve.
    Mr. Egan. There are some other changes that are needed, 
too. The issue of compensation is something that is going to 
continue to cause problems. There are some issuers that pay 
multimillion-dollar fees and they are given the benefit of the 
doubt. If there is a collapse, and there are some problem 
companies out there right now, it will cause huge problems for 
investors.
    The flip side is that there are some corporations that are 
being basically shaken down by the major rating agencies for 
their governance ratings, which is wrong. Also, some issuers 
are not given the opportunity to respond to ratings.
    Mr. Kanjorski. You have convinced me. You made your 
argument and you convinced me. Now I am just trying to find a 
remedy.
    Mr. Pollock. Congressman, if I could comment from this end. 
I support your idea that you ought to go ahead and try to take 
some action, and that more competition on the regulatory front 
is not a bad idea either.
    As I read the history of the NRSRO designation, it was 
something of an accident. It started off as part of the haircut 
capital rules for securities firms and which ratings you held 
in inventory determined how big a capital haircut the position 
got. It grew into this preferred designation of firms. This 
looks to me something by historical accident, as other 
regulators then picked up the theme of whose ratings could 
count for various regulations.
    So I think your notion to do something to move it along is 
correct.
    Mr. Kanjorski. Mr. Kaitz?
    Mr. Kaitz. I would also support that at AFP.
    Also the code of standard practice, as we have proposed, as 
you have suggested, lays out regulatory recommendations for 
both the issuer as well as the credit rating agencies; talks 
about transparency in the process; talks about all the issues 
that have come up here today that need to be addressed by some 
regulatory body.
    But we would very much support Congress pushing the SEC 
into some action based upon the code of standard practice, with 
a limited regulatory framework.
    Mr. Kanjorski. Do you sense that if we took such action 
like that it may reflect on what happened with FASB and the 
stock options question? That at that point the regulatory 
agencies would run up here to the Congress and at least 
disclose themselves that they want to maintain a monopoly?
    Mr. Kaitz. I think you can draw a lot of comparisons to the 
accounting profession, as well, as has been noted by Sean and 
the equity analysts on the research side. These are all the 
same issues of separation of responsibility. They are as 
critical to global capital markets and U.S. capital markets as 
those two professions. So I do not know what the SEC would do. 
Are you referring to the credit rating agencies coming up here?
    The other thing you could speculate is that the SEC does 
not want to address this issue because they realize they do 
have regulatory authority here and they would have to enforce 
that authority to more firms. So I do not know what kind of 
resources that would take, but it seems to me that there has 
been a compelling case made for the SEC to take action here 
today.
    Mr. Kanjorski. I am particularly impressed with the fact 
that you make the point that there is a greater cost for 
capital because of the failure to have competition in a broader 
rating agency marketplace. I think that is a very compelling 
argument. We tend to think that five, 10, 15 basis points do 
not make a difference.
    Mr. Egan. It is far greater than that.
    A typical company would be Nextel. Nextel is a vibrant, 
exciting company that is changing the telecommunications 
industry. It is still not rated investment-grade even though, 
from the traditional measures, just taking them out 6 or 12 
months, it is very clear that this is a strong, vibrant company 
that has a high chance of being bought out by some of the other 
highly rated companies in the industry.
    So the bottom line is that it is not just five or 10 basis 
points. It is closer to about 50 or 100 or 150 basis points, 
and you are talking about $5 billion to $10 billion worth of 
debt.
    That is significant, and it is hurting young, growing 
companies. Sometimes there are older companies that have 
improved, but it is hurting companies like that, where they do 
not get a fair chance in the capital markets.
    Mr. Kaitz. Also, to the extent that the European countries 
implement their own regulations, which is likely to happen, you 
are going to have a fragmented process here, and that is 
definitely going to raise the cost of capital because a U.S. 
multinational company that wants to raise debt in other 
countries is then going to have to comply with multiple rules 
and multiple companies, and you know who is going to be paying 
for that.
    Mr. Kanjorski. So you think if we concluded, if the 
Chairman and I get together and put a piece of legislation 
together to set up your criteria for a regulation and offer 
certification of these agencies, that we will either get them 
to move or appropriately improve the industry.
    Is there anyone here at the table that thinks that this 
would be injurious to the rating agencies?
    Very good, thank you.
    Chairman Baker. I thank the gentleman.
    Ms. Brown-Waite?
    Ms. Brown-Waite. Thank you very much, Mr. Chairman.
    I would like to ask Mr. Pollock a few questions, and if any 
of the other gentlemen would like to jump in.
    First of all, I am what is called a freshman, a little old 
to be a freshman, but I moved to this committee. Has the SEC 
ever revoked NRSRO designations? And what would you anticipate 
if you could wave a magic wand? What should be the criteria for 
such revocation?
    And also, if I understand this correctly, each of the four 
SEC-approved rating agencies derives the bulk of its revenues 
actually from fees charged to the companies they rate. Isn't 
this a blatant conflict of interest? Am I missing something 
here? Should we be concerned, as we have been about the 
conflicts created by equity analysts being compensated based on 
the investment banking business that they bring in?
    I think if the average investor out there had any clue, 
they would really use the term, a fox watching over the chicken 
coop. I would just like to hear your views on this.
    Mr. Egan. No rating agency has had its NRSRO designation 
withdrawn. What has happened in the industry is that the firms 
have consolidated. As of about 5 years ago, there were about 
seven NRSROs. Three of them merged into Fitch. That was 
Thompson Bank Watch, Duff & Phelps and a London firm called 
IBCA. So there has been no withdrawal of the NRSRO designation 
or threat of withdrawal.
    We tend to think that there should be some basis for 
threatening that designation. In the case of Enron, it was 
rated investment-grade 4 days before it went bankrupt. So 
basically, it just took the time for the bankruptcy attorneys 
to put together the papers and then it was in bankruptcy. That 
is outrageous.
    What should have happened, in our opinion, is that their 
license, if you will, in the investment-grade area or else in 
the energy or utilities area, should have been on probation for 
6-, 12-or a 24-month period. There has to be some threat.
    There are other horror stories in the manufactured housing 
area, the securitization whereby AAA ratings had been 
downgraded to junk in the period of just an hour or so. In that 
case, it shows clear negligence on the part of the ratings 
firm. There should be some process where the license is 
suspended or in some kind of penalty box-type area for a period 
of time when things like that happen.
    Lastly, you mentioned the conflict of interest. That is a 
problem. It is a huge problem. This industry is basically 
accepted because of the lack of competition. People throw up 
their hands and say, well, it is S&P and Moody's; they really 
designate the ratings; we strongly disagree with that, but they 
have become the currency, if you will, in this area.
    First of all, that should be disallowed. It might take some 
time. Maybe they have to do it over a 5-year period, but that 
should not happen. You are waiting for another huge accident. 
The incentives are in the wrong place.
    Secondly, they should not be allowed to use the term 
``independent.'' They are not independent. Take it away. You 
are misleading the people who need the protection the most. 
They think that these terms are independent and they are being 
paid huge fees by selected issuers.
    So that is our response to those three issues.
    Mr. Pollock. Congresswoman, I would only add, it would be 
better to have a competitive market instead of having a cliff-
type decision that a regular would have to make. ``I am now 
taking away your license,'' is a very hard decision for people 
to make.
    The market, if there is poor performance, like the examples 
just cited, can little by little take the business away if 
there are in fact alternatives. From an investor point of view, 
if investors like better the idea of having ratings that the 
rated entity did not pay for, that they paid for themselves, 
why then would they gravitate to those ratings. If they thought 
it was okay to have the issuing company pay for ratings, they 
could purchase them. But none of that can happen if you do not 
have alternatives in the market available to the users of 
ratings, investors and others, to choose from.
    Mr. Baker. Thank you, Ms. Brown-Waite.
    Ms. McCarthy?
    Mrs. McCarthy. Thank you, Mr. Chairman.
    I am just curious, Mr. Chairman, are we going to have 
another hearing with the SEC and find out why this is 
happening? Or have you had it and I did not see it. I was not 
here.
    Chairman Baker. We had one about 18 months ago which was 
particularly painful for the SEC at that time.
    Mrs. McCarthy. Okay.
    Chairman Baker. I do not see how we can avoid revisiting 
this subject at some appropriate time. I need to visit further 
with my chairman and Mr. Kanjorski on any initiatives that 
might be contemplated. But be assured, this is the beginning, 
not the end of our process.
    Mrs. McCarthy. Because again, even though we both came on 
the committee 18 months ago, I probably had no idea what I was 
hearing. I am sorry. It takes a while to learn this stuff.
    The questions that I was going to ask actually have been 
answered in a number of give and take back, so I am not going 
to bother with that. But it has been a real eye-opener for me 
on a number of things. Let us face it, the majority of people 
do not understand it. I did not know there was anything else 
out there, but the two competitions are there. I thought that 
was just the way it was, so this has been fascinating for me.
    I thank you for the testimony and I thank you for bringing 
this hearing forward.
    Chairman Baker. Thank you, Ms. McCarthy.
    Ms. Biggert?
    Mrs. Biggert. Thank you, Mr. Chairman.
    I, too, think that the really basic questions have been 
asked, so I will just have a couple of questions. The Northern 
Trust Company submitted a comment in response to the SEC's 
concept release in which it stated that the major rating 
agencies have requested payment for unsolicited ratings, and in 
some instances paid the invoices in order to preserve the 
goodwill with the rating agency.
    So my question from that is, how would enhanced competition 
in the rating industry prevent this type of abuse? That would 
probably be for anyone who would like to answer.
    Mr. Putnam. I would like to answer that question. First, 
Northern Trust is a very financially sound organization. It has 
one of our highest ratings. However, we are not an NRSRO 
company, so they cannot divert to that. That competition will 
help in that area.
    I would like, if I can grab the microphone, to make a point 
that it is not just that some people are paying a very high 
price for capital. Some of them do not have access to capital 
markets. The fees charged by Moody's and Standard & Poor's and 
Fitch are so high for a rating that it may be 5 percent of the 
issue. Small companies cannot afford to raise capital in that 
arena. We are providing information to the committee showing 
that we have rated some companies as small as $23 million in 
asset size. This is a very serious problem.
    Another very serious problem that I do not believe has 
really been addressed by the SEC is that there are billions of 
dollars of excessive, and I feel the fees are very excessive, 
fees that are being paid by municipalities and by corporations 
for these ratings. Competition can bring these prices down 
considerably if in fact it can be generated. That I think is a 
very tough thing to do.
    The expertise in a rating agency is very hard to develop. 
It takes time to do this, and usually these companies, like 
Sean and myself, we specialize in a certain area. Once you get 
the NRSRO status, then you can branch out and then hopefully 
you can bring somebody in that helps you build your company and 
the SEC or the new regulator allows that to happen. You have to 
be very proactive in this arena.
    Mr. Egan. The reason why I think Northern Trust paid those 
fees is because they are afraid of alienating the two, in their 
mind, only two firms in this industry. It is another 
manifestation of the lock that they have on this industry. An 
example might be if your utility in the dead of winter 
overcharged you $50 or $100 or $200. You are far more likely to 
pay that additional amount than be faced with the threat of 
having the utility cut off.
    That is the case here. These companies, issuers cannot 
afford to be cut off. This industry has deteriorated to the 
point where there are only two firms in many participants' 
minds, and it is highly unhealthy and it is going to cause some 
additional Enrons in the future. It is going to cause some 
other companies to continue to pay much more for capital, so it 
has to be cleaned up.
    Mrs. Biggert. Do you think that not only are these firms 
afraid not to go to these companies, but also do you think that 
the rating fees then affect the ability of some of the largest 
rating firms to provide objective rating analysis?
    Mr. Egan. There is no question that they do. There is 
another problem that comes up with the issuer compensation, and 
that is, it was about 8 years ago in the municipal area whereby 
two municipalities refused to pay Moody's. It is in the Wall 
Street Journal, and I can send the reference in later. It was 
in the Wall Street Journal where these issuers refused to pay 
the rating fees that were being charged by Moody's. And Moody's 
just said, well, you should participate in our process.
    The issuer said, no, we are not going to. Moody's said, we 
have enough information in the public domain and we are going 
to give you a rating, period. And they gave them what I call a 
punishment rating, which significantly increased the cost of 
floating that issue. The municipalities subsequently sued and 
they were unsuccessful. They were unsuccessful because Moody's 
said the ratings are opinions and we are entitled to the 
freedom of speech. So it is just another indication of this 
unhealthy industry.
    Mrs. Biggert. I know that you would like to get into this.
    Mr. Egan. We already are issuing ratings. There are a 
number of clients that want to use our ratings for regulatory 
purposes and we told them they cannot until we get the 
designation.
    Mrs. Biggert. Okay. But the current NRSROs have already 
absorbed three companies.
    Mr. Egan. Yes.
    Mrs. Biggert. So how are you going to do this?
    Mr. Egan. There are two things that distinguish us. One is 
our success, and no one can match that in flagging Enron, 
WorldCom and these others, number one. And number two, we do 
not charge the issuers. We think we can continue our success 
and do very nicely.
    Mrs. Biggert. Thank you.
    Thank you, Mr. Chairman. I yield back.
    Chairman Baker. Thank you, Ms. Biggert.
    I want to just go back for a few brief points. I know other 
members may have follow-up questions.
    As to the elements that possibly should be considered in 
our construction of some remedy, it would appear to me that 
requiring an enhanced standard of disclosure for material 
facts, that it would seem that the agencies today rely to a 
great extent on representations made by management, without the 
benefit of a true audit.
    To have a requirement on management to disclose to a rating 
agency in the course of its inquiry any material fact that a 
reasonable man would assume would have some positive or 
negative or any impact on shareholder value would be sort of a 
minimum opening requirement; that in the course of developing 
whatever standards of review the rating agency determines is 
appropriate, that the elements that go into a rating 
determination be made public; the process by which you get from 
beginning to end.
    I also think it is important to disclose whether or not 
nonpublic information is utilized. Not that you disclose it, 
but simply the statement that we are using only publicly 
available information would tell any outside observer, they are 
only feeding us back what is readily available in the market, 
or we have insight to information you do not have, therefore 
this rating is based on that information. I think those are 
very helpful tools.
    And then finally, before reaching the ultimate rating 
determination, that that decision not be made available to the 
subscriber before it is being made available to the public. 
This goes back to our old analyst-investment banker problems 
where we had people able to get access to important information 
even hours, much less days ahead of time, seems to be an 
obvious, well, I hate to say impropriety, but certainly 
something that needs to be addressed.
    Then the rating outlooks that are made available by the 
agencies are troubling. Now, we are making a determination 
about current value based on representations of management 
without an audit. So at best, you can say the critical analysis 
of present-day value ought to be carefully examined, but we are 
going to permit a national rating agency to do a forecast for 
the next 18 months?
    There seems to be a little problem here in my mind with 
just sending someone an invoice for services you did not ask 
for, and the ability to forecast what you are going to look 
like 18 months from now. Now, I do not know if that bothers 
you, but I am from Louisiana and I can see that one coming.
    And then lastly, it was an issue in Sarbanes-Oxley, 
consulting services. It seems to me to be highly questionable 
as to whether or not you ought to be able to consult with 
someone for whom you are being asked to issue a public rating 
on which others may make their investment decisions, which 
certainly speaks directly to the issue of fees and the 
appropriateness of fees being paid to great extent for someone 
who is going to give you your report card.
    Any adverse comments about those observations or 
problematic observations, anyone?
    Mr. Kaitz. I would just say that almost all the issues that 
you addressed, Mr. Chairman, have been included in the code of 
standard practices, both for the credit rating agencies, as 
well as the issuers. So we would be very supportive of your 
framework.
    Mr. Putnam. I think a very serious problem with the 
existing NRSRO companies, if they issue ratings, they do not 
show the date necessarily that the rating was issued, nor do 
they show the data from which the rating was derived. I think 
that is very, very important, because if you do that and you 
show that for many other companies as well, and one rating does 
not adjust to that data, you can see that something is wrong.
    In our comments to your committee, we had made a suggestion 
that one way, I do not think the fee problem is going to be 
resolved right away. We do not charge for our credit ratings. 
We do charge for new issue ratings. You cannot help but do it. 
The financial analyst involved in this and the discussions with 
management are just so important.
    But one point that you made, I do not think a rating agency 
worth its salt should ever take what management says they are 
going to and base a rating on that. You have to judge the 
financial condition of an institution based on its financial 
soundness. LACE comes from liquidity, asset quality, capital 
and earnings. Those are the major determinants of financial 
soundness.
    If you take those and you show these determinants, along 
with the rating, that helps. Plus, these rating agencies, 
existing NRSROs should rate more frequently. They charge so 
much money. The balance sheets and income statements of these 
companies are put out quarterly. They are generally audited, 
and you can take that information and you can confirm or deny a 
rating, rather than just change that rating somewhere in the 
timeframe of a company. But if you show that information, you 
are going to bring more credibility to the rating process.
    Chairman Baker. What is it that is gained from a rating 
company analysis that is not already available from the 
quarterly statement?
    Mr. Putnam. Interpretation, analyst interpretation.
    Chairman Baker. So if we went back and looked at the 
outlook forecast for S&P and compared it to say the analyst 
community, we ought to be astounded by how well S&P is able to 
forecast.
    Okay, thank you. I think I have exercised all the time I 
should take.
    Any further questions? Ms. McCarthy?
    Mrs. McCarthy. Thank you.
    I think part of the question was answered, because when you 
said earlier conflict of interest on the pay, and then you came 
back, because I was sitting here wondering how do you guys make 
any money.
    Mr. Egan. We get paid by institutional investors.
    Mrs. McCarthy. Okay.
    Mr. Putnam. We get paid by subscribers primarily, but about 
20 percent of our revenues are derived on new issue ratings, 
and we do charge for that. But we do, as I have said, show 
those ratings every quarter. I provided to the committee, on 
some of the pools that we rate for structured preferred stocks, 
for community banks.
    We will actually follow that pool each quarter, re-rate the 
pool each quarter, and re-rate every member of the pool each 
quarter. We have a follow-up rating report that does that. It 
is the most advanced report in the industry that exists. That 
has been supplied to the committee. That is what should be 
done.
    Mrs. McCarthy. Okay. Thank you.
    Chairman Baker. There being no further questions, I want to 
express my appreciation to each of you for your participation. 
You have been most helpful. As I have indicated earlier, this 
is just another step in our review of this sector. We do have a 
lot of additional work ahead of us, and we appreciate your 
contribution.
    The meeting is adjourned.
    [Whereupon, at 11:20 p.m., the subcommittee was adjourned.]


                            A P P E N D I X



                           September 14, 2004




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