    [House Hearing, 109 Congress]
    [From the U.S. Government Publishing Office]

                           LEGISLATIVE SOLUTIONS FOR
                           THE RATING AGENCY DUOPOLY

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

                                    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 NINTH CONGRESS

                                 FIRST SESSION

                                   __________

                                 JUNE 29, 2005

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 109-42

                        U.S. GOVERNMENT PRINTING OFFICE
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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
    DEBORAH PRYCE, Ohio                  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 Chair   JULIA CARSON, Indiana
    RON PAUL, Texas                      BRAD SHERMAN, California
    PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
    JIM RYUN, Kansas                     BARBARA LEE, California
    STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
    DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
    WALTER B. JONES, Jr., North          HAROLD E. FORD, Jr., Tennessee
        Carolina                         RUBEN HINOJOSA, Texas
    JUDY BIGGERT, Illinois               JOSEPH CROWLEY, New York
    CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
    VITO FOSSELLA, New York              STEVE ISRAEL, New York
    GARY G. MILLER, California           CAROLYN McCARTHY, New York
    PATRICK J. TIBERI, Ohio              JOE BACA, California
    MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
    TOM FEENEY, Florida                  STEPHEN F. LYNCH, Massachusetts
    JEB HENSARLING, Texas                BRAD MILLER, North Carolina
    SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
    GINNY BROWN-WAITE, Florida           ARTUR DAVIS, Alabama
    J. GRESHAM BARRETT, South Carolina   AL GREEN, Texas
    KATHERINE HARRIS, Florida            EMANUEL CLEAVER, Missouri
    RICK RENZI, Arizona                  MELISSA L. BEAN, Illinois
    JIM GERLACH, Pennsylvania            DEBBIE WASSERMAN SCHULTZ, Florida
    STEVAN PEARCE, New Mexico            GWEN MOORE, Wisconsin,
    RANDY NEUGEBAUER, Texas
    TOM PRICE, Georgia                   BERNARD SANDERS, Vermont
    MICHAEL G. FITZPATRICK,
        Pennsylvania
    GEOFF DAVIS, Kentucky
    PATRICK T. McHENRY, North Carolina

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

                     RICHARD H. BAKER, Louisiana, Chairman

    JIM RYUN, Kansas, Vice Chair         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              DENNIS MOORE, Kansas
    FRANK D. LUCAS, Oklahoma             MICHAEL E. CAPUANO, Massachusetts
    DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
    EDWARD R. ROYCE, California          RUBEN HINOJOSA, Texas
    SUE W. KELLY, New York               JOSEPH CROWLEY, New York
    ROBERT W. NEY, Ohio                  STEVE ISRAEL, New York
    VITO FOSSELLA, New York,             WM. LACY CLAY, Missouri
    JUDY BIGGERT, Illinois               CAROLYN McCARTHY, New York
    GARY G. MILLER, California           JOE BACA, California
    MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
    PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
    J. GRESHAM BARRETT, South Carolina   BRAD MILLER, North Carolina
    GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
    TOM FEENEY, Florida                  NYDIA M. VELAZQUEZ, New York
    JIM GERLACH, Pennsylvania            MELVIN L. WATT, North Carolina
    KATHERINE HARRIS, Florida            ARTUR DAVIS, Alabama
    JEB HENSARLING, Texas                MELISSA L. BEAN, Illinois
    RICK RENZI, Arizona                  DEBBIE WASSERMAN SCHULTZ, Florida
    GEOFF DAVIS, Kentucky                BARNEY FRANK, Massachusetts
    MICHAEL G. FITZPATRICK,
        Pennsylvania
    MICHAEL G. OXLEY, Ohio

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        June 29, 2005................................................     1
    Appendix:
        June 29, 2005................................................    41

                                   WITNESSES
                            Wednesday, June 29, 2005

    Bolger, Rita M., Managing Director and Associate General Counsel,
      Standard and Poor's............................................    15
    Egan, Sean, Managing Director, Egan-Jones Ratings Co.............    11
    Kaitz, James A., President and CEO, Association for Financial
      Professionals..................................................    17
    Partnoy, Frank, Professor of Law, University of San Diego School
      of Law.........................................................     7
    Pollock, Alex J., Resident Fellow, American Enterprise Institute.    13
    Stroker, Nancy, Group Managing Director, Fitch Ratings...........     9

                                    APPENDIX

    Prepared statements:
        Oxley, Hon. Michael G........................................    42
        Hinojosa, Hon. Ruben.........................................    44
        Kanjorski, Hon. Paul E.......................................    45
        Bolger, Rita M...............................................    47
        Egan, Sean...................................................    64
        Kaitz, James A...............................................    72
        Partnoy, Frank...............................................    83
        Pollock, Alex J..............................................    99
        Stroker, Nancy...............................................   102

                  Additional Material Submitted for the Record

    Baker, Hon. Richard. H.:
        Letter from Investment Company Institute, June 29, 2005......   126
    Kanjorski, Hon. Paul E.:
        Letter from Securities and Exchange Commission, June 6, 2005.   127
        The Bond Market Association, prepared statement..............   131

                           LEGISLATIVE SOLUTIONS FOR
                           THE RATING AGENCY DUOPOLY

                                  ----------

                            Wednesday, June 29, 2005

                 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 10:05 a.m., in
    Room 2128, Rayburn House Office Building, Hon. Richard H. Baker
    [chairman of the subcommittee] Presiding.
        Present: Representatives Baker, Shays, Kelly, Biggert,
    Kennedy, Tiberi, Brown-Waite, Feeney, Gerlach, Hensarling,
    Fitzpatrick, Kanjorski, Sherman, Hinojosa, Clay, Scott, and
    Wasserman Schultz.
        [10:05 a.m.]
        Chairman Baker. I would like to call this meeting of the
    Capital Markets Subcommittee to order. I am advised that Mr.
    Kanjorski, the ranking member, is en route, and we are going to
    proceed and reserve the right for Mr. Kanjorski to give his
    opening statement should he not arrive at the conclusion of my
    own statement.
        Today, the subcommittee meets to discuss, for a change of
    pace--we are not on GSEs today; we are going to be talking
    about GSDs. And what is that, you ask? It is a Government
    Sponsored Duopoly. Now I read over several witness's testimony
    this morning and found myself almost immediately being
    corrected.
        I read the words "dual monopoly." Then I read "partner
    monopoly." Then I read "oligopoly." I am not sure what kind of
    opoly we have got this morning, but it will be the subject of
    the committee's discussions and determinations over the coming
    couple of hours.
        Since the early 20th century, credit rating agencies have
    been issuing ratings on the likelihood of issuers' default on
    debt payments. As a result of the difficult corporate period we
    have come through and the fact that dominant rating agencies
    were not accurately predicting Enron and WorldCom's financial
    condition, reforming the rating agency industry practice has
    been the subject of discussion over the last several years.
        The Subcommittee on Capital Markets has held a series of
    hearings on credit rating agencies. And most recently in April,
    Ms. Nazareth, director of the Division of Market Regulation,
    testified that to conduct oversight of the industry, the SEC
    needed more direct and explicit congressional authority to do
    so.
        The SEC also announced last March a proposal to define
    nationally-recognized statistical rating organizations as firms
    generally accepted in the marketplace.
        Some critics have once again criticized the SEC for what
    they believe to be an anticompetitive definition. In 1997, a
    rule proposed to define the NRSROs; the SEC claimed that the
    most important factor was the firm be nationally recognized.
        That decision was not implemented in part because of a
    Department of Justice objection that the requirement, be
    nationally recognized, was an insurmountable barrier to entry
    of new market participants. Unfortunately, not much has changed
    since that proposal has failed.
        Today there are over 130 agencies, rating agencies.
    However, instead of allowing public companies' investors to
    decide which one of those 130 to utilize, the SEC makes that
    determination. Now, after three decades of uncertainty, Mr.
    Fitzpatrick has introduced H.R. 2990, which would return this
    decision to the markets and the choice by consumers.
        Beyond the difference in retaining the SECs staff's
    designation process, the SEC staff's outline contained
    provisions similar to those in the Fitzpatrick bill. It
    suggests mandating reporting and recordkeeping requirements for
    registered firms, as well as giving inspection, examination,
    and enforcement authority to the SEC.
        In short, H.R. 2990 incorporates most of the SEC staff
    outline without the anticompetitive system that the designation
    process was to establish. I believe that competition is the
    essential component of a healthy capital market.
        Currently, there just isn't competition in the rating
    industry. The SEC has chosen with specificity which agencies
    not only are acceptable, but which shall perform this singular
    duty.
        NRSROs are what they are because of a grant of privilege,
    not because they have earned it by competitive market choice.
    Competition has always proved to the benefit of investors and
    shareholders and consumers. Whether it is mutual funds,
    brokerage costs, insurance premiums, or whatever sector of the
    financial marketplace.
        Without competition in the ratings business, operating
    companies are frankly held hostage with S&P and Moody's
    controlling approximately 80 percent of the market. The
    question is, do they control 80 percent of the market because
    they are really that good or because the SEC and the SEC staff
    has merely given them that opportunity?
        Compounding the problem is a lack of transparency regarding
    the ratings process and the operation of the firms.
    Additionally, the companies held hostage by their ratings avoid
    speaking out for fear of the consequences of the rating
    evaluation system.
        It is my hope that free enterprise, competitive principles
    will direct the committee's decision in this arena. We should
    not seek to preserve a privilege. We should, however, fight to
    guarantee opportunity. Then the market will make the
    determination as to the winners and the losers. This is not and
    never has been the role of the Federal Government.
        Mr. Kanjorski.
        Mr. Kanjorski. Mr. Chairman, we return this morning once
    again to explore the issue of regulating credit rating
    agencies. As I have noted during our past hearings, entities
    like Standard & Poor's, Moody's, and Fitch have long published
    their views on the credit worthiness of the issuers of debt
    securities, and the significance of these opinions has greatly
    expanded in recent years.
        Although rating agencies received some scrutiny after the
    recent surge of corporate scandals, we have not yet mandated
    any substantive changes in their practices. We have, however,
    since our last hearing, begun to consider potential legislative
    reforms in this area.
        A bill, H.R. 2990, has been introduced by my colleague from
    Pennsylvania. In addition, at my request, the experts of the
    Securities and Exchange Commission have put together a
    conceptual legislative outline for our consideration.
        While I agree with you, Mr. Chairman, that something needs
    to be done in this area of the securities marketplace to
    improve transparency and oversight, H.R. 2990, as introduced,
    is not the solution to this problem. It would eliminate the
    current nationally-recognized statistical rating organization
    framework that we have had in place for three decades.
        Instead of casting this accepted framework aside, we should
    build on the work of the Commission in these matters. H.R. 2990
    is also, as one witness will note in her testimony today,
    "inconsistent with the overwhelming majority" of the
    commentators in the most recent Commission concept release.
        As I understand, less than 10 percent of the respondents to
    this concept release supported the elimination of the NRSRO
    framework. Additionally, we now have a classic quantity versus
    quality debate. H.R. 2990 focuses on increasing the quantity of
    raters. To protect investors, we should focus on the quality of
    ratings as the Commission's conceptual legislative outline
    seeks to do.
        In my view, the problems encountered by investors before
    Enron's downfall, WorldCom's bankruptcy, and New York City's
    debt crisis, among others, were related to the quality of
    ratings, not the quantity of raters.
        Nevertheless, Mr. Chairman, I understand the desire to
    increase competition in this field, and I am willing to explore
    these matters further. Additionally, in a statement prepared
    for today's hearing, the Bond Market Association notes that the
    bill "could ultimately dilute the important role credit rating
    agencies play in capital markets."
        Mr. Chairman, I ask unanimous consent to insert this
    statement into the record.
        Chairman Baker. Without objection.
        Mr. Kanjorski. Beyond quality issues, I am also concerned
    that H.R. 2990, could cause serious disruptions in the
    marketplace if enacted into law. Eliminating the recognition
    process and replacing it with a registration process could
    cause unintended consequences.
        The NRSRO concept, after all, has become embedded in many
    areas of the law. The term is used in about 8 Federal statutes,
    47 Federal rules, and more than 100 State laws. It is also used
    in laws related to communications, education, transportation,
    in addition to banking and security statutes.
        Moreover, changing the phrase could cause uncertainty and
    potential turmoil for any mutual fund that relies on a strategy
    of purchasing only those debt securities of investment grade as
    determined by an NRSRO.
        We must further be very sensitive to the First Amendment
    issues posed in these debates. The courts have previously ruled
    on matters such as the permissibility of registration
    requirements for publishers, which the NRSROs contend that they
    are. The courts have also ruled that we must be very precise in
    crafting statutes that impede upon the First Amendment.
        H.R. 2990 is vague, in its present construction, and needs
    work to withstand judicial scrutiny. Ultimately, we need to
    move deliberately in these matters. From my perspective, we
    need to focus on the prior work of the Securities and Exchange
    Commission. We should also put a great deal of weight on their
    conceptual legislative outline as a roadmap for our work in the
    months ahead.
        The outline seeks to establish an effective supervisory
    system to ensure that credit rating agencies operate in a
    transparent manner with adequate policies and procedures. To
    help us in these efforts, last week I called upon all
    interested parties to examine the roadmap of proposed reforms
    developed by the Commission's experts at my request, and I
    request unanimous consent to insert this document into the
    record.
        Chairman Baker. Without objection.
        Mr. Kanjorski. Today I again call upon all parties to
    review this legislative outline and offer comments on it before
    the end of August. In the meantime, I hope that the Commission
    and the rating agencies will expedite their deliberations over
    a voluntary agreement to improve transparency in the coming
    months. The success of these negotiations and the effectiveness
    in enforcing any final voluntary accord will help to determine
    the need for a compulsory bill and the speed of legislative
    action.
        In conclusion, Mr. Chairman, this issue is one on which we
    should focus in the 109th Congress. I commend you for your
    leadership in these matters and hope that we can work together
    to identify an appropriate consensus in the months ahead. Thank
    you, Mr. Chairman.
        Chairman Baker. I thank the gentleman.
        Mr. Shays, did you have a statement?
        Mr. Shays. No.
        Chairman Baker. Mrs. Biggert.
        Mrs. Biggert. No.
        Mr. Fitzgerald. Thank you, Mr. Chairman. And I appreciate
    the comments of my colleague from Pennsylvania and his
    recognition that there is some requirement for reform. And I
    look forward to working with my colleague from Pennsylvania in
    that.
        As the chairman was, in his opening comments, identifying
    all of the different opolies that are referenced in your
    opening statements, whether it be monopoly or oligopoly or
    duopoly, clearly one of them applies. Probably duopoly is the
    best description, but what it means is that there is lack of
    competition. And lack of competition is not good for the
    individual investor or the consumer.
        As a Bucks County Commissioner, I remember the financial
    hardships that the people of the 8th Congressional District of
    Pennsylvania faced when Enron and WorldCom went bankruptcy. And
    it is, for many of us, extremely disturbing that the two
    largest nationally recognized statistical rating organizations,
    Moody's and S&P, rated Enron and WorldCom at investment grade
    just prior to their filing of bankruptcies.
        Essentially, Moody's and S&P told the market that Enron and
    WorldCom were safe investments. Credit rating agencies claim
    that they are not in the business of detecting fraud, but they
    are most certainly in the business of impacting the bottom line
    of companies and also municipalities, school districts.
        The better the credit rating, the lower the interest rate
    the borrower must pay to expand its operations, construct a
    road, or build a school. The credit ratings industry is
    dominated by Moody's and S&P. Together, as you heard, they have
    over 80 percent of the market share.
        In three previous hearings, this subcommittee has received
    testimony that the lack of competition in the credit rating
    industry has lowered the quality of ratings, has inflated
    prices, stifled innovation, and allowed conflicts of interest
    to go unchecked. This duopoly cannot continue to be preserved
    by an artificial barrier to entry and anticompetitive industry
    practices.
        Last week I introduced the Credit Rating Agency Relief Act,
    H.R. 2990, that would inject greater competition, transparency,
    and accountability in the credit rating agency industry through
    market-based reform. My legislation would eliminate the SEC
    staff's anticompetitive designation process and prohibit
    anticompetitive industry practices by mandating reporting and
    record keeping requirements for registered firms as well as
    giving inspection, examination, and enforcement authority to
    the SEC.
        By eliminating the SECs staff's opaque designation process,
    the bill incorporates most of the SEC staff's outline of a
    regulatory framework. A minority of commentators have claimed
    that any registration of this industry amounts to a violation
    of First Amendment privileges. My bill does not infringe upon
    those privileges.
        H.R. 2990 neither bans nor restrict their First Amendment
    rights in any manner. The Government has an undeniable interest
    in registering rating agencies giving the credit rating
    industry's substantial impact and effects on the market. My
    legislation regulates the credit ratings industry through
    disclosure. This is the least restrictive means of any
    regulation.
        Currently, all five SEC-approved agencies already
    voluntarily register under the Investment Advisors Act of 1940,
    and many of the complaints seem hypocritical. By encouraging
    competition in the industry, prices and anticompetitive
    practices will be reduced. Credit ratings quality will improve,
    and firms will innovate.
        H.R. 2990 addresses the basic problems of the credit
    ratings industry and protects our robust marketplace and, thus,
    more importantly, the individual investors.
        I look forward to discussing my proposal with the
    distinguished panel here today as a solution in the credit
    rating industry.
        Chairman Baker, I thank you for your leadership on this
    issue, this vital issue, and I yield back the balance of my
    time.
        Chairman Baker. I thank the gentleman. Mr. Hinojosa.
        Mr. Hinojosa. Chairman Baker and Ranking Member Kanjorski,
    I want to express my sincere appreciation for you holding this
    fourth in a series of hearings on credit rating agencies.
        Chairman Baker, I want to thank you for doggedly pursuing
    the reform of the definition and oversight of the agencies.
    This hearing is of particular interest to me as a Member of the
    Texas delegation. The Enron bankruptcy and the harm it caused
    to its employees, the small businesses, the community, and the
    overall perception of public trust in corporations and the
    national recognized statistical rating agencies was enormous.
        So this hearing is timely and needed, despite the number of
    years that have passed since the Enron bankruptcy.
        Ranking Member Kanjorski, I commend you for working with
    the Securities and Exchange Commission to arrive at legislative
    language. Hopefully, it will not only increase competition
    among the credit rating agencies and make the system more
    transparent, but also ensure that the legislation does not
    violate the nationally recognized statistical rating
    organizations' First Amendment rights to free speech.
        I also believe that your actions have encouraged the
    Securities and Exchange Commission to begin working with these
    nationally-recognized statistical rating organizations on a
    voluntary framework to establish an SEC oversight regime. In
    essence, this could result in something resembling a best
    practices for the NRSROs.
        Additionally, the SEC has proposed a rule that would codify
    the definition of an NRSRO. Some of our Members of Congress and
    the SEC have suggested that legislation might be needed to give
    the SEC the oversight authority to increase its regulations of
    the NRSROs.
        I understand that my colleague across the aisle,
    Congressman Fitzpatrick, has introduced legislation to address
    the current oversight of the NRSROs, and this panel of
    witnesses is heavily weighted with those in support of that
    legislation, with the exception of Standard and Poor's.
        Mr. Chairman, I would like to hear from a more balanced
    panel in the future. Chairman Baker and Ranking Member
    Kanjorski, I believe that Congress should give the SEC, the
    NRSROs additional time to work on a voluntary framework and to
    develop and introduce any legislation needed to oversee the
    NRSROs and provide the SEC whatever statutory authority it
    needs to regulate them.
        Having said that, Mr. Chairman, I yield back the remainder
    of my time.
        [The prepared statement of Hon. Ruben Hinojosa can be found
    on page 44 in the appendix.]
        Chairman Baker. Thank the gentleman. Ms. Brown-Waite, did
    you have a statement?
        Ms. Ginny Brown-Waite. No, I do not have an opening
    statement. I just look forward to hearing the witnesses that we
    have today.
        Chairman Baker. I thank the gentlelady. Mr. Hensarling?
        Mr. Hensarling. No.
        Chairman Baker. Mrs. Kelly.
        Mrs. Kelly. Yes, I do, Mr. Chairman.
        Chairman Baker. Please proceed.
        Mrs. Kelly. First I want to thank you, Chairman Baker and
    Mr. Fitzpatrick, to your commitment to ensuring openness and
    competition within the debt rating industry. I want to thank
    all of the witnesses for being here today.
        I share the committee's view that it is important that debt
    rating firms provide the best possible analysis at the lowest
    possible price. I believe that encouraging more firms to enter
    this industry is critical, and I am glad the SEC is working
    within the industry.
        The nationally recognized statistical rating organizations
    and the SEC have entered into a process for ensuring that high
    standards and open competition are met within the industry
    without disrupting the bond markets or imposing unneeded
    regulation.
        These talks are continuing, and I hope that Chairman Cox,
    when confirmed, will be able to complete this process and
    present the committee with a finished product. I have serious
    concerns however, that any abrupt change to the ratings market
    could adversely impact the bond markets, confuse investors, and
    increase the size and scope of Government regulation.
        As the BMA noted, as currently--and I am quoting, "as
    currently drafted, H.R. 2990 could ultimately dilute the
    important role credit rating agencies play in the capital
    markets." Debt ratings are, as the courts have observed,
    journalistic products protected by the First Amendment.
    Mandatory regulation regimes on financial speech, however well
    intentioned, harm the very freedom to make qualitative
    judgments that make the debt rating process valuable.
        The ability to speak freely and honestly about a debt
    product without Government sanction needs to be protected by
    this committee. And I will closely examine all proposals for
    regulation of debt ratings agencies with that in mind. Thank
    you very much, Mr. Chairman.
        Chairman Baker. I thank the gentlelady. Any member, other
    member have an opening statement? If not, at this time, I would
    proceed to our panel of witnesses, and I would like to state
    the general rules by which the committee functions, that all of
    your official statements will be made part of the committee's
    record.
        We would request that, to the best of your ability, that
    you proceed with a 5-minute clock in mind to enable members to
    have the opportunity to ask questions in the course of the
    hearing this morning.
        And we will proceed from left to right, first with Mr.
    Frank Partnoy, professor of law, University of San Diego School
    of Law. Please proceed at your leisure, sir.

    STATEMENT OF FRANK PARTNOY, PROFESSOR OF LAW, UNIVERSITY OF SAN
                          DIEGO SCHOOL OF LAW

        Mr. Partnoy. Thank you, Chairman Baker and Ranking Member
    Kanjorski and members of the committee. I am a law professor at
    the University of San Diego, where I have spent much of the
    past 8 years studying the credit rating industry and credit
    ratings.
        I, before teaching, worked on the derivatives desks at
    Morgan Stanley and CS First Boston, where my group structured
    debt instruments that received ratings from S&P and Moody's.
    First, let me say that I agree with Chairman Baker and Chairman
    Oxley that this legislation marks an excellent starting point
    for debate. I commend Congressman Fitzpatrick for introducing
    this legislation.
        I also agree with much of what Ranking Member Kanjorski has
    said here today, and in the recent past; there should be
    bipartisan support for credit rating reform. The primary split
    in opinion is between those with a vested interest in
    preserving the status quo, namely S&P and Moody's, and
    virtually everyone else. So with respect, I actually think this
    panel is quite balanced.
        I want to discuss very briefly some background I hope will
    be useful to this committee. I have found in my research that
    credit rating agencies pose a troubling paradox. On one hand,
    credit ratings are enormously valuable and important. A
    downgrade can kill a company and issuers pay big money for
    ratings. Moody's alone had gross profits of more than a billion
    dollars last year. And its shares are worth almost as much as
    General Motors and Ford.
        On the other hand, there is overwhelming evidence that
    ratings are of scant informational value, particularly since
    the mid 1970s, the informational value of ratings has
    plummeted. You do not need to read academic studies to know
    this; just recall Orange County, Enron, WorldCom and most
    recently, General Motors and Ford.
        The Agency's response that ratings are correlated with
    actual default is misplaced because ratings can both correlated
    with defaults and have no informational value. All of you and I
    could publish ratings that were correlated with default
    experience simply by reading the newspaper.
        In my writings I have argued that this paradox, high market
    value, low informational value, is best explained by
    regulation. As Chairman Baker has stated, namely the rules that
    depend on ratings by nationally recognized statistical ratings
    organizations. It started in 1975, and during the next 3
    decades, numerous regulators, especially the Commission,
    established rules that depended on NRSRO ratings. Put simply,
    NRSRO ratings now are important because the rules say they are.
        NRSRO ratings are valuable as keys to unlock the benefits
    or avoid the costs of various regulatory schemes. Yet for more
    than 30 years, no one has bothered to say conclusively what the
    term NRSRO means. Not even George Orwell could have imagined
    such a state.
        Given that the Commission has designated just five NRSROs
    for regulatory purposes, it is not surprising that the industry
    is so concentrated. If regulators required that the Washington
    Wizards play just five basketball players, and one of the
    approved players was me, even I would get a lot of playing
    time. And if I played, you can be sure the others would score
    most of the points, even if they weren't very good.
        The Commission's proposals would not correct these
    fundamental flaws. Defining NRSRO is too little too late, and
    the commission is not an office of central planning; nor should
    it be. It generally does not designate which companies can
    issue securities to the public, and it certainly does not do so
    based on ambiguous standards such as whether ratings are
    "generally accepted."
        Instead, the Commission requires companies to disclose
    material facts and then permits market participants to make
    decisions based on those facts. That is the role the Commission
    should play with respect to NRSROs. Congressman Fitzpatrick's
    bill is a major step in the direction of resolving the paradox
    I just described.
        It permits the 130-plus non-NRSRO agencies to compete with
    current NRSROs. Perhaps most importantly, it encourages new
    rating agencies, which could use market-based measures in
    assessing companies. In my academic work, I have stressed that
    market-based measures are the best alternatives to current
    NRSRO ratings.
        We have already heard, and some will argue, that opening
    the market to competition will be disruptive and/or lead to
    rate shopping. But based on my experience and available
    evidence, I think the opposite is true.
        When markets such as credit ratings are opened to
    competition, they become more stable, indeed, because current
    ratings by S&P and Moody's distort the markets; they create
    incentives for dysfunctional regulatory arbitrized
    transactions, which this legislation would reduce.
        My further understanding is that NRSROs would be subject to
    liability for Federal securities fraud and/or State law causes
    of actions just like other gatekeeper firms. S&P and Moody's
    claim their ratings are merely opinions and there is the free
    speech argument that has already been mentioned today, which is
    a clever one; it has been accepted by some courts.
        But credit ratings are not really just opinions any more
    than fairness opinions of investment banks, audit opinions of
    accounting firms, legal opinions of attorneys, buy-sell ratings
    of security analysts, or even the certification of financial
    statements by CEOs and CFOs are mere opinions.
        So, in sum, I commend Congressman Fitzpatrick for
    introducing this legislation. I believe that this panel does
    represent all of the interests except perhaps one interest that
    is not here today, the millions of individual investors whose
    mutual funds and pension funds are in fixed-income investments
    and whose faith in S&P and Moody's has been shattered by events
    of recent years.
        Those people have much more to gain from this legislation
    than S&P and Moody's have to lose. I thank you, and they will
    thank you.
        [The prepared statement of Frank Partnoy can be found on
    page 83 in the appendix.]
        Chairman Baker. I thank the gentleman for his statement.
        Our next witness is Ms. Nancy Stroker, group managing
    director, Fitch Ratings. Welcome.

      STATEMENT OF NANCY STROKER, GROUP MANAGING DIRECTOR, FITCH
                                RATINGS

        Ms. Stroker. Good morning, Chairman Baker, Ranking Member
    Kanjorski, and members of the committee. My name is Nancy
    Stroker, and I am a group managing director at Fitch Ratings,
    responsible for overseeing the North American corporate
    financial institutions and public finance ratings.
        I would like to thank you for offering Fitch the
    opportunity to testify today and to share with you our views on
    the recently proposed Credit Rating Agency Duopoly Act and SEC
    staff outline on oversight of credit rating agencies that was
    delivered earlier this month.
        We commend Representative Fitzpatrick and the committee for
    recognizing the importance of fostering competition in the
    ratings industry. We hope you will find our views constructive.
        Fitch firmly believes in the power of competition, and we
    fully support the objectives of the Fitzpatrick bill, providing
    greater competition and transparency in the credit rating
    industry.
        While we have concerns about whether the Act as currently
    proposed will provide either greater competition or
    transparency, we believe that the Act and the debate
    surrounding it will serve as a constructive first step in
    fostering competition in the credit rating industry, a point
    made by both Representatives Oxley and Baker at the
    introduction of the bill.
        In terms of addressing the issues before this committee, we
    would like to make the following three points. First, any
    recognition or registration system should be a transparent
    process based on objective standards related to the
    demonstrated reliability of ratings that are uniformly applied.
        Second, any oversight regime should be designed to avoid
    unnecessary burdens and interference in the decision-making
    process of rating agencies. As the SEC staff has noted, any
    legislation in this area must make clear that the decision-
    making process of rating agencies and the content of the
    ratings assigned should be beyond the scope of regulation.
        And finally, we will state the obvious, but investors will
    benefit from increased competition. I would like to take this
    opportunity to elaborate on these three key points. Regardless
    of whether or not the NRSRO system remains intact or a system
    of registration is adopted, there needs to be clear and
    objective standards to assess the reliability of an agency's
    ratings.
        Indicators of reliability, including a proven track record,
    should be the key because the public interest will not be
    served if the ratings of potentially dozens of agencies without
    such a proven record are used in safety and soundness
    regulations.
        In terms of oversight, given the importance of unbiased
    credit ratings in the financial markets, we believe oversight
    and enforcement authority in matters such as conflict of
    interest and integrity are vitally important. Furthermore, we
    believe that the examination and oversight of rating agencies
    should be principally focused on objective measures of the
    ongoing reliability of a rating organization's rating, such as
    default and transition studies.
        Within this framework, any regulatory or legislative
    approach should provide a narrowly tailored oversight scheme
    specifically developed for rating agencies. We do not believe
    that the existing regulatory schemes under the Exchange Act or
    under the Investment Advisers Act are a plausible fit, as
    agencies are very unique.
        And finally, in terms of the increased competition and how
    investors will benefit, while the NRSRO system is often cited
    as a barrier to entry for new rating organizations, we believe
    that the debate over the NRSRO system ignores the single most
    important barrier to entry in the ratings market, and that is
    the S&P and Moody's monopolies.
        In Fitch's own experience, simply being recognized as an
    NRSRO or being registered will not ensure an organization's
    ability to compete. An organization would need to devote
    significant resources in demonstrating a record of reliability
    in winning the support of investors.
        We are proud of our growth over the past 15 years. We now
    rate over 60 percent of the bonds issued world-wide, but we
    account for only 15 percent of world-wide revenue. Fitch
    believes that our emergence as a global full service rating
    agency has created meaningful competition in the ratings market
    for the first time in years.
        Fitch's challenge to the Moody's and S&P monopoly has
    enhanced innovation, forced transparency in the rating process,
    and improved service to investors, and created much needed
    price competition.
        If Congress wishes to address barriers to entry in the
    ratings market and ensure competition, legislation should be
    adopted that eliminates the barriers and outright prohibits
    anticompetitive conduct, such as coercion, tying, and
    discriminating against ratings by other rating agencies for the
    purpose of preserving market share.
        Fitch believes that this is an area where focused
    legislation might help to protect rating agency competition.
    Fitch believes that any rating agency found to be using
    anticompetitive practices or unfair business practices should
    be subject to a full range of appropriate sanctions.
        In conclusion, we reassert our belief in competition, the
    importance of focusing on objective standards that demonstrate
    reliability of ratings, and the need for any legislation to be
    specifically tailored to the uniqueness of the rating industry.
    We also do not believe that increased regulation typically
    fosters competition, and the vague standards for registration
    will do little to advance a more transparent process for the
    Commission.
        Thank you for your consideration of our views. We would be
    happy to answer any questions.
        [The prepared statement of Nancy Stroker can be found on
    page 102 in the appendix.]
        Chairman Baker.I thank the gentlelady.
        Our next witness is Mr. Sean Egan, managing director of
    Egan-Jones Ratings Company. Welcome.

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

        Mr. Egan. Thank you. We at Egan-Jones strongly support the
    proposed legislation for reforming the rating industry since it
    does not impair the freedom of speech defense afforded rating
    firms, and it addresses the two major problems that have long
    plagued the industry.
        Number one, the dearth of competition and, two, the failure
    of the current rating firms to provide timely, accurate ratings
    for protecting investors.
        Perhaps the most appealing aspect of the proposed
    legislation is that it removes the SEC from the role of
    recognizing rating firms, i.e., NRSRO firms, a role in which it
    has failed miserably. The SEC's primary mandate is protecting
    investors.
        From the SEC's Web site "Who we are", the primary mission
    of the SEC is to protect investors.
        Within the past 3 years, we have experienced two of the
    largest credit failures in U.S. History, Enron and WorldCom,
    failures that resulted in the loss of hundreds of billions of
    dollars, tens of thousands of jobs, and the pensions of
    thousands.
        After these colossal failures, one would expect that the
    agency charged with recognizing rating firms would have shown
    some initiative for addressing the problems so that they would
    not occur again. Unfortunately, this has not been the case.
        Instead, the SEC is continuing its study of the industry, a
    study which began in the early 1990s, 15 years ago, and is
    continuing today. While the first NRSRO firm was recognized in
    1970, it is only 90 days ago that the SEC finally devised a
    definition of NRSRO.
        It seems obvious that a definition should have existed
    before the first NRSRO was designated. Furthermore the SEC's
    proposal for NRSRO requires that rating firms provide their
    ratings free to the public, which effectively means that the
    rating firms have to seek compensation form the Enrons and
    WorldComs of the world, which, in many people's view, is a
    system rife with conflict.
        Yes, the SEC has recognized two new NRSROs during the past
    18 months. However, neither firm warned investors about the
    recent major failures, nor did they provide any significant
    competition to the two partner monopoly firms, S&P and Moody's.
        The SEC has indicated that it consults with major rating
    firms before proposing any changes to the regulation of the
    industry. Perhaps they should have consulted also with
    investors who have been and continue to be hurt by the flawed
    industry structure.
        Conspicuously absent from the SEC's proposed definition of
    NRSRO rating firms are the following requirements. One is
    severing ties between the personnel of the issuers and the
    dealers. The ex-chairman of Moody's should not have served as
    director of WorldCom, nor should the rating firm's personnel be
    tied to broker-dealers or the broker-dealer industry
    association, such as the NASD.
        Two, discourage insider training. The proposal addresses
    the misuse of nonpublic information given to rating firms, but
    does not address misuse of information generated by the rating
    firms themselves, such as Moody's informing Citigroup of its
    intention to downgrade Enron below investment grade before the
    fact. By the way, no investigation was made of Citigroup's
    trading in advance of that downgrade.
        Three, take timely action. It has been over 3 years since
    the failure of Enron and yet the SEC has still not made any
    significant changes in the rating industry.
        Regarding Egan-Jones' ratings, Kafkaesque is probably the
    best description of our experience with the SEC. We have
    regularly issued timely, accurate ratings and provided warning
    for the Enron, Genuity, Global Crossing and WorldCom failures.
    See the attachment.
        Furthermore, we consistently identify improving credits.
    Most of our ratings have been higher than S&P and Moody's over
    the past 3 years, thereby assisting issuers in obtaining more
    competitive capital. Our success has been recognized by the
    Federal Reserve bank of Kansas City, which compared our ratings
    and has attached the conclusion of that.
        Since missing the failures of Enron in 2001, Moody's
    operating revenues have more than doubled from approximately
    $400 million to $814 million, and S&P's have increased from
    $435 to $893, an indication of the severe lack of competition
    in this area. After all of these failures, S&P's and Moody's
    operating income has more than doubled.
        The proposed legislation provides some hope for reform and
    real competition in the ratings area. It is artfully drafted to
    preserve freedom of speech protections. We continue to support
    the standards of practices for participants in the credit
    rating process published by the Association of Corporate
    Treasurers, the Association of Financial Professionals, and the
    Association in France.
        Until the fundamental problems in the rating industry are
    addressed, investors, employees, pensioners, and ultimately
    issuers will needless be harmed. The SEC should gracefully
    withdraw from this area in the interest of protecting
    investors.
        [The prepared statement of Sean Egan can be found on page
    64 in the appendix.]
        Chairman Baker. Thank you. Mrs. Biggert has requested the
    right to make the next introduction. Mrs. Biggert.
        Mrs. Biggert. Thank you very much, Mr. Chairman. I would
    like to welcome Mr. Alex Pollock back to the committee. And Mr.
    Pollock is an expert in banking and bond market matters.
        I would particularly like to highlight his experience, much
    of which he gained in the Windy City; that is Chicago. He
    served for 12 years as president and CEO of the Federal Home
    Loan Bank of Chicago, and as principal at Nolan, Norton and
    Company, Chicago, and then a senior vice president of Corporate
    Planning, Research and Development at Continental Bank.
        In addition, he received one of his masters degrees at the
    University of Chicago. In his current capacity as a resident
    fellow of the American Enterprise Institute, Mr. Pollock has
    dedicated much of his time to the issue that brings us here
    today. So welcome Mr. Pollock.
        Thank you, Mr. Chairman.
        Chairman Baker. Please proceed, sir.

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

        Mr. Pollock. Thank you, and thank you very much,
    Congresswoman. Mr. Chairman, Ranking Member Kanjorski, members
    of the subcommittee, I greatly appreciate the chance to testify
    on this important topic today.
        I spent 35 years in the banking business, dealt a lot with
    credit ratings, as you can imagine, including getting ratings
    for various entities. Thanks to the leadership of the chairman
    and the ranking member, I have spent a good bit of time over
    the last several months thinking about this issue while at the
    American Enterprise Institute.
        Based on all of that, it is a real pleasure to speak today
    in support of H.R. 2990. This is a pro-competitive bill. It is
    going to lead, if enacted, to more choice, more alternatives
    for the customers, and to reliance on market discipline, which
    is the best kind of discipline.
        It does this by moving from a regime of designation by
    regulation, by the SEC of course, to a regime of disclosure and
    competition. Having had the AEI be good enough to publish a
    paper of mine called "End the Government-Sponsored Cartel in
    Credit Ratings," and I guess we should add, Mr. Chairman,
    "cartel" to the "opolies", my view is summarized by that title.
        It is my view that decisions about credit ratings and which
    credit rating agencies should prosper and which not prosper,
    should be made by investors, financial firms, issuers, and, in
    general, the market.
        I think, as do a number of others, that it would be better
    not to have an NRSRO designation at all, and really have a
    market solution. But we have had a problem in thinking about
    that because, as has been referred to, there is a very large,
    very complex interlocking web of regulations and statutes, both
    at the State and Federal level, which refer to this term,
    NRSRO, as Congressman Kanjorski mentioned. How to move toward a
    market solution when faced with this interlocking web--or to
    change the metaphor, a Gordian Knot--of regulation and rules
    did puzzle me.
        In my view, H.R. 2990 cuts this Gordian Knot in a quite
    brilliant and creative way by keeping the abbreviation but
    changing what the "R" stands for, from "recognized" to
    "registered". That actually completely changes the meaning of
    the term and how it would operate in the market, while leaving
    in place all of this complicated set of rules that can keep on
    referring to the term, but they will be referring to something
    different.
        I find this both on the merits and also rhetorically a very
    pleasing and good solution. We ought to be moving toward a
    market discipline, as I said, where market actors are asked to
    make informed judgments and multiple decision-makers are acting
    on credit ratings. That will include multiple regulators
    because we have a lot of regulated entities using credit
    ratings.
        It will also include multiple pricing models in the
    business so that you can have pricing models paid for by both
    issuers and investors and we see what the market likes best.
        I would like to mention three clarifications. One is that
    there are high natural barriers to competition and barriers to
    entry in the credit rating business because of its dependence
    on judgment and on reputation and because of the conservative
    nature of risk policies. Therefore, when we do this, this is
    going to be an evolutionary transition.
        In my judgment, I do not see any disruption to markets or
    behavior because we are going to be going through an evolution
    in the face of natural barriers.
        The second is, whatever we do, we cannot hope to have no
    mistakes in ratings or perfect ratings. Anybody who is dealing
    with trying to anticipate the uncertainties and the risks of
    the future is going to make mistakes.
        I would hate to have the list of my own financial mistakes
    published. We have to address that as reality. The best defense
    to that reality is to have a vibrant marketplace of many
    competitors, many opinions, different kinds of analysis,
    different kinds of ideas for investors, and other users of
    ratings to choose from. That is the best possible defense.
        A third clarification is we want to make sure that the
    first "R" in NRSRO doesn't inadvertently slip into changing
    from "registered" to "regulated". We don't want a nationally-
    regulated rating agency business. Fitch Ratings, in their
    written comments, suggested that this might be a risk.
        I do think that we ought to look carefully at the language
    of the bill just to make sure that that does not inadvertently
    happen and that we do indeed carry out what is clearly the pro-
    competitive intent.
        In summary, Mr. Chairman, H.R. 2990 is a very positive move
    toward a pro-competitive disclosure regime, as opposed to a
    regulatory designation regime. I believe this move would lead,
    as competitive markets always do, along with their greater
    competition, to more choice in the market for customers, better
    service, lower costs and more price competition, less duopoly
    profits and more innovation, the very benefits we always look
    to from a competitive world.
        Mr. Chairman, thank you very much again for the chance to
    be here today.
        [The prepared statement of Alex J. Pollock can be found on
    page 99 in the appendix.]
        Chairman Baker. Thank you, sir, for your statement.
        Our next witness is Rita M. Bolger, managing director and
    associate general counsel, Standard and Poor's. Welcome.

     STATEMENT OF RITA M. BOLGER, MANAGING DIRECTOR AND ASSOCIATE
                  GENERAL COUNSEL, STANDARD AND POOR'S

        Ms. Bolger. Mr. Chairman, Ranking Member Kanjorski, members
    of the subcommittee, good morning. I am Rita Bolger, as
    introduced, managing director, global regulatory affairs and
    associate general counsel for Standard and Poor's, a division
    of the McGraw Hill Companies.
        At S&P, we are extremely proud of our well-documented track
    record of providing the market with independent, objective, and
    credible rating opinions. Our ratings are publicly available
    without charge and our rating criteria and methodologies are
    published on our Web site and elsewhere.
        As a result, we are subject to the scrutiny of the
    financial markets every day. On behalf of Standard and Poor's,
    I am pleased that the subcommittee has granted our request to
    be here. Standard and Poor's has been and remains committed to
    constructive change that would eliminate unnecessary barriers
    to competition in our industry.
        However, we have serious concerns about H.R. 2990 and the
    disruptive effect it could have on the efficient operation of
    the capital markets. When the SEC asked market participants in
    connection with its 2003 concept release whether it should
    retain the NRSRO concept, the vast majority unequivocally said
    yes.
        These commenters represented that eliminating the NRSRO
    concept would be disruptive to the capital markets and would be
    costly and complicated to replace.
        We agree. As does the Bond Market Association, an
    organization that, according to their submission in connection
    with this hearing, speaks for the bond industry worldwide. As
    the BMA observed, the NRSRO designation serves a unique purpose
    in SEC regulations for which a substitute is either not
    available or not practical.
        Additionally, we believe that intrusive regulatory
    oversight of the sort contemplated by the bill will result in
    ratings of lesser, not higher, quality because credit ratings
    are opinions, as to which reasonable analysts can and do
    disagree; there is no one correct way to go about forming them.
        Comprehensive regulation could produce standardized
    approaches and rating opinions that do not reflect the
    uncompromised view of the rating committee. In addition,
    intrusive regulation is likely to erect new barriers to entry
    that will inhibit, rather than promote, increased competition
    as it will force new entrants to bear significant regulatory
    costs that they currently do not bear.
        Importantly, and as has already been raised this morning,
    we also believe that H.R. 2990 as written is unconstitutional
    on its face. Rating agencies have consistently been afforded a
    high level of First Amendment protection by numerous State and
    Federal courts.
        This is so because at their core, rating agencies such as
    S&P perform the journalistic activities of gathering
    information on matters of public concern, analyzing that
    information, forming opinions about it, and broadly
    disseminating those opinions to the general public. We believe
    that the bill would specifically violate the First Amendment by
    making it illegal for a credit rating agency to publish its
    opinions without first registering with the Government,
    providing mandatory disclosures about its business activities,
    and obtaining approval of that registration.
        No legislation could constitutionally require the licensing
    of Business Week or the Wall Street Journal because they offer
    their opinions as to the credit worthiness of certain entities.
        Also, intrusive Government involvement in the manner and
    method of generating credit ratings, such as contemplated by
    the bill, would be the equivalent of unconstitutional
    Government supervision of publishers from within their own
    newsrooms. This direct intrusion into the editorial process is
    precisely the type of governmental activity that the First
    Amendment prohibits.
        As discussed more fully in my statement for the record,
    positive steps have been taken over the past 2 years by both
    the SEC and IOSCO, the International Organization of Securities
    Commissions, with input from a diverse array of market
    participants. These initiatives are being implemented and
    include as goals increased competition and enhanced oversight.
        Based on these serious concerns about the bill, we believe
    the best approach would be to allow these initiatives to move
    forward. Once these initiatives have been given a chance, then
    Congress would be in a better position to assess the necessity
    of legislation, and it is our belief that after these
    initiatives have been tested, you will conclude legislation is
    not the best approach for the market.
        In conclusion, on behalf of S&P, thank you again for the
    opportunity to participate this morning. I would be happy to
    answer any questions.
        [The prepared statement of Rita M. Bolger can be found on
    page 47 in the appendix.]
        Chairman Baker.I thank the gentlelady for her statement.
        Our next witness is Mr. James A. Kaitz, president and CEO,
    Association for Financial Professionals. Welcome.

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

        Mr. Kaitz. Good morning, Chairman Baker, Ranking Member
    Kanjorski, and members of the committee. AFP appreciates the
    opportunity to participate in today's hearings on the
    legislative solutions to the many issues and concerns raised
    with regard to the credit ratings market.
        AFP represents more than 14,000 finance and Treasury
    professionals, representing more than 5,000 organizations. Our
    members are responsible for issuing short and long-term debt
    and managing corporate cash and pension assets for their
    organizations.
        Previously, AFP has stated that the SEC's existing
    recognition process has created an artificial barrier to entry
    to the credit ratings market. This barrier has lead to a
    concentration of market power with the recognized rating
    agencies and a lack of competition and innovation in the credit
    ratings market.
        To remove this barrier to entry and stimulate competition,
    AFP has long advocated that the commission clarify the
    recognition process. Further, we believe that recognition of
    credit rating agencies must be conditioned on whether an
    organization can consistently produce credible and reliable
    ratings based on adherence to published methodologies.
        We have also urged regulators to require that rating
    agencies document internal controls that protect against
    conflicts of interest and anticompetitive and abusive practices
    and ensure against the inappropriate use of nonpublic
    information.
        This past spring, the SEC issued a proposal that attempts
    to address some of the concerns we have raised. However, we do
    not believe that the SEC proposal would foster a truly
    competitive market and fails to address the need for ongoing
    oversight of the credit ratings market.
        The Credit Rating Agency Duopoly Relief Act of 2005,
    introduced by Representative Fitzpatrick, would require the SEC
    to register credit rating agencies based on the criteria
    recommended by AFP. By eliminating the ambiguous NRSRO
    designation process in favor of a more transparent registration
    process, the Act will foster meaningful competition in the
    credit ratings market.
        As such, AFP supports the legislative proposal before the
    committee today.
        Mr. Kaitz. In nearly 30 years since creating the NRSRO
    designation, there has been no review of the ongoing
    credibility and reliability of the ratings issued by the
    NRSROs. Any effort to address these concerns, either through
    regulation or voluntary agreement, will be entirely ineffective
    without an oversight and enforcement mechanism.
        AFP is pleased that the proposed legislation directs the
    Commission to censure, suspend, or revoke the registration of
    any registered statistical rating organization that violates
    certain sections of the act or ceases to meet the registration
    criteria.
        If the credit ratings market is opened up to competition,
    it will be incumbent on the SEC to take an active role in the
    ongoing oversight of registered organizations to ensure that
    they continue to merit SEC registration. We believe that the
    proposed legislation gives the SEC the authority, flexibility,
    and guidance needed to conduct the necessary oversight without
    placing an overly restrictive legislative regime on either the
    Commission or the credit ratings agencies. For the committee's
    consideration, we believe there are several key areas where
    additional clarification will strengthen the act.
        The first area is with regard to ratings performance
    measurement statistics. As AFP has consistently suggested, the
    key criteria for rating agency recognition should be whether
    the rating agency can consistently produce credible and
    reliable ratings. We believe that it is imperative that the
    applicant not simply file statistics, but also demonstrate that
    its ratings are, in fact, credible and reliable.
        The second area in need of clarification is the
    registration requirement contained in section 4 of the
    legislation. The bill requires all credit rating agencies that
    meet the definition to register with the SEC, even those that
    do not seek to have their ratings approved for use by regulated
    portfolios. There are currently more than 130 ratings agencies,
    many of which have not sought and may not seek SEC recognition
    or registration.
        Further, new rating agencies that are established will not
    be able to file long-term ratings performance measurement
    statistics required for registration, shutting out these new
    market entrants.
        AFP recommends that the act limit registration requirements
    to those that seek approval for use by regulated portfolios or
    those that the Commission determines must be registered to
    protect the public interest.
        We also recommended that the act explicitly direct the
    Commission to develop an oversight and an examination regime
    that ensures that registered statistical rating organizations
    continue to issue credible and reliable ratings, that they have
    and adhere to policies that protect nonpublic information and
    prevent conflicts of interest and unfair and abusive practices.
    Such an oversight framework is described in the Commission
    staff outline of key issues for a legislative framework for the
    oversight and regulation of credit rating agencies, developed
    at the request of Ranking Member Kanjorski. This type of
    oversight will protect capital market participants without
    injecting regulators into the decision making of the rating
    agencies or impinging on their First Amendment rights.
        We believe that the registration process proposed in the
    Credit Rating Agency Duopoly Relief Act of 2005 will minimize
    barriers to entry and foster competition among existing NRSROs
    and those that may be later registered. The enactment of the
    bill, along with the development by the Commission of an
    oversight regime that ensures that registered statistical
    credit rating organizations continue to meet the registration
    requirements will improve investor confidence in the rating
    agencies and global capital markets.
        Thank you, Mr. Chairman.
        [The prepared statement of James A. Kaitz can be found on
    page 72 in the appendix.]
        Chairman Baker. I thank the gentleman for his statement.
        I would like to start my questions with Mr. Partnoy.
        As I understand the pending SEC proposal, it requires a
    firm to be generally accepted in the marketplace in order to be
    a first step to NRSRO designation by the SEC. In your
    observation, how would one become generally accepted in the
    market for some period of time, in other words, be utilized, if
    you don't have the SEC designation to begin with? Is that a
    workable remedy to enhance competitive opportunity?
        Mr. Partnoy. No, Chairman Baker, I think that is a very
    good point. It is what I would call a Catch 22. It is virtually
    impossible for an agency to establish that it is generally
    accepted if the NRSRO framework is in place and they are not a
    designated NRSRO.
        Chairman Baker. So you would have to be in the rating
    business, expend the money to do the analyticals, convince
    companies to pay you, do that for some period of time on a
    national basis, when the companies know that it has no merit or
    impact on their publicly disclosed rating standard?
        Mr. Partnoy. That is absolutely right. And companies know
    that loud and clear because they know about the proliferation
    of regulations that virtually require that you get a rating
    from an NRSRO so that you can sell it to folks who have to have
    one of those ratings.
        Chairman Baker. So at the moment, we are not clear how we
    get additional competition in the marketplace because you have
    to be generally accepted, but you can't be generally accepted
    without the designation? But that is the standard by which we
    gauge whether you can become one?
        Mr. Partnoy. That is precisely right. And that is why it is
    a Catch 22, an intractable problem. And that is one reason why
    the idea of eliminating this notion of an NRSRO entirely is an
    attractive one.
        And that has a host of difficulties, as Mr. Pollock
    mentioned, but I completely agree.
        Chairman Baker. Thank you.
        Mr. Egan, you have been critical this morning of rating
    agency performance. Is there, in your view, any consequence to
    a rating agency today that doesn't meet, let's just call it
    "fiduciary obligations," in rating appropriately? Is there a
    professional standard of conduct which someone holds up and
    measures you and say, Oops, you didn't do your job; here is the
    penalty box?
        Mr. Egan. For the non--
        Chairman Baker. I think you just cut yourself off.
        Mr. Egan. Thank you.
        Chairman Baker. Thank you.
        Mr. Egan. For the non-S&P and -Moody's of the world, there
    is a very tough standard. In our case, we are paid by
    institutional investors. If we don't succeed in issuing timely
    accurate ratings, clients will cut us off. It is just that
    simple. Their concerns are a little bit different from the
    issuers; issuers want the lowest cost of capital generally.
        On the national recognition, though, we do have that
    national recognition, have had it for a long period of time,
    and we still don't know what the SEC wants for us to get--
        Chairman Baker. So you are saying you are nationally
    recognized with a record of accurate performance, and yet you
    are still mystified by what constitutes the remaining step for
    you to become nationally recognized?
        Mr. Egan. That is correct. In fact, there is a study of our
    recognition versus DBRS, a Canadian firm.
        The SEC's prior regulation is that an NRSRO has to be
    nationally recognized in the United States. We had more than
    four times the recognition of DBRS; and AM Best, I think we had
    five times recognition among users of credit ratings. These are
    institutional investors, mutual funds. We had more than four
    and five times the recognition of the other firms. We brought
    this to the SEC's attention, and they said nothing.
        Chairman Baker. It is your view, then, it is no longer an
    inability to meet their standard? You are meeting the standard,
    but you still can't get an approval?
        Mr. Egan. That is correct. And what they have said is they
    are going to wait until this NRSRO process plays out.
        Chairman Baker. Is that like a 30-year wait?
        Mr. Egan. I don't know. They won't set a time frame for it,
    which is very frustrating.
        Chairman Baker. Let me get to Mr. Pollock before my time
    runs out.
        Do you believe, given your analysis of the market
    performance of S&P and Moody's in a parallel path in a free
    market system, it is likely that two companies could own 80
    percent of any market without some governmental grant of
    privilege?
        Mr. Pollock. Mr. Chairman, in my opinion, their market
    position and the market power reflects Government sponsorship
    through the NRSRO process, not unlike the Government
    sponsorship we have often discussed in the GSE world.
        Chairman Baker. I don't want not to get to Ms. Bolger. It
    is my expectation we will get to another round of questions,
    but with the number of members, I am going to stick to the 5-
    minute rule and recognize Mr. Kanjorski.
        Mr. Kanjorski. Thank you, Mr. Chairman.
        Ms. Bolger, exactly why do you think that H.R. 2990
    violates the First Amendment in specific?
        Ms. Bolger. The proposed bill, the bill has a requirement,
    in effect, for--it is a licensing regime. There is a procedure
    for filing your application, documents, certain policies and
    procedures, all on issues that we believe are important to the
    market and to quality. But then the SEC would have the ability
    to accept or deny, and there is a process for denial of that
    application.
        So there is some--there is a mechanism built in here for
    not just notice filing of information to the SEC, but their
    evaluation and, ultimately, approval. And that licensing, in
    effect, requirement is not constitutionally viable.
        Publishers are free, by long-standing case law, to freely
    disseminate their opinions. And rating agencies are members of
    the financial press, the financial press being equally
    protected by case law.
        Mr. Kanjorski. Thank you. To all of our witnesses, could I
    request that you review the SEC staff outline and send specific
    comments to the committee before the end of August? Is that a
    reasonable request?
        This is a very delicate area. I guess in the best of all
    worlds--and I appreciate Mr. Egan's problem; I have lived with
    his frustration on several hearings. Is there a possibility of
    having both the recognition and the registration concept? I
    mean, it seems to me that I don't want the Good Housekeeping
    Seal of Approval out there to 100 different agencies who can
    qualify and register and then just offer themselves up for
    bidding purposes. Not that most would do that, but a few
    probably would.
        On past occasions I have expressed my concept of the
    "bastard rule". It is my rule about why we have so many laws
    and regulations. It is not that most of us need those rules or
    regulations, but there are always 3 to 5 percent of
    participants in any sector that go to the edge of the envelope
    or beyond for greed or for value. I assume that we would have
    to recognize that rule in this industry, that greed would be
    particularly attractive.
        So how would we avoid encouraging, recognizing, or
    registering agencies that are literally up for grabs to the
    highest bidder?
        Mr. Kaitz. I think we recommended in our oral testimony,
    sir, that, first of all, only those that would want to be in
    regulated portfolios would be one alternative. And as long as
    there is a process to determine credible and reliable ratings,
    I think that is going to put market disciplines on those
    ratings agencies or agencies shopping for the best deal.
        So I think you have to distinguish between 130 and those
    that would want to be in the regulated portfolios, and then
    make sure that there is a criterion to ensure that credible and
    reliable ratings are given over a period of time.
        Mr. Kanjorski. But isn't that an after-the-fact situation?
        Mr. Kaitz. No. You could look at--you could do some
    correlation analysis of their methodologies and go back and see
    how they did in the marketplace.
        The reality is, though, you would not probably look at a
    new organization that would want to be in a regulated
    portfolio. They likely would be already established agencies
    with a track record that the SEC could take a look at.
        Mr. Kanjorski. So are we only arguing here whether or not
    we have just a limited number of recognized entities and we
    want to enlarge that number? Or are we just looking for a
    methodology to enlarge that number?
        Mr. Kaitz. I think if you put the right discipline in the
    market, then you are going to get those agencies that are going
    to be the major players. Also, as an organization that
    represents the issuers, it is not in the issuers' best
    interests to use a rating agency that is not going to be
    credible, that you now have to defend before the audit
    committee and the board. So our members have a fiduciary
    responsibility to make sure those ratings are accurate.
        Mr. Kanjorski. If we open it up by registration, what is to
    prevent investment banking houses from making the decision of
    where the business goes and who makes the ratings? Aren't they
    doing that to some extent today?
        After all, companies are doing that with the accounting
    firms that they hire and the legal firms that they hire. They
    are saying, you know, we are just not going to deal with this
    security unless these people put their opinions in place. They
    just don't open it up to the whole bar or to the whole
    accounting profession.
        Mr. Kaitz. Again, from our--I don't want to dominate here,
    but from our perspective, that is why it is critical that there
    is SEC oversight of the rating agencies and that they are
    really looking at credible and reliable ratings. I think that
    is the role, from AFP's perspective, that we have envisioned.
        Mr. Kanjorski. Mr. Egan, didn't you suggest that the SEC
    should withdraw from this field? Is that the key point of your
    testimony?
        Mr. Egan. Yes, I did.
        Mr. Kanjorski. And who would be the regulator? Who would be
    the protector of the investor and the public if they withdraw?
        Mr. Egan. I think you need a board of industry participants
    to be involved in the oversight.
        Mr. Kanjorski. Self-regulatory?
        Mr. Egan. Perhaps, but it would be broader, as it
    represents some individuals.
        The Bond Market Association is held up as representing the
    industry; we disagree with that. In our experience, they
    represent the interests of the larger rating firms and the
    larger broker-dealers. The interested parties is much broader
    than that.
        We don't understand why the SEC has not taken action faster
    than this, but obviously, there must be some pressures there or
    they would have acted. So we think there should be a broad
    group that is represented.
        Mr. Kanjorski. Isn't it sort of underfunded? While the SEC
    was given all kinds of regulatory authority, they just don't
    have the personnel and money to do the job?
        Mr. Egan. I find that hard to believe.
        Mr. Kanjorski. Well how about the problem we have here in
    Washington on unavailability of office space? You're indicating
    another bureaucracy, if I understand it, or another agency or
    quasi-governmental agency to do this work?
        Mr. Egan. I think it could be a rotating board of industry
    participants that are charged with overseeing this area until
    some--or perhaps with a new SEC commissioner, there will be
    some reasonable--
        Mr. Kanjorski. What kind of enforcement would be available
    if we have an industry board? What powers would they have?
        Mr. Egan. I think, start with the recognition of ratings
    firms; and that has been a bottleneck for quite some time.
    There isn't any real competition. Even with these new firms,
    they don't present any real competition.
        As far as the oversight, I think that there has to be some
    review of the anti-competitive practices that are being
    undertaken by S&P and Moody's. They have been raised a number
    of times; they are not addressed in the current NRSRO
    designation definition, and those should be addressed.
        So I think it would be this rotating advisory board that
    could be both in the front end of identifying companies and on
    the review process.
        Mr. Kanjorski. Do you want to defend the monopolistic
    practices of your organization, Ms. Bolger?
        Ms. Bolger. Yes.
        S&P has been on record for quite a long time as being fully
    supportive of more competition in the industry. We do, though,
    of course, see tremendous value in the market recognition and
    acceptance portion of the NRSRO designation. It is really the
    fundamental criterion to be an NRSRO and upon which--a premise
    for which a lot of regulations have embedded NRSRO ratings. So
    to strip that out, as the current bill does, would be--would
    have, we believe, a vast effect; and we believe other people
    have enunciated that view as well.
        In terms of any anti-competitive practices, we just feel
    that there is a tremendous amount of value out in the
    marketplace. And we believe that the initiatives that are
    already moving forward, both with the SEC's proposed rule,
    which does enunciate criteria to judge market acceptance, which
    does open up the market to geographic-specific rating agencies
    and those with some industry specifics, that those initiatives
    should be allowed to proceed.
        I also want to mention in terms of oversight, a lot of work
    has been done internationally. You may have seen the IOSCO code
    of conduct that was concluded in December 2004.
        I believe the rating agencies have taken that very much on
    board, have been part of the process. These are global ratings
    agencies, and that has been the decision after some of these
    same questions have, over the last 2 years, been debated in
    Europe primarily. Things like an arbitration board or just
    having a few people decide has been ruled out in favor of more
    of a code industry standard and self-regulation to some extent,
    but knowing that credibility, if we don't abide by a code,
    could certainly impact the bottom line.
        Chairman Baker. The gentleman's time has expired.
        Mr. Shays.
        Mr. Shays. Thank you very much. I am conflicted because I
    basically believe in open markets, and yet I have such a
    tremendous respect for McGraw-Hill and Standard & Poor's.
        So that conflict notwithstanding, Mr. Partnoy, in your
    testimony you stated the philosophical approach the Commission
    has suggested with respect to NRSROs is inconsistent with its
    approach in other areas and, indeed, with legislation purposes,
    security laws.
        Could you please elaborate on this idea?
        And let me just throw this out as well. Are there other
    entities that the Securities and Exchange Commission approves?
    In the manner in which it approves rating agencies, does the
    Commission approve brokers, investment advisors, mutual funds?
        Mr. Partnoy. Those are very good questions, and I think
    gibe well with the ranking member's questions about how to have
    registration and recognition coupled in some way.
        The philosophical, the general philosophical approach is to
    permit companies to register and then have the markets work on
    the back end as the disciplining measure. And the
    attractiveness of that is that it ideally does precisely what
    the ranking member has said he would like legislation to do
    because it provides a disciplining function. But it also
    provides an initial screening function, so you can really have
    it both ways.
        And I think the U.S. Securities markets are the best in the
    world for precisely this reason, that we have achieved this
    balance by having oversight at the beginning in terms of who
    can register, which companies can raise money, and then let the
    markets do the oversight at the end. So that is what I meant by
    those sentences.
        And in terms of other--the second part was, with respect to
    other similar kinds of areas, there aren't any explicit areas
    where the SEC, for example, will say, only these entities can
    come in, but there are somewhere implicitly.
        Accounting firms and underwriters are given special
    privileges. And to the extent there is not as much competition
    as people would like in the investment banking business or in
    the accounting Industry, where we see also not as much
    concentration as in credit ratings, but some concentration, I
    think that part of it is due to that at least implicit
    requirement that you be a Big Four accounting firm or you have
    a certain amount of reputational capital or that you are
    registered or licensed in a certain way.
        And let me just respond: This notion that licensing
    financial institutions somehow is a violation of the First
    Amendment is not something that--that argument shouldn't apply
    uniquely to credit rating agencies. It should also apply in all
    these other areas that I think your question is getting to. And
    I don't think it is correct to say that, for example,
    investment banking fairness opinions which are made public, or
    accounting opinions, which are in every Form 10-K filing, are
    subject to the same kinds of problems.
        Mr. Shays. Would any of the other panelists care to
    respond?
        Ms. Bolger. If I could just address briefly to Mr.
    Partnoy's point also, to point out that Standard & Poor's is
    submitting a detailed memo on the First Amendment issues that
    are raised under the bill. So that will be submitted shortly.
        But there are distinctions in the case law, and I certainly
    won't go into all the cites and details, but between--and
    among, actually--auditors, investment advisors, and ratings
    agencies, namely, based on the core function, a rating agency's
    core function is the publication of rating opinions, whereas
    auditors are required by regulation to publish. Rating
    agencies, on the other hand, have the option; they have full
    editorial control. And unlike the case law on rating agencies,
    there simply is not case law that covers auditors to that
    extent.
        Mr. Partnoy. May I briefly say one thing?
        Chairman Baker. Really quick, and then we will go to Mr.
    Pollock.
        Mr. Partnoy. The core function of a rating agency is not
    publication. It is not publication; it is not a publishing
    firm.
        Moody's market capitalization is more than three times that
    of the New York Times. We don't know what the S&P's value is
    because they don't say publicly. But that kind of value doesn't
    come from publishing; it comes from selling ratings that unlock
    the keys to this regulatory compliance in the capital markets,
    not from publishing.
        Mr. Shays. If I have time, I want to get into the whole
    issue of shopping for ratings.
        But, Mr. Pollock.
        Mr. Pollock. Congressman, I think there is an interesting
    positive analogy of ratings and publishing. So I think we ought
    to think about applying the NRSRO concept as a mental
    experiment to publishing.
        Suppose we said we are going to have nationally recognized
    publishing companiesand a whole range of regulated entities--
    banks, pension funds, mutual funds--are only allowed to use the
    publications of these nationally recognized companies. I think
    we would all agree that would be a pretty foolish situation.
        What I like about this bill that is it moves the credit
    rating sector, which is a business, which does have analogies
    to publishing, into a competitive market like most, at least,
    of our market economy--namely, a disclosure and competition
    model, as opposed to a regulatory designation model. That seems
    to me very positive.
        Thank you.
        Mr. Shays. Thank you, Mr. Chairman.
        Chairman Baker. Gentleman yields back.
        Mr. Hensarling.
        Mr. Hensarling. Thank you, Mr. Chairman.
        Ms. Bolger, I have listened a couple of times now, and it
    is a matter of great interest; and I look forward to reading
    the brief on the First Amendment implications because I am
    struggling a little bit with them in some respects.
        How would you address the argument that the SEC, de facto,
    has registered two rating agencies today through their
    regulations, and to this proposed legislation, as opposed to
    putting their imprimatur on two or perhaps five ratings
    agencies, they may end up putting their imprimatur on 100?
        So why don't the same First Amendment concerns apply to the
    status quo?
        Ms. Bolger. The status quo is not--rating agencies don't
    have to be designated as an NRSRO, so there is not the same
    level or approach. With this front door, one must have a
    license before one can even speak or else it is an illegal type
    of approach.
        So there is a fundamental difference in the way the
    existing system works and even, we believe, with the proposed
    rule that the SEC has promulgated. There will certainly be, as
    we understand it, more clarity around the process than the
    actual criteria for designation. But we don't take a position
    as to whether there is an ultimate perfect number of NRSROs or
    even credible rating agencies, but we do believe it is very
    important to still maintain that market acceptance factor, even
    putting aside the legal First Amendment issues just from a
    policy and market protection perspective.
        Mr. Hensarling. Next question I have--and, first, I do have
    a bias in favor of competition and open markets. And I
    certainly respect and appreciate the approach of my colleague,
    Mr. Fitzpatrick, on this piece of legislation, and I haven't
    studied it in detail.
        I have one issue that causes me a little bit of concern,
    and that might be the revelation of certain methodologies
    involved in ratings of various companies. I just want to know,
    is there any concern in the revelation of perhaps something
    that can be seen as proprietary, data that could actually prove
    to be an anti-competitive measure, as opposed to a pro-
    competitive measure?
        I understand that transparency is quite good and seeing
    one's batting average and prognosticating on what has actually
    occurred, but I just wonder if there is any concern that at
    some point we cross the line to revelation of proprietary today
    and become more anti-competitive?
        Is there anyone who would like to take a shot at that?
        Mr. Egan, you look like you are going to the microphone.
        Mr. Egan. I would be happy to because I think many market
    participants recognize our ratings as being the most timely and
    most accurate, not only domestically but internationally. We
    are not concerned about any sort of technology being
    distributed out into the marketplace and impeding us.
        I think at the base, it is really an understanding of the
    business. It is judgment. We got WorldCom right because we were
    concerned about the bear market in long distance capacity. We
    were concerned about Bernie Ebbers' $400 million loan from the
    company. We are concerned about the deterioration in the
    company. You know, if we send the technology out into the
    marketplace, it is not going to hurt us very much.
        The technology is not proprietary. It is the judgment.
        Mr. Partnoy. I will say briefly, I believe both Moody's and
    S&P describe a fair amount of their process already.
        Mr. Hensarling. Another question for you, Ms. Bolger. In
    your testimony, you talked about how Mr. Fitzpatrick's bill
    could actually erect new barriers to competition through its
    burdensome mandates. Clearly, your opinion appears to be in the
    minority on this particular panel.
        But could you explain in a little greater detail because I
    don't think I understand your position.
        Ms. Bolger. I think, fundamentally, the issue is setting up
    a structure, this approval licensing regime, and the breadth of
    entities that would be covered essentially, since one would
    need a license in order to issue opinions. And if that is your
    primary business over, I believe, 3 consecutive years, it picks
    up a large group of entities, maybe intended, maybe unintended.
    That is not clear.
        But the cost of doing, of abiding by that type of system,
    of preparing the policies, of submitting to that, and adhering
    to the whole process, the 90 days here and there, could
    definitely pose an issue, we believe, for newcomers to the
    market.
        Mr. Hensarling. But isn't it true that the vast majority of
    your competitors, who don't enjoy your designation, are on
    other side of this issue and believe it would be pro-
    competitive?
        Ms. Bolger. Well, yes, and we don't have a problem with
    that whatsoever. But our position is, the aim to open the
    industry up to more competition can be addressed in a way other
    than this bill. We really believe, after a lot of thought, that
    the bill simply doesn't work, both for legal and policy
    reasons. And we would turn, as I mentioned, to some of these
    other initiatives that have opening up the market in mind as
    one of their goals.
        Mr. Hensarling. Thank you. My time has expired.
        Chairman Baker. Thank the gentleman.
        Mr. Fitzpatrick.
        Mr. Fitzpatrick. Thank you, Mr. Chairman. I appreciate the
    time and testimony and expertise of all the panelists. We have
    all found it very helpful in this process.
        I agree with Mr. Egan that there are questions to be
    answered, and I am perplexed as to why the SEC has not dealt
    with this in a more timely fashion, just following up on that
    question Mr. Hensarling asked of Ms. Bolger and her answer.
        Going to Mr. Partnoy, could you explain the SEC staff
    designation process and how that only adds to the duopolistic
    position of Moody's and S&P?
        Mr. Partnoy. Well, it is difficult to explain. It has been
    a bit of a black hole because there is not much specification.
    And you hear the frustrations from Mr. Egan here in trying to
    get designated. And he is certainly not alone; there are many
    entities that have tried.
        Formally, the process works through no-action letters. So
    it is an informal process, and the goal is to try to get the
    SEC to write a no-action letter. But just as we, Chairman Baker
    and I and others, have said, there isn't even a definition of
    an NRSRO. There isn't much guidance. So I describe it as a
    "black box." I don't think that anyone knows precisely what
    they need to do in order to qualify.
        Sorry I can't give you a better answer to that, but I just
    don't think there is one.
        Mr. Fitzpatrick. Mr. Pollock, you were at one time head of
    the Federal Home Loan Bank of Chicago, and you have significant
    experience in the financial services market.
        Could you explain your comments that you believe--and we
    have heard some concern here about disruption to the markets as
    a result of this bill. Do you believe that there would be no--I
    think you said "no disruption" to the fixed income markets,
    that there is a more competitive rating agency sector?
        Mr. Pollock. Congressman, that is my opinion, as I said in
    my testimony. These are big markets; they are full of
    sophisticated people. They will also, in my judgment, move in
    an evolutionary fashion because there are natural, conservative
    tendencies in anything that revolves around the question of
    estimating risks and estimating future losses and
    uncertainties.
        I think we should be moving the market to where all
    financial actors, both issuers and buyers of securities,
    creditors, and all users of these ratings, are asked to
    exercise their judgment, have that judgment as informed as
    possible, and then let the market action decide which ratings
    are successful, which pricing models they like, which ratings
    models the market will prefer.
        But I am convinced that all that would happen in an
    evolutionary, nondisruptive way because everybody is going to
    be very careful about this so that what we will see is a smooth
    transition from what we have now, the Government-sponsored
    cartel, to what we should have, which is a real competitive
    market.
        Ms. Stroker. If I can address that, as well, representing
    Fitch's view. We are sort of the man in the middle here where
    we are an NRSRO and yet we are not S&P or Moody's; we don't
    have their market strength.
        I think the big concern that we share is that the process
    of getting from here to there, that it be constructive and
    evolutionary. And as Congressman Kanjorski pointed out, ratings
    are infused in numerous statutes--in the financial markets, in
    mutual funds--and simply opening up the ability to be included
    to these 140 market participants, or whatever the number is,
    could be quite disruptive.
        Mr. Egan. I would like to put things in perspective. You
    know, you have had major failures here, billions of dollars
    lost. And we are concerned because one, probably two, of the
    major rating firms whose revenues operating income, by the way,
    has doubled in the last couple of years, they are concerned
    about moving forward because they might lose the freedom of
    speech defense because they don't want to be registered under
    this new scheme.
        It makes no sense to me. But then again, neither does the
    SEC's registration process. So you really want to put the whole
    thing in perspective; people are getting hurt badly. And it has
    been 15 years since the SEC has been studying this.
        We have had an application in for 8 years. I am a patient
    man, but this is getting absolutely ridiculous. What do we
    need, another couple of Enrons to fail?
        Mr. Fitzpatrick. One more question, Ms. Bolger. In your
    written testimony, page 8, you liken this bill to--"throwing
    the baby out with the bath water" is the analogy you use.
        I am wondering, who is the baby in this particular case and
    what is the bath water?
        Ms. Bolger. The baby would be the test for market
    recognition since that would disappear under the bill. And we
    do believe, in response to some of the other statements and
    questions this morning, that this is not just a matter of
    terminology and changing "recognized" for "registered" or
    whatever the term might end up being, because the premise, the
    fundamental premise upon which States and Federal regulations
    have embedded NRSRO ratings, has been market recognition.
        I think that has been the SEC's key criteria for a long
    time, and while, perhaps, the process is not clear--and we are
    also on record as being very much in favor of a more
    transparent process and a more formalized process to increase
    competition and provide the quality ratings out there--it just
    seems that to eliminate the market recognition or acceptance,
    that is, you know, for independent credible ratings, is the
    wrong way to go. We think it is just too fundamental, the
    system.
        Chairman Baker. I thank the gentleman and want to
    compliment him on his good work in this matter.
        I want to try to put in a construct that makes sense to me,
    the concerns that I think Mr. Fitzpatrick is addressing with
    the legislation.
        As indicated earlier by Mr. Pollock, there isn't a
    Government agency that says, okay, you can be a newspaper.
    Under the First Amendment, not only are newspapers protected, I
    am protected.
        I am going to make a statement you are going to disagree
    with it. I have the right to make the statement; I don't have
    to be licensed to make the statement, and there are no
    consequences when I make the statement. Now, if Mr. Kanjorski
    and I agree and we introduce a bill, that might have
    consequences, but short of that, the statement itself has no
    effect.
        You were arguing that you have a First Amendment privilege
    as a result of your reaching and opining as to someone's
    financial condition. Very similar in concept and scope to that
    of a CPA, now subject to the PCAOB in multiple regulatory
    levels.
        At the same time, you are saying that to be designated an
    NRSRO is of no consequence, but statutes make repetitive,
    duplicative reference to NRSRO; hence, the reason why we didn't
    change NRSRO to another acronym, but rather "registered" as
    opposed to "recognized," so we didn't have to change all the
    other statutes. It was a way to address the structural problems
    without getting into all that legislative, legal detail.
        The current system is a system which designates NRSROs as a
    result of an SEC governmental determination and establishes a
    status on those so designated. That is not an operative
    principle distinguished from a registration process.
        I have, as Exhibit Number 1, Mr. Egan, who is now an 8-year
    advocate for registration "recognition," for nationally
    "recognized." He can't get there. So it is a barrier in
    performance of NRSRO obligations.
        The very thing you say you do not wish to see occur with
    the adoption of 2990, I suggest the current system, therefore,
    is unconstitutional and subject to First Amendment privilege.
    If we agree that you are now designated by governmental
    enterprise, and I even cede to you the point that there are
    First Amendment questions, I will refer you to Hudson v. New
    York in 1980, in which the Court held that should there be an
    overriding governmental reason and the remedy prescribed by the
    Government is reasonable and properly prescribed, then there
    even can be a prescription of First Amendment privilege based
    upon an overwhelming necessity for governmental action, the
    capital markets.
        If S&P determines that an enterprise is--an issuer's
    ratings should fall below BBB, no longer investment grade,
    there are consequences. If an issuer wishes to go into the debt
    markets to provide security investments into its firm and does
    not get a rating of at least two independent enterprises, there
    is a market consequence.
        A newspaper writes a bad editorial; people get mad, but
    there is no measurable, quantifiable market effect. When you
    issue an opinion contrary to an issuer's interest, there is a
    measurable, consequential effect. Therefore, preservation of a
    stable capital market is clearly in the interests of this
    committee and of the Federal Government, and it should have
    been under the purview of the SEC. And that is what gets us to
    the current moment.
        The SEC has not acted; for 30 years it has not acted. And
    we have a handful of individuals granted the responsibility to
    engage in this enterprise conduct, which is specifically
    referenced by Federal law for which there are market
    consequences if they are engaged and they, the issuers, do not
    meet your standards of performance.
        I am a free market guy. I find this extraordinarily
    troubling. You are what you are because of an act of a
    governmental agency.
        Now let's take a look for a moment at your owner, McGraw-
    Hill. They are a publisher. They should be availing themselves
    of the First Amendment privilege, which you prescribe for your
    own interests since they are in the publishing business.
        I went to the Internet, and strange as it seems, I found on
    the Internet all of their financial disclosures, annual
    operating revenues of $5.25 billion--I won't bore you with the
    details. Suffice it to say, they are Sarbanes-Oxley compliant
    and make all the disclosures that anyone should make in the
    current market environment for a corporate governance standard
    of conduct. While at the same time, S&P makes no disclosures of
    financial income or resources. There is no accountability for
    conduct which might not be a market standard of professional
    conduct. It is a large black box into which a lot of stuff goes
    and a few opinions leak out the back door.
        Now, according to another First Amendment-protected source,
    which shall remain named, the New York Times, alleged that 65
    percent of McGraw-Hill's net operating profit was generated
    from Standard & Poor's, which according to the numbers I
    calculated, that is only 491 million. Mr. Egan was referencing
    an $800 million figure. I don't know who is right, but between
    5 and $800 million, this leads me to conclude this could
    possibly be about money. I don't know. Maybe that is a too
    pessimistic view.
        But you then have to look at the market performance and
    others have called into question market performance relating to
    the last decade. The response by S&P has been, well, people
    lied to us. What standard of due diligence does an analytical
    person have to look at the numbers?
        I read through the protocols provided to me by S&P and what
    is done in order to determine an issuer's status; and there is
    no reference to a requirement to look at audited statements or
    to conduct an audit. It really is the best guess that one can
    make, given what is commonly available in the public markets.
        If one were really that good in a open competitive
    marketplace--I want to make clear, if Moody's and S&P could
    control 80 percent of the market in a free, open system, I
    would defend that right. I defend the right of anyone to go out
    and make money. It is my opinion, whether well-founded or not,
    that the current circumstance is the consequence of the
    governmental designation to the prejudicial effect of all those
    others who wish to compete in the marketplace.
        If 2990 is, on its face, defective, I need to hear
    specifics other than what I consider a specious First Amendment
    argument. And I know you will have briefs to forward for us to
    later review, and I look forward to that.
        But as to the elements of having someone register, putting
    that aside, knowing that your difficulty with registration is
    that you think that is an arbitrary and capricious inhibition
    to market function, what is the down side of what Mr.
    Fitzpatrick has established as the guiding principles for
    governance of a rating agency in the market structure we have
    described?
        Ms. Bolger. You raised a number of very important issues--
        Chairman Baker. I hope so.
        Ms. Bolger. --and a number that we very much agree with in
    terms of concerns.
        Putting aside the First Amendment issues, pure legal
    issues--again, the main policy concern we have--I would suggest
    we certainly would like to discuss this with you further. It is
    this whole element of market recognition. And I understand that
    that is not always well articulated or perhaps enunciated.
        I believe there is an effort, though, to more formally
    enunciate standards, to measure it. But to take that out of a
    system that has been in existence--and we would say, based on
    what others have also said, it is not just Standard & Poor's;
    it has really worked extremely well.
        Chairman Baker. Well, then is it that keeps Mr. Egan from
    getting his approval? What deficiency is there in his
    application?
        Ms. Bolger. I cannot speak for the SEC. And, yes, we too
    have been, on occasion, frustrated with the SEC as well. We
    have a proposal in for an oversight framework, which I think
    has been alluded to this morning, that we have been working on
    at the SEC's request and are awaiting comments from them on.
    And we do hope it proceeds.
        And I can go into a little more detail if you would like.
        Chairman Baker. Let me rephrase it a different way.
        It is, rather than being so specific to another applicant,
    are there others who perform this function in the market today
    whom you believe should be designated NRSROs?
        Ms. Bolger. I personally--and I don't believe S&P has a
    view that there is one specific entity out there because we
    don't necessarily know who may have applied or--
        Chairman Baker. In the general function of credit ratings,
    are there other companies who perform this duty in a manner
    which you think would be satisfactorily compliant with the
    SEC's standards?
        Ms. Bolger. Yes, I believe there probably are and probably
    not just here in the United States. This is a global business.
    So we also tend to look at these issues from a global
    perspective.
        So, yes.
        Chairman Baker. So you would conclude that there are people
    that should be approved, but have not been, and we don't know
    why?
        Ms. Bolger. Well, again, I can't speak to what the
    deficiencies might be or where they might be in the queue here
    and certainly, again, for what may be the situation with Egan-
    Jones. But we do share the goal of opening up the market to
    whomever it might be, but keeping in place some of the key
    fundamental standards, making them more formal, making them
    more transparent. I think to your point--
        Chairman Baker. But you are arguing, with due respect,
    against yourself. You are saying we need to have standards, we
    need to make sure we have the right people doing this work who
    are responsible in conduct, but at the same time you are
    telling me we should not have governmental oversight of the
    function. How is that consistent?
        Ms. Bolger. The standards are ones that the SEC would
    articulate for designation. We don't believe the current system
    of designating, because not everyone has to be an NRSRO, raises
    again the constitutional issues that we feel that the bill--
        Chairman Baker. Well, stay away from the Constitution. We
    are doing good here. We are getting disclosure.
        We agree there are other people who are out there who
    should be approved NRSROs. We don't know the reasons within the
    SEC why they have not been. We are not sure who in the SEC is
    making the determinations.
        But moving forward, you are arguing that when we let those
    people in, they should meet certain standards of conduct. And
    those standards of conduct look pretty much to me, whether you
    call them "registration," if you don't fit this box, you don't
    get in. That is where we are now.
        Ms. Bolger. Yes. Let me clarify a couple of points.
        First of all, in terms of the whole NRSRO regime, we have
    been in favor and on record as having market participants also
    weigh in on the process, be it the initial designation or be it
    some ongoing surveillance, should one continue to be an NRSRO.
    I believe the SEC is looking at time frames to be an NRSRO.
        In terms of the standards issue, what we are looking at--
    and I believe the other rating agencies have also or are in the
    process of implementing our codes of conduct. These are not
    mandatory by regulation or law, but they are effectively
    industry standards. And given that this is a business largely
    built on credibility and reputation, one, we believe--I won't
    talk for everybody, but I believe--just in our conversations,
    we all feel that this is very necessary.
        This code goes to the transparency of the process, it goes
    to how we do our business, and it goes to a number of other
    issues that are both covered by the bill as concerns and the
    SEC has enunciated as policy issues. But they are not mandatory
    by law, and that is why there is a distinction in approach.
        Chairman Baker. Well, I have gone way beyond reasonable
    time, and I should afford Mr. Kanjorski an opportunity, if he
    chooses, to make another round.
        Mr. Kanjorski. Just a few questions.
        Chairman Baker. Mr. Kanjorski, let me conclude.
        I hope I have made clear the basis on which Chairman Oxley
    and I are both concerned about the current methodology. We are
    strongly supportive of Mr. Fitzpatrick's approach, but we would
    welcome constructive comment going forward about how we get out
    of this conundrum where we have five--at most, two--controlling
    80 percent of the market. It is very restrictive,
    noncompetitive.
        But we are not in the business of promoting nonprofessional
    individuals to frivolously rate issuers and create havoc in
    markets. That is not where we want to wind up. We want what you
    want, respected people doing professional work for the benefit
    of an active and vibrant capital market, and we think we can
    enhance that opportunity.
        And there are reasonable questions, we believe, on our side
    of table to be resolved. And I thank you.
        Mr. Kanjorski.
        Ms. Bolger. Yes. And thank you, Mr. Chairman. We share your
    concerns and hope to continue the dialogue.
        Mr. Kanjorski. Maybe I should raise the question, Mr.
    Chairman, but rather than having this panel here today, we
    should have had the SEC here again today and in order to find
    out how they put this scheme together, as well as why and what
    they are doing about it to make it a fairer situation.
        It is very difficult on my side of the aisle to argue
    against H.R. 2990 or anything else in terms of total
    competition, in which you, Mr. Chairman, always state you are
    for. Then why should we have any designation? We could just let
    the marketplace play out.
        Chairman Baker. I will sign on.
        Mr. Kanjorski. Well, why then are we looking for a
    regulatory scheme of any sort? Let's just declare it open,
    because it is my thought that ultimately we would end up with a
    somewhat similar structure. Investment banking houses,
    investors, and the consuming public has to have had some
    insight as to where to put their money before the designation
    of NRSROs, like Standard & Poor's, Moody's, Fitch, and others
    existed, didn't they? Yes, sir.
        Okay, what happened when they existed without this
    designation? Did they occupy a large portion of the market? Did
    they get that market share because of their credibility or did
    they get it because they were monopolistic?
        Mr. Partnoy. May I address that?
        The business was significantly different. It was actually
    more like a publishing business and more like the business that
    Mr. Egan's company engages in. It was actually a very well
    functioning market, and those same entities participated. There
    was lots of competition during the 19--
        Mr. Kanjorski. Why did we change it?
        Mr. Partnoy. We changed it because the SEC promulgated one
    rule in 1975, and then it was off to the races. And people saw
    that it was easy. Instead of making a determination on their
    own as a regulator as to, for example, what net capital
    requirements could be, it was easy just to push that off onto
    the private sector and in this peculiar way pushing it off only
    onto a handful of folks.
        And it really hasn't been done in other areas before, but
    it was easy, and it just--it was a monster; it got out of
    control. And if you look, I have written a couple of articles
    on this and just shown the simple chart that shows growth in
    regulations, and it goes up, up, up, up, up.
        Mr. Kanjorski. What is your opinion and the rest of the
    panel; should we go back to the pre-1975 world?
        Mr. Partnoy. I think there is a strong argument for going
    back to eliminating this concept of NRSROs entirely. I have
    said there are alternatives.
        For example, you could have decisions made based on the
    market spreads, the credit spreads that exist in the market,
    which would be a nice way of capturing all of the information
    in the market, not just the information associated with credit
    rating agencies. I think that is a viable alternative.
        I have submitted that to the SEC. I don't think that it has
    been considered adequately. It would be something on the plate
    for this committee to think about.
        I think it is a very difficult problem. I think that the
    bill that we were talking about now is actually a nice
    compromise. But going back to pre-1975, ironically, even with
    all the modernization of financial markets, actually a nice way
    to think about what we should try to do is go back before we
    had this regulatory superstructure.
        Mr. Kaitz. It might be a nice way to think about it, but it
    is totally unrealistic. You have to undo legislation and
    regulation and all those regulated portfolios to do away with
    the NRSRO--
        Mr. Kanjorski. Congress doesn't have to do anything?
        Mr. Kaitz. It is embedded in insurance, mutual fund,
    banking regulation. You would have to then address each one of
    those separate pieces of legislation.
        Mr. Kanjorski. We have created a monster. Now we have to
    dress that monster?
        Mr. Kaitz. I am afraid you have to. I don't think it is
    realistic to just go back to 1975.
        Mr. Kanjorski. Mr. Egan, would that solve your problem if
    we went back to pre-1975?
        Mr. Egan. The short answer is, I don't know. I know it is
    not working right now. It is not working because of the odd
    process for becoming an NRSRO, the fact that applicants are not
    told specifically what the requirements are, what has to be
    done.
        Mr. Kanjorski. We are going back. We are going to throw
    that out and go back to pre-1975. Would that solve your
    problem?
        Mr. Egan. I think there are some suggestions about spreads
    and other quantitative measures. We use them internally. And,
    in fact, there is a big--there is an organization called KMV
    that uses equity-based information.
        The problem with some of these approaches is that they have
    some flaws that when you have the rating firm overlooking, you
    offset those flaws. For example, spreads, if there is a spread-
    based system, you get traders together and you could manipulate
    the spreads.
        I think the core issue--and I agree, you can't go back to
    the old system because it would be too disruptive to the
    market. I think what really needs to be done is, the process
    has to be cleaned up. It is a mystery why the SEC is acting the
    way it is, but you need somebody else to look over it, to
    review the industry.
        But I don't think you can go back to what was done before
    because it would be too disruptive in the short run to the
    market.
        Mr. Kanjorski. But if I hired all of Mrs. Bolger's analysts
    in a new company called Apex, I couldn't qualify for an NRSRO
    rating, yet I would have all her expertise, a new entity, and a
    want to go into business.
        Now why shouldn't I then be able to issue opinions if I
    have got the best analysts in the field, assuming Standard &
    Poor's has the best in the field? Yeah, I know that you would
    argue that point, but I assume that they are and I hire them in
    bulk. I am a John Mack.
        Mr. Egan. You would go bankrupt.
        Mr. Kanjorski. I am going to the start a whole new
    business.
        Mr. Egan. You would go bankrupt in a short period of time
    because you wouldn't have the revenues to offset expenses. The
    competition will come from firms like us, that are fast,
    aggressive, know what they are doing, are recognized by the
    market, and don't have the size of S&P and Moody's, but have
    the--
        Mr. Kanjorski. So nobody in the marketplace really cares
    how qualified the analysts are or how good they are; they care
    about a name. If I understand what you are saying, I would go
    bankrupt. There is maybe really little value to having all this
    analysis and all these formulas and all these models.
        Mr. Egan. It is the weight of the name in the marketplace.
        Everybody knew that the auto companies were under pressure
    a couple of years ago in fact. But the market moved
    dramatically when S&P changed the rating--I forget whether it
    was GM or Ford, just because there is so much tied into it.
        Mr. Kanjorski. Only because of their name?
        Mr. Egan. Correct.
        Mr. Kanjorski. If Apex did it with all their analysts,
    nobody would pay any attention.
        Mr. Egan. It is the typical thing with a monopoly. Is
    Microsoft software the very best software for an operating
    system? The answer is probably no, it is not. It is just that
    they have all these different tie-ins.
        That is the core problem here. The term used by the Justice
    Department for describing this industry is a "partner
    monopoly", and it has all the problems associated with a
    monopoly. It is not that S&P and Moody's are incredibly smart.
    It is not that they are fast. In fact, you can show time and
    time again that they are slow, and yet, at the same time, the
    operating revenues are double.
        Mr. Kanjorski. But it sounds to me like you want to break
    up this monopoly in a little way and put a few more people into
    the game to maintain the monopoly. If you are really
    competitive, let's wipe them out and let everybody play the
    game.
        Mr. Egan. Too disruptive to the market.
        Mr. Kanjorski. Mr. Pollock, I see you are smiling and being
    entertained by my examination.
        Mr. Pollock. I think your examination is very good,
    Congressman. It raises the question that you rightly asked, how
    did all of the current dominant rating agencies start? They
    were all started early in the 20th century in 1910-1920 era by
    entrepreneurs doing exactly what you just said, hiring some
    analysts, starting to publish ratings, going around trying to
    get customers, getting people to pay. Standard & Poor's was
    originally the Poor's Publishing Company, I believe, and John
    Moody, and I guess there was a Mr. Fitch.
        Ms. Stroker. Yes.
        Mr. Pollock. And they all succeeded doing exactly what you
    just said. I agree that ought to be an opportunity that is open
    in this sector, as it should be open in every other sector.
        But as has been pointed out--and as you, yourself,
    Congressman, pointed out--we have got dozens and dozens of
    regulations and laws affecting thousands of regulated entities
    with this term "NRSRO". That is why I thought the bill's
    approach was so clever in making a move toward a disclosure
    registration competitive regime that could live with the
    existing complex, interacting regulations. Moving toward a more
    competitive regime would allow entrepreneurs like you to try to
    get into this business if you wanted to.
        Mr. Kanjorski. Does anyone else want to respond?
        Ms. Stroker. I would just add, I wouldn't give up on your
    business plan yet. I think Fitch has demonstrated over the past
    several years that we have been able to grow and compete by
    offering innovative research and good criteria and price
    competition and different things that the market values.
        So while you might not have the NRSRO status on the first
    day that you open your doors, I think others have proven the
    ability to grow and be recognized without it.
        Mr. Kanjorski.Isn't really the essence of one of the
    problems here is where the funds come from and how the profit
    is made, as opposed to on the publishing side or on the getting
    paid for the analysis? If in some way we didn't have that
    conflict, and the money is to be made on the publishing side,
    wouldn't that release the pressures that are here? It would
    probably dozens Standard & Poor's an awful lot of money. I
    suspect they are not making it on the publishing side; they are
    probably making it on the fee side to get in there. But maybe
    that, in itself, is an inherent conflict.
        Mr. Egan.It is an inherent conflict. However, that is a
    secondary problem to the structure of the industry.
        There is no question that the problems that existed in the
    equity research side of the business, whereby Jack Grubman was
    getting paid via investment banking fees and that the same
    problem does exist in the rating industry. I think it makes
    total sense to address the conflict problem. It is just that I
    think you want to address the industry's structural problems
    first, and that is a lack of competition.
        In fact, it is kind of odd that on the one hand, the SEC is
    fining all of those broker-dealers because they are getting
    paid by investment banking fees, but at the same time, in the
    latest NRSRO definition, they are locking it in that you must
    get paid by the issuers, by the very fact that they are
    insisting that those ratings be made free to the public. And
    perhaps that is an indication of the influence of the current
    market participants.
        Chairman Baker. Mr. Fitzpatrick I think had a follow-up.
        Mr. Fitzpatrick. Just following up on that issue of
    anticompetitives leading to potential conflict. There has been
    little discussion of some of the anticompetitive practices that
    you have witnessed, such as offering unsolicited ratings.
        I was wondering if any of the panelists have any comment on
    those practices and, specifically, whether you think that they
    should be prohibited?
        Ms. Stroker. I would like to take that, because Fitch does
    engage in unsolicited ratings, and we do it to be
    procompetitive rather than anticompetitive.
        In order to establish our name and reputation in the
    marketplace, we have had to grow our coverage to a level that
    interests investors and grabs their attention and gives us an
    opportunity to comment across a wide range of credit
    categories. So we feel that it has been an important tool for
    us to grow. And we do it in ways and in a style that is not
    meant to be abusive or coercive or any of those bad words, but
    it is meant to inform investors.
        Mr. Partnoy. Let me just mention one other area that has
    not been covered so far that I think should be in the back of
    everyone's mind, and that is structured finance.
        Increasingly, institutions are using structured finance
    techniques to game ratings, to take advantage of ratings. And
    the ranking member was discussing what would it matter. It
    often helps when a rating is wrong, paradoxically. When ratings
    are wrong, that can create incentives for people to create
    transactions, and there are now trillions of dollars of credit
    derivatives in particular, or collateralized debt obligations,
    which were essentially created just because there are
    regulations that gives a ratings benefit.
        And it goes back. It is the same rationale, going back to
    Orange County, where there were created all of these AAA-rated
    instruments that were really wolves in sheep's clothing. The
    same sort of thing is happening right now in the collateralized
    debt obligations market.
        And if you look at the fastest growth area of the NRSROs
    and where a lot of the profit is coming from, you will see that
    it is from structured finance. And that is a deeply troubling
    piece of this market, where institutions are trying to take
    advantage of the fact that regulations depend on ratings to
    have transactions that are rated inaccurately.
        Mr. Kaitz. I would just suggest that if you are an issuer
    that gets an unsolicited rating with no competition in the
    marketplace, you have absolutely no place to go. And while it
    might be pro-business for Fitch, it is certainly not viewed
    that way by the issuer, who is then faced with having to
    essentially give in or be coerced or have to pay for a rating,
    especially if they are going to be issuing debt. So what looks
    as pro-business from Fitch's perspective, is not the same from
    the issuer perspective.
        Chairman Baker. I would like to ask for a point of
    clarification. If you are the victim of an unsolicited rating
    and there is some confusion about whether you should pay or
    not, is that a segue into being on a watch list?
        What is the consequence of nonpayment?
        Ms. Stroker. There is absolutely none. The analysts that
    are opining on the creditworthiness of the issuers and the
    securities they rate are blind to whether there is compensation
    involved or not. So there is no consequence.
        In fact, we have arrayed our ratings to see if there are
    any difference between unsolicited ratings across the spectrum
    and solicited ratings.
        Chairman Baker. But I understand your point, that the
    analyst conducting the evaluation may be blind to the revenue
    situation, but somebody in management back in Fitch has got to
    measure and match those things up or you are going to have a
    lot of unpaid bills and nobody is watching. How does that work?
        Ms. Stroker. Again, it is based on our need to have
    coverage, sufficient coverage to serve investors well.
        Chairman Baker. I understand the point and why it is done.
    But I am just saying that as a practical matter, somebody
    within an organization has to know to whom invoices were sent
    and whether they are paid or not; and that has some consequence
    at some point, if the issuer calls you up and says I would like
    to now have a rating, and are you delinquent on an unsolicited?
        Ms. Stroker. Right.
        Mr. Kaitz. The unsolicited rating forces the issuer to then
    engage in formal discussions. That is essentially how it works.
        Chairman Baker. That is what I was trying to get at: What
    is the consequence?
        Mr. Kaitz. The consequences is, in most cases, having to
    then engage with the rating agency.
        Chairman Baker. You have no other choice. The friendly
    monthly payment plan.
        Mr. Egan. By the way, the Washington Post had a very good
    description of that process whereby the Washington Post said
    that Moody's shook down a German insurance company. They issued
    an unsolicited rating. They asked for payment. They did not get
    payment. And over a period of about 2 years, Moody's kept
    asking. When the issuer refused, Moody's would take a negative
    action. And that documents some of the negative publicity
    surrounding unsolicited ratings.
        Keep in mind, though, for firms such as Egan-Jones that are
    not paid by the issuers, by definition all of our ratings are
    unsolicited.
        Mr. Fitzpatrick. Does Fitch also engage in the practice
    known as notching?
        Ms. Stroker. No, we don't. Just to clarify the point,
    notching would be if we penalized the ratings of other ratings
    service in the way we analyze a portfolio of securities.
        We do not notch the ratings of S&P and Moody's
        Mr. Fitzpatrick. Do other firms notch?
        Ms. Stroker. Yes. S&P and Moody's notch Fitch ratings and
    each others' ratings.
        Mr. Kanjorski. Mr. Chairman, maybe I can direct this
    inquiry at the author of H.R. 2990. Maybe using the SEC as the
    enforcement mechanism for competitiveness in this field is the
    wrong way to go. In most instances, I think of the SEC as an
    entity that determines disclosure and transparency in corporate
    life, as opposed to the enforcement of competitiveness.
        I think of enforcement of competitiveness as being in the
    jurisdiction of the Federal Trade Commission or the Justice
    Department. Maybe that is one of the hang-ups that I have. This
    bill is sort of looking to change the culture of the Securities
    and Exchange Commission. Maybe they are resisting it because it
    is not in their nature to worry about competition; that is not
    one of their considerations. Their major consideration is to
    make sure that there are rules and regulations in place for
    full and adequate disclosure.
        Should we look at changing the enforcement mechanism in
    this situation? Maybe if the panel wants to look at that, we
    should.
        Mr. Egan. The primary obligation is protecting investors.
    That is what they say. Job number one is protecting investors.
    They have not protected investors.
        Mr. Kanjorski. But they do not do it by nurturing
    competition. That has never been their charge.
        Mr. Egan. Perhaps not. But why not recognize some rating
    firms that have succeeded in pointing out the problems with
    Enron and WorldCom. They have refused to.
        Mr. Kanjorski. Mr. Egan, you get a 30-second advertisement
    in here regardless of how we decide.
        Mr. Egan. I am sorry. If you were looking at this area for
    8 years and got no response, you would feel the same way.
        Mr. Kanjorski. I understand. I just want to compliment you.
    Whoever is your PR firm, fire them and hire yourself.
        Chairman Baker. I thank the gentleman for his observations.
    And I had previously erred in not submitting for the record a
    letter from the Investment Company Institute signed by Mr.
    Schott, its president, relative to their position on H.R. 2990.
    I would make that part of the record.
        I also want to express my appreciation to you and disclose
    a side bar conversation I had with Mr. Kanjorski, the content
    of which is in going forward there is no rush to judgment. The
    Fitzpatrick measure is a point of departure, but it is a
    meaningful statement, I think, on at least our thinking of
    where we might go. And we appreciate the exchange of views
    presented here today. It is indeed helpful to the committee's
    work in going forward.
        I would just make the comment that although we will not
    move precipitously or with an unwarranted proposal, we
    certainly do want to move because we believe this is an area
    where action is fully appropriate and necessary for the conduct
    of a vibrant capital market.
        And with that, I would adjourn our meeting. Thank you.
        [Whereupon, at 12:10 p.m., the subcommittee was adjourned.]

                                A P P E N D I X

                                 June 29, 2005

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