[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



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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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