[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
H.R. 2990--THE CREDIT RATING
AGENCY DUOPOLY RELIEF ACT
=======================================================================
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
__________
NOVEMBER 29, 2005
__________
Printed for the use of the Committee on Financial Services
Serial No. 109-66
_____
U.S. GOVERNMENT PRINTING OFFICE
26-754 WASHINGTON : 2006
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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
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Page
Hearing held on:
November 29, 2005............................................ 1
Appendix:
November 29, 2005............................................ 29
WITNESSES
Tuesday, November 29, 2005
Egan, Sean, Managing Director, Egan-Jones Ratings Co............. 15
Macey, Jonathan R., Sam Harris Professor of Corporate Law,
Corporate Finance, and Securities Law, Yale Law School......... 13
Reynolds, Glenn L., Chief Executive Officer, CreditSights, Inc... 6
Roberts, Richard Y., Partner, Thelen Reid & Priest LLP, on behalf
of Rapid Ratings Pty Ltd....................................... 11
Stevens, Paul Schott, President, Investment Company Institute.... 9
APPENDIX
Prepared statements:
Egan, Sean................................................... 30
Macey, Jonathan R............................................ 37
Reynolds, Glenn L............................................ 42
Roberts, Richard Y........................................... 51
Stevens, Paul Schott......................................... 68
Additional Material Submitted for the Record
Financial Executives International:
Letter to Securities and Exchange Commission, June 9, 2005... 82
Letter to Hon. Richard H. Baker, November 29, 2005........... 89
H.R. 2990--THE CREDIT RATING
AGENCY DUOPOLY RELIEF ACT
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Tuesday, November 29, 2005
U.S. House of Representatives,
Committee on Financial Services
Washington, D.C.
The committee met, pursuant to call, at 10:05 a.m., James
A. Byrne Courthouse, Ceremonial Courtroom, Philadelphia,
Pennsylvania, Hon. Michael G. Oxley (chairman of the committee)
presiding.
Members present: Representatives Oxley, Baker, and
Fitzpatrick.
ChairmanOxley. The committee will come to order.
Good morning. We are here today in the beautiful City of
Philadelphia, the City of Brotherly Love, to focus on H.R.
2990, the Credit Rating Agency Duopoly Relief Act, introduced
by Bucks County's own Congressman, Mike Fitzpatrick. I would
like to take a few minutes to assess the committee's oversight
of the rating agency industry. In response to the largest
corporate scandals in U.S. history, Congress passed the
Sarbanes-Oxley Act, strengthening the role of gatekeepers, such
as auditors and boards of directors, audit committees, and
equity analysts.
Another gatekeeper, the credit rating agency, became a
focus of Congressional interest because the dominant rating
agencies had rated WorldCom and Enron investment grade just
prior to their bankruptcy filings. Wanting to understand an
industry with such a significant impact on the markets,
Congress directed the SEC to study the credit rating industry.
Since the release of the SEC's report in January of 2003, the
Capital Markets Subcommittee, under the leadership of Chairman
Baker and Ranking Member Kanjorski, has held a series of
hearings to explore the areas highlighted in the SEC's report
about the industry, the barriers to entry, the conflicts of
interest, and the lack of transparency regarding rating
methodologies.
The SEC, a number of rating agencies, public company trade
associations, and academics have all testified before the
subcommittee about the industry. Congressman Fitzpatrick's
legislation, the Credit Rating Agency Duopoly Relief Act,
reflects many of the reform ideas suggested by these witnesses.
Witnesses repeated three problems in the credit rating agency
industry: the lack of competition, the lack of transparency,
and the lack of accountability.
Congressman Fitzpatrick's legislation works to correct all
those problems. First, H.R. 2990 fosters competition by simply
requiring all eligible rating agencies to register with the
SEC. The registration of credit rating agencies would resemble
the registration of broker-dealers and investment advisors
under the Federal securities laws. Registration would replace
the opaque recognition process the SEC staff now uses to select
rating agencies. The designation of only a select number of
agencies has led to troubling concentration in the industry,
with two firms controlling a vast majority of market share.
This is far from an efficient market with robust competition.
The bill takes a further step at encouraging competition by
prohibiting anticompetitive practices, such as notching, tying,
and unsolicited rating. Smaller rating agencies and public
companies have repeatedly alleged that the larger firms engage
in such practices. To improve transparency, H.R. 2990 requires
the disclosure of procedures and methodologies used in
determining ratings, performance statistics, and conflicts of
interest. These requirements would go far in shedding light on
the operation of these powerful players in the financial
markets. In addition, the legislation permits the SEC to adopt
further reporting and recordkeeping requirements in the
interest of investor protection. And finally, H.R. 2990 enables
the Commission to oversee the rating agencies through
inspection, examinations, and enforcement actions.
We do hope to pursue this reform in the new year. We are
holding this second hearing on the bill to ascertain from our
distinguished panel of witnesses their views on and suggested
enhancements to Congressman Fitzpatrick's legislation. I look
forward to hearing their testimony. I now yield to the
gentleman from Louisiana, Mr. Baker, the chairman of the
subcommittee.
Mr. Baker. Thank you, Mr. Chairman. I want to express my
appreciation to you for conducting this field hearing and make
the observation that when we return to Washington, we really
ought to examine the structure of our own committee room. I
feel a bit smarter sitting this high up. It certainly is
helpful to be up here, I think.
I also want to express appreciation to Mr. Fitzpatrick for
the introduction of H.R. 2990. This is a really big issue. As
you appropriately pointed out, the rating agencies are
essentially the gatekeepers to the capital markets for access
by businesses of all sizes to engage in corporate growth and
job creation, product development, and all of the things that
we see in free enterprise as appropriate and good for our
national economy.
A system such as this should be subject to extraordinary
scrutiny and held to the highest standards of marketplace
accountability. At the current time, I don't believe that can
actually be claimed. We have a system which has worked, but
markets have changed dramatically. The provision of credit
flows differently than any time before in our country's
history. Technology continues to press the change, and as a
consequence, it is time for us to look at the gatekeeper's role
in asserting whether or not there could be modifications made
that would benefit all players. It is my view that 2990 brings
about an important discussion that we should have engaged in
some time ago, but certainly have an obligation to carefully
consider the provisions of the bill, as Mr. Fitzpatrick has
proposed them.
The current and existing leaders in the provision of
ratings would no doubt, after implementation of 2990, remain
the predominant providers of ratings in the system, were the
system changes brought about as proposed under the Fitzpatrick
plan. But certainly, it would give at least regional
specialists the opportunity to stay in the oil patch, to do
skilled work, and be helpful in bringing about a higher degree
of accountability by the major players, not only as to the way
in which the work is engaged, but the product quality itself.
It shouldn't need to be said again, but probably needs to be
said again, that very few sectors of the market performance met
our expectations during the Enron-WorldCom days. And to look at
the performance of these enterprises in that light, there
certainly is hope for improvement in future performance as we
make needed changes to the regulatory system.
It is my hope, Mr. Chairman, that the committee will return
to Washington sooner rather than later to formally consider the
provisions of 2990, move forward on the bill as best we can,
and certainly in the course of the hearing today, as witnesses
give us their perspectives on how the bill may be enhanced,
improved, or otherwise modified, to certainly welcome those
comments. It is important that if we are going to have a
market-based ratings system that we communicate with the
professional leadership of the market in helping structure how
that plan should best be implemented.
To that end, I am appreciative for your time in being here
in the great City of Philadelphia this morning, Mr. Chairman.
Thank you.
ChairmanOxley. I thank you and now recognize the gentleman
from Pennsylvania, who is the author of the legislation, Mr.
Fitzpatrick.
Mr.Fitzpatrick. Thank you, Mr. Chairman.
First, let me welcome Chairman Oxley and Chairman Baker to
the City of Philadelphia, sometimes referred to as the Cradle
of Liberty, where 230 years ago, not too far from here, some
patriots decided to challenge the status quo and make a better
life for themselves and for their children. We are certainly
very proud of our history in this area, and I am very proud
indeed to represent this part of Pennsylvania in the United
States Congress. And I also appreciate, Mr. Chairman, you
calling this important field hearing today on improving the
credit rating industry and allowing me the opportunity to speak
on behalf of legislation that I introduced, the Credit Rating
Agency Duopoly Relief Act, H.R. 2990.
Credit ratings agencies have been issuing credit ratings on
the likelihood of an issuer's default on debt payment since the
early 20th century. Today, credit rating agencies rate not only
companies, countries, and bonds, but also assets and
securities, collateralized debt obligations, commercial paper,
private placements, certificates of deposit, preferred stocks,
medium term notes, and shelf registrations. Despite being often
underestimated and overlooked, their power is indeed immense.
Credit rating agencies have a great impact on the bottom line
of companies, municipalities, and school districts. The better
the credit rating, the lower the interest rate that the
borrower must pay.
This expansive influence finally came into question on
account of the recent corporate scandals and the fact that two
of the largest nationally recognized statistical rating
organizations, NRSROs, Standard & Poor's and Moody's, rated
Enron and WorldCom at investment grade just prior to their
bankruptcy filings. Essentially, they told the market that
Enron and WorldCom were safe investments, even though their
problems were very apparent to the marketplace. As a result,
reforming the rating agency industry has been the subject of
much debate in the House Financial Services Committee.
Before being elected to Congress last year, for 10 years, I
served as a county commissioner in the county just north of
here, Bucks County, and many of my constituents held stock in
Enron and WorldCom, and they were greatly impacted by their
bankruptcies, just as countless others were across the Nation.
S&P and Moody's' monitoring and reviewing of Enron and
WorldCom, in my view, fell far below the careful efforts one
would have expected from organizations whose ratings hold so
much importance.
Today there are over 130 credit rating agencies in the
market. However, only five are designated as an NRSRO by the
U.S. Securities and Exchange Commission. The SEC coined the
term NRSRO without defining it in its 1975 rule on net capital
requirements when an obligated broker-dealer is to hold more
capital for those bonds rated junk by an NRSRO. Since then,
other regulators and the private investment community have
taken up the term also, though, without defining it. Over the
past decade, the SEC has issued various releases, reports, and
proposals relating to the NRSRO designation process and credit
agency reform generally. In 1994, the SEC issued a concept
release stating that the most important factor is that the
rating agency be nationally recognized, that is, considered by
the financial markets to be an issuer of credible and reliable
ratings. In 1997, the SEC issued a proposed rule to codify the
requirements for designation outlined in the 1994 release, but
the SEC failed to implement the proposal. A possible reason is
that the Department of Justice objected to the proposal's
requirement that NRSROs be nationally recognized, that that
would have been anticompetitive, prohibiting the entry of new
market participants.
The SEC's national recognition system is the root of the
problem. The NRSRO process is practically an insurmountable
artificial barrier to entry. Credit ratings matter only if they
are issued by an NRSRO; thus, since debt issuers typically seek
ratings from NRSROs to comply with a regulation or a contract,
a rating agency's lack of designation significantly hinders its
ability to garner the national recognition required to obtain
status. This difficulty in obtaining the NRSRO label, due to
the nationally recognized requirement and the lack of clarity
in the designation process, has created a chicken and the egg
situation for non-NRSRO credit rating agencies trying to enter
the credit rating agency, further fostering a duopoly in the
credit rating industry.
The credit ratings industry is dominated by S&P and
Moody's. Together, they have over 80 percent of the market
share. Under the leadership of Chairman Oxley and Subcommittee
Chairman Baker, the House Financial Services Committee has
received testimony that the lack of competition in the rating
industry has lowered the quality of ratings. They have inflated
prices. They have stifled innovation and allowed conflicts of
interest and anticompetitive practices to go unchecked.
I introduced the Credit Rating Agency Duopoly Relief Act to
inject greater competition, transparency, and accountability in
the credit rating agency industry through market-based reform.
It enhances investor protection by replacing the SEC's opaque
designation scheme with a more thorough, transparent
registration process that protects investors. Instead of
allowing public companies and investors to decide whose ratings
to use, the SEC decides for them under the current regulatory
regime. Ironically, the same regulatory agency that freely
allows individual investors, regardless of their
sophistication, to choose a mutual fund, steps in and refuses
rating consumers the same freedom of choice. Stranger still is
the fact that most of the consumers of ratings data are
institutional investors, sophisticated actors in the investment
community.
Given the current regime, it comes as no surprise that more
often than not, the SEC decides to force consumers to use the
two largest agencies in the market, S&P and Moody's. My
legislation would eliminate the SEC staff's anticompetitive
NRSRO process. H.R. 2990 would ensure a level playing field for
all rating agencies. All eligible credit rating agencies would
be registered with the SEC under the Securities Exchange Act of
1934. Any credit rating agency meeting the definition of a
statistical rating organization must register with the SEC. To
become eligible for and comply with registration as a
nationally registered statistical rating organization,
companies must be engaged in the business of issuing credit
ratings for at least 3 consecutive years prior to filing an
application for registration. In addition, this new definition
does not discriminate against certain business models, as the
SEC currently does in its current definition process, but
instead accepts firms with a purely quantitative model and
investor fee-based model.
As an additional protection for investors, the Act would
also prohibit anticompetitive industry practices and mandates
reporting and recordkeeping requirements for registered firms,
similar to those for mutual funds, investment advisors, and
brokers. A nationally registered statistical rating
organization will be required to disclose in its registration
application not only its long and short term record at rating
securities and public companies through performance statistics,
but also the methodologies it uses in deriving its ratings and
the conflicts its business model raises and the manner in which
it manages those conflicts. The Credit Rating Agency Duopoly
Relief Act directs the SEC to develop other reporting
requirements as it deems appropriate in the interests of
investor protection. Moreover, registered rating agencies will
be held accountable under the securities laws. The SEC will be
able to inspect, examine, and bring enforcement actions against
rating agencies under the 1934 Act. My legislation incorporates
most of the SEC staff's proposed outline of the regulatory
framework.
A minority of commentators have claimed that any
registration in this industry amounts to a violation of First
Amendment privileges. H.R. 2990 does not infringe upon those
privileges. The legislation neither bans nor restricts First
Amendment rights in any manner whatsoever. The Government has
an undeniable interest in registering rating agencies, given
the credit rating industry's substantial effects and impact on
the market.
My legislation regulates the credit ratings industry
through disclosure, which is the least restrictive means of
regulation. It is important to note that currently, all five
SEC approved agencies already registered voluntarily under the
Investment Advisors Act of 1940. By encouraging competition in
the industry, prices and anticompetitive practices will be
reduced, credit ratings quality will improve, and firms will be
required to innovate. H.R. 2990 presents a commonsense, market-
based approach to reform, the basic problems of the credit
ratings industry, while protecting our robust marketplace.
Chairman Oxley and Subcommittee Chairman Baker, thank you
for your continued leadership in the credit rating industry,
and I yield back the balance of my time.
ChairmanOxley. I thank the gentleman and want to also
congratulate him for his excellent work on this important
subject. The committee, as all of us have indicated, since the
fall of Enron, WorldCom, has really concentrated on what I
guess we would consider the gatekeepers over time, and this is
one of the areas that we felt really needed some attention, in
terms of more transparency, more competitiveness, and the like,
and the committee will proceed, when we return in January, with
a markup on your legislation.
Let us now turn to our distinguished panel of witnesses. We
thank all of you for coming here today to Philadelphia to
participate: Mr. Glenn Reynolds, chief executive officer of
CreditSights, Inc; Mr. Paul Schott Stevens, president of the
Investment Company Institute; Mr. Richard Y. Roberts, partner
of Thelen Reid & Priest LLP, on behalf of Rapid Ratings Pty
Ltd.; Mr. Jonathan R. Macey, Sam Harris Professor of Corporate
Law, Corporate Finance, and Securities Law, with the Yale Law
School; and Mr. Sean Egan, managing director of Egan-Jones
Ratings Company.
Mr. Reynolds, we will begin with you.
STATEMENT OF GLENN REYNOLDS, CHIEF EXECUTIVE OFFICER,
CREDITSIGHTS, INC.
Mr.Reynolds. Thank you. It is my pleasure to be here this
morning.
My name is Glenn Reynolds. I am the CEO of CreditSights. We
are an independent research firm offering a range of research
and data products and with a heavy focus on credit research.
Our primary business is not credit ratings, however, but we do
compete with some of the rating agencies in some areas. We
probably chose a different business model than credit ratings,
since entering the ratings business was essentially impossible
under the current regulatory framework. Based on our current
business model, we are a registered investment advisor
regulated by the SEC in the U.S. and by the FSA in the UK.
We have had the opportunity to testify before on the rating
agency topic in front of the Senate in March 2002, and the SEC
in November 2002, and it has been interesting to watch the
process evolve. A lot of man hours have been directed at this
issue. A lot of hearings have been conducted, a lot of
testimony filed. The level of due diligence has been
impressive. It is clear that many parties have a strong
interest in seeing some progress made and have a lot at stake
in the issue. It is equally clear that some parties have a big
stake in seeing no action.
With 4 years since the Enron fiasco and various other
market implosions now behind us, it is also clear that there
has been dramatic change in the securities, banking, and
accounting industries as we all moved ahead and learned from
past experiences. It is safe to say that this has not been with
the credit agencies. The banking and brokerage industry had
paid out billions of dollars, totally overhauled their
approaches to research, addressed conflicts of interest, and
altered compensation strategies to deal with some of the well-
documented issues. The accounting profession has also seen
sweeping changes in the industry. Business lines have been
reorganized. Entire firms have disappeared. The ruling
accounting bodies have made sweeping changes in disclosure and
accounting requirements. In the broader market, corporate
management teams are now under more stringent guidelines to
take responsibility for their financial statements and internal
controls.
Remarkably, the one major segment of the capital markets
that remains on structural cruise control through all of this
change is the credit rating agencies, or more narrowly, the
NRSROs. The NRSROs have somehow been able to slow the pace of
change, frustrate the timely lowering of artificial barriers to
entry, and continue to expand into non-ratings business lines
at breakneck pace from their protected enclave as an NRSRO.
They remain largely insulated from competition by an outdated
and anachronistic regulatory framework that the overwhelming
majority of reasonable people, disinterested or otherwise, see
as overdue for an overhaul to allow more competition. The
agencies have mounted the usual defenses, but some facts of
life have to be clear. The rating agencies are, in fact, a
major force in the capital markets, and they toe the line
between being an information provider and a de facto part of
the underwriting process. The regulations have woven the rating
agencies in the fabric of the securities markets, and the
agencies have taken every opportunity to tighten the stitching.
They hold sway over many capital market segments, and most of
the major trade groups and individual companies are not going
to mess with them publicly.
Every next move influences mark-to-market adjustments,
reserve requirements, asset allocation decisions, forced sale
of assets, and access to the capital markets generally. They
are unique in that position and being essentially devoid of
meaningful regulation. They have a sweet regulatory deal, and
that brings us to H.R. 2990. H.R. 2990 will immediately address
the issue of barriers to entry and start the process of
injecting some competition into the ratings sector. As the
debate continues, it may also shine some light on the array of
non-ratings businesses that the rating agencies are entering,
all the while as they are structurally protected in their main
credit rating business. As it stands today, an unlevel playing
field has undermined economic efficiency, kept prices
artificially high, limited innovation, tapped the brakes on
quality, and limited diversity of opinion in the marketplace.
Competition does not cure all ills, but historically, has sure
proven to be a good start. H.R. 2990 gives it that fresh start.
There is no doubt that, if passed, we will see more
competition.
We can state clearly from our own experience at
CreditSights that both strategic operators in the financial
media space and sources of private equity capital see
investment opportunities in the credit ratings, financial
information, and financial data space. H.R. 2990 will open up
the opportunities, and change will come fast. H.R. 2990 is pro-
competition, and it is also rational. It will lower the
artificial barriers to entry and allow market entrants to
tackle the natural commercial barriers to entry which are
demanding enough. The longer the artificial barriers remain up,
the higher the natural barriers will be stacked by Moody's and
S&P. The ratings industry is, if anything, not a natural
duopoly or even a natural oligopoly. In fact, it should be
naturally competitive, just like the brokerage industry, the
banking industry, the asset management industry, and the media
industry. Those industries only get more competitive. The
ratings industry is in stark contrast. With Moody's and McGraw-
Hill posting remarkable financial performances, exception
profit margins, especially in their financial businesses at
McGraw-Hill, and generally dwarfing the stock returns of the
overall market in the broader peer group of financial
companies, it is worth asking why we have not seen major market
entrants. Economics 101 tells us something is wrong. That is
where the artificial barrier part comes in. It is intuitive and
obvious that market competition is being held back
artificially. Scrapping the NRSRO designation entirely is
preferable to the status quo, but some regulation still is
prudent, and the disasters of 2001 and 2002 are there to remind
us of that. We realize that the NRSROs are mounting a furious
defense against even light-handed regulation after years of
being essentially protected by regulation and generating
massive financial benefits from the regulation that kept out
competitors.
We would refer you to our formal testimony on some of those
issues, but a few things are clear. The rating agencies win by
delay. H.R. 2990 speeds up the process and does so with a
measured series of steps. It could use some definitional
tweaking, but has all the right parts to get a little
resolution to the dilemma. The market holds more opportunities
today than ever in the credit markets for rapid growth, and
competition will flourish. Moody's and S&P would like to keep
the status quo to capture a bigger slice of that growth. Large
firms and small firms are waiting in the wings. The interests
of the duopoly will be for more delay or to water down the
bill. They will propose to make it voluntary or promise a
fight. They never offered to make entry voluntary over all
these years as they frustrated competition. The policy decision
here either calls for a major force in the capital markets to
be free of all regulation or not. Moody's and S&P will try to
make this about the First Amendment. The agencies, on the one
hand, would have you believe their views are like a good or bad
movie review in Variety. We cannot even believe they can
seriously and truly believe this is about journalism.
Philadelphia is a great place for these hearings, to drive
home the points that this is not about the Constitution. Then
again, Philly is the right place, since this is all about the
Benjamins. It is about profit, and it is about who gets it. It
is about choice and not having it. In some ways, it is that
simple.
Thank you to the committee for the opportunity to weigh in
on these issues.
[The prepared statement of Glenn L. Reynolds can be found
on page 42 in the appendix.]
ChairmanOxley. Thank you, Mr. Reynolds. Mr. Stevens.
STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT, INVESTMENT COMPANY
INSTITUTE
Mr.Stevens. Mr. Chairman, thank you, and I am delighted to
be able to join the committee here in Philadelphia this
morning.
As you know, I head the national association of U.S.
Investments Companies, and our members include both open-end
companies, or mutual funds, closed-end funds, exchange-traded
funds, and sponsors of unit investment trusts, and the credit
rating agencies are important to each and every one of these
classes of our members. Our mutual fund members have assets of
$8.5 trillion, representing more than 95 percent of all U.S.
mutual fund assets. They serve about 87 million shareholders
and more than 51 million households.
The Institute commends the Financial Services Committee for
holding this hearing on H.R. 2990, the Credit Rating Agency
Duopoly Relief Act of 2005, which is intended to improve the
quality of credit ratings by fostering competition,
transparency, and accountability in the credit rating industry,
and to address concerns regarding the current NRSRO designation
process. This is my second opportunity as president of the ICI
to testify before the committee which you have so ably led,
Chairman Oxley. Under your leadership, and that of Ranking
Member Frank, and Capital Markets Subcommittee Chairman Baker,
and Ranking Member Kanjorski, the committee has been active in
critically important issues affecting all aspects of our
capital markets. This legislation is one more example, and I
would like to recognize Congressman Fitzpatrick for his
leadership in advancing this important bill.
Credit rating agencies play a significant role in the U.S.
securities markets generally, and other of the witnesses will
talk about that. I would like to address their importance vis-
a-vis mutual funds in particular. Mutual funds employ credit
ratings in a variety of ways: to help make investment
decisions, to define investment strategies, to communicate with
their shareholders about credit risk, and to inform the process
for valuing securities.
The most significant influence of credit ratings on the
fund industry is on the $2 trillion invested in money market
mutual funds. Money market funds are a truly remarkable chapter
in the history of U.S. mutual funds. Initially, they were used
as savings vehicles. Today, retail and institutional investors
alike rely on them as a broader cash management tool because of
the high degree of liquidity, stability, of principal value and
current yield that they offer. ICI estimates that between 1980
and 2004, roughly $100 trillion, a staggering number, flowed
into, and the same amount out of money market funds.
Now if the money market fund industry is a success story
for Institute members, money funds are also, most certainly, an
SEC success story as well. Since 1983, money market funds have
been governed very effectively by Rule 2a-7 under the
Investment Company Act of 1940. Rule 2a-7 limits the types of
securities in which money market funds can investment in order
to help them achieve the objective of maintaining a stable net
asset value of one dollar per share. Credit ratings form an
integral part of these limitations. For example, money market
funds may only invest in securities either rated by an NRSRO in
its two highest short-term rating categories or if the
securities are unrated, they must be determined by the fund's
board of directors to be of a quality comparable to such rated
securities.
Now it is important to note that no Government entity, such
as the FDIC, insures money market funds. Nevertheless, despite
an estimated $200 trillion flowing into and out of these funds
over the past 25 years, through some of the most volatile
markets in our history, only once has such a fund failed to
repay the full principal amount of its shareholders'
investments. In that case, many years ago, a small
institutional money fund broke the buck due to extensive
derivatives holdings.
It is critically important that this record of success
achieved under Rule 2a-7 continues for the benefit of money
fund investors. This, in turn, depends upon the ratings issued
by NRSROs providing credible indications of the risk
characteristics of those instruments in which money market
funds invest.
To promote the integrity and quality of the credit ratings
process and, in turn, serve the interests of investors who use
credit ratings, we believe that there are several steps that
should be taken. First, the NRSRO designation process should be
reformed to facilitate the recognition of more rating agencies
and, thereby, introduce much needed competition in the credit
rating industry.
The mutual fund industry is one in which intense
competition has brought unparalleled benefits to investors. I
firmly believe that robust competition for the credit ratings
industry can do the same and is the best way to promote the
continued integrity and reliability of credit ratings.
Unfortunately, the current designation process does not promote
but, in fact, creates an affirmative barrier to competition. In
particular, the current SEC process for designating credit
rating agencies through the issuance of no action letters has
not worked effectively. In place of this no action process, the
Institute recommends mandatory expedited registration with the
SEC. We are, therefore, pleased that H.R. 2990 properly moves
the basis for NRSRO designation from a national recognition
standard to an SEC registration requirement.
Second, there should be appropriate regulatory oversight by
the SEC to ensure the credibility and reliability of credit
ratings. We believe this can be achieved through a combination
of one, periodic filings with the SEC and, two, appropriate
inspection by the SEC coupled with adequate enforcement powers.
Specifically, H.R. 2990 would require that certain important
information be provided to the SEC upon registration. We
believe that NRSROs should be required to report to the SEC on
an annual basis that no material changes have occurred in these
areas. Similarly, NRSROs should be required to report any
material changes that do occur on a timely basis, and this
information should be made available promptly to investors who
rely on NRSRO ratings. Such disclosures should be accompanied
by an appropriate SEC inspection process tailored to the nature
of their specific business activities.
Third, investors should have regular and timely access to
information about NRSROs to provide them a continuous
opportunity to evaluate the ratings that they produce. In
discussions with our members, they have emphasized the
importance to them, as investors, of access to information
about an NRSRO's policies, procedures, and other practices
relating to credit rating decisions. In particular, it would be
helpful for NRSROs to disclose to investors their policies and
procedures, addressing conflicts of interest, as well as the
conflicts themselves, and periodically to disclose information
sufficient for investors to evaluate whether they have the
necessary staffing, resources, structure, internal procedures,
and issuer contacts to serve effectively as NRSROs.
Finally, we believe NRSROs should have some accountability
for their ratings in order to provide them with incentive to
analyze information critically and to challenge an issuer's
representations. Specifically, we believe that any reforms to
the credit ratings process should, at a minimum, make NRSROs
accountable for ratings issued in contravention of their own
disclosed procedures and standards. Even if the First Amendment
applies to credit ratings, it does not, in our view, prevent
Congress from requiring rating agencies to make truthful
disclosures to the SEC and to the investing public.
Now the SEC has been aware of issues relating to credit
rating agencies for over a decade now. During that time, it has
issued two concept releases, two rule proposals, and submitted
a comprehensive report to Congress addressing credit rating
agencies and NRSRO practices. In the process, the Commission
has received scores of comment letters, including several from
the Institute, urging action in this area. No action has been
forthcoming. In light of this history, we believe action by
Congress is now necessary. The Institute strongly, therefore,
supports the goals of H.R. 2990: increased competition,
appropriate SEC oversight, greater transparency, and heightened
accountability. These are the right objectives for reform of
the credit rating industry from the perspective of mutual
funds, other investment companies, and other investors, and,
indeed, the securities market as a whole.
I very much appreciate the opportunity to share the
Institute's views with you today. We have a number of technical
comments about the bill that we will be providing separately,
and we do look forward to working with the committee on these
and other issues in the months ahead.
Thank you, Mr. Chairman.
[The prepared statement of Paul Schott Stevens can be found
on page 68 in the appendix.]
ChairmanOxley. Thank you, Mr. Stevens. Mr. Roberts.
STATEMENT OF RICHARD Y. ROBERTS, PARTNER, THELEN REID & PRIEST
LLP, ON BEHALF OF RAPID RATINGS PTY LTD.
Mr.Roberts. Mr. Chairman, I appreciate the opportunity to
appear today on behalf of Rapid Ratings. I am Rick Roberts. I
am an attorney in Washington, D.C., with the firm of Thelen
Reid & Priest. The views that I express today are to be
considered my own and do not necessarily represent those of my
law firm or the clients of my law firm. Matter of fact, if the
views are not well received, I will disclaim them as my own
after the hearing.
From 1990 to 1995, I was privileged to serve as an SEC
Commissioner. During my SEC life, in a couple of speeches in
1992, I highlighted what I viewed as the potential problems
imbedded in the NRSRO designation criteria utilized by the SEC.
First and foremost among them is that that acronym really
stinks, and it needs to be a lot shorter. It is very hard to
pronounce. Unfortunately, not much has changed since 1992. I
believe that H.R. 2990 will introduce much needed competition
and additional integrity to the rating process for debt
securities and will reduce systemic risk in the marketplace. In
my view, H.R. 2990 will serve as a catalyst for reforms that
will greatly enhance the quality of information provided to
investors.
It may be helpful if I talk for a few minutes about Rapid
Ratings. Rapid Ratings is an organization founded in 1997 and
is an independent global corporate credit rating agency
headquartered in Australia, with other offices in New Zealand,
Singapore, the UK, Canada, and the U.S. Rapid Ratings is
currently licensed by the Australian Securities and Investment
Commission as a credit rating agency to provide financial
advice to wholesale and retail markets. Rapid Ratings
anticipates that it will file an application seeking to obtain
NRSRO designation with the SEC in the near future.
Using proprietary software, Rapid Ratings rates
approximately 15,000 listed companies globally, including 7,000
in the U.S. Rapid Ratings follows the original rating agency
model of being paid by buy-side subscribers, rather than by
issuers of securities. Unlike current NRSROs, Rapid Ratings
credit ratings assess the financial health of an institution
based on industry-specific quantitative models, and the ratings
are derived solely from publicly disclosed financial
statements.
The current NRSRO criteria were designed for rating
agencies with an issuer-paid business model, despite their
origins of being paid largely by subscribers. Since NRSRO
status was introduced in 1975 for net capital rule purposes,
the largest rating agencies have been increasingly and now
predominantly paid by issuers of debt to rate those parties,
and I refer to this as a Type 1 business model. This was,
perhaps, one of the unintended consequences of the creation of
NRSRO status. Type 1 rating agencies employ highly skilled and
highly paid people that go onsite to acquire nonpublic
information to rate companies. New generation rating agencies,
such as Rapid Ratings and many others, have an entirely
different business model, which I will refer to as the Type 2
model.
New generation rating agencies are paid by investors or
other buy-side third parties, such as banks, insurance
companies, mutual funds, pensions funds, large creditors, et
cetera, to rate second parties, such as listed and/or unlisted
companies and their securities, and use only publicly available
information. Type 2 rating agencies also typically use software
rather than analysts. Thus, in the Type 2 model, there may be
no contact between the rating agency and the companies it rates
and, thus, little potential for conflict of interest. In
assessing eligibility for NRSRO status, it would be unfair to
require a Type 2 company to conform to criteria that pertain
only to Type 1 companies that have such conflicts.
Now Rapid Ratings believes H.R. 2990 would achieve many of
the goals that are necessary to promote greater efficiency in
the debt markets. It would remove most of the current
restrictions, instituting a registration process for rating
agencies that have been in business for more than 3 years, and
substituting "registered" for "recognized" in the NRSRO
acronym. It also would permit quantitative firms to be
registered and would allow subscription fees to be charged for
ratings by not requiring wide dissemination of ratings at no
cost. Thus, the legislation will ensure that the pre-1975
practice of having the ratings largely paid for by investors
and other buy-side subscribers is revived by new generation
rating agencies with new technology and a strong record for
providing early warnings to the market. This bill, if enacted,
goes a long way toward removing the barriers to entry created
by the current regulatory standards while assuring the
integrity of the rating process by providing credible market-
based standards.
And in conclusion, I believe, as I always have, that
regulation is no substitute for competition in the marketplace.
Consumer choice is often the best policeman. In my opinion, the
real potential for enhancing ratings competition arises with
the entry of innovative rating agencies that offer alternate
business models. If a level playing field is created to permit
Type 2 rating agencies with innovative business models that are
paid by investors to compete effectively with Type 1 rating
agencies that are paid by issuers, there will be, in my
judgment, significant benefits to the marketplace, and these
benefits include earlier warnings to the market of potential
problems, enhanced protection and choice for investors, greater
accuracy in ratings, broader coverage of securities and
issuers, lower costs to issuers and investors, greater
independence and objectivity, and less risk of systemic shocks.
In my view, the reduced barriers to entry afforded by H.R. 2990
will provide substantial benefits to the market and will
improve the efficiency of the capital allocation process.
Again, I appreciate the opportunity to participate in the
hearing, and I will be happy to attempt to respond to any
questions that you may have at the appropriate time.
[The prepared statement of Richard Y. Roberts can be found
on page 51 in the appendix.]
ChairmanOxley. Thank you, Mr. Roberts, for your testimony.
We now have Professor Macey.
STATEMENT OF JONATHAN R. MACEY, SAM HARRIS PROFESSOR OF
CORPORATE LAW, CORPORATE FINANCE, AND SECURITIES LAW, YALE LAW
SCHOOL
Mr.Macey. Thank you. It is a pleasure to be here, and
Chairman Oxley and Subcommittee Chair Baker and Congressman
Fitzpatrick, I am delighted to be here.
The previous four speakers did a great job and said a lot
of the--made a lot of the points I was going to make, so I will
try to focus on some new and different aspects. But let me
begin by saying that I think the statute proposed, H.R. 2990,
provides a very valuable legislative framework that will
promote more vigorous competition in the rating agency business
and provide not only better ratings, but also provide strong
protections for individual investors. I would add to that that
I think the statute is very simple, elegant, well tailored to
the problem, so I think that it is something that I strongly
support.
There is this strange puzzle in the--those of us who study
credit rating agencies often observe, which is, as was pointed
out earlier, we see an industry that makes tremendous amounts
of profits, but at the same time, seems to do a really bad job,
as we see with respect to the performance of rating agencies in
contexts like Mercury Finance, Orange County, Pacific Gas &
Electric, Enron, WorldCom, and more recently, the lagging
ratings for companies like General Motors and Ford. And I think
that there was nothing unintentioned, or there is nothing
intentioned, rather, or evil in the way this developed. I think
it was basically inadvertent that the NRSRO designation evolved
in such a way that it created an artificial demand for ratings
and people in the financial marketplaces, as was the case with
the example earlier of Rule 2a-7 of the Investment Company Act
of 1940. It created a demand for ratings regardless of the
content or quality of those ratings. We have very little
competition in that area.
So I fully support this statute. I want to just say in a
couple of additional points. One is while I certainly agree
that there have been drastic improvements in--since the sort of
Enron era, I don't think it is the case that the credit rating
agencies are the only sort of noncompetitive node in the
capital markets, that the GAO has, I think, amply demonstrated
the lack of competition among the remaining four accounting
firms for auditing large U.S. companies, stock exchange
specialist firms, bulge bracket underwriting firms. Self-
regulatory organizations in the financial markets are also like
the current NRSRO situations where in a perfect world we would
spend time thinking about how to make those areas of the
capital markets more competitive. The nice thing about the
credit rating agency problem, if you will, is that we have
before us a very, I think, discrete functional solution, and it
is a terrific, terrific place to start. I would just urge this
committee to continue down this very good path towards making
capital markets more competitive.
A couple of other points. One is on the First Amendment
issue. Let me just say that generally speaking, I think this is
a complete red herring. If this statute violates the First
Amendment, then I think the Securities Act of 1933 registration
requirements for initial public offerings also violates the
First Amendment, so we could stop IPOs. I don't think either
one of them does. I think that is simply a red herring put
forth by people who want to, for obvious economic reasons, to
maintain the current status quo.
One kind of footnote to that is, one aspect of this statute
would prohibit the newly created registered rating
organizations from issuing unsolicited or free ratings. I think
that, given the other changes in the bill, I am not sure that
is necessary. I do agree that unsolicited ratings are a very
big problem. There is this issue of whether rating agencies
engage in shakedowns of companies and municipalities in the
market for credit. Do agencies demand payment by companies and
municipalities for ratings? If that is the case, I certainly
think that there should be regulatory action taken against the
rating agencies. I also think that rating agencies should be
required to disclose when the ratings they issue are
unsolicited, and they should also be required to disclose when
they are offering services on a fee basis to the entity being
rated, but were declined, and I think that the agencies
similarly should be required to disclose whether information on
which their ratings are based is as complete in the case of an
unsolicited rating as information that they ordinarily possess
when generating a solicited fee paid rating. But I am not sure
I would go as far as the legislation goes and require--and ban
unsolicited ratings.
Last is, I certainly support specific features of the
legislation that would require disclosure of conflicts of
interest and the procedures and methodologies used in
determining ratings, as well as the procedures used to prevent
the misuse of nonpublic information. I would be--certainly,
though, you would want to--we would want to be careful in
implementation that, to the extent that companies have
developed proprietary trade secrets, which would be of use to
rivals, with respect to the ways that financial data is
analyzed, and for the generation of a rating, we would want to
protect that property right.
But with that said, I think--excuse me, 2990 is an
important and valuable statute, which I will hope will pass,
and will improve the quality of the information provided by
credit rating agencies and establish credit rating agencies as
an important component in the U.S. system of corporate
governance and investor protection.
Thank you.
[The prepared statement of Jonathan R. Macey can be found
on page 37 in the appendix.]
ChairmanOxley. Thank you very much, Professor. And our
final witness is Mr. Sean Egan. Mr. Egan.
STATEMENT OF SEAN EGAN, MANAGING DIRECTOR, EGAN-JONES RATING
CO.
Mr.Egan. Thank you. I am Sean Egan. I am managing director
of Egan-Jones Ratings.
We support the proposed legislation for reforming the
rating industry, since it significantly increases competition.
The primary purpose of rating firms is to facilitate the
allocation of capital by assessing the relative riskiness of
various issuers. The job can be compared to the trucking
industry, in the sense that capital, rather than goods, are
moved throughout the financial system. Unfortunately, the
regulatory process for the trucking industry makes a great deal
more sense than does the regulatory process for the rating
industry. In the trucking industry, there are various tests
drivers need to take to ensure that they are able to operate
vehicles in a safe manner. The tests are straightforward, and
passing them is similar to passing a driving test. In the
rating industry, there has never been a formal process for
obtaining a license, and at the current rate, there never will
be. Regulators have been studying the area since the early
1990s and have yet to establish a set of requirements for
applicants. Yes, two firms in the past couple of years have
been recognized, but for the most part, the firms provide
little competition to the major firms in the industry, S&P and
Moody's. DBRS rates mainly Canadian issuers, and AM Best
focuses on insurance firms.
In the trucking industry, if a shipper is unhappy with the
rates or service of one particular shipper, there are a variety
of other shippers available. In contrast, in the rating
industry, there is relatively little competition. S&P and
Moody's garner approximately 85 percent of the revenues for
U.S. corporate debt, and a rating from two firms is normally
needed for a public issue. The costs for the lack of
competition is borne by issuers, investors, employees,
retirees, and non-recognized rating firms.
To address some of the concerns that have been raised about
H.R. 2990, facilitating the emergence of a plethora of
unqualified rating firms, we recommend the following additions
to Section 3(a) of the Act--of the bill.
Independence. No NRSRO shall be affiliated with a broker-
dealer, bank, financial institution, issuer, investor, or user
of credit ratings. Experience. The rating firm shall have
issued ratings for the past 7 years and shall have generated at
least $1 million in revenues from such activities in the U.S.
for a period of 7 years or more. Quality. To reflect the impact
of events such as acquisitions, major share repurchases, and
buyouts, all ratings issued will be reviewed using qualitative
methods. Additionally, the NRSRO shall be available to issuers'
personnel and capable of reflecting issuer comments in ratings.
Note, credit ratings based on security prices and spreads can
be easily manipulated and provide profit opportunity to
unscrupulous investors.
Regarding objections to H.R. 2990, below are rebuttals.
H.R. 2990 does not disrupt the markets. Increased competition
should improve market conditions. H.R. 2990 does not violate
First Amendment. Additional competition should not affect First
Amendment protections. H.R. 2990 does not promote rogue firms.
Additional competition should encourage the issuance of timely,
accurate ratings.
Moving forward on this issue is critical. We are all aware
of the problems caused by the faulty ratings of WorldCom,
Enron, and other failed issuers. However, less obvious are the
problems caused by underrating firms, such as Nextel. As can be
seen in the attachment, we rated Nextel at BBB-, as of November
2003, when S&P rated the company at BB-, and Moody's at only
B2. The difference in cost between a BBB- rating and a B2
rating is approximately 300 basis points, or 3 percent. Nextel
had $10 billion of debt at the end of 2003. The additional cost
is $300 million per year of these faulty ratings, $300 million
is the amount greater than the earnings of most public firms.
By the way, both S&P and Moody's raised their rating to
investment grade in August of 2005.
Thank you for your time and interest. Attached is
additional information on Egan-Jones.
[The prepared statement of Sean Egan can be found on page
30 in the appendix.]
ChairmanOxley. Thank you, Mr. Egan, and thank all of you
gentlemen for excellent presentations.
Let me begin with a few questions. One of the critiques
that we have heard over the last few months regarding
Congressman Fitzpatrick's legislation is there will be--this
legislation would lead to rating shopping, with the rogue firms
jumping up and lowballing and the like, creating perhaps an
artificially competitive marketplace. Are those criticisms
justified, and let us just begin with Mr. Reynolds and go to my
left to right.
Mr.Reynolds. Well, it is, excuse me, it is certainly not
without past history. That was something that was done in the
money market business in the '80s, where, with all due respect
to some of the roll ups, the idea was if you couldn't get
Moody's and S&P over from an A to a P to a 1 rating, you'd go
shop at Fitch and Duff to get the Def One F1, so, you know,
that is a pretty benign form of it. I think the way the reform
is more likely to play out is you are going to have more
companies entering the space using investor-based models, not
issuer-based. Because right now, there is a stranglehold on the
issuers, and, frankly, the issuers will have a very hard time
going to smaller organizations that are just on the way up. So
it is not going to be the issuer that drives the reform. It is
bringing high information content, high quality ratings to
investors, and they are certainly not looking for anything
other than good input to manage their risks. So I think that is
a real risk, but I would say that is the one in 10 piece of the
equation. The nine in 10 is how do you build a revenue model,
how do you build a firm of scale, and in order to do that, you
are going to have to go to the investors, not the issuers.
ChairmanOxley. Mr. Stevens.
Mr.Stevens. For various purposes, mutual funds, as
investors already have to do independent credit analysis. They
can't simply rely on ratings. What we would like to see the
legislation do, Mr. Chairman, is to provide much more
information about the ratings agencies and their processes so
that we can assess the quality of the ratings that they are
producing. There is no incentive that I can see for a mutual
fund investor to rely upon or to shop for bad, poorly produced
ratings. Quite the contrary. But as institutional investors, if
they have access to the information, they can make judgments
about the quality of the ratings agency and what they are
producing, and I think then, they will go to the strongest and
best ratings to utilize in making their investment decisions.
ChairmanOxley. Mr. Roberts.
Mr.Roberts. Well, I don't believe that there is that much
risk with respect to the issue of ratings shopping. First of
all, as Mr. Reynolds indicated, any organization has to worry
about its reputational risk, and the marketplace should be able
to discern pretty easily, through readily available performance
benchmarks, if someone is systematically an easy grader. There
are ample, verifiable statistical measures, such as default
statistics and rating comparisons on issuers rated jointly by
multiple agencies, which should reveal any such easy grader
pretty quickly. In my judgment, this concern is probably
already addressed in the marketplace, where market pricing
mechanisms such as bond spreads routinely second guess the
credit rating and would highlight firms that are consistently
assigning higher ratings than would be warranted by an issuer's
financial condition. So I would consider the risk fairly
slight, certainly as compared to the benefits of competition.
ChairmanOxley. Professor Macey.
Mr.Macey. I agree with what Mr. Roberts just said. I would
add to that that given the prominence of institutional
investors in today's investing world, my inclination is that
new entrants into the credit rating game are going to be
extremely concerned about screwing up and giving a high rating
to somebody that, like to a company, that later implodes and
getting branded with the sort of moniker of being too easy. So
I think the market will take care of itself, with the
institutional investor community being able to sort out the new
entrants that are providing valuable information and ignoring
those that are engaged in the sort of race to the bottom that
was just suggested. So I am not--I think it is--that we will
see much better quality ratings, and we will see pressure that
we don't observe now on firms to compete along the vector of
quality.
ChairmanOxley. Professor, if I could--let me digress just a
minute because in your testimony-- I have got to do this before
I think of it; otherwise it is gone. That is just the way my
mind works. I was in law school a long time ago, so I am trying
to come back to this. But anyway, your testimony was regarding
the accounting firms and the lack of competition now that we
are down to the final four. I wonder if you could help us
through that. How do we create an atmosphere in which we create
more competition and get back to what used to be the Big Eight,
or at least some semblance of that? How do we recreate that, or
can we, and what are the prospects?
Mr.Macey. Well, just to be clear, it is easy, in my view
anyway, to explain why we have no competition or very little
competition in accounting, and I want to make it clear also
that according to the General Accounting Office, the level, the
lack of competition is much worse than is suggested by the fact
that there are only four accounting firms. Because if you look
at the level of specialization in the accounting industry, so
you have these accounting firms that are focusing on aerospace,
or focusing on biotech, that, in fact, companies in those
industries may really, as a practical matter, after the demise
of Arthur Andersen, only have a couple of firms to choose from.
So it is really bad.
Now the reason that we have this problem is very similar in
many ways historically to the reasons we have this credit
rating problem, which is it is, if you will forgive me for
saying so, a little largely attributable to what has turned out
to be misguided regulation by the SEC, the NRSRO designation,
in this case. With the case of accounting firms, the problem is
in order for an accounting firm to qualify to regulate a
company, it has to be the earning, the income that the
accounting firm makes from the audit business has to be a small
percentage of the audit firm's overall revenue, which means
that you have to be a giant accounting firm, like Arthur
Andersen, to qualify to audit a firm like Enron because,
otherwise, your billings to Enron will be too big of a
percentage of your overall earnings.
My own view, based on empirical work in the accounting
industry, which I would be thrilled to discuss with you,
suggests that the way that we ought to get rid of that
regulation, and we ought to allow little bitty accounting
firms, smaller accounting firms, the non-Big Four, and I will
add, you know, the drop-off after the Big Four is pretty steep,
to get into the business of auditing big companies, bearing in
mind that I think this percentage test for independence is
meaningless. As we saw with Arthur Andersen, what really
mattered from the standpoint of the independence of the
auditing firm wasn't Arthur Andersen as a company; it was the
audit engagement team that was actually doing the work, and
there, you had this guy David Duncan, and he didn't do anything
else but Enron, and he lived at Enron, and he basically took,
acted in many ways like an Enron employee.
A statute you undoubtedly are aware of, the Sarbanes-Oxley
Act, deals with that to some extent, with the auditor rotation
provisions, and I would suggest as an add-on to that that we
relax these independence restrictions so that we could open up
competition in the accounting business for the largest U.S.
companies, beyond just the final four accounting firms that
remain.
ChairmanOxley. Thank you. Mr. Egan.
Mr.Egan. I have to differ with the other panelists. We
think it is a huge problem, and let me explain why.
Approximately 90 percent of the revenues in the rating industry
are generated by the issuers. People respond to the money, and
there is no reason why you wouldn't have rogue firms emerging
that are giving very generous ratings. It would be difficult to
prevent that.
An extreme example would be, under the current Act, an
underwriter can form a rating firm. It could be under the
underwriter's name, Merrill Lynch Ratings, or it could be an
affiliate of Merrill Lynch, and could say, "Come to us. Don't
worry about the ratings; we will take that. Yes, we will go to
S&P and Moody's because they have been there forever. We will
take care of the ratings. And by the way, there will be a fee
for that." There is little that can prevent that under the
current Act.
If you look at the business, there is about $6 billion in
revenues. Over $5 billion of it is generated from issuer
compensation. So I think the fear of the emergence of rogue
firms is very real, and it makes sense to set up some
protections against that. In my testimony, I used the analogy
of trucking firms or drivers. The credit rating market is
fundamentally different than the investment advisory field. You
don't want drunk drivers on the road. You don't want
inexperienced drivers on the road. It is too important. Why is
it important? Because a lot of parts of the regulatory system
rely on these ratings. I think you want to have some initial
checks. If firms don't abide by it, like S&P and Moody's should
have been put on some kind of probation as a result of the
Enron, WorldCom ratings, and that didn't exist. There should be
some kind of checking system, but before they even get on the
road to issue these ratings, there should be some tests.
ChairmanOxley. Thank you. Mr. Reynolds, you indicated in
your testimony that the bill needed definitional tweaking. What
were you suggesting?
Mr.Reynolds. In particular, just the area between ratings
and investment advisory work. It gets greyer by the day, and it
is--for example, I mean, we are investment advisor. The fact
that we would probably say buy, hold, or sell on some
securities is an aspect that would make us want to do that, so
we did that. With the rating agencies, they have always been
very clear that they stop short of that, and there is quite a
bit of a blurring here, not only how they operate today, but
also really how it is construed in the marketplace. It is the
form versus substance debate. They have launched a product
recently, for example, Moody's has, called market implied
research strategies. They frame their ratings against where
securities are trading, or where derivatives are pricing risk,
and it is presented with, as a contrast. If they don't say buy,
hold, or sell, but it is just about the same thing, it will
take you right to the doorstep, and everyone sees it who uses
that product for what it is, and there are other products like
that as well. You know, you are the third base coach in
baseball signaling the guy on first to steal second. You don't
have to scream steal, you know; you just tip your hat. The
rating agencies are doing the exact same thing. They are in the
advisory business in substance, if not explicitly in form.
So one of the aspects of the bill that was a little murky
for me around investment advisor versus NRSRO, and there are
quite a bit of overlaps that people should be sensitive to, and
it is just a little more drilled now in clarification of how
companies typically operate. Everyone talks about default risk
as the main issue. The great bulk of assets and risks that is
managed out there, it is not about default risk. It is in terms
of perception of default risk, but mostly, it is about short
term, rapid changes in the risk that affect portfolio
performance and the result and losses being realized. As this,
you know, I know I am overdoing the sports metaphor, but the
great bulk of the activity in the credit markets takes place
between the 20 yard lines, not in the end zone. The end zone
would be a default. Default risks are historically very low,
but credit volatility historically can be very high, and that
is where investors are harmed, because of short term, sudden
changes that drive losses. And that is where that investment
advisory and NRSRO designation starts to overlap, and that
probably should be worked on a bit.
ChairmanOxley. Thank you. The gentleman from Louisiana.
Mr.Baker. Thank you, Mr. Chairman.
I want to return to Mr. Egan and the response to the
chairman relative to the potential for creation of rogue firms.
It would seem from your comment that there should be some
requirement that a firm must meet beyond registration in order
to engage in the practice, which might be just a slightly
different standard than what we have today, as opposed to a
registration and a free market driven system, which would
enable a participant to enter without necessarily establishing
credentials. Am I understanding your objections correctly, or
is there a slightly different view?
Mr.Egan. Yes, there should be some credentials before
someone enters. As it is currently written, anybody, my son, 10
years old, he can be issuing ratings and become a rating firm
and--
Mr.Baker. But do you think an issuer is going to pay your
son a fee? I mean--
Mr.Egan. No, he's not going to receive a fee, but that is
an extreme example, but it could be something like Merrill
Lynch, who wants to get as much market share as they possibly
can underwriting, set up their own or another rating firm, you
know, that is affiliate and facilitate the underwriting
process.
Mr.Baker. Well, I take your point, worthy of further
examination, but it seems to take me back to the dark days of
the investment banker analyst issues and how one prescribes a
system that allows the two to simultaneously coexist, but
provide disclosures to the ultimate users of information, or
judges of risk, about how a particular decision is being made
so that if there is a particular unusual relationship between
Merrill Lynch Ratings and a Merrill Lynch issuer activity, that
those disclosures would help, in some measure, address it. My
concern is that if we go to a hard and fast standard of entry,
we are replicating in just a little bit broader methodology
that we have today. Today, we are calling it artwork. We don't
know what one is, but when we see it hanging on the wall, we
see you are a rating agency. We might want to describe the
frame. We might want to describe the colors. We might want to
have the artist's name checked off, but we are really just
going to have a little bit broader mechanism than we have
today. If we really go to some sort of undescribed set of
standards that one must meet. Perhaps, your suggestion of some
criteria of time in the market--
Mr.Egan. I think that makes sense. I think money talks. I
think a certain revenue base makes a lot of sense. I think that
the fundamental problem that we have right now is that you have
two firms that are really, and have exerted a lot of influence
in this process. There are other firms that do qualify, that do
issue credible ratings, and have not been able to get the NRSRO
designation, for a variety of reasons. Unfortunately, the
current regulators aren't willing to state what the problems
are, why their applications haven't been approved or
disapproved, or what even the status of the application is.
Bringing it back to the driver analogy, you need to have some
fundamental tests because it is too dangerous to the market to
go from the current market structure right now to wide open
whereby anybody is allowed to shoot any game they want to. You
need some levels of credibility, and I think being in the
market for a couple market cycles makes perfect sense, and
having a minimal level of revenues from the activity makes a
huge amount of sense. It also makes sense to exclude certain
affiliated firms. It makes no sense for a bank to be allowed to
generate their rating firm because it opens the system to
abuse. It makes no sense for an underwriter to be allowed to
set up a rating firm. So--
Mr.Baker. I don't disagree. I am merely trying to bore down
a little bit.
Mr.Egan. Right.
Mr.Baker. Get a better understanding as to your driver
example and not letting your 10-year-old son drive. It would be
just as advisable not to have an 80-year-old grandmother who no
longer can see.
Mr.Egan. Absolutely.
Mr.Baker. Even though she has been driving for 50 years.
Mr.Egan. Right.
Mr.Baker. The consequences could be the same. But Mr.
Stevens, you made a note in your testimony, the NRSROs should
have some accountability for their ratings in order to provide
them with an incentive to analyze information critically, and
then I am not--I am just pointing out that you raised a very
important issue. Then Mr. Roberts, in your testimony, you talk
about output criteria should be the measurement that we use,
for example, ability to anticipate corporate demise ahead of
the necessary deterioration of share price. Then, you go on
talking about the qualities of the Type 2 agencies that mark-
to-market using software models often paid for by the buy side,
which have track records of issuing early warnings and
objectivity, and then I wind up back at the professor, who
states that you oppose the disclosure of the requirements of
telling someone how you go about issuing your ratings. It seems
across the three of you, we go for a need to have disclosure
and accountability so that the market can look at a rating
agency's set of performance standards, then we go to Mr.
Roberts' output measurement criteria to say this is how we are
going to look at you and, therefore, hold you accountable. What
is wrong with some sort of generic disclosure? I understand
proprietary business formula not being necessarily put on the
street, but if I am going to be the end user of the rating to
make a risk judgment, shouldn't I have some appropriate
disclosure of how they go about doing it? Professor.
Mr.Macey. Yeah, let me just say I agree with that, the
generic disclosure, as long as there is not any proprietary
information. With respect to the sort of--the problem of this
rogue, or rating agencies popping up like mushrooms in the wake
of the statute, I want to--it seems that--it is important to
realize that if this statute were enacted, we would be in a
much different world, in the sense that we would be--we would
no longer be in the current situation where companies are only
permitted to invest in a wide variety of circumstances under
both Federal law and various State laws, particularly insurance
laws, in companies that lack this NRSRO ratings, so that the
vector along which these organizations would compete would be a
vector of quality, and to be frank, I appreciate Mr. Egan's
frankness in sort of engaging the discussion. I don't really,
with all due respect, sort of buy the car analogy because if
there is some underage driver, or unqualified driver, he poses
a risk to other people on the road, so you have this sort of
externality problem that makes sense to regulate. If I am--if I
exhibit sufficiently bad judgment that I make an investment
decision on the basis of a rating from a rating agency with a
poor track record or that is one of these rogue ones that we
are concerned about existing, I internalize that problem. It is
not as though I am in the car running someone else over. This
is, in the world that we are going to see in the wake of the
statute, if it passes, and I hope it will, then the people who
make bad judgments with respect to utilizing bad rating agency
information are going to internalize those costs in a free
market in exactly the same way they are going to internalize
the cost of getting bad investment advice from a broker or
something of that nature, and I think that the markets will do
a very good job in sorting out the good ones from the bad ones.
Mr.Baker. Mr. Chairman, I have just got one more follow up.
Mr. Stevens, you mentioned the--holding the rating system
accountable in some form or fashion. Do you share the view that
has been described by Mr. Roberts, outcome analysis as an
appropriate measure of enforcing accountability, or how would
you view a system that would be appropriate to create that
accountability?
Mr.Stevens. Well, outcome analysis is important information
to have in the market so that the people who are looking to use
a particular rating agency or particular rating, have some
sense of what the track record has been. When I referred to
accountability in my testimony, it was really accountability of
the nature that contemplated that if a ratings agency says here
is my process, this is what I do, then they are to be held to
do that. If, for example, they say we don't really simply rely
upon publicly available information. We go and do research on
the premises. We talk to the officials of the company. We kick
the tires in other ways as well. And if they then produce a
rating where they haven't done that, that they really were
relying on a smaller universe of information, it seems to me
they ought to be liable and accountable for having
misrepresented their process.
This notion of proprietary methods, I think, is a little
overstated, with all respect. We deal with this issue in
disclosures all the time. Corporations that are seeking to
raise money in the marketplace will talk about business
systems, business activities, business methods. There is a line
that you can draw between what is truly proprietary and what is
informative, detailed disclosure--I wouldn't call it generic;
that suggests boilerplate. It can go into greater detail that
that. So I think that is a line that we can draw.
If I might, Mr. Chairman, just add one other thing to this
question about the drunk driver, the point I am making is, from
the perspective of an investor, if you can administer the
breathalyzer, right, and you can determine whether the driver
is drunk, you can make a decision about whether to pile into
the vehicle or not, and that is the value of disclosure in the
marketplace. I see no reason why, well, there have to be
changes in the way in the SEC has written 2a-7; I see no reason
why a mutual fund firm that offers a money fund and has its
franchise and its reputation on the line is going to be
attracted to a schlocky ratings agency. There is going to be a
tremendous attraction for the ones with the best track record,
the best methods, and the greatest reliability and integrity in
the market because the reputation and the dollars, essentially,
the wealth of the firm, is going to be on the line in that
process.
Mr.Baker. I take your point, and I only one I had entering
into the new methodology and how we start it up is probably so
critical because if we have missteps in the early days, it
really makes recovery in the out years much more difficult. To
put a personal experience in the discussion, yesterday, when we
were flying in, we thought we had made it, and everything was
fine, and we were going to get on the boarding door, and the
pilot comes on and says he pulled up about 5 feet too far, and
they are going to have to bring a tug out and push us
backwards. If I had known my pilot was going to miss my
boarding door by 5 feet, I probably would have elected another
flight. You don't want to find that out at your arrival gate.
You really want to know, did he run over the dog when he came
to pick me up, or do you keep it on the highway. I think that
is really the issue right now. I want to get to this outcome
based analysis. That means you have a record. That means I can
look at what you've been doing. The problem is from where we
are now to how do we get there, and I am not yet fully
conversant with the remedy that gets us past that, but I
certainly want to go where each of the witnesses have indicated
they would like to see us go.
I yield back, Mr. Chair.
ChairmanOxley. The gentleman from Pennsylvania.
Mr.Fitzpatrick. Thank you, Mr. Chairman.
Mr. Reynolds, I appreciate your references to the history
of the city and Constitution, and in your written testimony,
you are referring to some of the players out there that
wouldn't be interested in the success of H.R. 2990,
specifically those who want a little less free speech, and what
you say is as it stands now, Moody's and S&P seem to be saying
Congress shall make no law respecting an establishment of
competition to the NRSROs.
With respect to the NRSROs, can you describe how they may
be using their protected status to get involved in other
business lines, including some of those lines that your firm,
CreditSights, is involved in?
Mr.Reynolds. They are probably coming as close to the line
of being an investment advisory business as they have ever
been, and partly, that is a response to building revenue. I
have heard a lot today about different rules and regulations,
but at the end of the day, it is about building revenue,
whether you are at Moody's or you are at a startup, whether you
are taking it from--we have been in business 5 years; we went
from eight to a hundred people, and it is painstaking work,
reinvestment, but you have to have a viable product, and
someone writes you a check for it. If they write you a check
for it, it is real, and if they are a sophisticated investor,
you are getting warm. And the same thing for Moody's, when they
want to continue to grow their top line, to drive their stock,
and it certainly has done quite well, they have to find new
ways to get out of the ratings areas, so they bought KMD; they
have been buying content assets up. They recently bought a
group of economists. They will continue to buy assets in
because at the end of the day, they are a research firm, a
ratings agency, but they are also in the content business, and
they have to grow and leverage that fixed cost base. So they
are pushing into a lot of different ancillary businesses, which
are meaningful businesses, and how do you reach the equity, the
stock analysts for example, with credit information?
As we saw in the last 5 years, turns in the credit market
can drive the equity performance of different names, so they
are trying to figure out ways to go after all different types
of investors using their basic infrastructure and making select
investments, so they are in the investment advisory business in
substance. They know it. The market knows it, but they need to
run a story line because they have to plan their legal
defenses. They are doing everything but stopping short of
saying sell, and they are doing that by trying to be also more
relevant to the market. One of the criticisms, say, 10 years
ago, was well, you are just a rater, there is low information
value, and some of your earlier panelists in past hearings have
testified on the low information content of ratings. So the way
you crack the line up is you get into the information intensive
business, something that a powerful institutional investor, or
a bank, or a brokerage house will write you a check for. That
is how you build a business. It is the economic reality of
growth for all of these companies, and I think that Moody's and
S&P clearly are getting that. KMD was obviously a big landmark
transaction, getting into default risk analytics. They keep
that separately housed. But they are into the consulting
business, for example. They are into economic forecasting. They
are into all the same things the Street has been into for
years, except it is not as NASD framework. So that is just a
fact; I mean, people know it. It is like an ill-kept secret
from X rating agency, and they will say, they will chuckle
about the First Amendment discussion because they know that it
is really not the main issue. They just want to stay free clear
of any encumbrances and go back to the business line strategy.
There is a reason why a lot of people want to get in this
business. Moody's has 55 percent profit margins. That is just
mind-boggling of pretax margins. The accounting firms don't
have that, so there is a reason people don't want to get in the
accounting business, but do want to get in this business. And
also, at the end of the day, they are not staying up late at
night worrying about CreditSights, Rapid Ratings, or Egan-
Jones. In a way, we are all boutiques in the context of what
they do. They are worried about Thompson, Bloomberg, Fax,
Bertelsmann, Morningstar; these are the guys who will be
stepping in, so the more barriers you put for their entry and
their acquisitive activities, the more it is that Moody's and
S&P will be the same old duopoly 5 years from now. So be
cognizant of the fact that it takes a lot of capital, a lot of
resources, a lot of mergers, and a lot of activity the next 5
years to even mount a viable competitor against a group of
people who have dominated the industry with what are
increasingly higher natural barriers to entry. So I am a firm
believer in letting the market work, and if Fidelity or Imgo or
these top debt shops will pay you for your service, I think you
have passed a test that the SEC is less qualified to opine on
than people who live and breathe that business day in, day out,
and have responsibility for a lot of retail assets. So I would
say competition is better and quality is better. Constraints
impact both in the wrong way.
Mr.Fitzpatrick. Do any of the other panelists want to
comment on that? Professor Macey, I think you were--you have
spoken about the First Amendment issues, as one of the NRSROs,
I think it was S&P, it seems to be the loudest about the impact
of this potential legislation on their First Amendment rights.
You went right to the ledge of saying why you think they may be
raising that issue. Do you want to expand on that at all?
Mr.Macey. Well, as I said, with the exception of the
provision that would prohibit unsolicited ratings, there is
nothing in this that has the remotest impact on free speech. I
think that, you know, if I were a paid consultant for S&P or
Moody's, you know, I might play the First Amendment card
because it gets people's attention. It slows the process down.
And it seems to have been--it seems to be the case that the
process slowed down quite a lot. Mr. Reynolds and I were--
testified together before that Senate committee--I guess it was
a couple of years, 2 or 3 years ago now--and we are still
working toward some resolution of this issue. So, I mean, as I,
you know, I don't think that there is a--I don't think there is
a respectable argument. I think a lot of the things we have
talked about today, Mr. Egan's point is perfectly respectable
that, you know, this is a concern about, I don't happen to
agree with it myself, but it is certainly a respectable
argument to say you know, we are worried about quality of the
new entrants and the issues about disclosure that Mr. Stevens
is raising quite--I may come out a slightly different place,
but quite respectable. The First Amendment issue is, in the
context of the development of the securities laws in the United
States and the high premium that we put on disclosure and
investment, investor protection, this is really--this doesn't
even ruffle the waters in the pond with respect to First
Amendment concerns. I think it is purely a tactic to impede the
progress of legislation that would improve the competition in
this industry.
Mr.Fitzpatrick. To that issue of, I guess, Mr. Egan's
concerns about his 10-year-old son issuing rating, getting
recognized. I mean, the statute, the bill as written does
require 3 years background and does require disclosure of short
term and long term performance statistics, so if you are in the
business for 3 years, and there are benchmarks, and you are
reaching those benchmarks, as Chairman Baker says, you know, if
somebody is willing to pay your 10-year-old son, wouldn't it be
discriminatory, if your son was only 10 years old and they--
Mr.Baker. We have this freedom of speech, I think, is what
you are talking about.
Mr.Fitzpatrick. If you are doing a great job, I mean, you
wouldn't want to prohibit your 10-year-old son genius from
being involved in this business.
Mr.Egan. Maybe he can get it right. However, I think that
this NRSRO designation is too important. It is used in too many
different areas of financial markets, and I think more than 3
years is needed. I think you need some kind of market test, and
a revenue based test isn't a reasonable way. I think you have
to exclude some firms that have an inherent conflict, such as
underwriters becoming rating firms, or having underwriting
affiliates, or major investors, or banks, or insurance
companies. I think that there are some--to go from where we are
right now to a more competitive market, you have to be careful
in the way you take those steps. It would be foolish to open it
up to anybody who applies after a 3-year waiting period. It
makes--that doesn't--it would hurt the market too much. It is
too great a risk. Yes, it might work, but you know, it is--we
are not talking about a small economy here. It is very
important to get it right. Another thing is that somebody
brought up the breathalyzer test. I don't know if the guy who I
am facing on the road has taken that test when I am driving and
he is driving at 80 miles; I don't have that information. So I
want somebody to test him before he gets in the vehicle, and
there are certain safeguards if he messes up that he loses his
license. I think that that is what you need. Also, some people
say don't worry, the market is going to sort it out. Well, the
reality is that that is fantasy. It is fantasy because S&P and
Moody's rated Enron at investment grade approximately 30 days
before it went bankrupt. They had similar faults with WorldCom.
So the market doesn't necessarily respond to good information.
In fact, S&P and Moody's operating income has doubled. It has
doubled over the past 3 years. You hear about it all the time
in the economist book, but it doesn't work; full disclosure
just simply doesn't work or else S&P and Moody's revenue and
operating income would not have doubled during the process of
these major debacles. So you need some safeguards on the front
end of this, and you also need safeguards as you go along.
Mr.Fitzpatrick. It looks like Professor Macey--do you want
to respond to that?
Mr.Macey. Well, I guess I will pay a visit from fantasy
land over here, in terms of having faith in the markets. First,
with respect to the point about Enron. Certainly, Mr. Egan is
right. This was not a poster day for the credit rating
agencies. It seems to me the question that we need to ask
ourselves is not the question, you know, will there be errors,
and will credit ratings agencies screw up under the new
regulatory regime, the new statutory regime that we are talking
about today. The question is will the quality of information in
the marketplace be better, not will it be perfect. And
certainly, I think one thing Mr. Egan and I would agree about
is that the quality of the information that is out there now
is, generated by the credit rating agencies, is not good. It is
not good for two reasons. Number one, it tends not to be very
accurate and, number two, the adjustments that are made to
credit ratings come very slow, and they are--that every
financial economist or empirical scholar who has looked at this
for the last 30 years has understood that credit ratings
systematically lag stock market prices and that anybody, for
free, can look at stock market prices and get a much better
view of what is going on at Enron, what is going on at
WorldCom, what is going on in any of the companies that have
been so much in the press over the last 3 or 4 years. If we
open the system up to competition, certainly, there will be
errors. Certainly, some of the new firms that emerge in this
business will make mistakes, but on balance, consumers in this
market will have a lot more to choose from. They don't have to
rely on one rating. They can look at several, and the market
will sort out the poor performers and, again, the people who
are--make the misjudgment, the miscalculation, to rely on the
bad ratings that emerge in a new competitive environment will
bear the costs associated with that, which is exactly what
ought to happen in a free market economy.
Mr.Stevens. Mr. Fitzpatrick, may I add something in
response to the questions that you had posed, just very
briefly? The question of 3 years or 7 years is one of these
classic conundrums I suspect that the committee, the Congress
faces all the time. I think of it as the prunes issue. Are 3
too few; are 7 too many to get, you know, regularity restored?
The fact is seven years strikes me as fine if you are part of a
firm that has been doing this for the past 7 years, but it
might be that you have a wonderful new market participant ready
to enter, and if they are told well, no, you have to do this,
theoretically, for 7 years before you can get into the
business, that has a significant anticompetitive impact. So
while, you know, this is sort of in the eye of the beholder, I
think, some proving ground or time period, where you are
involved, and can demonstrate to potential users that you are
serious about this business, that you have been doing it with
the kind of rigor and quality, is fine. Three years strikes me
as a good choice in that regard. Seven years strikes me as not
really trying to serve opening up this market to the kind of
competition which I think has been your purpose and the purpose
of other supporters of your legislation.
ChairmanOxley. The gentleman yields back. On behalf of the
members, I want to thank all of you for excellent
participation. The record that we have continued to build for
this legislation I think is extraordinary. We have had a
diverse group of witnesses over a number of months, and this
may or may not be the last hearing, but it certainly was one of
the most productive, and I thank you, and I also want to thank
the Federal District Court for providing this wonderful place
for a hearing. This is as close as I am going to get to being a
Federal judge.
Mr.Fitzpatrick. I hope it is as close as I get to a Federal
judge.
ChairmanOxley. That is right. I would like to sentence a
couple people right now, but I don't have it in me. Again,
thank you all, and the committee is adjourned.
[Whereupon, at 11:40 a.m., the committee was adjourned.]
A P P E N D I X
November 29, 2005
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