[Senate Hearing 109-465]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-465

 
                  EXAMINING THE ROLE OF CREDIT RATING
                    AGENCIES IN THE CAPTIAL MARKETS

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

  EXAMINATION OF THE ROLE OF CREDIT RATING AGENCIES IN CAPITAL MARKETS

                               __________

                            FEBRUARY 8, 2005

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                    Douglas R. Nappi, Chief Counsel

                         Mark Oesterle, Counsel

                       Bryan N. Corbett, Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                       TUESDAY, FEBRUARY 8, 2005

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     3
    Senator Sununu...............................................     4
    Senator Reed.................................................     4
    Senator Martinez.............................................     4
    Senator Dodd.................................................     5
    Senator Bunning..............................................    24
        Prepared statement.......................................    50
    Senator Stabenow.............................................    27
        Prepared statement.......................................    50
    Senator Hagel................................................    30
    Senator Corzine..............................................    32
    Senator Schumer..............................................    36

                               WITNESSES

Kathleen A. Corbet, President, Standard & Poor's.................     5
    Prepared statement...........................................    50
Sean J. Egan, Managing Director, Egan-Jones Ratings Company......     6
    Prepared statement...........................................    55
    Response to a written question from Senator Shelby...........    82
Micha S. Green, President, Bond Market Association...............     8
    Prepared statement...........................................    57
    Response to a written question from Senator Shelby...........    82
Yasuhiro Harada, Executive Vice President, Rating and Investment 
  Information, Inc...............................................    10
    Prepared statement...........................................    63
    Response to a written question from Senator Shelby...........    83
Stephen W. Joynt, President and Chief Executive Officer, Fitch 
  Ratings........................................................    12
    Prepared statement...........................................    66
James A. Kaitz, President and Chief Executive Officer, 
  Association for Financial Professionals........................    13
    Prepared statement...........................................    72
    Response to a written question from Senator Shelby...........    84
Raymond W. McDaniel, Jr., President, Moody's Investors Service...    15
    Prepared statement...........................................    75

              Additional Material Supplied for the Record

Letter to Senator Richard C. Shelby from Kathleen A. Corbet, 
  President, Standard & Poor's dated March 28, 2005..............    82
Letter to Senator Richard C. Shelby from Yasuhiro Harada, 
  Executive Vice President, Rating and Investment Information, 
  Inc. dated March 1, 2005.......................................   108
Letter to Senator Richard C. Shelby from Raymond W. McDaniel, 
  Jr., President, Moody's Investors Service dated February 22, 
  2005...........................................................   110
Letter to Senator Jim Bunning from Raymond W. McDaniel, Jr., 
  President, Moody's Investors Service dated February 22, 2005...   114
Letter to Senator Jim Bunning from Charles D. Brown, General 
  Counsel, Fitch Ratings dated March 8, 2005.....................   154
Letter to Senator Jon S. Corzine from Charles D. Brown, General 
  Counsel, Fitch Ratings dated March 8, 2005.....................   173
Statement of Kent Wideman, Executive Vice President, Dominion 
  Bond Rating Service............................................   192
Article from The Washington Post, ``Credit Raters' Power Leads to 
  Abuses, Some Borrowers Say'' by Alec Klein, Washington Post 
  Staff Writer dated November 24, 2004 submitted by Sean J. Egan, 
  Managing Director, Egan-Jones Ratings Company..................   196


  EXAMINING THE ROLE OF CREDIT RATING AGENCIES IN THE CAPITAL MARKETS

                              ----------                              


                       TUESDAY, FEBRUARY 8, 2005

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing shall come to order.
    Since their inception nearly a century ago, credit rating 
agencies have come to occupy a prominent role as gatekeepers to 
the capital markets. These entities wield extraordinary power 
in the marketplace, and their ratings affect an issuer's access 
to capital, the structure of transactions, and portfolio 
investment decisions. A high rating effectively serves as a 
``seal of approval'' that can save an issuer millions of 
dollars in interest payments. Conversely, a low rating or a 
ratings downgrade can trigger a sell-off of an issuer's stock 
and a drop in its bond prices, while making future financing 
more expensive.
    As new corporate and municipal issuers seek to access an 
increasingly global market and as issuers develop innovative 
and complex financial products, there is every reason to expect 
that the importance and influence of credit rating agencies 
will continue to grow. Given investors' reliance on these 
agencies, I believe that it is important for this Committee to 
carefully examine the industry, the ratings process, and the 
regulatory landscape.
    In 1975, the SEC began using the designation of a 
``Nationally Recognized Statistical Rating Organization,'' or 
``NRSRO,'' for the purpose of determining the appropriate 
amount of capital that a broker must hold to protect against 
trading losses. Although the SEC initially created this 
designation for a narrow purpose in the ``Net Capital Rule'' 
that applies to broker-dealers, the designation now serves as a 
universally accepted benchmark for investment quality, and has 
been used in legislation, various regulations, and financial 
contracts.
    Some contend that the NRSRO designation has evolved into a 
quasi-official stamp of market credibility that acts as a 
barrier to entry. Although there are approximately 150 credit 
rating firms worldwide, there are only four firms with the 
designation. Not surprisingly, revenues are concentrated in the 
firms with the designation. Moody's, S&P, and Fitch represent 
95 percent of the market share. Some assert that the SEC has 
effectively granted these companies a franchise and that 
meaningful competition is nearly impossible without the 
designation. There seems to be a ``catch-22'' because a firm 
cannot compete nationally without the NRSRO designation, but it 
cannot obtain the designation without a national reputation in 
the first instance. Understanding the level of competition in 
this industry and the impact of the NRSRO designation is an 
important element of this Committee's inquiry.
    We will also examine the SEC's role in regulating the 
industry. The SEC has never adopted a formal approval process 
or promulgated official recognition criteria for obtaining the 
NRSRO designation. Instead, the SEC makes determinations on a 
case-by-case basis that leads many to question the transparency 
and fairness of the entire approval process. Further, once the 
SEC grants the designation, it does not maintain any form of 
ongoing oversight. Some believe that there is a misperception 
in the market that NRSRO's are regulated because they initially 
received the SEC's stamp of approval. We will evaluate the 
SEC's authority and regulatory actions concerning the industry 
and consider whether additional oversight is necessary. In the 
coming months, we will ask Chairman Donaldson to appear before 
this Committee to address these particular issues.
    Further, we will review the structure and operation of the 
rating agencies. Some have raised concerns regarding the 
transparency of the ratings process and the information that 
rating agencies make available to issuers and the public at-
large. Typically, rating agencies do not disclose their 
methodologies and analysis for determining a particular rating, 
identify the information they reviewed in making a rating, or 
disclose the qualifications of the lead analyst. This lack of 
transparency leads some to question the reliability and 
credibility of ratings and whether the ratings process is too 
subjective. Some contend that the marketplace needs to more 
fully understand the reasoning behind a ratings decision and 
the information on which it is based.
    Finally, we will address the potential for conflicts in 
this industry. Too often, this Committee has held hearings on 
industry practices where corporate insiders exploit conflicts 
that ultimately hurt investors. In the ratings industry, most 
agencies rely on payments from the issuers that they rate. Some 
suggest that there may be a strong incentive for ratings 
inflation. This situation is reminiscent of the analyst 
independence charges that were the focus of the Global 
Settlement. A second potential conflict involves the sale of 
consulting and advisory services by rating agencies to their 
ratings clients. This practice is analogous to an auditor's 
sale of consulting services to an audit client: A conflict that 
was a focal point of the Sarbanes-Oxley Act. The underlying 
concern is that these conflicts could undermine the independent 
and objective status of rating agencies and their ratings, 
leading investors to make important investment decisions based 
on compromised ratings.
    To discuss these important issues with us this morning, we 
have a panel of leading industry participants: Ms. Kathleen 
Corbet, President, Standard & Poor's; Mr. Sean Egan, Managing 
Director, Egan-Jones Ratings Company; Mr. Micah Green, 
President, Bond Market Association; Mr. Yasuhiro Harada, 
Executive Vice President, Rating & Investment Information, 
Inc.; Mr. Stephen Joynt, President and Chief Executive Officer, 
Fitch Ratings; Mr. James Kaitz, President and Chief Executive 
Officer, Association for Finance Professionals; and Mr. Raymond 
McDaniel, Jr., President and Chief Operating Officer, Moody's 
Investors Services, Inc.
    Each witness will have the opportunity here to make a short 
opening statement. Given the number of witnesses this morning, 
I would ask you to limit your statement to no more than 5 
minutes, and I look forward to your testimony.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to commend you for holding this hearing. During the past two 
Congresses, this Committee has undertaken continuous review of 
the securities markets and sought to respond to problems which 
have occurred in those markets. Today, under your leadership, 
we resume this very important oversight function.
    Credit rating agencies have played an important role in the 
capital markets for almost a century by providing analytic 
opinions to investors on the ability and willingness of issuers 
to make timely payments on debt instruments over the life of 
those instruments. Issuers pay for the ratings in order to 
lower the cost of and increase their access to capital. 
Investors trust the agencies' impartiality and quality, and 
rely on these ratings. The SEC created the designation of 
Nationally Recognized Statistical Rating Organization, NRSRO, 
which it applies to only four agencies, and many institutional 
investors buy only debt rated by a NRSRO.
    In recent years, concerns have been raised about the 
industry. In late 2001, the major credit rating agencies 
maintained an investment grade rating on Enron debt after its 
major financial restatements and up until 4 days before Enron's 
declared bankruptcy. As a result, as Business Week reported, 
there was ``a barrage of criticism that raters should have 
uncovered the problem sooner at Enron, WorldCom, and other 
corporate disasters.''
    This subject was raised during hearings before this 
Committee, as well as before the Senate Governmental Affairs 
Committee. Section 702 of the Sarbanes-Oxley Act, a section on 
which Senator Bunning provided important leadership, directed 
the SEC to study the role and function of credit rating 
agencies. The SEC issued a report in compliance with that 
requirement and, in June 2003, published a concept release on 
which they have received public comments. I understand the SEC 
is continuing its analysis of the issues. It has not yet 
proposed a course of action.
    Questions have been raised about the Federal regulation of 
credit rating agencies. James A. Kaitz, a witness today, who is 
President and CEO of the Association for Financial 
Professionals, has said, ``Here we have a huge issue that has a 
significant impact on the U.S. economy and the global economy, 
and nobody seems to be paying attention.''
    Well, Mr. Chairman, you are paying attention and this 
Committee is paying attention. Today's hearing gives us an 
opportunity to hear testimony from the industry on issues that 
have been raised both in the concept release of the SEC and in 
the press, including: The extent of the SEC's authority to 
regulate, examine, or imposed requirements on Nationally 
Recognized Statistical Rating Organizations; whether the NRSRO 
recognition process should be more transparent; conflicts of 
interest that arise because rating agencies are paid by and 
sell consulting services to the issuers they rate; the 
influence of issuers on the ratings they receive; alleged 
anticompetitive processes; corporate governance and the 
potential for conflicts of interest when the director of a 
rating agency also sits on the board of an issuer that is 
rated; and analyst compensation. And obviously there are many 
others as well.
    Mr. Chairman, I look forward to hearing the testimony of 
the witnesses this morning. You have assembled a very good 
panel, and I look forward to hearing testimony from the SEC and 
Chairman Donaldson on a future occasion.
    Thank you.
    Chairman Shelby. Thank you.
    Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman. I am anxious to 
hear the testimony of the panel. I do not know a great deal 
about this industry, but anytime you have an industry where two 
firms comprise 80-percent market share, I think it is safe to 
say that there probably has not been enormous motivation or 
incentive for dramatic changes. And I think a lot of the issues 
raised by the Chairman and Ranking Member attest to that. So 
this will be not only an opportunity for further education of 
our Members, but also to understand how and why certain 
decisions are made at the rating agencies regarding not just 
firms that are out there competing in the private equity and 
bond markets, but also some of the recent decisions to speak 
out on legislation that is before this Committee.
    So, I anxiously await the testimony. Thank you.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Mr. Chairman, thank you for holding these 
hearings, and I am, like my colleague from New Hampshire, eager 
to listen to the witnesses. And you have assembled a very good 
group of witnesses today.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Martinez.

                COMMEMTS OF SENATOR MEL MARTINEZ

    Senator Martinez. Thank you very much. I appreciate your 
holding the hearing and look forward to the witnesses' 
testimony. I have had a little experience in the rating world 
with municipal credit, but I look forward to learning more and 
hearing the witnesses.
    Thank you.
    Chairman Shelby. Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman, and let me commend 
you and Senator Sarbanes. This is a tremendously important 
hearing, and you just cannot overstate the importance that 
these credit agencies have on capital markets. And the Good 
Housekeeping Seal of Approval that the SEC gives, whether 
intended or not, has huge implications. So this is very 
important, and I am very grateful to you for holding it.
    Let me associate myself with your remarks and the remarks 
of Senator Sarbanes as well. Thank you.
    Chairman Shelby. Ms. Corbet, we will start with you, if you 
will sum up your testimony. All of your written testimony will 
be made part of the record in its entirety, if you will just 
sum up your top points.

                STATEMENT OF KATHLEEN A. CORBET

                  PRESIDENT, STANDARD & POOR'S

    Ms. Corbet. Thank you. Mr. Chairman, Members of the 
Committee, good morning. I am Kathleen Corbet, President of 
Standard & Poor's, and I welcome the opportunity to appear at 
this hearing to discuss the important role of credit rating 
agencies, such as S&P Ratings Services, in the capital markets. 
This morning I will briefly focus my remarks on three topics: 
First, our ongoing initiatives to safeguard the independence, 
integrity, and transparency of our ratings process; second, our 
management of potential conflicts of interest; and, third, our 
support for greater transparency in the SEC's NRSRO designation 
process and for the reduction of regulatory barriers to entry 
in the credit rating industry.
    As background, a credit rating is our opinion of the 
creditworthiness of an issuer or of a specific issue. Unlike 
equity analysis, a credit rating is not a recommendation to 
buy, hold, or sell a particular security. Credit ratings have 
provided benchmarks for issuers and investors around the world, 
facilitating efficient capital raising and the growth of new 
markets. S&P also publishes credit research on new markets and 
new asset classes; and it is through this process that there is 
more information, a wider array of tools for understanding 
credit, and far greater transparency in the marketplace today.
    At S&P, independence, transparency, and quality have been 
the cornerstones of our business for nearly a century, and they 
have driven our longstanding track record of analytical 
excellence and effectiveness in alerting the market to both 
deterioration and improvements in credit quality.
    The unprecedented corporate misconduct that has been 
revealed in recent years has resulted in constructive responses 
by market participants, including S&P. Many of these cases have 
involved issuer fraud. In Enron, for example, key personnel 
have expressly admitted their role in deliberately misleading 
S&P and other rating agencies.
    While we believe that the credit rating system works 
effectively, we have, consistent with our tradition of self-
evaluation, reviewed our ratings process from top to bottom in 
order to ensure that ratings are responsive to evolving market 
needs. We have also taken a number of actions as part of this 
effort, including updating our policies and procedures and 
aggregating them in a newly published Code of Practices and 
Procedures, which is publicly available on our website. Among 
the other measures described in my written testimony, we have 
added specialized forensic accounting expertise and expanded 
the scope of our published commentary.
    We have had a longstanding commitment to ensuring that any 
potential conflicts of interest do not compromise our 
analytical independence. Our code contains a significant number 
of policies, procedures, and structural safeguards.
    For decades, issuers have generally paid for our rating 
opinions, and these opinions have been published for the 
benefit of all investors and the public without cost.
    Numerous market participants, including the great majority 
of witnesses before the SEC and IOSCO, as well as economists at 
the Federal Reserve Board, have reached the same conclusion: 
There is no evidence that the issuer-paid model undermines the 
objectivity of these ratings.
    Indeed, the value of our ratings lies in their objectivity 
and independence; without these essential attributes, our 
rating opinions would cease to be credible.
    As the Committee is aware, the SEC developed the NRSRO 
designation in 1975, and S&P Ratings Services is one of four 
credit rating agencies designated by the Commission. As you 
also know, the Commission is currently in the process of 
reviewing this system and considering possible changes. We 
support greater transparency in the designation criteria and 
the reduction of regulatory barriers to entry into the credit 
rating industry.
    The Commission is also considering whether and to what 
extent it should engage in enhanced regulatory oversight if the 
designation system is retained. And as we have expressed to the 
Commission, we believe that it is imperative to avoid overly 
intrusive Government supervision of credit rating agencies, 
particularly supervision that may suggest a substantive role 
for Government in the ratings process itself.
    Let me conclude by saying that independence and objectivity 
are critical to the effectiveness of the credit rating agencies 
in serving the marketplace and the investing public, and great 
care should be taken to ensure that the principles and the 
structures that have so greatly benefited the market are not 
compromised.
    Thank you for the opportunity to participate in this 
hearing. I look forward to your questions, comments, and the 
ensuing discussion.
    Chairman Shelby. Mr. Egan.

                   STATEMENT OF SEAN J. EGAN

         MANAGING DIRECTOR, EGAN-JONES RATINGS COMPANY

    Mr. Egan. Thank you. Chairman Shelby, Members of the 
Committee, good morning. I am Sean Egan, Managing Director of 
Egan-Jones Ratings Company, a credit rating firm. By way of 
background, I am co-founder of Egan-Jones, which was 
established to provide timely, accurate credit ratings to 
institutional investors. Our firm differs significantly from 
other rating agencies in that we have distinguished ourselves 
by providing timely, accurate ratings and we are not paid by 
issuers of debt, which we view as a significant conflict of 
interest. Instead, we are paid by approximately 400 firms 
consisting mainly of institutional investors and broker-
dealers. We are based in Philadelphia, Pennsylvania, although 
we have employees throughout the world.
    The rating industry is in crisis. At a time when the 
capital markets have become increasingly reliant on credit 
ratings, the rating industry is suffering from a state that is 
hard to characterize as anything other than dysfunctional. The 
problems are:
    One, severe consolidation. The Department of Justice 
personnel referred to the industry as a ``partner monopoly'' 
since S&P and Moody's control over 90 percent of the revenues 
and do not compete against each other for the two ratings which 
are normally required. This is important. They do not compete 
against each other.
    Chairman Shelby. Explain.
    Mr. Egan. What I mean by that is that if S&P is brought 
into a transaction, Moody's is soon to follow, so they both get 
paid for the issuance of bonds. That is a key difference. 
Everyone refers to this as an oligopoly. It is not an oligopoly 
if you just look at 90 percent of the revenues. It is a partner 
monopoly.
    Number two, severe conflicts of interest. Issuers' payment 
for ratings create conflicts of interest that are similar to 
those experienced by the equity research analysts.
    Number three, freedom of speech defense. There is no 
downside to bad rating calls by the two dominant firms. 
Basically there is no place else for the issuers to go.
    Manifestations of the flawed structure are:
    Failure to warn investors about credit problems such as 
Enron, the California utilities, WorldCom, Global Crossing, 
AT&T Canada, and Parmalat. Enron was rated investment grade by 
the NRSRO's 4 days before bankruptcy. The California utilities 
were rated A minus 2 weeks before defaulting. And WorldCom was 
rated investment grade 3 months before filing for bankruptcy. 
Parmalat was rated investment grade 45 days before filing for 
bankruptcy.
    Chairman Shelby. What was Parmalat rated before bankruptcy?
    Mr. Egan. I think it was rated BBB minus, and I can confirm 
that later.
    Chairman Shelby. Who issued that rating?
    Mr. Egan. S&P. Moody's was not involved in it.
    Losses from the Enron and WorldCom failures alone were in 
excess of $100 billion--some people have estimated it at $200 
billion--thousands of jobs, and the evaporation of pensions for 
thousands. It is likely that some of these failures could have 
been avoided had the problems been identified and addressed 
sooner. This is basically the ``nail in time saves nine'' 
concept. Enron was left with only Dynergy as an acquirer by the 
time the alarm was sounded.
    Another problem in the industry is under-rating credits. 
Firms such as Nextel, American Tower, and Tyssenkrupp were 
assigned credit ratings which were too low, thereby 
significantly increasing their cost of capital and restricting 
growth.
    Another problem with the industry is insider trading. 
CitiGroup and probably other institutions were given advance 
information about the Enron downgrade. Additionally, S&P and 
Moody's request advance information about transactions and 
other major events which creates opportunities for insider 
trading. S&P analyst Rick Marano and his associates traded on 
confidential information relating to the acquisition of 
ReliaStar and American General, two insurance companies.
    Another problem is investor fraud. The NRSRO firms pulled 
their ratings on an Allied Signal entity so Allied could 
repurchase the debt more cheaply. This is outrageous.
    Another problem is issuers coercion, forcing issuers to pay 
rating fees. There is a Washington Post article elaborating on 
Hanover Re's experience.
    Two other problems are punishment ratings--we have that in 
the municipal area--and expansion of the monopoly. S&P and 
Moody's are getting into corporate debt ratings, governance 
ratings, and also consulting.
    You will hear today that the rating agencies were misled by 
Enron and the others. They have defenses for why they did not 
take action.
    The first defense is basically ``they did not tell us'' 
that is, it was an issuer misdeed.
    The second one is the Jack Grubman defense, that they have 
little incentive for not taking action since they are a 
relatively little portion of the overall revenue base.
    The next one is the Arthur Andersen defense: Our reputation 
is key. We do not buy that.
    The next defense is the committee approach. We refer to 
that as the Lemming defense.
    There are a few others, too.
    What we recommend in this industry is to recognize some 
rating firms that have succeeded in providing timely, accurate 
ratings.
    Number two, wean the rating firms from issuer compensation. 
It is fine that S&P and Moody's get paid for their analysis, 
but the SEC should not give them their seal of approval if they 
have a conflict of interest.
    Also, adopt the Code of Standard Practices for Participants 
in the Credit Rating Process issued by the ACT, AFP, and AFTE--
you will hear that later today on this.
    Also, prohibit rating firms from obtaining insider 
information.
    The last thing is sever the ties between rating firm 
personnel and issuers and dealers. Moody's Chairman was sitting 
on--this is outrageous--WorldCom's board basically 6 months 
before the bankruptcy.
    I have some additional comments, and you can refer to the 
written material. Thank you for your time.
    Chairman Shelby. Mr. Green.

                  STATEMENT OF MICAH S. GREEN

               PRESIDENT, BOND MARKET ASSOCIATION

    Mr. Green. Thank you, Chairman Shelby and Members of the 
Committee, for the opportunity to testify today on credit 
rating agencies.
    My name is Micah Green. I am President of the Bond Market 
Association. As you know, the Association represents securities 
firms and banks that underwrite, distribute, and trade debt 
securities in the United States and internationally--a global 
market that is estimated at about $44 trillion today. Our 
efforts include outreach to retail investors as well, among 
other things through our family of websites. Last week, in 
fact, we launched a new version of our Investinginbonds.com 
website which offers a wide range of investor education 
information, and for the first time ever real-time bond price 
information--which, frankly, this Committee deserves a great 
deal of credit for--that is free to any user on the site. And 
an important element included in that investor education 
material is the credit rating attached to the bond.
    The past 15 years have seen dramatic growth in the number 
of issuers and the range and complexity of fixed-income 
securities. The importance of credit ratings to investors and 
other securities market participants has increased 
proportionally. Rating agencies are critical to the efficient 
functioning of the fixed-income markets.
    What credit rating agencies do is offer an opinion, known 
in the market as a rating, the credit risk of a bond. The 
credit rating process employs both quantitative and subjective 
judgment. Factors such as a security's yield, maturity, call 
features, and covenants specific to a bond can be objectively 
determined from the issuer's mandated disclosure. Independent 
analysis of an issuer's credit quality, however, involves 
individual judgments of professional credit analysts. It is a 
valuable complement to an investor's own credit analysis 
precisely because it is independent.
    As Chairman Shelby correctly pointed out earlier, credit 
ratings also guide the market's pricing decisions. Bonds with 
lower ratings are viewed as riskier than higher-rated bonds by 
investors who demand a yield premium as compensation. 
Conversely, higher-rated bonds will offer a relatively lower 
yield as a reflection of their stronger credit standing.
    In order for credit ratings to have credibility as a 
pricing guide, rating agencies must be viewed by the market as 
independent. Recently, regulators in the United States and in 
Europe have stepped up their focus on rating agencies and 
question the need to make changes in the current approach to 
regulatory oversight. In 2003, the SEC issued a concept release 
intended to draw a response on several rating agency-related 
issues.
    Last year, the International Organization of Securities 
regulators, commonly known as IOSCO, drafted a comprehensive 
Code of Conduct for rating agencies. Currently, the European 
Commission has requested public comment on whether to develop 
rating agency regulation.
    The Association's response to these initiatives in both the 
United States and in Europe is fundamentally the same. We have 
attached our comment letters on the subject as part of our 
written testimony.* While those are detailed in the written 
testimony, I will briefly summarize those positions.
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    We believe that the criteria adopted by regulators for 
approving designated rating agencies should be flexible enough 
to allow increased competition, while ensuring that designated 
rating agencies have the expertise to produce accurate ratings. 
In the United States, we favor eliminating the current 
requirement that a rating agency be widely recognized rather 
than accepted in a defined sector of the market, either by 
product or by geographic specialization.
    We believe credit rating agencies should have policies and 
procedures to ensure the independence of the credit rating 
process. In fact, the IOSCO Code of Ethics details a number of 
different measures that can be taken by the rating agencies to 
deal with many of those inherent conflicts. Again, it is about 
managing those conflicts. A good example of how this can be 
done can be seen by the Bond Market Association's own 
comprehensive guiding principles on research in the fixed-
income marketplace. In the aftermath of the settlement in the 
equity marketplace, our members believed that they needed to 
come up with a very tough, very comprehensive way of managing 
those conflicts, and our guiding principles provided that.
    We believe that credit rating agencies should publish their 
rating methodologies for various types of securities so that 
both issuers and users will understand the agencies' 
requirements and standards, and so that different rating 
analysts in the same agency will produce consistent ratings.
    We do not believe that regulation of the credit rating 
process is necessary or desirable, since Government regulation 
would tend to result in less diversity of opinion and would be 
less responsive to the changing marketplace and new product 
developments.
    We believe issuers should be given an opportunity to 
correct factual misstatements in rating agency reports, but not 
to appeal rating designations outside the rating agency. This 
should not be a lobbied rating agency. It should not be a 
subjective influence from the outside. It should be an 
objective independent rating.
    We believe rating agencies should publish information on 
the historical accuracy of their rating assessments.
    In conclusion, as the capital markets develop and mature 
globally, the need for a measured approach by regulators toward 
the conduct of rating agencies grows in importance. The 
Association does support those actions by regulators that we 
believe will help enhance competition among rating agencies. We 
do not support steps that would limit the independence of 
rating agencies to determine their opinions of the 
creditworthiness of issuers. This would make the fixed-income 
markets less efficient, ultimately harming investors, issuers, 
dealers, and regulators.
    Again, thank you for the opportunity to testify. I look 
forward to answering any questions that you have.
    Chairman Shelby. Mr. Harada.

                  STATEMENT OF YASUHIRO HARADA

                   EXECUTIVE VICE PRESIDENT,

            RATING AND INVESTMENT INFORMATION, INC.

    Mr. Harada. Thank you, Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Senate Banking Committee, for your 
kind invitation to present testimony at today's hearing. My 
name is Yasuhiro Harada. I am the Executive Vice President of 
Rating and Investment Information, Inc., a Japanese rating 
company.
    We are very pleased to offer our thoughts on this topic as 
well as some more specific information about the challenges 
faced by our company as we have sought to clear the hurdles 
necessary to become a new competitor in the U.S. market. Even 
though our company is the most recognized credit rating agency 
in Japan and the broader Asian markets, obtaining designation 
in the United States as a national recognized statistical 
rating organization has been an exercise in delay and 
disappointment.
    R&I is a respected independent source of financial 
information for the overwhelming majority of United States 
broker-dealers and financial institutions that conduct 
operations in Japan. Market participants particularly 
appreciate that R&I calculates and publishes a default ratio 
based on a 27-year record which indicates the probability that 
an issuer that has been given a publicly released rating will 
fall into default within that given period of time. Our 
company's ratings are regularly announced and published by the 
leading financial electronic and print media in Japan, and in 
the United States as well.
    In order to compete effectively in the U.S. market, a 
designation by the SEC as a NRSRO is a critical factor. From a 
procedural standpoint, the problem is that the NRSRO 
application process has little regulatory structure and no 
established timetables for agency decisionmaking. The 
substantive problem for us is the entry barrier presented by 
the SEC requirement that a new NRSRO be ``nationally 
recognized'' by the predominant users of such ratings in the 
United States before it can gain such a designation to enter 
the U.S. market. As Chairman Shelby indicated, this is a 
circular test. It was precisely this circular standard which 
the Antitrust Division of the U.S. Department of Justice 
singled out in 1998 as likely to preclude new competitors in 
this credit rating market. Moreover, concern about the lack of 
new competitors in this market led the Justice Department to 
recommend to the SEC in 1998 that NRSRO designation be 
specifically awarded to some foreign rating agencies.
    For over a decade, our company, R&I, and its predecessors 
have engaged in an effort to receive NRSRO designation. In 
2002, R&I submitted an amended request for NRSRO designation 
that was limited in scope in that R&I sshould be recognized as 
an NRSRO solely with respect to yen-denominated securities. 
Such recognition on a limited basis is considered appropriate 
if a rating agency can demonstrate that it possesses unique 
expertise in rating particular securities, or securities of a 
particular currency denomination.
    R&I is well-qualified to contribute to the flow of 
information and expert analysis so valuable to U.S. investors 
and issuers. Therefore, the lack of progress on our company's 
application harms both R&I and investors. If allowed to enter 
the market, U.S. investors, especially institution investors 
such as life insurance companies, would benefit from having an 
additional source of proven credit analyses and U.S. issuers 
benefit from having more providers of rating services in the 
Samurai bond market.
    Without the NRSRO designation, we operate at a competitive 
disadvantage every day under the current regulatory scheme. 
Until such time as a new regulatory scheme is implemented with 
respect to credit rating agencies, we respectfully suggest the 
SEC should be focusing on approving qualified NRSRO's. We 
encourage the Committee to advise the SEC not to neglect 
pending NRSRO applications nor require such applicants to await 
further rulemaking prior to approval.
    Thank you for the opportunity to present these views.
    Chairman Shelby. Mr. Joynt.

                 STATEMENT OF STEPHEN W. JOYNT

      PRESIDENT AND CHIEF EXECUTIVE OFFICER, FITCH RATINGS

    Mr. Joynt. Thank you, Mr. Chairman and Members of the 
Committee. I am pleased to be here this morning. I would like 
to share some brief comments on competition, regulatory 
recognition and oversight, and conflicts of interest.
    After an ownership change and capital injection in 1989, 
Fitch worked continuously to build its reputation for a credit 
research, modeling, and analysis in the corporate finance, 
public finance, and securitization markets in the United 
States. By 1997, we were well-respected and prominently 
recognized for our contributions, especially in the rapidly 
expanding mortgage- and asset-backed markets. Subsequently, in 
1997 and also in 2000, we merged with the fourth, fifth, and 
sixth largest NRSRO's to create the product breadth and 
geographic coverage demanded by today's global investors. At 
Fitch, we firmly believe in the power of competition. Fitch's 
emergence as a global full-service rating agency capable of 
competing with Moody's and Standard & Poor's across all 
products and market segments has created meaningful competition 
in the ratings market. Fitch's expanding business profile has 
enhanced innovation, forced transparency in the rating process, 
improved service to investors, and created price competition.
    Regarding regulation, Fitch has been actively participating 
in a dialogue with many United States and international 
organizations, such as the SEC, the United Kingdom's FSA, the 
Committee of European Securities Regulators, and the 
aforementioned IOSCO committee, about the role and function of 
the rating agencies in the global capital markets. In September 
2002, IOSCO, with the important involvement of the SEC, 
published its Statement of Principles, and in 2004 also 
published its Code of Conduct Fundamentals for Credit Rating 
Agencies.
    Fitch supports the four high-level principles outlined by 
IOSCO and presented in the code. These four principles include 
transparency, symmetry of information to all market 
participants, independence, and freedom from conflict of 
interest. We believe that our present operating policies and 
practices exemplify the principles of the IOSCO code, and we 
expect to embody them clearly in a Fitch Code of Conduct.
    Regarding the U.S. recognition structure, we believe there 
is value in the NRSRO system that assures recognized 
organizations possess the competence to develop accurate and 
reliable ratings. Many investment practices and guidelines 
interwoven in the fabric of the capital markets reference this 
system. However, this recognition is only the beginning as 
one's market reputation and usefulness to investors must be 
built over time. In fact, after 15 years of effort, only this 
year has Fitch Ratings been recognized by several global bond 
indexes.
    Given the importance of credit ratings in the financial 
markets, Fitch concurs that there is a strong need for credit 
rating agencies to maintain high standards, and we do. Fitch 
culture emphasizes the importance of integrity and independence 
as critical foundations of our most important asset--our 
reputation. Fitch goes to great efforts to assure that our 
receipt of fees from issuers does not affect or impair the 
objectivity of our ratings. Our analyst compensation philosophy 
reflects quality of effort and individual accomplishment in 
research and ratings. Individual company fees, revenue 
production, and individual department profitability do not 
factor into analyst compensation, and analysts may not own 
securities in companies they rate.
    We are aware of the potential for conflict that is inherent 
in our business model, and we do our utmost to maintain our 
objectivity and preserve our reputation in world markets. For 
each of these themes, we are, of course, open to all ideas that 
help us improve the quality of our product and the business 
practices and profile of our company.
    Thank you.
    Chairman Shelby. Mr. Kaitz.

                  STATEMENT OF JAMES A. KAITZ

             PRESIDENT AND CHIEF EXECUTIVE OFFICER,

            ASSOCIATION FOR FINANCIAL PROFESSIONALS

    Mr. Kaitz. Good morning. I am Jim Kaitz, President and CEO 
of the Association for Financial Professionals. AFP represents 
more than 14,000 finance and treasury professionals 
representing more than 5,000 organizations. Our members are 
responsible for issuing short- and long-term debt and managing 
corporate cash and pension assets for their organizations.
    AFP believes that the credit rating agencies and investor 
confidence in the ratings they issue are vital to the efficient 
operation of global capital markets. Yet as evidenced by AFP's 
research, confidence in rating agencies and their ratings has 
diminished over the past few years.
    Why is reforming the credit rating system so important? 
Along with the SEC and other regulators that have incorporated 
the NRSRO designation into their rules, institutional and 
individual investors have long relied on credit ratings when 
purchasing individual corporate and municipal bonds. Further, 
nearly every mutual fund manager that individuals and 
institutional investors have entrusted with over $8 trillion 
relies to some degree on the ratings of nationally recognized 
agencies. Rating actions on corporate debt also have an 
indirect but sizeable impact on the stock prices of rated 
companies.
    Debt issuers rely on the credit rating agencies to issue 
ratings that accurately reflect the company's creditworthiness. 
These ratings determine the conditions under which a company 
can raise capital to maintain and grow their business.
    Finally, while credit rating agencies have long played a 
significant role in the operation of capital markets, the 
Administration's recent single-employer pension reform proposal 
would tie pension funding and Pension Benefit Guaranty 
Corporation premiums to a plan sponsor's financial condition as 
determined by existing credit ratings. In some cases, plan 
sponsors would be prohibited from increasing benefits or making 
lump sum payments based on their credit rating and funded 
status. Such a proposal would further codify the NRSRO 
designation and increase the already significant market power 
of the rating agencies.
    More than 10 years after it first began examining the role 
and regulation of credit rating agencies and despite the 
increased reliance on credit ratings, the Securities and 
Exchange Commission has not taken any meaningful action to 
address the concerns of issuers and investors. These concerns 
include questions about the credibility and reliability of 
credit ratings and conflicts of interest and potential abusive 
practices in the ratings process. Chairman Shelby and Members 
of the Committee, these issues are far too important for the 
SEC to remain silent while investors and regulators worldwide 
wait for it to take action.
    Now I would like to briefly outline some of our concerns.
    When the SEC recognized the first Nationally Recognized 
Statistical Rating Organization in 1975 without outlining the 
criteria by which others could be recognized, it, in effect, 
created an artificial barrier to entry to the credit ratings 
market. This barrier has led to a concentration of market power 
with the recognized rating agencies and a lack of competition 
and innovation in the credit market. Only the SEC can remove 
the artificial barrier to competition it has created. 
Therefore, we strongly recommend that the SEC maintain the 
NRSRO designation and clearly articulate the process by which 
qualified credit rating agencies can attain the NRSRO 
designation.
    The SEC must also take an active role in the ongoing 
oversight of the rating agencies to ensure that they continue 
to merit NRSRO status.
    The Commission further empowered the rating agencies when 
it exempted them from Regulation Fair Disclosure. Through this 
exemption, the rating agencies have access to nonpublic 
information about the companies they rate. The Commission has 
done nothing to ensure that those who are granted this powerful 
exemption do not use the nonpublic information inappropriately. 
The SEC must require that NRSRO's have policies in place to 
protect this valuable and privileged information. This must be 
part of the SEC's ongoing oversight of the rating agencies.
    As highlighted in some recent media reports, rating 
agencies continue to promulgate unsolicited ratings which are 
issued without the benefit of access to company management or 
nonpublic information about the issuer. The resulting ratings 
are often not an accurate reflection of an organization's 
financial condition. Credit ratings are critical to an 
organization's ability to issue debt, and issuers often feel 
compelled to participate in the rating process and pay for the 
rating that was never solicited. The potential for abuse of 
these unsolicited ratings by the rating agencies must be 
addressed by the SEC.
    Finally, an NRSRO is also in a position to compel companies 
to purchase ancillary services. These ancillary services 
include ratings evaluations and corporate governance reviews. 
Further, the revenue derived from these services has the 
potential to taint the objectivity of the ratings. You need 
look no further than the equity research and audit professions 
to understand why these potential abusive practices and 
conflicts of interest must be addressed by the SEC.
    Chairman Shelby and Members of the Committee, we strongly 
recommend that you hold the SEC accountable on the issues that 
have been raised here today. With credit ratings being so 
important to investors in this country, Congress should also 
not allow the SEC to cede oversight of the agencies to an 
organization outside the United States that has no binding 
authority, including oversight authority, of the rating 
companies.
    Finally, it has been 10 years since the SEC has considered 
regulating credit rating agencies, and as reported in today's 
Washington Post, we find it incredible that they have now 
concluded they do not have oversight authority over the rating 
agencies.
    In conclusion, Mr. Chairman, AFP commends you and the 
Committee for pursuing this issue.
    Chairman Shelby. Mr. McDaniel.

             STATEMENT OF RAYMOND W. McDANIEL, JR.

              PRESIDENT, MOODY'S INVESTORS SERVICE

    Mr. McDaniel. Good morning, and thank you, Mr. Chairman, 
Senator Sarbanes, and all the Members of the Committee for 
inviting Moody's to participate in today's hearing.
    Moody's offers forward-looking credit rating opinions and 
credit research about entities active in the debt capital 
markets globally. As the oldest and one of the most established 
credit rating agencies, we have more than 1,000 analysts in 18 
countries worldwide. Moody's distributes our opinions broadly 
and free of charge to investors in the form of credit ratings. 
We also public credit research about the debt obligations and 
issuers we rate. We sell this research to about 3,000 
institutional investors.
    Our opinions are communicated to the market through a 
symbol system originated almost 100 years ago. The system ranks 
relative credit risk on a scale with 9 broad letter categories 
from Aaa to C. Most of the letter categories are further 
refined with numbers, 1 through 3. Overall our ratings have 
consistently done a good job in predicting the relative credit 
risk of debt securities and debt issuers. Ratings are not pass/
fail assessments of an entity's future performance or 
performance guarantees, investment recommendations, or 
statements of fact; rather, Moody's ratings intend to predict 
the relative probability that debt obligations will be repaid 
on a full and timely basis with the probability declining at 
each lower level in the rating scale. The attributes of ratings 
as offered by major rating agencies include their predictive 
content, public availability, and free distribution. The 
combination of these attributes has encouraged use by diverse 
groups, including issuers, intermediaries, parties to financial 
contracts, institutional investors, and regulators.
    For these users, ratings must meet demands for accuracy, 
stability, and timeliness. Accuracy is measured by the 
predictive content of the ratings, the ability of the rating 
system to properly rank order the relative riskiness of credit 
from low to high. Moody's publishes on our website a quarterly 
report card of the accuracy of our ratings reaching back 20 
years. Moody's rating stability is an important attribute 
because ratings volatility has consequences for, among other 
things, the composition of investment portfolios and capital 
adequacy calculations. As a result, rating reversals, a rating 
downgraded followed shortly by an upgrade, or vice versa, may 
add unnecessary volatility and costs. It is, therefore, 
important for Moody's to manage its ratings so that ratings are 
changed only after judicious deliberation and in response to 
changes in fundamental creditworthiness, not transitory events.
    In order to balance the market's demand for accuracy and 
stability with its demand for timeliness, Moody's uses 
additional public signals called watchlists and outlooks 
through which we communicate our opinion on possible trends in 
future creditworthiness. Rating outlooks and the watchlists 
permit rating agencies to signal developing trends and 
preliminary views without disrupting markets. In an effort to 
learn from our mistakes and to keep pace with complex credit 
markets, we continue to augment our analytical process. Some of 
the initiatives we have instituted include formation of 
analytical specialist teams in areas such as accounting and 
financial disclosure; mandatory professional development 
programs; introduction of new credit monitoring tools; the 
expansion of our centralized credit policy function; and the 
appointment of chief credit officers.
    Most of Moody's revenue comes from fees paid by debt 
issuers. Issuers request and pay for ratings from us because of 
the broad marketability of their bonds that ratings facilitate. 
Issuers pay these fees rather than investors because we broadly 
distribute our ratings to all investors simultaneously free of 
charge. The issuer-payment business model has potential 
conflicts of interest, as does a subscription-based business 
that some firms use as an alternative. The critical question is 
not which model is used, but whether potential conflicts of 
interest are prudently and effectively managed and disclosed. 
In Moody's case, we have a range of policies and procedures in 
place to achieve this goal, including that rating decisions 
must be taken by a committee and not by an individual analyst; 
that analyst compensation must not related in any way to the 
fees received from the issuers they evaluate; and that analysts 
may not own securities in the issuers they rate.
    Finally, Mr. Chairman, turning to the regulatory 
environment, over the past 3 years much attention has been 
focused on the global financial services industry, including 
rating agencies. To the extent that here in the United States 
the NRSRO designation is seen to limit competition, Moody's 
supports its discontinuation. Moody's has consistently 
supported competition in the industry and eliminating barriers 
to entry caused by, for example, vague or difficult to achieve 
recognition standards. A healthy industry structure is one in 
which the role of natural economic forces is conspicuous and 
where competition is based on performance quality to promote 
the objectives of market efficiency and investor protection.
    The obligation to assure that the U.S. financial market 
remains among the fairest and most transparent in the world is 
one that all market participants should share. I look forward 
to answering any questions the Committee may have. Thank you.
    Chairman Shelby. Thank you.
    Ms. Corbet, Mr. Joynt, and Mr. McDaniel, I will pose this 
first question to the three of you. About 2 years ago, this 
Committee held a hearing on the Global Settlement and examined 
potential conflicts of interest with research analysts. 
Essentially, analysts were being paid to tout a banking 
client's stock. Some contend that a similar conflict of 
interest exists in the credit ratings industry. How do you 
respond to concerns that this conflict compromises the 
independent and objective analysis of the rating agencies?
    We will start with you, Ms. Corbet.
    Ms. Corbet. Thank you, Mr. Chairman----
    Chairman Shelby. How do you defend that, in other words?
    Ms. Corbet. Sure. The conflicts of interest are indeed ones 
that we must be vigilant in terms of managing, and similar to 
the provisions in our Code of Policies and Procedures, which 
are similar to those raised by Mr. McDaniel, we also would add 
that analysts are not engaged in any commercial or business 
matters with respect to ratings. In addition to strict 
procedures prohibiting trading and securities ownership in the 
companies that they rate, we also prohibit any board 
representation by analysts.
    Chairman Shelby. Mr. Joynt.
    Mr. Joynt. As I mentioned, I think the culture of our 
company is probably the first line of defense, instructing all 
our employees and our analysts and building over time on the 
importance of integrity and independence.
    As was mentioned earlier, but I think it is a positive, the 
ratings are done by a committee and not by individuals, so it 
is harder for individuals to sway the rating by themselves, 
although I would concede that a primary analyst and a secondary 
analyst that lead those committees would have more knowledge 
and information and I suppose could try to have undue 
influence, and also compensation of analysts, which is probably 
the most direct issue. From the beginning of our development we 
have focused all compensation away from any kind of revenue 
production activity on the part of the analyst. I think those 
are all important ingredients.
    Chairman Shelby. What about serving on boards that you 
rate?
    Mr. Joynt. None of our analysts or executives nor do I 
serve on any boards.
    Chairman Shelby. Mr. McDaniel.
    Mr. McDaniel. In addition to the actions that were listed 
by Ms. Corbet and Mr. Joynt, Moody's has published a set of 
core principles which guide our behavior. The core principles 
include the independence of the analyst from the issuer, that 
there is not permitted to be any link to the analyst 
compensation from either the ratings or the fees received from 
the issuers that they are responsible for reviewing.
    Chairman Shelby. What about perception? You say link, but 
what about perception?
    Mr. McDaniel. We have publicly disclosed that the analyst 
compensation is unrelated to the issuers that they rate. That 
is how we try to manage the perception issue, sir.
    In addition, commercial considerations with respect to 
issuers are prohibited from being discussed or considered in 
rating committees. We have a codification of all of our 
methodologies which are available publicly, and there is a 
requirement that those methodologies be followed by the rating 
committees. We have a rating compliance unit. We publish our 
quarterly ratings performance, which is available in verifiable 
formats. And we avoid concentration of fees from issuers so 
that no one issuer is material to Moody's commercial interests.
    Chairman Shelby. A second question to all three of you. 
Collectively, Moody's, S&P, and Fitch account for about 95 
percent of the market share in the ratings business. Some 
people contend that by designating these firms as NRSRO's, the 
SEC has granted them a franchise that deters new competitors.
    How does this market concentration that has developed--
discuss whether it is good thing for investors, and how would 
you propose to increase competition, if you would? We will 
start with you, Mr. McDaniel, and go back.
    Mr. McDaniel. As I mentioned----
    Chairman Shelby. Ninety-five percent is a lot of 
concentration.
    Mr. McDaniel. As I mentioned in my opening, Senator, this 
is an important issue. We recognize that. I believe that there 
are natural economic forces that are important in guiding the 
structure of this industry. However, the issue is very 
distractive if it is not dealt with, and I believe that one of 
two solutions should be pursued: Either the elimination of the 
national recognition designation as currently used, or the 
opening of the industry to more nationally recognized agencies.
    Chairman Shelby. Okay. Mr. Egan, do you have any comment 
here?
    Mr. Egan. I do not think it is a natural monopoly or 
oligopoly. I think it is far from it. The case of the equity 
research analysts, you had some 20-odd analysts following AT&T 
as Jack Grubman, who had the most bullish opinion, and the 
equity research firms were fined $1.4 billion for their poor 
behavior.
    I think that what has happened is that there are some 
natural ways that the two major firms are able to maintain and 
extend their monopoly. It is very interesting that the poor 
investment banker that would try to recommend any other rating 
firm to rate securities would find it very difficult to go in 
front of S&P and Moody's the next time they come around. As I 
said before, there is no problem with these firms getting paid 
by the issuers. It is just that the SEC should not be in the 
business of encouraging a basic conflict of interest.
    Chairman Shelby. Mr. Kaitz.
    Mr. Kaitz. Senator, one of the recommendations I heard from 
Mr. McDaniel was to eliminate the NRSRO designation. I would 
suggest if you do that, you have eliminated an artificial 
barrier to competition, and you have erected a permanent 
barrier to competition. As we have all discussed, the ratings 
are embedded in banking law, insurance, mutual funds, and 
potentially into the pension area. So that would create a 
permanent barrier to competition from any other organizations.
    Chairman Shelby. Three with a stamp of approval, and no one 
else, right?
    Mr. Kaitz. Yes, sir.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman.
    I just want to underscore that last point that was being 
made. Since 1931, the Federal Reserve Board, the Comptroller of 
the Currency, and Federal and State laws have regulated the 
debt held by banks and other financial institutions using 
credit ratings assigned to the debt. Pension funds, banks, and 
money market funds are barred from buying debt issues that 
carry ratings below a certain level. So the ratings have in a 
sense kind of a life-and-death impact. I think it is pretty 
clear.
    Let me ask the people at the table just a very general 
question. Does everyone think that there is a problem here that 
needs to be addressed? Or do some at the table think there is 
really not a problem and the situation is pretty good, and 
whatever there is, we are fixing it up okay? How many think 
that there is a problem that really needs to be dealt with?
    Mr. Egan. I think there is a huge problem.
    Mr. Green. Senator Sarbanes, I think there is a problem of 
competition, and I think expanding the scope of designated 
rating agencies would be a very good thing for the marketplace. 
The one thing we have not talked about and that I think was 
implied by Mr. Harada, the marketplace has become inherently 
global now. There has been growth of the capital markets in 
Asia, tremendous growth most recently with the development of a 
comprehensive European economy. That really does raise the 
opportunity for new entrants into the marketplace, and the SEC 
really should review the designation process to be more open.
    But make no mistake about it. Opening up----
    Senator Sarbanes. How do I get some assurance that the 
process, even if more people are participating in it, is going 
to be objective? Gretchen Morgenson had an article in The New 
York Times on Sunday entitled: ``Wanted, credit ratings, 
objective ones, please.'' How do I get some assurance--and now 
the credit--as I understand it, the credit rating agencies are 
now beginning to do consulting for the companies with respect 
to whom they issue ratings. Is that correct? Mr. McDaniel, are 
you doing consulting?
    Mr. McDaniel. No. Moody's does not engage in consulting. 
There is one activity which we believe is part of the core 
rating process called a rating assessment service, where we 
answer hypothetical questions that companies have for a fee. 
That is the only activity we engage in that might be considered 
consulting. It is less than 1 percent of our business and will 
remain so.
    Senator Sarbanes. Mr. Joynt.
    Mr. Joynt. We also would only have a few cases of rating 
assessments, but no broad consulting practice.
    Senator Sarbanes. Do you have a narrow consulting practice?
    Mr. Joynt. Pardon me?
    Senator Sarbanes. Do you have a narrow consulting practice?
    [Laughter.]
    Mr. Joynt. No. However, I might add that our parent company 
has recently acquired a company called Algorithmics, which is 
an enterprise risk management, and they are a financial 
software company and often would consult with people on the 
installation of the financial software.
    Senator Sarbanes. Ms. Corbet.
    Ms. Corbet. Senator, within our rating services practice, 
we have no consulting or advisory business. Indeed, we 
similarly have a ratings evaluation service that we provide to 
issuers at their request.
    Senator Sarbanes. Well, am I to draw from that is that 
these concerns some are raising that there is consulting going 
on are without any foundation or basis, Mr. Egan?
    Mr. Egan. No. It is an extension of the monopoly. Fannie 
Mae had a corporate governance rating from S&P of 9 on a scale 
of 1 to 10 up until just a week ago. Basically they said Fannie 
Mae was fantastic, and we all found out that it was not. What 
were the problems? They had the same Chairman and CEO. They had 
accounting problems, CFO problems, evaluation of securities, 
regulatory problems, on and on and on. And it is a 9 on a scale 
of 1 to 10, 10 being the best.
    Basically these firms are using their SEC-sanctioned 
monopoly in one area, and extending it to the other areas, and 
there is no check on them.
    By the way, the conflicts cannot be managed. They simply 
cannot be managed. If I am selling a company and I am 
representing Company A and instead I am getting paid by Company 
B, which is buying Company A, I cannot say, well, I am going to 
set up barriers or Chinese walls and somehow manage that. That 
does not work.
    If I am hiring a litigator and I find out that the 
litigator is paid by the other side, you have a basic conflict 
there.
    The Philadelphia Eagles just lost the Super Bowl. If my son 
found out that Philadelphia coach Andy Reid was paid by the New 
England Patriots, he would hit the roof. You know, it does not 
work.
    Senator Sarbanes. That is a very understandable example.
    [Laughter.]
    Mr. Egan. Thank you.
    Senator Sarbanes. I do not understand why you would get any 
consulting fees. The reason I am concerned about this, over a 
period of 25 years consulting services have replaced audits as 
the principle source of accounting firms' revenues. Now, the 
legislation we passed, as you know, precluded certain 
consulting services altogether, set up a rigorous process for 
any others that they might want to engage the auditor for. 
There is one other thing, just a little thing that does not 
amount to much. You said you limit it to 1 percent.
    In 1977, core auditing and accounting fees accounted for 70 
percent of revenues of the auditing firms while management 
advisory services accounted for just 12 percent. By 1998, a 
little more than 20 years later, the pattern had been reversed. 
Just 34 percent of revenues came from auditing and accounting 
services and over 50 percent from management advisory services.
    I do not understand why you should do any consulting 
services if you are doing the rating. I mean, we have other 
issues here to discuss. Who pays you to do the ratings? How do 
you do it? I see I have used up my time. I want to take just 
this one narrow area. Why should you get any fees from 
consulting services?
    Ms. Corbet. Senator, if I may, the ratings evaluation 
service that we provide to issuers at their request is truly an 
extension of the ratings process. It helps a company evaluate 
certain financial decisions that they may take with respect to 
potential acquisitions, with respect to financial policy in 
terms of dividend or share buy-back policies. And so, someone 
described it as a what-if scenario in terms of what the issuers 
may undertake, and we provide that evaluation for them in this 
particular service. It is truly an extension of the ratings 
process.
    Senator Sarbanes. Mr. Harada.
    Mr. Harada. Thank you very much. R&I does not carry out any 
consulting business which is closely linked to the rating 
activities. We strictly refrain from those kind of activities 
to keep the independence of the rating performance.
    Senator Sarbanes. Mr. Joynt.
    Mr. Joynt. The alternative to receiving fees on this kind 
of consulting assignment for rating assessments would be to 
charge all issuers more, spread across the advice, because 
essentially we have free-flow information back and forth from 
the analytical committees to the issuers. They come in and 
present their financial information. We describe our process, 
our standards, their expectations. And so there is a regular 
dialogue. So the identification of specific dialogue and 
assigning a consulting fee to that could be replaced by just 
higher fees.
    Senator Sarbanes. It would get you out of this potential 
conflict, would it not?
    Mr. Joynt. I do not think it would because the dialogue 
would continue anyway. I think part of what we want to do is 
have a transparent dialogue with everyone in the market, 
including all issuers, investors, and so describing our rating 
process I think is important.
    Senator Sarbanes. Mr. Kaitz.
    Mr. Kaitz. Senator, all of these are commendable, except 
there is no competition. Where else are these companies going 
to go other than Moody's, S&P, and Fitch? So in a perfect 
world, maybe consulting would be fine, but this is hardly a 
perfect world when it comes to the competitive nature of this 
business.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sununu.
    Senator Sununu. I am amazed to see an industry with three-
firm concentration of 95 percent where there is a regulatory 
status conferred by the Government that bars all entrants, 
actually coming before the Committee and saying, you know, if 
we are not allowed to engage in any line of business we want, 
we are going to raise prices. But I have another line of 
questioning I want to engage in, and maybe that will just be 
food for thought for further questions for the rest of the 
Committee Members.
    Ms. Corbet, less than a year ago, one of your analysts, 
Michael DeStefano, suggested that the GSE legislation we were 
considering before this Committee would cause S&P to reconsider 
the AAA rating it had for GSE unsecured debt. I read this 
account to mean that if we included receivership provision in 
that bill, then you would basically downgrade the credit rating 
of the GSE's. What was the process that S&P used to arrive at 
that conclusion?
    Ms. Corbet. First of all, Senator, if I may, let me start 
by saying that Standard & Poor's does not advocate positions on 
any legislation. And indeed in that particular case that you 
reference, consistent with our published commentary on the 
GSE's, which dates back to the early 1980's, we have always 
stated that any change in the relationship between the GSE's 
and the Government would necessarily be an important factor in 
our ongoing ratings assessment.
    Indeed, back in March, I believe, a statement was made by 
our senior analyst that our analysis of any legislation would 
be to examine each individual proposal as well as the 
legislation as a whole. We have never said that any specific 
factor within proposed legislation would result in an automatic 
downgrade.
    Senator Sununu. What data was the analyst using to make the 
statement he made?
    Ms. Corbet. He was using and referencing our published 
commentary on our position on the GSE's. We have published 
commentary during the course of 2004, in January, in May, and 
most recently in December 2004. And that commentary has been 
consistent.
    Senator Sununu. Is it still S&P's position then the 
legislation being considered would result in a weakening of the 
credit rating?
    Ms. Corbet. In May 2004, our ratings committee concluded 
that we no longer had the highest degree of confidence of 
Government support and determined that our ratings on GSE's 
would reflect both the financial strength of the GSE's and the 
degree of confidence in Government support. And based on this 
combined criteria, not simply the Government support criteria, 
we affirmed the GSE ratings at AAA.
    Senator Sununu. You say that it is not your intention or 
your policy to have analysts comment on or lobby for or against 
specific pieces of legislation. But do not you think weighing 
in with a perspective on how this affects the credit of a 
particular company is a de facto position on legislation?
    Ms. Corbet. As I said, we do not advocate positions on any 
legislation. What we did do is reaffirm our position that we 
have taken on the GSE's for many years, and we did comment on 
that in March.
    Senator Sununu. Mr. McDaniel, you talked about volatility 
and your concerns about volatility in issuing credit ratings, 
that if they moved back and forth, that would have undesirable 
consequences, and I certainly would not disagree with that.
    Do you think that is worse than the alternative, which is 
to lag behind, as was obviously the case in Enron and MCI, and 
shift position or in this case downgrade credit too slowly and 
as a result not give markets a clear indication of what might 
be happening at a company?
    Mr. McDaniel. The situations such as Enron are clearly 
situations that Moody's was unhappy with. We do not benefit, we 
do not have our reputation enhanced by having investment grade 
companies of the size of an Enron default. That obviously was a 
matter of serious concern for us.
    We do believe that timeliness is extremely important to the 
rating process. As I said in my opening statement, we try to 
balance the need for stability with the need for timeliness by 
using additional signals in the marketplace, the signals being 
watchlists and outlooks, which are more forward-looking in 
terms of potential credit trends. And we think that those are 
important elements of the management of the rating system to 
provide responses to both demands for stability and for 
timeliness.
    Senator Sununu. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Ms. Corbet, I think Senator Sununu touched on this 
question, which is comments made by S&P analysts about the 
possible legislation affecting the Government Sponsored 
Enterprises. In fact, I think a quote from a report by Mr. 
DeStefano and Ms. Wagner would be, ``The slightest evidence 
that Congress would in any way agree to lessen its authority or 
cede it to others would in itself necessitate a rethinking of 
how much confidence bondholders should have that their 
interests would be taken into consideration in the case of a 
failed GSE.'' And I think your response was you do not comment 
on legislation, but can you comment on that quote?
    Ms. Corbet. Sure, happy to. Thank you, Senator.
    Indeed, again, as that quote indicated, and as other 
published criteria about our ratings opinion on the GSE's 
indicted we take into consideration all and each factor in any 
legislation, whether proposed or actual legislation, to 
determine whether or not it would result in any change in our 
ratings opinion.
    Indeed, we furthermore stated--and this is most recently--
in our publication in December 2004 that, whatever the course 
of any legislative change in the relationship between the GSE's 
and the Government, whatever change it may take, our analysts 
consider the credit implications and will be responsive to the 
intent of Congress.
    Senator Reed. Thank you. I think we all recognize why this 
is an important issue since we are actually contemplating 
changes, which you apparently will take into consideration.
    Mr. Joynt, Fitch Ratings, do you have a position with 
respect to this issue of potential changes with respect to 
issues like receivership and others?
    Mr. Joynt. We would. Actually, we follow the same credits. 
We have ratings on the GSE's, their mortgage securities as well 
as their unsecured obligations and preferred stock. We would 
have offered our opinion around that same time also, focused on 
the credit impact of whatever the change might be.
    Senator Reed. Again, this may be from popular reporting, 
but the impression that I received was that you would not 
necessarily make changes based upon statutory changes. Is that 
fair?
    Mr. Joynt. I think that was the conclusion that we 
presented, yes, that at that time we did not see the impact. We 
see the potential, and it is, of course, a complicated set of 
legislation and influences.
    Senator Reed. And, Ms. Corbet, is that a fair summary of 
where you are today, that you would not necessarily make 
changes but you would look very carefully at what we did?
    Ms. Corbet. That is correct, Senator.
    Senator Reed. And just for the sake of completeness, Mr. 
McDaniel, Moody's position on this issue of statutory changes 
affecting GSE's?
    Mr. McDaniel. We do not believe that the proposed 
legislation would have an effect on our credit rating opinion 
of the GSE's.
    Senator Reed. Thank you very much.
    Mr. Green, again, because we are very near to considering 
legislation--in fact, I think we are having a hearing later 
this week--what would be the impact from an economic standpoint 
across the economy as a whole if, in fact, there was a 
downgrade of the GSE's based upon statutory changes or based 
upon their performance in the marketplace, or a combination?
    Mr. Green. Senator Reed, as you have heard, there is not 
necessarily agreement that there would be a downgrade. But 
obviously with the amount of securities outstanding by the 
GSE's directly and through their mortgage portfolio as well, 
any question as to their creditworthiness would have a 
significant impact on the marketplace. And I would add it is a 
marketplace that is vastly global in nature with investors of 
differing degrees of knowledge and understanding, so they would 
look to the credit rating as a very key element of information 
with which to make an investment decision.
    To the extent that any business practice, legislative or 
regulatory activity would affect their credit rating, because 
of the amount of debt outstanding, it would have a market 
effect.
    Senator Reed. Thank you very much.
    Does anyone else want to generally comment on this line of 
questioning? Mr. Egan.
    Mr. Egan. From our perspective, neither Fannie Mae nor 
Freddie Mac are AAA-rated credits. They are far from a AAA. If 
you speak to anybody in the Government, they will not give you 
the confidence that there is the full faith and credit of the 
U.S. Government behind them, number one. Number two, they have 
2 percent and possibly even less than 2 percent equity to 
assets, and the typical A or A plus-rated bank has 8 percent.
    So we have told our clients and will continue to tell our 
clients that these are not AAA-rated credits, we do not care 
what our competitors say. Some people claim the Government will 
step in. Yes, they might step in, but that will be for the new 
capital. It is not for the existing capital. It would be like 
the airlines.
    We think right now you have an untenable situation with 
Fannie Mae and Freddie Mac. Something has to be done and done 
quickly. Really probably the best model is the Sallie Maes. 
Sallie Mae is doing very well. It does not have any support, 
either implied or not implied, from the U.S. Government, and 
that is the right way to look at it. But get there quickly. You 
know, the lesson learned from Enron and WorldCom and all these 
other failures is you have to address the problem quickly. You 
do not wait until everybody panics. We have had our rating, 
maintained it for 2 years. You know, people are adjusting, our 
clients and others are adjusting to it. But do not keep up this 
falsehood that they are AAA-rated because they are not. And if 
they continue to grow, it creates a bigger problem in another 2 
years. So address it as quickly as you possibly can.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. I just want to ask a general question 
since I have had some experience in this business since 1961. 
Is there anyone at the table currently rating credit that has a 
relationship with the corporation they are rating and/or any 
kind of fiduciary responsibility other than independent credit 
rating?
    Mr. Egan. At Egan-Jones, we do not sit on any board, serve 
on any committees. It is public knowledge that in the case of 
Moody's, Clifford Alexander, the ex-chairman----
    Senator Bunning. I will let Moody's speak for itself.
    Mr. Egan. Okay.
    Ms. Corbet. As my earlier testimony indicated, we prohibit 
analysts from sitting on any corporate boards.
    Senator Bunning. For how long has that been happening?
    Ms. Corbet. It has been as long as I know, but we have 
codified that in our policies and procedures that are publicly 
available.
    Senator Bunning. Is that just recently, or has that been in 
the past 30 years?
    Ms. Corbet. I can only speak for the period of time that I 
have been involved at S&P, and I know that since that time, and 
even before that, it has been our policy.
    Senator Bunning. How long has that been?
    Ms. Corbet. I joined Standard & Poor's in April of last 
year.
    Senator Bunning. How about officers of your company?
    Ms. Corbet. In terms of myself, I do not participate in the 
ratings process, but I do sit on the board of a university.
    Senator Bunning. No, no, no. How about officers of your 
company that are involved with other companies?
    Ms. Corbet. There are no officers of the company that are 
involved in the ratings process who sit on any issuer or any 
public board that issues debt.
    Senator Bunning. You are missing the point. Do you have any 
officers of Standard & Poor's that sit on any other boards of 
any other companies? Not that are involved in the rating 
system.
    Ms. Corbet. We do not have any officers at Standard & 
Poor's, that I am aware of, that sit on any public boards.
    Senator Bunning. At McGraw-Hill?
    Ms. Corbet. At McGraw-Hill, we are part of McGraw-Hill. 
Standard & Poor's is a division of McGraw-Hill, and there are 
members of that board of directors----
    Senator Bunning. Joint.
    Ms. Corbet. Excuse me?
    Senator Bunning. They are joint board of directors.
    Ms. Corbet. They are not joint board of directors. They are 
directors of McGraw-Hill Companies.
    Senator Bunning. And Standard & Poor's?
    Ms. Corbet. Standard & Poor's is a division of the McGraw-
Hill Companies.
    Senator Bunning. Well, okay. It is publicly held.
    Does anyone else have anything to say about this?
    Mr. McDaniel. For Moody's, employees at Moody's do not sit 
on the boards of any rated companies. We do have members of the 
Moody's----
    Senator Bunning. Now. And how long has that been?
    Mr. McDaniel. I believe that is an accurate statement 
through our history.
    Senator Bunning. Through your history.
    Mr. McDaniel. I would have to go back and confirm that.
    Senator Bunning. Mr. Joynt.
    Mr. Joynt. Since I have been involved with Fitch, 1989, 
none of the analytical people, whatever level, have been 
involved on any public boards. I am not sure it was a written 
requirement, but it has certainly been our practice and 
continues to be our practice.
    Senator Bunning. In the Enron case, are the two on the ends 
the Enron rating people of the debt?
    Ms. Corbet. We did rate Enron.
    Mr. McDaniel. Moody's rated Enron, yes.
    Senator Bunning. Moody's and S&P.
    Mr. Joynt. Fitch did as well.
    Senator Bunning. Fitch did as well.
    Mr. Egan. And Egan-Jones.
    Senator Bunning. And Egan-Jones. What was the first time 
that you notified the public that there was a problem?
    Mr. Egan. We had it listed as part of our----
    Senator Bunning. No, the three people that are rating 
them----
    Senator Hagel. He rated them, too.
    Senator Bunning. Oh, I apologize. Go right ahead.
    Mr. Egan. It is in our written testimony.
    Senator Bunning. I have three meetings today, so the 
written testimony did not get read.
    Mr. Egan. By the way, as far as that last question, you 
should ask it very carefully and you are not. These people are 
deferring it. You want to ask: Are there any directors, 
officers, or anybody affiliated with the rating firm, do they 
serve on any other corporations?
    Senator Bunning. That is exactly the question I asked.
    Mr. Egan. Well, it was not answered that way.
    Senator Bunning. You mean I was deceived in the answer?
    Mr. Egan. You may want a written request because you did 
not get the answer that----
    Senator Bunning. Well, that was my question.
    Mr. Egan. Okay. It was not answered accurately. They 
misunderstood the question.
    Senator Bunning. Well, speak up, Mr. Egan, if you know 
others that are then.
    Mr. Egan. Well, it is public knowledge that the chairman--
and they make the distinction between credit officers versus 
chairmen. The Chairman of Moody's, Clifford Alexander, sat on 
the board of WorldCom. And he sat on the predecessor board, 
MCI. Now it is back to the MCI name, but it was MCI, then 
WorldCom, because WorldCom acquired MCI. And Clifford Alexander 
was on the board for about 8 years, resigned probably about 9 
or 12 months before it went bankrupt. He was an insider's 
insider. He was one of the three people on the nominating 
committee. And so they answered the question there is no rating 
officer or credit officer. That is true. But, you have to ask a 
broader question.
    The second point is that the prior President of Moody's 
current chairman, served on the board of the NASD. The NASD 
overlooks all the broker-dealers. That is a cozy relationship. 
Also, the chairman sat on Wyeth, and I think there is another 
corporation. It is part of the writeup in The Washington Post 
as of November of last year. But that question was not 
answered. I do not know if McGraw-Hill directors or chairmen 
sit on any other boards, but that would not be unusual. But 
that question was not answered.
    Senator Bunning. I will get my second round in then. Thank 
you, Mr. Chairman.
    Chairman Shelby. Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman, and thank you to 
each of you for being here. It is a very important topic.
    I would like to go back to the catch-22 that was talked 
about earlier today. There would appear to be a significant 
hurdle to many firms who are seeking the NRSRO status, and I 
would like to talk more about that. The fact that a firm cannot 
be nationally recognized until they have had wide acceptance in 
the market but cannot get wide acceptance in the market until 
they are nationally recognized places incredible hurdles in the 
path of qualified firms. Of course, since the SEC issues the 
NRSRO designation, it has taken on a quasi-governmental stamp 
of approval in this process.
    So my question would be: How do you feel, could you speak 
about the SEC issuing guidance in terms of the designation 
process? What would the standards look like to achieve status? 
What would the provisions look like from your perspective that 
would address this obvious catch-22? I would be happy to have 
each of you answer that. Yes, we will start here.
    Mr. McDaniel. From Moody's perspective, I think there are 
probably several solutions to the question that you pose. We 
certainly support greater transparency in the recognition 
process. We support competition in the industry. And we think 
that transparency in the standards necessary to become an NRSRO 
will invite more competition, and that will contribute to, in 
our opinion, a healthy industry structure.
    Senator Stabenow. Get a little more specific for me, if you 
would. What does that look like?
    Mr. McDaniel. The SEC has in the past identified criteria 
that it felt were relevant to national recognition, and I think 
that those criteria, if they were used formally, would 
certainly add to the transparency of the process. But one of 
the things that gets away from the chicken and egg or catch-22 
problem that you have identified is whether or not, in fact, 
national recognition is necessary or whether there are other 
more limited forms of recognition or a lower hurdle for 
recognition, in fact, that would open the industry to 
competition. And there is some precedent for this historically 
where smaller agencies were nationally recognized for their 
particular industry expertise.
    Mr. Kaitz. Senator, I again would reiterate that if you 
eliminate that NRSRO designation without any SEC involvement, 
you erect a permanent barrier to competition. AFP has laid out 
with our counterparts in Britain and in France a code of 
standard practice in the credit rating process that addresses 
the regulatory issues we believe the SEC needs to address. But 
I think just for a quick answer, we need to have credible and 
reliable ratings, and that really needs to be the criteria by 
which they start to look at rating agencies.
    Again, we have laid this all out in our standard code of 
practice, and we think it is critically important that the SEC 
do this.
    Senator Stabenow. Thank you.
    Mr. Joynt. Senator, as I mentioned in my opening remarks, 
Fitch is a combination of four rating agencies that merged 
together, and in fact, as of 8 years ago, the SEC had 
designated other rating agencies. There were more. There were 
six different rating agencies. And some of the companies that 
we merged with were designated for individual disciplines. For 
example, IBCA, International Bank Credit Analysts, was 
recognized for their expertise in bank analysis, and Thompson 
Bank Watch, another firm that we acquired, was recognized for 
its expertise in bank analysis as well.
    So it has only been recently--the combination of those 
mergers was to deal with an economic reality about the 
requirement for investors to have a rating agency that had a 
global presence and could offer credit opinions on corporations 
and structured financings globally, not just in the United 
States. So that is an economic reason for the mergers. But it 
seems like there would be a pattern and an availability for the 
SEC to approve based on their past precedents to open up the 
approval process, and I do not think anything is necessarily 
stopping them from doing that at this point.
    Mr. Harada. May I?
    Senator Stabenow. Yes, please.
    Mr. Harada. R&I as a foreign rating agency, as you suggest 
before, the requirement of national recognition is very hard to 
overcome to us. But, nevertheless, we did some efforts, that 
is, we have already received 10 letters of support from the 
very established, leading financial institutions in the United 
States. So, I think to some extent such effort to be recognized 
by the national financial institutions might be necessary, but 
I do strongly ask the SEC, first, to set the clear requirements 
as far as possible and to the foreign rating agencies, I think 
that such a barrier or such a standard or such a requirement 
should be lowered, taking into consideration the avoidance of 
such a catch-22 problem.
    Thank you.
    Mr. Green. Senator, the hurdle is too high, but it does not 
mean the hurdle should be low. The fact is you can broaden the 
number of participant designated rating agencies and not 
necessarily--and not at all--lower the quality of the rating 
because there are lots of rating agencies that have particular 
specialties, particular markets that they have expertise in, 
that the currently ``widely accepted,'' as you correctly 
stated, just sets too high of a burden.
    If you step back from the ``widely accepted'' but still 
maintain the quality, because it is all about credibility, I 
think you could have many more participants in the marketplace, 
and that is particularly important now as these markets have 
become global, and the four designees right now all come from 
North America. And as the markets grow in Europe and Asia, it 
is not necessarily the most healthy situation. So, I think they 
can do a better job.
    Senator Stabenow. Yes, thank you.
    Mr. Egan. We have no problem with the SEC's national 
recognition. In fact, there is a firm that was recognized in 
the past year, year and a half, DBRS. It is a Canadian firm. 
There are independent surveys done. We have about three times 
recognition of that firm as of about 2 years ago, and it has 
grown since then. So we do not have a problem with that issue.
    We have had an application in, now I guess it will be 7 
years--I guess we are on the fast track--8 years this August 
with the SEC, and the hang-up appears to be the SEC looking at 
our staffing and saying it is not large enough.
    Now, keep in mind we are early and right with Enron, 
WorldCom, Global Crossing, and Genuity. We have to take issue 
with the process that the SEC is using for evaluating it. It is 
hard not to conclude that the ultimate objective might be 
maintaining the status quo, which is fantastic for the existing 
firms.
    Senator Stabenow. So from your perspective there is not a 
catch-22. Is that what you are saying?
    Mr. Egan. No, it is not. But even if we were recognized--
and hopefully we eventually will be recognized. I think the 
market is really being mis-served by not recognizing firms like 
ours, others that are early and right with these ratings, that 
is not going to solve the problem. The problem is the 
fundamental conflicts of interest.
    There were seven firms, seven NRSRO firms 10 years ago or 
so. You still have the problems of the fundamental conflict of 
interest. What happens is that there is a separation between 
the interests of the country, in terms of enabling these 
companies to grow, encouraging jobs, reducing costs of capital, 
and a few bad apples, the Bernie Ebbers of the world who had 
$400 million positioned with WorldCom. He wanted to do 
everything possible to keep that company afloat. And the rating 
firms that were paid millions of dollars, too, would give him 
the benefit of the doubt. That is the problem. And by the time 
it comes to light, you have no alternatives.
    Enron might have been able to be saved, it really could 
have, if the problems came to light a year or 2 years earlier. 
You know, we rated it and we downgraded the company. But by the 
time S&P, Moody's, and Fitch cut it from investment grade to 
noninvestment grade, they had 4 days before filing for 
bankruptcy. Basically the bankruptcy attorneys were already in 
there drafting the papers. There had just one firm that they 
could deal with, and that is Dynergy. If that deal went away, 
there is nobody else. That is a real problem.
    It is like a child. If you have a child that has a speech 
impediment, you are better off taking that child to the speech 
therapist and getting them on the right track so they are not 
criticized in school. Or if you have a child that has a music 
talent. Give them the extra instruction, do it early. And it is 
not being done right now. And it is because of the SEC's 
approach to this industry which has had the effect of severe 
limits on competition.
    Ms. Corbet. Senator, to your original question, we also 
support--and I think what you have heard collectively across 
all the participants and more broadly throughout the market--
increased competition, and we believe we can get there through 
more transparency in the designation criteria and the process. 
And indeed, with rating agencies that either focus on specific 
areas or geographic areas, we think the opportunity for them to 
compete is potentially very good.
    Senator Stabenow. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    I wanted to go back to a point that Senator Sununu raised 
on GSE's, and then we will move on to a couple of other areas. 
But one of the specific points that I wanted to cover is this--
and I think, Ms. Corbet, you were the only one of the three 
rating agencies that responded to Senator Sununu's question. 
But in the past few months, all three of the major rating 
agencies placed Fannie Mae's subordinated debt and preferred 
stock on watches or outlooks, for possible downgrades. But yet 
all three rating agencies continued to reaffirm Fannie's AAA 
rating, AAA ratings with long-term debt with a stable outlook.
    Why is that? Is that because of the implied Government 
backing? Or why would that be the case if you would put them on 
a watch or an outlook but continue to list them as AAA credits? 
And you mentioned to some extent, Ms. Corbet, why Standard & 
Poor's would do this. But in light of the specific rating you 
have given them, explain, if the three of you would, why that 
would be the case. Would you do that with some other company? 
For example, Fannie Mae has a situation, which we all now know, 
of $9 billion of income restatement. I do not know if you 
consider that serious. I do.
    Ms. Corbet. Indeed.
    Senator Hagel. But yet you still have them as a AAA rating. 
Now, there may be justifiable reasons for that, but would you 
explain to this poor Senator?
    Ms. Corbet. Sure.
    Senator Hagel. Thank you.
    Ms. Corbet. Thank you, Senator. Indeed, after reviewing the 
situation involving the senior unsecured debt of the GSE's, 
indeed, we combined now both the financial strengths of the 
GSE's with the degree of confidence that we had in the 
Government support. Indeed, after going through our evaluation 
and the ratings process, the rating committee concluded that 
while it no longer had the highest degree, which it had 
earlier, it did have some degree of confidence that a 
combination of both the financial strength of the GSE's--and I 
would point out we do not--on a financial strength basis, we do 
not have them as AAA. We have them as AA minus, combined with 
the Government support or degree of confidence in the 
Government support, resulted in an affirmation of the ratings 
at AAA, and we hold that view today.
    Senator Hagel. So it just essentially meets the threshold, 
as you said, some degree of confidence.
    Ms. Corbet. Correct.
    Senator Hagel. So that merits AA minus.
    Ms. Corbet. On financial strength alone, we have published 
our opinion that the GSE's, Fannie Mae and Freddie Mac, would 
be AA minus for their senior unsecured debt.
    Senator Hagel. Thank you. Mr. McDaniel.
    Mr. McDaniel. It is very important to our thinking to 
consider the status of the GSE's and their relationship to the 
Government, their strategic position and role in housing 
finance policy, and those are critical supports to why we have 
a AAA rating on Fannie Mae and Freddie Mac and why that is a 
stable outlook from our perspective.
    Senator Hagel. A $9 billion income restatement does not 
trouble you that much?
    Mr. McDaniel. Not for the GSE's given, as I said, their 
Government-sponsored status and their strategic position in the 
housing market. That is correct.
    Senator Hagel. Thank you.
    Mr. Joynt.
    Mr. Joynt. Maybe I could just possibly read this short 
paragraph from one of the public releases we made, which I 
think addresses the issue:

    Importantly, the subordinated debt and preferred stock of 
Fannie and Freddie, respectively, are primarily based on their 
stand-alone financial profiles and prudent management of risks. 
Their AAA senior debt ratings reflect the benefits they receive 
from their GSE status, principally with access to capital 
markets and favorable pricing. Their GSE status is an extension 
of the role that Government has played in all areas of social 
interest, a role that Fitch believes will not be changed by the 
legislative and regulatory proposals under consideration.

    Senator Hagel. All right. Thank you.
    I would like to ask each of you very quickly the issue of 
transparency. Starting with you, Mr. McDaniel, in answer to 
Senator Stabenow's question about, I think you said, supporting 
greater transparency in the process. How are you doing that? 
Isn't it a reality that lack of transparency cuts to the 
credibility and the reliability of ratings organizations? What 
have you done, what are you doing? And why don't, for example, 
your agencies develop public--any methodology or how you get to 
where you are with these rating agencies? Can you start there 
and give us some brief answers? I know there are no brief 
answers, but if you could in the interest of time--and I would 
like to hear from all of you because I think the transparency 
issue is pretty critical here. And you said you think it is 
important for the process, but what are you doing?
    Mr. McDaniel. We certainly agree that lack of transparency 
undermines credibility and reliance on rating agencies. Among 
the things that we are doing, we publish and make available on 
our website all of our rating methodologies. We have rating 
methodologies for all industries and sectors that Moody's 
rates. We have added to our research specific commentary that 
says what will move the ratings up and what will move the 
ratings down.
    When we are considering changing methodologies, we are now 
publishing on a request for comment basis from the market our 
thinking about the reasons for the change and seeking the best 
information we can from the best thinkers in the marketplace 
about what would most inform a change in methodology before we 
are implementing that.
    I think those are probably three of the most important 
things we are undertaking. As I mentioned earlier, we have 
been, since 2003, publishing on a quarterly basis our ratings 
performance so that can be judged for accuracy and stability.
    Senator Hagel. Thank you. Mr. Kaitz.
    Mr. Kaitz. To the extent that Mr. McDaniel has laid out 
that they are looking at publishing methodologies, we commend 
that. That is something, I think, that we feel very important, 
especially those of us that are--we represent the issuers of 
debt, but we also feel this is something that the other rating 
agencies need to do as well as part of the process.
    Senator Hagel. Mr. Joynt.
    Mr. Joynt. I think that was a quote from a reporter, and 
actually I think that may not be representative of the market 
view. I think the market view is that rating agencies have been 
very transparent over time. We also have published our criteria 
on all areas of ratings consistently for 15 years. I am 
surprised by that comment. On individual company credits, 
individual securitizations, we put our information also on the 
Web, freely available, so I think we are actually quite 
transparent.
    Senator Hagel. Thank you. Mr. Harada.
    Mr. Harada. Yes, Senator, R&I also discloses almost all the 
criteria and the methodology at the website so that everybody 
can check and can read our methodology, and if such methodology 
might be changed, very soon we disclose such change, and we 
also disclose all of the outcomes of our rating performance. We 
disclose every material with which every outsider can check our 
rating performance.
    Senator Hagel. Thank you. Mr. Green.
    Mr. Green. Senator, the Bond Market Association completely 
supports transparency of the methodology and consistent 
application of that methodology, as well as communicating as 
quickly as possible any changes in the methodology, keeping in 
mind, though, that we also need to make sure that there is 
enough flexibility for rating agencies to adapt to differing 
markets and new products as quickly as possible, too. But 
transparency is very, very important to the marketplace.
    Senator Hagel. Thank you. Mr. Egan.
    Mr. Egan. We provide issuers with the supporting materials 
for our ratings. Typically, we get a lot of grief from those 
issuers where we are different, significantly lower than the 
other rating firms. That is normally not the case. In fact, we 
have been more bullish than the other rating firms for the past 
2\1/2\ years or so. But they will take issue with the ratings 
we assign. We give them what our projections are and explain 
why we assume these different things. They offer to provide us 
with inside information. We say we do not want that, in 
contrast to the other rating firms. We want it to be released 
to the market, and then they can give it to us. So we provide 
all the support that they need on how we base our ratings 
decisions.
    Senator Hagel. Thank you. Ms. Corbet.
    Ms. Corbet. Transparency is critical. We publish our 
ratings methodology, our criteria, our default and transition 
studies, and we also publish any changes in methodology.
    Senator Hagel. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. I have a 
statement for the record which I would like to submit. That 
statement deals with opaque or transparent issues, barriers to 
entry, lack of oversight on the SEC, which I will follow on in 
a question, and also potential conflicts. I am also just a 
little worried about asking tough questions. If you ever show 
up as someone who is responsible for asking for a rating, you 
might get in trouble with these guys. The conflict works both 
ways.
    The questions I have are really three parts, and different 
ones of you will work. First of all, I think it is the 
Investment Company Act that is the governing statute with 
regard to oversight of the rating agencies. Is that how you all 
understand it? Is there any pattern, regular or random, of the 
SEC or other regulatory authorities ever coming in and checking 
the kinds of questions that one might ask about whether your 
ratings actually match up or you are actually following through 
on the calculations that you make? Is there any outside 
observer to the processes that go on?
    The second question I have, really on an entirely different 
issue but an important one, I would love to have people's 
written responses if they do not have time to answer here. Do 
any of you believe that requiring stock options to be expensed 
is a sound policy and one that allows you to have a sense of 
the underlying economic fundamentals of a company? Or are you 
handicapped if that were not the case? I would love to hear 
your views on that.
    And third, I have a particularly parochial question. A 
number of you--S&P, Moody's, and Fitch--I believe all decided 
to opine on New Jersey's Homeownership or Predatory Lending Act 
that was implemented, signed into law in May 2003, and I just 
want to clarify that after some toing-and-froing that you all 
think this is an act which is not inhibiting markets and it is 
on sound footing. I would be more than happy to accept that in 
written form, but I want to make it clear there continues to be 
a debate in my State about whether the Predatory Lending Act is 
too far reaching, somehow handicapping mortgage markets. And I 
think you all, either in public writing or other, have said 
that you are satisfied with where the law is, but I would like 
to hear it.
    So, first of all, I will go through and ask on the 
oversight process, because I think it is the most general of 
the questions about who is watching whom and is there any check 
and balance to the rating agency activity. Is the SEC doing its 
job? Stock option expensing. And then the predatory lending 
issue, if you have time. I will start with Mr. McDaniel.
    Mr. McDaniel. Thank you, Senator. To answer your first 
question, yes, Moody's does file under the Investment Adviser 
Act. We are periodically inspected by the Securities and 
Exchange Commission.
    Senator Corzine. When is the last time?
    Mr. McDaniel. The last time was approximately 18 to 24 
months ago.
    Senator Corzine. Not since the WorldCom and Enron scandals?
    Mr. McDaniel. Yes, it was following Enron, and I think it 
was following WorldCom, but I would have to come back to you 
with a specific date.
    With respect to expensing stock options, Moody's 
Corporation, the parent of Moody's, does expense stock options.
    Senator Corzine. I would like to know, by the way, when the 
previous review by the SEC was.
    Mr. McDaniel. I will have to make that available to you. I 
do not know when the prior inspection before that was. As I 
said, Moody's Corporation does expense stock options.
    In terms of whether the expensing impairs our ability to 
conduct credit analysis, I think the question is really not 
whether the options are expensed per se, but whether there is 
enough information for us to evaluate the cost of the stock 
options in a company that we are looking at from a credit 
rating perspective. So as long as there is sufficient 
disclosure to be able to work back to what the costs are, we 
are able to work with that.
    Senator Corzine. I take it you think there are real costs.
    Mr. McDaniel. Yes, we do. Because I am not an expert on the 
Predatory Lending Act, I would request that Moody's submit 
information to you in writing on that.
    Mr. Kaitz. Sir, I can give you an opinion on the first 
question on the oversight of the rating agencies. Our testimony 
is pretty clear on this. We believe it is wholly inadequate. It 
has been 10 years since the SEC has taken any action, and it is 
time for them to do something. So we hope that this hearing is 
the start of the Senate taking some firm action, to get the SEC 
to act on oversight of the rating agencies.
    On the other two issues I have no opinion.
    Mr. Joynt. On the first question, I do not believe there is 
another regulatory body that would come in and inspect us in 
any kind of way, at least not in the United States. However, we 
have frequent contact with people that use our ratings, like 
the Federal Reserve and the FDIC, where they expect us to come 
present to them and talk to them about how we run our business 
and also, of course, our opinion on many important issues to 
them. Outside of the regulatory framework, we would do the same 
thing in the United States and everywhere with important 
institutional investors. So, I think there is a lot of public 
market scrutiny of us, if it is not directly a regulatory 
response. And then, of course, internationally, more 
international regulators have become involved in meeting with 
the rating agencies, in the United Kingdom the FSA and in 
France, their regulatory body as well, and others, as a part of 
the IOSCO process, the securities regulatory process, CESR 
process that was mentioned earlier, and then individually as 
well.
    Senator Corzine. When is the last time you have had an SEC 
review?
    Mr. Joynt. I do not have that information, but I will be 
happy to provide it to you.
    Senator Corzine. Actually, the last two would be 
interesting.
    Mr. Joynt. No problem.
    Senator Corzine. Thank you.
    Mr. Joynt. Again, I am not an expert on the predatory 
lending either, and I would be happy to provide written answers 
on both the other questions.
    Senator Corzine. Thank you.
    Mr. Harada. As a foreign rating agency, R&I is registered 
with SEC as an investment adviser pursuant to the Investment 
Advisers Act of 1940, and, if we have a very substantial change 
of the corporate structure, we will make a report to the SEC 
under the requirements of the Investment Advisers Act. And 
apart from such kind of contact with the SEC, as the Japanese 
rating agency we have very close contact with FSA in Japan with 
regard to the IOSCO Code of Conduct Fundamentals, and the 
recent Basel II for the capital adequacy requirements as well.
    Mr. Green. Senator, I think the oversight of the credit 
rating agency process is the credibility of the report itself. 
What is being bought by either issuer or investor or dealer is 
the credibility of the particular rating agency, and that is 
one reason why we are calling for greater competition in 
opening up the designation so that there is more competition, 
and that will ensure that the marketplace is measuring the 
credibility in a more competitive environment.
    We also do believe that transparency of the historical 
record of the rating agencies is very important to that 
process. On stock options, the Bond Market Association, I do 
not believe, would necessarily have an opinion, but on the 
predatory lending issues, there is no question that we have an 
opinion. We oppose predatory lending, but we have opposed the 
concept of assigning liability, which creates uncertainty in 
the securitization process around certain noninvestment grade 
lending that goes on across the country. And we believe very 
strongly that clarity of the liability is very important for 
underwriters to be able to accept the liability that they are 
willing and knowledgeable of accepting, and that has entered 
into the credit rating agency process when various States, and 
in certain cases localities, have passed various ordinances and 
statutes that have created uncertainty in that market process. 
We have testified both, I think, before this Committee and 
certainly before the House Committee as well on the issue of 
providing some kind of national standard so that we can deal 
with the predatory lending issue without creating these 
uncertainties in the marketplace leading to rating agencies not 
giving ratings in certain high-cost-loan situations, which I 
believe is the case in New Jersey. So it would be our hope that 
we could work with this Committee in trying to adopt some 
standard that helps deal with this issue.
    Senator Corzine. Mr. Green, I believe that my point was 
that I think the law was modified to deal with the assignee, 
not to the perfection of everybody's wants but in a way that 
the rating agencies were comfortable. And that is what I want 
to get on record, because it does set a pattern that we can 
discuss when we deal with it on a national level, if that were, 
in fact, the case.
    Mr. Egan. We are not a registered investment adviser. We 
have advised the SEC that if we are awarded the NRSRO 
designation--also, we think of it as the ``no room/standing 
room only.'' That is the only way I can remember it quickly. 
But we would register.
    We do, however, have some outside observers regarding the 
quality and timeliness of our ratings. In fact, there have been 
two recent independent studies. One was conducted by the Kansas 
City Federal Reserve Board, and I quote from it: ``Overall''--
and they wanted to know is there stickiness at the investment 
grade versus noninvestment grade level, and they said, 
``Overall, it is robustly the case that S&P regrades from BBB 
minus''--which is the lowest rung of investment grade--``moved 
in the direction of EJR's earlier ratings. It appears more 
likely that this result reflects systematic differences between 
the two firms' rating policies than the number of lucky guesses 
by Egan-Jones Ratings.''
    And then there is another study, a joint one by Stanford 
and the University of Michigan. This is in my written 
testimony. ``We believe our results make a strong case that the 
noncertified agency''--Egan-Jones--``is the leader, and the 
certified agency''--Moody's--``is the laggard.'' We have huge 
competitive pressures on us. S&P, Moody's, after they failed 
with Enron and WorldCom, Moody's operating income over the last 
4 years has grown about 250 percent. They do not have the 
pressures. We do, and we have to get to the truth quickly, and 
it shows it with these independent studies.
    Your other question--expensing stock options, we do not 
care. We can handle it either way. We are sophisticated enough 
to deal with it, and I do not have a comment on the predatory 
lending practices.
    Ms. Corbet. Senator, to your original questions as well, we 
are governed by the Investment Advisers Act, and the last SEC 
inspection was in 2002, but it was post-Enron, and we will get 
back to you as the previous review. That said, we often talk to 
the SEC about our policies and procedures and subjects covered 
by any and all inspections.
    On the point regarding stock options, we do view them as 
costs, and they are taken into consideration in terms of our 
credit analysis.
    And, finally, we, too, would be willing to submit a written 
form of our view on predatory lending and particularly the New 
Jersey statute.
    Senator Sarbanes. [Presiding.] I think we have two Members 
who have not yet had a first round.
    Senator Bunning. That is correct.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, Mr. Ranking 
Member--Mr. Acting Chairman.
    [Laughter.]
    Senator Sarbanes. Do not get carried away.
    Senator Schumer. I hope soon we will strike that ``acting'' 
and get rid of the adjective.
    Anyway, I want to thank everyone for their testimony. I 
just want to make a brief statement and then ask a few 
questions.
    I appreciate the opportunity to examine the credit ratings 
industry. I think that is a good idea. Many of the companies we 
are talking about have been around for close to a century. They 
provide a vital service to our capital markets by sharing their 
opinions on the credit worthiness of a particular company or 
the risk of default on a security. These companies aid small 
and large investors alike in making informed decisions to 
better serve individual investment needs.
    I understand that some concerns have been raised regarding 
the transparency surrounding the ratings process and the 
information that rating agencies make available to issuers and 
the public at-large. I have always believed in transparency and 
disclosure. These elements are fundamental to every industry, 
and so I am joining others here in encouraging the SEC to 
develop an oversight regime that clarifies the steps needed to 
be taken to provide greater transparency, but I do believe this 
must be done with a level of care to ensure that the 
responsible regulatory policies are put in place.
    While I do support regulation, I have to be clear I do not 
support the SEC altering the business model or the rating 
products that these companies utilize. The regulation of these 
entities should not mean dictating the content of their 
businesses. Credit rating agencies serve a special purpose to 
the capital markets, providing relevant information in the form 
of opinions to contribute to fair and efficient markets.
    Looking at regulatory policies, as we do that, it is 
important to remember that these companies are just, you know, 
these companies do just that--give their opinions. I strongly 
oppose an oversight structure that would allow market 
participants to sue in the event that they disagree with the 
ratings or a company fails to live up to that rating. I think 
that would be a mistake.
    I will end here. I look forward to hearing the SEC's plans 
for the credit rating agencies. I hope they will move more 
quickly than they have so far. And while I have not had a 
chance to speak at length about the issue of competition, I am 
also interested in how the SEC plans to encourage more 
competition in an industry that provides an important service 
to our capital markets.
    My first question is for you, Mr. McDaniel. You stated in 
your testimony, as high-profile corporate frauds in recent 
years have demonstrated, if issuers abandon the principle of 
transparency, truthfulness, and completeness in disclosure, 
neither rating agencies nor any other market participants, 
including regulatory authorities, can properly fulfill their 
roles.
    I agree with you, obviously. I have always believed 
disclosure is vital to any industry's success. In light of the 
recent corporate scandals, from Enron to WorldCom, we have seen 
the firsthand dangers of nondisclosure. What specific steps has 
your company taken to improve the quality of information you 
receive from companies in order to conduct responsible rating 
analysis. Obviously, some of these companies sent you false 
information. I do not blame you for that. That is really not 
ultimately your job, but what are you doing to assure that that 
does not happen again?
    Mr. McDaniel. Thank you, Senator.
    The most critical action we have taken in the post-Enron 
environment, in order to try and better vet the information 
that we are receiving from companies, is what we call our 
Enhanced Analysis Initiative. We have hired over 40 specialists 
in, accounting financial disclosure, off-balance sheet risk 
transference, and corporate governance, who do not have 
separate rating responsibilities for companies. Their job is to 
sit alongside our credit-rating analysts in meetings with the 
companies, and outside of meetings with the companies and 
provide their particular expertise to demonstrate and find 
better insight into the information we are receiving to ask 
more probing questions about the information we are receiving 
and, as a result of that process, hopefully, to find more 
vulner-
abilities in the information we are receiving.
    Senator Schumer. Would you like to answer that, Ms. Corbet?
    Ms. Corbet. Sure, Senator. Thank you.
    As well, Standard & Poor's has also expanded a number of 
initiatives, in terms of analytical information. They include 
additional specialized forensic accounting expertise, which 
includes new chief accountants in both the United States and in 
Europe.
    Also, we have, at the request of investors, expanded our 
liquidity analysis and our recovery assessment and have 
published it in our ratings analyses.
    We have, also, enhanced the use of quantitative tools and 
models in both the ratings and the surveillance process, and we 
have increased our commentary on issuers and industry sectors.
    Senator Schumer. Mr. Joynt.
    Mr. Joynt. We, also, have hired additional expertise, and 
centralized in our credit policy and credit research area, a 
function that allows us to look across all the analytical areas 
and make sure that we are consistently seeking all the best-
quality information.
    I think there are two parts to the information. One is 
publicly disclosed information. We have been encouraging deeper 
and wider public disclosure of information. And the other is 
our own ability to go in and meet with companies and collect 
information on our own. So we have materially strengthened our 
training from the top to the bottom of the analytical 
organization, so that when we have the ability to go interview 
companies, we can screen and interview better than ever.
    Senator Schumer. Next question. Mr. McDaniel, there has 
been some talk here about what happened with MCI.
    Senator Sarbanes. Why do we not take that question----
    Senator Schumer. I do not mind waiting. Jim has been 
waiting.
    Senator Bunning. Fine. I have been waiting a while.
    Just so there is no misunderstanding about the question I 
was asking, I am going to ask all of you to respond in writing.
    Do any of your company's officers or employees sit on any 
corporate boards or Government boards or agencies like the 
NASD, like the New York Stock Exchange, like Nasdaq, like the 
SEC? And I would like that information for the past 20 years.
    Senator Sarbanes. Do you include directors within the 
phraseology of officers and employees?
    Senator Bunning. Officers and directors.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. [Presiding.] I have a few questions. Ms. 
Corbet and Mr. Joynt, I will direct it to you, and then anybody 
else can comment if you want to.
    Recent press accounts have detailed the practice of rating 
agencies providing unsolicited ratings to issuers. The ratings 
agency will issue an opinion based on publicly available 
information, such as SEC filings, without talking to the issuer 
or reviewing relevant confidential information. If a ratings 
company can issue an opinion without the issuer's permission 
and cooperation, then what is the incentive for an issuer to 
pay for a rating? How does an unsolicited rating benefit 
investors if it is not based on complete information?
    Ms. Corbet.
    Ms. Corbet. Thank you, Senator.
    Indeed, as a publisher of information, we will rate and 
issue, without request, if really two factors; the first, if 
there is meaningful market interest, and this largely depends 
on----
    Chairman Shelby. And how do you define that.
    Ms. Corbet. This largely is defined on terms of size and 
significance of the issue.
    Second, if there is adequate public disclosure to support 
the initial analysis and then the ongoing surveillance. Just to 
qualify, it does not necessarily mean that there is not 
communication with the issuer or discussion with the issuer. We 
do believe that the market benefits from our objective opinions 
even if we are not paid. And we will always indicate in our 
credit opinions when a rating is unsolicited.
    Typically, in developed markets, where ratings are well-
accepted, unsolicited ratings are a very small percentage of 
the overall business, but entry into new markets and new asset 
classes largely start with unsolicited ratings.
    Chairman Shelby. Mr. Joynt.
    Mr. Joynt. We have had a program of initiating Fitch-
initiated ratings, also, for issuers or issues we feel have 
significant interest to the investor community broadly or 
investors that are interested in Fitch's opinion.
    I think regarding the quality of the rating, we can rely on 
the public disclosure as being adequate for a reasonably 
knowledgeable bond rating agency to reach a good conclusion in 
almost all situations. So, if we did not feel like we had 
enough public information to be able to arrive at what we 
thought was a reasonable rating conclusion, we would not issue 
or initiate a rating.
    It is true that we feel there is significant benefit from 
meeting with management. We call management and ask to meet 
with them, but it is not required to meet with management nor 
to reach a reasoned conclusion.
    Chairman Shelby. But your information would be incomplete.
    Mr. Joynt. Pardon me?
    Chairman Shelby. Your information would not be complete, 
would it?
    Mr. Joynt. I think, if the public disclosure of information 
companies in the United States that we expect investors to be 
able to make their own conclusions based on that being adequate 
disclosure, I would think that we would be knowledgeable enough 
to reach a reasonable conclusion.
    Chairman Shelby. Mr. Egan.
    Mr. Egan. This is a very subtle area, and it is important 
that it be understood properly.
    Chairman Shelby. Lay it out, then. Take your time.
    Mr. Egan. I will not hesitate. None of our ratings are 
solicited. We do not get paid by the issuers. They do not come 
in and solicit it, and we do not want to get paid. They have 
offered to pay us, and we say, no, we do not want any payment 
from issuers. Again, that is a conflict of interest.
    And so we rely on public information. Companies offer to 
provide us with nonpublic information, but there are two 
problems with that: Number one, it does not help us in getting 
to the rating on a timely, accurate basis and, number two, it 
increases our liability; that is, we worry about how that 
information is used. In the case of the auto companies, they 
said we will give you the whole slew of nonpublic information, 
and we said, no, make it public and give it to us, and we would 
be happy to review it. So that is one aspect.
    The second aspect is, with the firms that get most of their 
compensation from issuers which is S&P, Moody's, Fitch, and 
DBRS, we have some real problems with their approach to this 
area. And it was detailed in a November 24 article in The 
Washington Post. I refer to this as the ``hobnail boots'' 
approach to marketing. It goes through how, in the case of 
Hannover Re, Moody's was not paid by Hannover Re. S&P was paid. 
And Moody's went to Hannover Re and said, ``We are going to 
rate you. You do not have to pay us, initially, but we would 
appreciate it if you did.''
    And Hannover Re said, ``No, we do not have any need for it 
at all. Moody's rated them.''
    And they went back another 6 months later.
    Chairman Shelby. Did they get a good rating?
    Mr. Egan. They got an okay rating. It was one notch below 
S&P, but it did not stay there. They went back 6 months later, 
``Please pay us,'' and Moody's took a negative action. They 
went back another 6 months later and said, ``Well, we have new 
people. Please pay us again.'' They did not get paid. They took 
another negative action, and another negative action, and 
another negative action all the way to the point where they are 
noninvestment grade. This is Hannover Re. They are still rated 
at investment grade by S&P.
    Finally, Hannover Re said, ``This is absolutely ridiculous. 
It is hurting our stock price, and so we will pay you 
Moody's.''
    Chairman Shelby. Did the rating improve after they paid 
them?
    Mr. Egan. I think they put it on positive outlook and I 
think they are heading up.
    Senator Schumer. So it improved.
    Mr. Egan. It improved, and nothing else major had happened 
in the meantime. And I am sure, if you speak to the analysts, 
they will say, well, four things happened here, there and 
there, but the reality is nothing really happened. So, I refer 
to it as the ``hobnail boots'' approach because, again, there 
is no place else to go. S&P and Moody's have incredible 
influence in the marketplace, and they are using this 
unsolicited rating process to extend their monopoly. It is 
different in our case or in other firm's cases that are not 
paid by the issuer.
    So, when you are handling this issue, be careful how it is 
applied. In the case where the companies are regularly getting 
paid by the issuer, they will abuse it.
    There is another case where they abused it, where they had 
a rating, and this is in the case of Allied Signal. Allied 
Signal acquired a company, Grimes Aerospace. It had a rating, 
but Allied Signal wanted to buy in those bonds cheaply, and so 
it asked the rating firms to withdraw the rating on Grimes, so 
that they could buy the bonds more cheaply. That is if there is 
not a rating, there were a number of institutions that cannot 
hold it. We rated it to help out those investors, but we do not 
have the market power of S&P and Moody's. So the corporation 
was able to buy the bonds more cheaply than they would have. So 
it is amazing the steps that they go through to enhance their 
business position.
    Chairman Shelby. Mr. Harada, do you want to come in here?
    Mr. McDaniel. Mr. Chairman.
    Chairman Shelby. Just a minute. I will get to you.
    Mr. Harada. As far as the rating of R&I is concerned, in 
principle, we do not to carry out any unsolicited rating. In 
principle, we are now conducting solicited rating.
    But there is same possibility that we might conduct some 
unsolicited ratings. Because, if there is some very influential 
issuers that exist, and also they disclose very substantial 
degree of information, and if the investors have strongly asked 
us to rate this very big corporation in that case, although it 
is a very much exceptional case, we might carry out such an 
unsolicited rating, but we have not yet such concrete example 
at this moment.
    Chairman Shelby. Thank you.
    Mr. McDaniel, you wanted to comment.
    Mr. McDaniel. Yes, Mr. Chairman. I just wanted to point out 
that the information that was just communicated with respect to 
Hannover Re was not accurate, and I think that the Committee 
should be aware of that.
    Chairman Shelby. Corrected. Corrected.
    Mr. McDaniel. We had a solicited rating relationship, a 
paid relationship with Hannover since 1999. We did not 
downgrade any of Hannover's debt until 2001, and there was 
never any linkage between paying and the maintenance of ratings 
at any level. That would be a violation of our ethics. It would 
be subject to severe sanction, in my opinion dismissal, of any 
individual who did that.
    Senator Sarbanes. Was your rating of Hannover, the initial 
rating solicited or unsolicited?
    Mr. McDaniel. The initial rating was unsolicited.
    Senator Sarbanes. And when was that?
    Mr. McDaniel. In 1998.
    Senator Sarbanes. So you started rating them on an 
unsolicited, unpaid basis; is that correct?
    Mr. McDaniel. They received a financial strength rating on 
an unsolicited, unpaid basis in 1998. They decided, through 
Hannover Finance, to access the bond markets, in 1999, and 
approached Moody's for a rating, which we gave.
    Senator Sarbanes. And they paid.
    Mr. McDaniel. Yes.
    Senator Schumer. Wait. Let me just make that clear, if I 
might.
    Chairman Shelby. If I could, let Mr. Kaitz, and then I will 
call on you, Senator.
    Mr. Kaitz. Obviously, they have to answer these questions, 
but this is clearly an issue that needs to be addressed by the 
SEC. You only have three rating agencies.
    They have no place else to go. We represent the issuers. 
The reason I am testifying here today, as the President and 
CEO, is because there is not anyone in our organization who is 
going to get up here and testify and be concerned about what is 
going to happen to their bond rating. I mean, this is a serious 
issue here that has to be addressed. We need transparency. When 
these are unsolicited ratings, the public needs to know they 
are unsolicited ratings because they only have access to public 
information.
    So there are a lot of issues involved here where, 
hopefully, either the Senate is going to get involved or the 
SEC really has to clarify this issue.
    Chairman Shelby. Senator Schumer.
    Senator Schumer. What Mr. Egan said is very serious. So, 
what you are saying is you gave an unsolicited rating in 1998. 
They then paid you in 1999.
    Mr. McDaniel. For a different bond rating.
    Senator Schumer. Bond rating.
    Mr. McDaniel. They had a financial strength rating in 1998.
    Senator Schumer. And your rating went down after they paid 
you, not up.
    Mr. McDaniel. In 2001, that is correct.
    Senator Schumer. So are you alleging that----
    Mr. Egan. The article----
    Senator Schumer. Wait. Let me just ask the question because 
this is serious stuff, and it is easy to throw it around. You 
are a competitor of theirs.
    Mr. Egan. Right.
    Senator Schumer. And you want to break into the big leagues 
and so let us make sure----
    Mr. Egan. We are already there.
    Senator Schumer. Okay. You want to break into the bigger 
leagues.
    [Laughter.]
    Again, this is serious.
    Mr. Egan. Right.
    Senator Schumer. Are you alleging that they change the 
rating based on whether they were paid or not?
    Mr. Egan. I am referring to a November 24, 2004, article--
--
    Senator Schumer. I am not asking what The Washington Post 
wrote, okay? I am asking because we all deal with reporters all 
the time.
    Senator Sarbanes. Especially Senator Schumer.
    Senator Schumer. Especially me, exactly.
    [Laughter.]
    Senator Sarbanes. I could not resist that.
    Senator Schumer. I am serious here. I am happy to deal with 
reporters. I want to know are you, Mr. Egan--you did not 
mention The Washington Post article----
    Mr. Egan. I certainly did.
    Senator Schumer. When you gave your little peroration here 
about this company----
    Mr. Egan. You can check the record. I did say the November 
24 article of The Washington Post. I have a copy of the article 
right here.
    Senator Schumer. Yes, I have it in front of me, too.
    Mr. Egan. We were not directly involved in Hannover Re.
    Senator Schumer. Right.
    Mr. Egan. We were directly involved in Allied Signal and 
Grimes----
    Senator Schumer. I did not ask that. I am asking you, in 
Hannover Re, are you alleging that the payments that were made 
affected the rating, are you, Mr. Egan, of a competitive 
company?
    Mr. Egan. I am referring to----
    Senator Schumer. I did not ask what you are referring. I 
asked are you alleging that? You are a rater. You know these 
things. You have a pretty sharp view of this, and I understand 
that. That is capitalism.
    Mr. Egan. Right.
    Senator Schumer. But I am asking you are you alleging that 
the payments affected their ratings, yes or no?
    Mr. Egan. I will respond in this way. We were not involved 
in Hannover Re. When I started, when I raised this issue, I 
referred to The Washington Post. I can say that there have been 
many instances where it is hard to draw the conclusion that the 
payments do not affect the rating.
    The latest example of this was a--well, there are constant 
examples of it, and you do not have to follow the market for 
very long.
    Senator Schumer. But I listened to you, and it seemed to me 
pretty clear that you were saying this happened, this happened, 
and you were implying that there was a relationship. That was 
my sitting here. I heard your whole statement.
    Mr. Egan. It is hard to draw anything else.
    Senator Schumer. But now you are not saying that there was 
a relationship.
    Senator Sarbanes. You do not know.
    Senator Schumer. You are saying you do not know. That is 
right.
    Mr. Egan. No. It would be difficult to draw any other 
conclusion, when they were not paid, and then all of a sudden 
they were paid, they were not paid, and they took a series of 
negative actions, and the other rating agency did not take the 
negative action, that there is a high probability that the 
payment had something to do with it. And I was referring to The 
Washington Post article.
    Now, there have been other instances where it is difficult 
to draw the conclusion, when they are getting paid millions of 
dollars for ratings, they delay in taking an action, that that 
does not have some impact, despite all the Chinese Walls and 
everything else.
    In fact, in the case of the equity research analyst, that 
was the core issue, that they were getting paid via investment 
banking fees, was it Citigroup and Salomon Brothers were 
getting paid, via investment banking fees, for a much more 
bullish opinion than what they truly believed. That is the core 
issue here.
    Senator Schumer. Yes, it is the core issue, and the bottom 
line is you are saying you have no proof of it. You just think 
it might occur; is that fair to say?
    Mr. Egan. It would be hard to draw any other conclusion 
based on the evidence.
    Senator Schumer. Do you agree with that, Ms. Corbet, about 
what Moody's did on----
    Mr. Egan. No one else will who is getting paid on the other 
side.
    Senator Schumer. Yes, okay.
    Go ahead. Do you agree?
    Ms. Corbet. No, I do not agree.
    Senator Schumer. Could you explain that.
    Ms. Corbet. Well, I think Mr. McDaniel outlined 
specifically that rating downgrades actually happened after 
they were paid.
    Senator Schumer. After they were paid, yes. I do not get 
it.
    Mr. Egan. I referred to the article, and it suggests that 
it was not getting paid after. You, also, have to be careful 
about what rating is paid----
    Senator Schumer. Mr. McDaniel, were you paid in 1999 by 
this company?
    Mr. McDaniel. Yes, we were paid for the bond rating.
    Senator Schumer. And did you then lower their rating on 
whatever it was after that?
    Mr. McDaniel. Let me be as clear as I can. We had two 
ratings outstanding, a financial strength rating and a bond 
rating. The financial strength rating was initially assigned on 
an unsolicited basis and remained an unsolicited rating. The 
bond rating was assigned on a solicited basis or a requested 
basis, and both ratings continue to be outstanding, both 
ratings were downgraded in 2001.
    Senator Schumer. So why did you not mention that, Mr. Egan?
    Mr. Egan. I was referring to----
    Senator Schumer. When you went through your little litany, 
you did not mention that the same company, after they were 
paid, downgraded the rating. You said they upgraded it after 
they were paid probably later, right, in 2003 or something?
    Mr. Egan. This is an issue. Let me read from The Washington 
Post.

    So we told Moody's, ``Thank you very much for the offer. We 
really appreciate it. However, we do not see any added value,'' 
said Herbert Haas, Hannover's Chief Financial Officer at the 
time. As Haas recalled it, a Moody's official told them, if 
Hannover paid for a rating, it could have a positive impact on 
the grade.

    This is from The Washington Post.

    Haas, now Chief Financial Officer at Hannover's parent 
company, Talanx AG, laughed at the recollection. ``My first 
reaction was this is pure blackmail.'' Then, he concluded that, 
for Moody's, it is just business. S&P was already making 
headway in Germany and throughout Europe in rating the 
insurance business. Moody's was lagging behind and Haas thought 
Hannover represented a fast way for the credit rater to play 
catch-up. Within weeks, Moody's issued an unsolicited rating on 
Hannover, giving it a financial strength rating of Aa2, one 
notch below that given by S&P. Haas sighed with relief. Nowhere 
in the press release did Moody's mention that it did the rating 
without Hannover's cooperation, but Haas thought it could have 
been worse.
    Then, it got worse. In July 2000, Moody's dropped 
Hannover's rating outlook from stable to negative. About 6 
months later, Moody's downgraded a notch to Aa3. Meanwhile 
Moody's kept trying to sell Hannover its rating service. In the 
fall of 2001, Zeller, Hannover's Chairman, said he bumped into 
a Moody's official at an industry conference in Monte Carlo and 
arranged a meeting for the next day at the Cafe de Paris. 
There, the Moody's official pressed his case, pointing out that 
the analyst who had been covering Hannover, a man whom the 
insurer disliked, had left Moody's. Zeller still declined 
Moody's services.

    Senator Schumer. But they were paid by this company in 
2001. Is that not the point? You are going on after this, but 
they were paid at some point. They were not, I mean, do you 
want to respond, Mr. McDaniel?
    Mr. Egan. This article suggests that it was not paid.
    Senator Schumer. Let us get the truth.
    Mr. Egan. It has, ``Two months later--''
    Senator Schumer. Wait. Let us get the truth. Excuse me.
    Mr. Egan. ``Two months later, Moody's cut the insurer's 
ratings by two notches.''
    Senator Schumer. Excuse me. Let me just ask Mr. McDaniel.
    Chairman Shelby. Let us put the article in the record in 
its entirety.
    Senator Schumer. Yes. But I just want to give Mr. McDaniel, 
I mean----
    Mr. McDaniel. Perhaps the most constructive thing that 
Moody's can do, I should say, when we read this information in 
the Post, we were more concerned, I think, than anybody else 
because there were actions alleged in that article that were 
violations of our policies, practices, and ethics. I think that 
perhaps the most constructive thing we can do is to submit a 
written report of our investigation of that to the Committee, 
if you would find that helpful.
    Senator Sarbanes. That is a good idea.
    Chairman Shelby. That would be a good idea. If you do that, 
we will accept it.
    Senator Sarbanes. Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Let me just say, Mr. Egan, you, of your 
own knowledge, do not know about, I mean, you are just citing a 
story in the Post.
    Mr. Egan. Yes, and I said that at the beginning.
    Senator Sarbanes. All right. I think we should be clear 
about that.
    Mr. Egan. I am familiar with Allied.
    Senator Sarbanes. Yes, a different case.
    Mr. Egan. I was, personally, involved in Allied.
    Senator Sarbanes. Now, the Chairman has asked for the 
article to be put in the record, and I think, Mr. McDaniel, you 
should be able to put in whatever report you have----
    Chairman Shelby. Absolutely. Anything you want to put in, 
we will----
    Senator Sarbanes. --that deals with the record.
    Mr. McDaniel. We conducted an internal investigation, and I 
would be happy to make it available.
    Senator Schumer. I have just one question.
    Senator Sarbanes. That may lay out a different----
    Senator Schumer. Excuse me. And did the article--you have 
read it--did the article mention that they paid you, rather, in 
2001?
    Mr. McDaniel. No. While I do not recall the whole article, 
but I do not know what it said with respect to that.
    Senator Schumer. Did it, Mr. Egan? You are familiar with 
it.
    Senator Sarbanes. If we are going to pursue this, let us be 
clear about this. You were getting paid for one rating, but not 
getting paid for another rating; is that correct?
    Mr. McDaniel. That is correct, yes.
    Senator Sarbanes. That is right. And the rating that was 
downgraded was the rating you were not getting paid for?
    Mr. McDaniel. Both ratings were downgraded.
    Senator Sarbanes. Both ratings, all right.
    Mr. Kaitz, I want to put a question to you. You said 
earlier that if you drop the rating system, that would be the 
worst thing you could do. And I want you to elaborate on that. 
I take it what you mean by that is that those who have already 
the rating are so far ahead of the game that if the ratings 
were dropped, there would be no way anyone else could become a 
competitor; is that correct?
    Mr. Kaitz. Yes, Senator, that is correct because the 
ratings have been embedded in insurance regulation, mutual fund 
regulation, and potentially pension fund. So it is so embedded 
in regulated industries, if you did away with the designation, 
I think it would be a permanent barrier to competition for 
anyone to break into that market.
    Senator Sarbanes. And then the question is how would 
somebody else get into the competitive pool. At the moment, at 
least they have maybe a chance to get in the pool by being 
given the designation; is that correct?
    Mr. Kaitz. Yes.
    Senator Sarbanes. I take it that is what you are seeking, 
Mr. Harada; is that correct? Are you seeking that designation?
    Mr. Harada. Yes, we are seeking the designation.
    Senator Sarbanes. Yes, and you are seeking it, Mr. Egan.
    Mr. Egan. Yes, and we are also seeking that the industry be 
cleaned up, that the conflict of interest be addressed.
    Senator Sarbanes. Let me ask this question. I want to ask 
the people of the panel, anyone who wants to respond to this, 
do you think that the SEC has the power and the authority to 
regulate the rating agencies?
    Mr. Kaitz. Well, the SEC--I hesitate to quote anything from 
The Washington Post at this point----
    [Laughter.]
    Senator Schumer. They are sometimes right.
    Mr. Kaitz. Yes, I know. It makes me a little bit nervous, 
but it appears that they are saying, no.
    Senator Sarbanes. I want to ask the rating agencies whether 
they think the SEC has the authority to regulate them.
    Ms. Corbet.
    Ms. Corbet. In my view, I think they have the appropriate 
authority with respect to the NRSRO designations, but we have 
publicly said that we would like that designation criteria to 
be more transparent.
    We think that we are not in favor of any additional 
regulatory oversight that would increase the barriers to entry 
or to compromise the independence of the ratings process. 
Furthermore, we think that any further regulation might have 
the potential of encouraging standardization and deferring the 
diversity and innovation within the credit rating industry.
    Senator Sarbanes. So does that mean you think that they 
cannot take any measures that affect how you do your 
activities?
    Ms. Corbet. We think that what they currently have in terms 
of oversight in the NRSRO designation process is sufficient.
    Senator Sarbanes. Mr. Joynt, what do you think?
    Mr. Joynt. As a technical matter, I am not sure whether 
they have the authority, but we would be fully--and have been--
responsive to all requests for information, changes in our 
practices. We have had open discussion and dialogue with them.
    Senator Sarbanes. Mr. McDaniel.
    Mr. McDaniel. The Commission, I certainly believe, has the 
authority to define what a NRSRO is and to identify the 
standards that would accompany a NRSRO.
    As to the scope of authority in areas of the content of the 
work we do, I think that we would work as constructively as we 
can with the Commission.
    Senator Sarbanes. You think they have the authority to 
effect that?
    Mr. McDaniel. I am sorry, sir?
    Senator Sarbanes. Do you think they have the authority to, 
in effect, pass on those practices and establish standards for 
it?
    Mr. McDaniel. I believe that they do simply because the 
NRSRO designation is a SEC designation, and they determine who 
is one and who is not one.
    Senator Sarbanes. Was it only to determine who is a NRSRO 
or can they also affect the practices of an entity that has 
been so determined?
    Mr. McDaniel. Well, they could, as far as I understand, 
they could determine what the criteria are to be a NRSRO, and 
if a rating agency chose not to follow that criteria, it could 
be de-designated or delisted.
    Senator Sarbanes. No, I know. But the criteria to become 
designated may differ from overseeing the practices once you 
have been designated, otherwise it is a sweetheart deal for you 
all, is it not? You get designated. So now you get the special 
status conferred upon you by the SEC, a rather unique status.
    Mr. Kaitz says, well, we cannot drop the designation 
because, if you do that, the ones who have already been 
designated, it is all theirs. There is no way anyone can 
compete with them. So we have to keep the designation, which 
has given you a very privileged position, and I just want to 
make certain because I think the SEC needs to move in this 
area--I think there are some problems, and they need to address 
them--that we are then not going to run into the argument, by 
those who have been favored by the designation, who say, well, 
you cannot really address our practices. I mean, it would seem 
to me to almost follow logically that if they can give you this 
designation and establish this special status for you, that 
encompassed within that grant of a privileged position would be 
the authority to pass on your practices to assure that they are 
adhering to appropriate standards.
    Now, do you disagree with that?
    Mr. McDaniel. I think I would agree with Mr. Joynt that the 
matter of technical authority is one that I am probably not 
best positioned to opine on, but we would certainly work to 
adhere to standards that are promulgated. We have already 
publicly announced that we will adhere to the international 
standards promulgated by the International Organization of 
Securities Commissions.
    Senator Sarbanes. Do you think the Commission can inspect 
your agency in terms of your practices and what you are doing 
to be assured and to assure the public that they are proper, 
objective, and meeting all standards?
    Mr. McDaniel. They do inspect us. They have periodically in 
the past, yes.
    Mr. Joynt. Again, whether they have the technical 
authority, I do not know, but we are fully responsive to them, 
and we would be happy to have them----
    Senator Sarbanes. I just want to make sure that if the SEC 
moves with something, you are not going to then rise up and 
say, ``Oh, no. You do not have the power or authority to do 
that.'' That is what I am trying to ascertain here today.
    Now, I take it, Mr. McDaniel, you would not say that. You 
would say, well, they do have it.
    What would you say?
    Mr. Joynt. The only question that has come up regarding 
practices and outside influence for the rating agencies that I 
am aware of is managing or attempting to manage the content of 
the rating process itself, which we believe is a pretty 
important independent responsibility of ours. And so outside of 
that, other aspects of the process, and the number of 
employees, and the way they would conduct an inspection or they 
have so far, and all of the issues they have presented to us 
that we have been fully open to, I think I am comfortable with.
    Senator Sarbanes. Ms. Corbet.
    Ms. Corbet. We cannot opine in terms of what their specific 
legal counsel may have advised them as to whether or not they 
have authority, but, again, we are subject to inspections 
currently by the SEC, and we believe that the current NRSRO 
designation process, with the amendments that we support, is 
sufficient, in terms of regulatory oversight.
    Senator Sarbanes. We will see how this develops. We will 
have the SEC in here at some point, and we will proceed down 
the path. But, obviously, there are a number of problems, which 
you all have recognized here at the table.
    Senator Schumer. Mr. Chairman, I do have one more question.
    Chairman Shelby. Senator Schumer, go ahead.
    Senator Schumer. It is not related to, but I wanted to get 
your opinion. Since you are rating agencies and you give 
unsolicited opinions, I wanted to get your opinion on another 
issue, which is the Federal budget.
    The President released his fiscal year 2006 budget. It 
projects that the debt held by the public as a percentage of 
GDP will rise and then level off to about 39 percent in 2010. 
But this is a fundamentally misleading budget, in my judgment, 
because it leaves off major proposals that we know are going to 
be in there. Adding the President's Social Security proposal, 
permanent tax cuts, cost of the war in Iraq and Afghanistan 
will bring the debt held by the public to close to 50 percent 
of GDP by 2015, if not higher.
    So here is my question. Deficits are rising, debt is 
rising, yet according to the CBO Director, Mr. Holtz-Eakin, 
these deficits are structural, meaning we will not be able to 
grow our way out of them.
    If a private company were in the same situation as the 
Federal Government, with this greatly increasing debt, namely, 
exploding debt in the case of a private company as a share of 
sales, with no expected future revenue stream to pay back the 
debt, how would the leading credit agencies rate it?
    Chairman Shelby. I think that is a hypothetical question.
    Senator Schumer. It is.
    [Laughter.]
    Mr. Chairman, it is becoming less hypothetical.
    Chairman Shelby. I do not think they answer hypothetical 
questions--I hope not.
    Senator Schumer. Any rating agency want to make a comment 
on that?
    Chairman Shelby. I will answer it. It will be AAA graded.
    [Laughter.]
    Senator Schumer. Oh, yes. Well, then, Mr. Chairman, I would 
urge the SEC not to certify your firm to rate the agencies.
    Chairman Shelby. Well, I am going to be with the 
Government, like you.
    [Laughter.]
    Thank you, Senator.
    We will continue to examine the issues here that were 
raised this morning. We will hear, as Senator Sarbanes just 
said, we will hear from Chairman Donaldson, among others. 
Credit rating agencies, such as yours, play a very prominent 
role in the markets. And it is important, I think, that we 
fully understand the range of issues that confront you and the 
SEC here.
    A couple of things, observations brought up here today: 
Possible conflicts of interest--let us be honest with each 
other--lack of competition. I think those are two things that 
have to be explored further, but that will be another day, but 
we thank you for the hearing today.
    [Whereupon, at 12:41 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR JIM BUNNING

    Thank you, Mr. Chairman. I would like to welcome all of our 
witnesses here today. I applaud Chairman Shelby for holding this 
important hearing on the role of the Credit Rating Agencies in the 
Capital Markets.
     As you know, this is a issue I have been working on for some time. 
In the Sarbanes-Oxley legislation I inserted language to direct the SEC 
to study credit rating agencies. In light of the events that have 
happened over the course of the last few years, I think this is a very 
important and needs further examination.
     Credit ratings have become an important investor tool in the 
financial markets. The average American investor relies heavily on 
ratings that the four Nationally Recognized Statistical Credit 
Organizations (NRSCO's) make. NRSCO's have special access to the 
companies they deal with and they can have private conversations with 
companies' management that analysts cannot have. They can see financial 
information about companies that is not public, and SEC exempted them 
from the Regulation Fair Disclosure (FD). In short, they have insight 
into the financial well-being of a company average investors do not 
have. The markets expect you to anticipate what happens and to also 
warn people if something is producing a red flag.
     As we have seen, in the case of Enron and others, these extra 
advantages are not always enough for the NRSCO's to issue ratings that 
properly reflect a company's true investment value or credit 
worthiness. I know that NRSCO's rely heavily on the information that 
companies provide them. But, in light of the Enron fiasco, the NRSCO 
and the other credit rating agencies have a major obligation to look 
beyond what is given to them by any corporation. Also, the average 
investor has the right to know what procedures NRSCO's use to determine 
a credit rating. Right now, there is no transparency in the process. 
For all investors know, you could be pulling a rabbit out of a hat.
     I look forward to hearing from all of our witnesses and getting 
their opinions and expertise on the questions facing us.

                               ----------

             PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

    Mr. Chairman, thank you for holding this important hearing. I look 
forward to working with you on many such issues during the 109th 
Congress.
     The role of credit rating agencies in our Nation's economy can not 
be overstated. Like individuals, companies, cities, counties, and 
States rely on their credit worthiness to determine if they can borrow 
money and at what interest rate. If there are problems in the process 
used to determine creditworthiness, then we should address them. The 
matter is too important to be left to fester until a crisis occurs.
     The matter that most concerns me today is the possibility that 
conflict of interests may exist at the rating agencies--for instance, a 
rating analyst trading on confidential information or a rating agency 
senior executive sitting on a corporate management board.
     I am also concerned that rating agencies may be billing clients 
for work they do not perform. There are reports, for instance, that 
companies occasionally receive bills for ratings on upcoming equity and 
debt issues that they did not request. In the 1990's, there were cases 
in which Michigan school districts were billed for such unrequested 
ratings and while compared to corporate ratings these bills may be 
small, they represent a big problem to the school superintendent that 
is trying to find money in the budget to pay for text books. An 
unexpected bill of this sort trickles down to the taxpayer in the form 
of higher tax levies for repayment of school bonds. We clearly have an 
obligation to do what we can to make sure the system is working 
properly and that taxpayers and consumers are not taken advantage of.
     I look forward to hearing from our witnesses today, determining 
what problems exist, and how we can best address them.

                               ----------

                PREPARED STATEMENT OF KATHLEEN A. CORBET
                      President, Standard & Poor's
                            February 8, 2005

    Mr. Chairman, Members of the Committee, good morning. I am Kathleen 
A. Corbet, President of Standard & Poor's (S&P), a division of The 
McGraw-Hill Companies, Inc. On behalf of S&P and S&P Ratings Services, 
the S&P unit responsible for assigning and publishing credit ratings, I 
welcome the opportunity to appear at this hearing to discuss the 
important role of credit rating agencies in the capital markets. By way 
of background, I joined S&P as President almost one year ago. While I 
may be a new face at the table today, I have spent more than 20 years 
in investment management where I was responsible for fixed income 
research and bond portfolio management for institutional and mutual 
fund investors. Accordingly, my comments this morning are based on my 
perspective as S&P President, as a capital markets participant and as a 
former rating agency customer.
    Today, I would like to address five topics: (1) S&P Ratings 
Services' rigorous and market-tested ratings process, which is designed 
to ensure our ratings are objective, independent, transparent, and 
credible; (2) S&P Ratings Services' Code of Practices and Procedures 
which, along with other similar measures, addresses potential conflicts 
that may arise in the ratings process; (3) S&P Ratings Services' 
responses to recent corporate misconduct; (4) S&P Ratings Services' 
support for greater transparency in the Securities and Exchange 
Commission's (the Commission) NRSRO designation process and for 
reduction of barriers to entry in the credit rating industry; and (5) 
S&P Ratings Services' responsiveness to U.S. and international markets 
and regulators with respect to the ratings process.
Background on S&P Ratings Services and the Nature of Credit Ratings
    Before turning to these topics, I would first like to provide some 
background on S&P Ratings Services. S&P Ratings Services began its 
credit ratings activities almost 90 years ago, in 1916, and today is a 
global leader in the field of credit ratings and risk analysis, with 
credit rating opinions outstanding on approximately $30 trillion in 
debt representing 745,000 securities issued by roughly 42,000 obligors 
in more than 100 countries. S&P Ratings Services has established an 
excellent track record of providing the market with independent, 
objective, and rigorous analytical information in the form of credit 
rating opinions. A rating from S&P Ratings Services represents our 
opinion, as of a specific date, of the creditworthiness of either an 
obligor in general or a particular financial obligation. Unlike equity 
analysis, a credit rating opinion:

 is not recommendation to buy, sell, or hold a particular 
    security;
 is not a comment on the suitability of an investment for a 
    particular investor or group of investors;
 is not a personal recommendation to any particular user; and
 is not investment advice.

    More detail on the nature of our rating opinions is available on 
our website: www.standardandpoors.com.
    Credit ratings are an important component of the global capital 
markets and over the past century have served investors extremely well 
by providing an effective and objective tool to evaluate credit risk. 
Credit ratings provide reliable standards for issuers and investors 
around the world, facilitating efficient capital raising and the growth 
of new markets. Indeed, credit rating opinions have supported the 
development of deeper, broader, and more cost effective global debt 
markets. S&P Ratings Services has made significant contributions to 
this development by taking credit research into new markets and new 
asset classes; it is through this process that there is more 
information, a wider array of tools for understanding credit risk and 
far greater transparency in the marketplace today than ever before.
    Critical to a credit rating agency's ability to serve this role in 
the market is its commitment to, and achievement of, the highest 
standards of independence, transparency and quality. At S&P Ratings 
Services, these principles are the cornerstones of our business and 
have driven our longstanding track record of analytical excellence. 
Indeed, studies on rating trends have repeatedly shown that our ratings 
are highly effective in alerting the market to both deterioration and 
improvement in credit quality. For example, over the past 15 years, 
less than 1 percent of issuers initially rated in the ``AAA'' category 
have defaulted while approximately 60 percent of those initially rated 
in the ``CCC'' category have failed to meet their obligations. 
Moreover, out of 36 S&P rated issuers that defaulted in 2004, every one 
was rated in speculative grade categories prior to default, and most 
from inception.

The Credit Rating Process
    At the heart of this market-tested and accepted track record is a 
process by which S&P Ratings Services arrives at a particular credit 
rating. Our rating and editorial process begins with analysts being 
assigned to a particular issuer. The analysts gather economic, 
financial, and other information directly from the issuer, from public 
filings and from other sources deemed to be reliable. As part of our 
rating process, we press issuers to respond to comprehensive questions 
that help our analysts develop a full picture of the issuer's true 
credit quality. That said, our analysts are not auditors and do not 
perform an audit of information provided by a rated company: Indeed, 
one important informational component is the public information 
available about an issuer. Accordingly, we support the actions taken by 
Congress in enacting the Sarbanes-Oxley Act of 2002 to strengthen the 
process by which financial information is audited and provided to the 
market. Our analysts also rely expressly and necessarily on issuers to 
provide timely and accurate information. We may, depending on the 
circumstances, decline to issue a rating or even withdraw an existing 
rating if an issuer refuses to provide requested information.
    Our rating analysts examine information carefully as it is 
gathered. When sufficient information to reach a rating conclusion has 
been received and analyzed, we convene a rating committee comprised of 
S&P Ratings Services personnel who bring to bear particular credit 
experience and/or expertise relevant to the rating. A lead analyst 
makes a presentation to the rating committee that includes an 
evaluation of the issuing company's strategic and financial management, 
its business and operating environment, an analysis of financial and 
accounting factors and the issuer's business and financing plans. Our 
rating committee meetings involve serious and lengthy discussion that 
includes frank, and often animated, exchanges.
    Once a rating is determined by the rating committee, the issuer is 
notified and S&P Ratings Services disseminates it to the public. Along 
with the rating, we publish a narrative rationale explaining to the 
marketplace the key issues considered in the rating.
    Similarly, when a rating change occurs, our analysts report on the 
change and the rationale for it. We have a longstanding policy of 
making our public credit ratings and the basis for those ratings 
broadly available to the investing public as soon as possible and 
without cost. Public credit ratings (which constitute 99 percent of our 
credit ratings in the United States) are disseminated via real-time 
posts on our website, and through a wire feed to the news media as well 
as through our subscription services. Members of the investing public 
receive credit ratings at the same time as subscribers.

Management of Potential Conflicts of Interest
    S&P Ratings Services has a longstanding commitment to ensuring that 
any potential conflicts of interest do not compromise our analytical 
independence. To that end, S&P Ratings Services has had in place for 
many years a significant number of policies, procedures, and structural 
safeguards. In September 2004, these policies and procedures were 
updated, aggregated into one document, and released publicly in S&P 
Ratings Services' Code of Practices and Procedures (Code of Practices 
and Procedures). The Code of Practices and Procedures provides, for 
example, that:

 rating opinions must be assigned by rating committees, not by 
    an individual;
 at least two analysts must attend all meetings with the 
    management of an issuer;
 analysts are not to be compensated based upon the ratings 
    assigned to issuers they cover;
 analysts are prohibited from engaging in negotiations with 
    issuers about fees or other business matters; and
 analysts are prohibited from engaging, directly or indirectly, 
    in any Standard & Poor's activities with respect to nonratings 
    businesses, including any cross marketing of nonratings services.

    Consistent with the recent ``Code of Conduct Fundamentals'' 
published by the International Organization of Securities Commissions 
(IOSCO), S&P Ratings Services' Code of Practices and Procedures 
requires strict separation of marketing and analytical activities and 
contains tight restrictions on securities ownership and trading so as 
to minimize any conflicts of interest in the conduct of the credit 
ratings process. The Code of Practices and Procedures, which we have 
previously provided to the Committee, is available on our website and 
is attached to this testimony (see Appendix 1).*
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    S&P Ratings Services has also established strong infrastructure 
designed to safeguard the integrity of our credit rating process. Our 
Analytics Policy Board, chaired by S&P Ratings Services' Chief Credit 
Officer, monitors and ensures consistent application of our criteria 
and methodologies. The Analytics Policy Board also examines significant 
downgrades to determine if any changes in criteria or methodology are 
warranted.
    S&P Ratings Services believes that these measures contribute to our 
objectivity and independence and the market's acceptance of S&P Ratings 
Services as a credible publisher of credit ratings. Indeed, in the 
Commission's January 2003 ``Report on the Role and Function of Credit 
Rating Agencies in the Operation of the Securities Markets,'' prepared 
pursuant to Congress' direction in the Sarbanes-Oxley Act of 2002 and 
following an extensive review of credit rating agencies, the Commission 
found that market participants generally believed that any potential 
conflicts of interest have been ``effectively addressed by the credit 
rating agencies.'' Likewise, two Federal Reserve Board economists 
recently concluded after intensive study that S&P Ratings Services and 
the other rating agencies consider their reputations in the marketplace 
to be of ``paramount importance'' and, in fact, are ``motivated 
primarily by reputation-related incentives.'' \1\
---------------------------------------------------------------------------
    \1\ See Daniel M. Covitz and Paul Harrison, Testing Conflicts of 
Interest at Bond Ratings Agencies with Market Anticipation: Evidence 
that Reputation Incentives Dominate, The Federal Reserve Board Finance 
and Economics Discussion Series (December 2003), at 1, 3.
---------------------------------------------------------------------------
Response to Recent Corporate Misconduct
    The unprecedented corporate misconduct that has been revealed in 
recent years has resulted in constructive responses by market 
participants, including rating agencies such as S&P Ratings Services. 
Like many other market participants, S&P Ratings Services was misled by 
parties who committed fraud. In the Enron case, for example, key Enron 
personnel have now expressly admitted their role in deliberately 
misleading S&P Ratings Services and other rating agencies. It was their 
intention, they said, to defraud the rating agencies by making false 
representations and failing to disclose material facts related to 
Enron's financial position and cashflow.\2\
---------------------------------------------------------------------------
    \2\ In a statement attached to his Oct. 5, 2004 Cooperation 
Agreement, Enron's former Assistant Treasurer Timothy Despain admitted, 
among other things, that ``[i]n communicating with representatives of 
the rating agencies, I and others at Enron did not truthfully present 
the financial position and cashflow of the company and omitted to 
disclose facts necessary to make the disclosures and statements that 
were made to the rating agencies truthful and not misleading.'' 
Similarly, in his January 14, 2004 Plea Bargain Agreement, former Enron 
CFO Andrew S. Fastow, stated, among other things, that ``[w]hile CFO, I 
and other members of Enron's senior management fraudulently manipulated 
Enron's publicly reported financial results. Our purpose was to mislead 
investors and others about the true financial position of Enron and, 
consequently, to inflate artificially the price of Enron's stock and 
maintain fraudulently Enron's credit rating.'' (emphasis added).
---------------------------------------------------------------------------
    While at S&P Ratings Services we continuously review and enhance 
our processes, these events led us to examine our practices from top to 
bottom. We have concluded, after careful thought and examination, that 
our credit rating process works well and effectively. This view is 
reflected in many of the public comments filed with the Commission, 
IOSCO, and the Committee of European Securities Regulators, or 
``CESR''. Indeed, in April 2003 testimony before the House Subcommittee 
on Capital Markets, Insurance and Government Sponsored Entities, the 
Director of the Commission's Division of Market Regulation, observed 
that ``in general the credit rating agencies have done remarkably 
well.''
    The recent cases of issuer misconduct underscore how important it 
is to the ratings process that issuers provide accurate and reliable 
information to the marketplace and S&P Ratings Services. S&P Ratings 
Services believes that the initiatives of Congress and the Commission 
to improve the quality, transparency, and timeliness of disclosures by 
public companies such as those included in the Sarbanes-Oxley Act were 
an important and necessary response to these instances of corporate 
misconduct. Such measures should promote timely and accurate disclosure 
by issuers. Recent accounting standard initiatives should likewise 
result in better accounting information available to the market, 
including S&P Ratings Services.
    As part of our commitment to continuous improvement and in order to 
ensure ratings are responsive to evolving market needs, S&P Ratings 
Services has recently initiated a broad range of actions that support 
our mission to provide high-quality, objective, and rigorous analytical 
information to the marketplace. These initiatives have included:

 additional specialized forensic accounting expertise including 
    new chief accountants in both the United States and Europe;
 expanded liquidity analysis and recovery assessment in our 
    ratings analyses;
 enhanced use of quantitative tools and models in the rating 
    and surveillance process;
 increased commentary on issuers and industry sectors;
 enhanced focus in our criteria and practice on the role of 
    corporate governance practices in credit ratings analyses;
 expanded training programs; and
 consolidated and updated codes of policies and practices.

    We will, of course, continue to take appropriate steps to enable us 
to continue to provide rigorous analytical information to the 
marketplace.

SEC Regulatory Oversight
    The concept of a Nationally Recognized Statistical Rating 
Organization (NRSRO) was first utilized by the Commission in 1975. S&P 
Ratings Services was designated as an NRSRO in 1976 (though did not 
affirmatively seek that status) and is now one of four designated 
NRSRO's. The Commission is currently in the process of reviewing the 
NRSRO system and considering possible changes. The initial phase of 
this review included the Commission's January 2003 report mentioned 
earlier, prepared pursuant to Congress' direction under the Sarbanes-
Oxley Act. Following this report, the Commission issued a Concept 
Release in June 2003. One of the key questions raised by the Concept 
Release is whether to continue the use of the NRSRO framework and, if 
so, how best to designate NRSRO's. Based on the public comments by 
market participants, which generally favored retaining the system, the 
Commission may well conclude that abandoning the NRSRO concept could 
increase costs to the capital markets and disrupt current efficiencies 
in the regulatory system, without any increase in investor protection.
    If the Commission does retain the NRSRO system, S&P Ratings 
Services believes that the Commission should provide greater 
transparency in the designation process and reduce regulatory barriers 
to entry into the credit rating industry--a view expressed in many 
public comments. One way to accomplish this goal would be to extend 
NRSRO status to firms that limit their rating opinions to particular 
sectors of the capital markets or particular geographic regions. S&P 
Ratings Services supports increased competition in the credit rating 
industry. We believe, however, that the key criterion for designation 
must continue to be that a firm is widely accepted by users of credit 
rating opinions as a provider of credible and reliable ratings.
    The Commission is also considering whether and to what extent it 
should enhance regulatory oversight of NRSRO's if the designation 
system is retained. S&P Ratings Services believes that it is imperative 
for the Commission to avoid overly intrusive supervision of NRSRO 
firms, particularly supervision that may suggest a substantive role for 
Government in either the business operations of credit rating agencies 
or the ratings process itself. Because there is no one model or 
methodology for producing sound credit rating opinions, regulatory 
regimes focused on the credit rating decision process could have a 
number of adverse effects, including:

 compromising the independence of the credit ratings process;
 encouraging firms to standardize their approaches and thereby 
    deterring diversity and innovation in credit analysis;
 creating the impression that rating opinions have governmental 
    approval; and
 encouraging issuers to provide less information to credit 
    rating agencies.

    Moreover, regulatory oversight involving governmental intrusion 
into how and why a rating agency forms a particular rating opinion 
could chill the robust analytical process that has served the markets 
extremely well for nearly a century for fear of governmental ``second 
guessing.'' Governmental intrusion also risks interfering significantly 
with the strong First Amendment protections that courts have applied to 
the ratings process of gathering and analyzing information, forming 
opinions, and disseminating those opinions broadly to the marketplace.

International Review of Credit Rating Agencies
    The capital markets are increasingly global in nature and the same 
is true of the credit ratings business. As a result, IOSCO and CESR (as 
requested by the European Commission) have initiated their own 
independent reviews of credit rating agencies. S&P Ratings Services has 
been an active participant in these reviews and believes that many of 
the initial conclusions of these bodies, and the public commentary they 
have received, can and should inform the consideration of these issues 
by this Committee, the Commission, and others.
    As noted, IOSCO released its ``Code of Conduct Fundamentals'' for 
rating agencies this past December. After months of deliberation and an 
extensive market comment period, IOSCO determined that its Code of 
Conduct Fundamentals should be flexible, allowing rating agencies to 
incorporate its principles into their own respective codes of conduct, 
but not creating rigid, universally applicable regulations. Roel 
Campos, SEC Commissioner and the Chairman of the IOSCO Task Force, said 
that IOSCO's flexible approach would be ``more effectively enforced 
than would be the case if IOSCO had drafted a universal code for all 
credit rating agencies to sign on to.'' Commissioner Campos explained 
that a degree of flexibility was appropriate because rating agencies 
vary considerably in size, business model, and rating methods. S&P 
Ratings Services agrees that IOSCO's flexible approach will both 
preserve the independence and integrity of the credit rating process 
around the world and better serve investors and the marketplace as a 
whole far better than rigorous regulation.
    CESR is preparing a response to the European Commission's request 
for advice concerning credit rating agencies. At a public hearing held 
by CESR in Paris last month, the overwhelming majority of participants, 
including representatives of issuers and users of ratings, called on 
CESR to advise the European Commission to allow market forces to 
operate and not to impose intrusive regulation. In particular, most of 
those speaking at the meeting expressed support for an approach which 
allows rating agencies to develop their own practices and procedures 
based on the IOSCO Code of Conduct Fundamentals and expressed concerns 
that detailed regulation would increase barriers to entry.

Conclusion
    History reflects that credit rating opinions and credit rating 
agencies have served the markets extremely well for nearly a century. 
The key drivers of this success have been the independence and 
objectivity of credit rating agencies. S&P Ratings Services believes 
that its policies and procedures, established through decades of 
experience and innovation, address the potential challenges to that 
independence and objectivity. Great care should be taken to ensure that 
the principles and structures that have so greatly benefited the market 
for so many years are not compromised.
    On behalf of S&P Ratings Services, thank you again for the 
opportunity to participate in these hearings. I would be happy to 
answer any questions you may have.

                               ----------

                   PREPARED STATEMENT OF SEAN J. EGAN
               Managing Director, Egan-Jones Ratings Co.
                            February 8, 2005

    Chairman Shelby, Members of the Committee, good morning. I am Sean 
Egan, Managing Director of Egan-Jones Ratings Company, a credit ratings 
firm. By way of background, I am a Co-Founder of Egan-Jones Ratings 
Co., which was established to provide timely, accurate credit ratings 
to institutional investors. Our firm differs significantly from other 
ratings agencies in that we have distinguished ourselves by providing 
timely, accurate ratings and we are not paid by the issuers of debt, 
which we view as a conflict of interest. Instead, we are paid by 
approximately 400 firms consisting mainly of institutional investors 
and broker/dealers. We are based in the Philadelphia, Pennsylvania 
area, although we do have employees that operate from other offices.
    The rating industry is in a crisis. At a time when the capital 
markets have become increasingly reliant on credit ratings, the ratings 
industry is suffering from a State that is hard to characterize as 
anything other than dysfunctional. The problems are:

    Severe consolidation--Department of Justice personnel referred to 
the industry as a ``partner monopoly'' since S&P and Moody's control 
over 90 percent of the revenues and do not compete against each other 
as two ratings are normally needed for issues;
    Conflicts of interest--issuers payment for ratings create conflicts 
of interest that are similar to those experienced by the equity 
research analysts;
    Freedom of speech defense--there is no downside to bad rating calls 
by the two dominant firms.

    Manifestations of the flawed structure are:

    Failure to warn investors about problem credits such as Enron, the 
California utilities, WorldCom, Global Crossing, AT&T Canada, and 
Parmalat.

 Enron was rated investment grade by the NRSRO's 4 days before 
    bankruptcy,
 The California utilities were rated ``A-'' 2 weeks before 
    defaulting;
 Worldcom was rated investment grade 3 months before filing for 
    bankruptcy;
 Global Crossing was rated investment grade in March 2002 and 
    defaulted on loans in July 2002;
 AT&T Canada was rated investment grade in early February 2002 
    and defaulted in September 2002; and
 Parmalat was rated investment grade 45 days before filing for 
    bankruptcy.
 Losses from the Enron and WorldCom failures alone were in 
    excess of $100 billion, thousands of jobs, and the evaporation of 
    pensions for thousands. It is likely that some of these failures 
    could have been avoided had the problems been identified and 
    addressed sooner. (Enron was left with only Dynergy as an acquirer 
    by the time the alarm was sounded.)

    Under-rating credits--such as Nextel, American Tower, and 
Thyssenkrupp were assigned credit ratings which were too low, thereby 
significantly increasing their cost of capital and restricting growth.
    Insider trading--CitiGroup and probably other institutions were 
given advanced information about the Enron downgrade. Additionally, S&P 
and Moody's request advance information about transactions and other 
major events which creates opportunities for insider trading. S&P 
analyst Rick Marano and his associates traded on confidential 
information relating to the acquisition of ReliaStar and American 
General.
    Investor fraud--the NRSRO rating firms pulled their ratings on an 
Allied Signal entity so Allied could repurchase debt more cheaply;
    Issuer coercion--forcing issuers to pay rating fees (see The 
Washington Post article for a description of Hanover Re actions and 
Northern Trust comments to SEC) http://www.washingtonpost.com/wp-dyn/
articles/A8032-2004Nov23.html;
    Punishment ratings--see the municipality lawsuits; and
    Expansion of monopoly--expansion into consulting and corporate 
governance ratings despite rating failures.

    Despite the recent credit rating debacles, S&P and Moody's revenues 
and earnings have continued to grow because of their lock on the market 
(Moody's operating earnings have increased 230 percent over the past 4 
years) and the lack of normal checks and balances. To put the industry 
structure in perspective, it is as though there were only two major 
broker-dealers for corporate securities and the approval of both were 
required before any transactions could be completed.
    The arguments used to by the NRSRO's to defend their actions and 
inactions are the following:

    ``Issuer Misdeeds'' (they did not tell us)--S&P, Moody's, and Fitch 
claim they did not assign the correct rating because WorldCom, Enron, 
et al. did not provide accurate information. We believe it is a 
pathetic state when major rating firms are unable to recognize when an 
issuer and its executives are desperate to keep their firms solvent; it 
was public knowledge that Bernie Ebbers owed WorldCom more than $400 
million. Fraud is present in most failures, and the rating firms (at 
least those recognized by the SEC) should be able to detect the 
majority of egregious cases.
    ``Little Incentive'' (the Jack Grubman defense)--another argument 
used by the current NRSRO's to defend their actions is that any single 
issuer represents only small portions of their overall revenue bases. 
However, revenues produced by equity analysts Jack Grubman and Henry 
Blodget were likewise only a small portion of CitiGroup's and Merrill's 
revenues. Furthermore, when large investment banks are pressing the 
rating firms to hold off on any rating action, it becomes difficult not 
to listen.
    ``Our Reputation is Key'' (the Arthur Andersen defense)--Arthur 
Anderson argued that it would not do anything untoward because it would 
hurt the firm's reputation. Likewise, the current NRSRO's argue that 
they would not risk their reputation for any one issuer. However, since 
most issuers believe their ratings are too low and the lack of 
competition provides little downside for inaccurate ratings, there are 
few checks in the industry.
    ``Committee Approach'' (the Lemming defense)--a final defense 
normally proffered for the flawed industry is that unlike the 
investment banks, the NRSRO's use a committee approach for assigning 
ratings, which is harder to manipulate. Unfortunately, one analyst 
typically covers a firm and during rating committees what superiors 
want is probably clear.

    To reform the ratings industry, we recommend the following changes:

    (1) Recognize some rating firms which have succeeded in providing 
timely, accurate ratings--The problems with the current system are: (a) 
improving firms have been penalized by paying too much for capital, and 
(b) investors have been hurt by not obtaining warning of deteriorating 
firms. The recognition of some firms that have succeeded in providing 
timely, accurate ratings would be of great benefit.
    (2) Wean rating firms of issuer compensation--the crux of the 
equity research analysts' scandal is that analysts were paid by issuers 
via investment banking fees, thereby corrupting the investment 
analysis. The same conflicts exist in the credit rating industry. 
Studies from the Kansas City Federal Reserve Bank and Stanford 
University and the University of Michigan support the superiority of 
nonconflicted firms.
    (3) Adopt the Code of Standard Practices for Participants in the 
Credit Rating Process issued by the ACT, AFP, and AFTE--the proposed 
guidelines will assist in increasing the transparency and credibility 
in the ratings industry.
    (4) Prohibit rating firms from obtaining inside information--the 
rating firms should not be given preferential treatment over other 
financial analysts.
    (5) Sever ties between rating firm personnel and issuers and 
dealers--the ex-chairman of Moody's should not have served as a 
director of WorldCom nor should ratings firm personnel be tied to 
broker/dealers or broker/dealer industry associations such as the NASD.
    Broker/dealers were fined $1.4 billion for the issuance of 
conflicted equity research. In contrast, the SEC has been studying the 
rating industry since the early 1990's and has not yet made any 
substantive changes. The SEC has provided a false sense of security by 
giving its seal of approval to conflicted firms. If the SEC is unable 
to implement these changes rapidly, we recommend it withdraw from 
providing NRSRO designations and protecting the currently recognized 
firms from competition. Perhaps a board made up of users of credit 
ratings (excluding broker/dealer affiliated firms) is best able to 
assess the competency of rating firms.
    Regarding Egan-Jones Ratings, we have provided warning for the 
Enron, Genuity, Global Crossing, and WorldCom failures (we did not rate 
Parmalat). Furthermore, we regularly identify improving credits; most 
of our ratings have been above S&P's and Moody's over the past 2 years 
(thereby providing issuers with more competitive capital). Our success 
has been recognized by the Federal Reserve Bank of Kansas City which 
compared all our ratings since inception in December 1995 to those of 
S&P and concluded:

        ``Overall, it is robustly the case that S&P regrades from BBB- 
        moved in the direction of EJR's earlier ratings. It appears 
        more likely that this result reflects systematic differences 
        between the two firms' rating policies than a small number of 
        lucky guesses by EJR.''

    Source: Research Division, Federal Reserve Bank of Kansas City, 
Feb. 2003
    Link: http://www.kc.frb.org/publicat/reswkpap/RWP03-01.htm.

    Stanford University and the University of Michigan drew similar 
conclusions:

        ``we believe our results make a strong case that the 
        noncertified agency [Egan-Jones] is the leader and the 
        certified agency [Moody's] is the laggard.''

    Link: aaahq.org/AM2004/display.cfm?Filename =SubID--
1213.pdf&MIMEType =application percent2Fpdf.

    In August 1998, we applied for recognition by the SEC as a ratings 
firm (that is, NRSRO status). We continue to provide information to the 
SEC and hope eventually to be recognized.
    Timely, accurate credit ratings are critical for robust capital 
markets. Investors, issuers, workers, and pensioners will continue to 
be hurt by the flawed credit rating industry until someone addresses 
the basic industry problems. I would be happy to answer any questions.

                               ----------

                  PREPARES STATEMENT OF MICAH S. GREEN
                 President, The Bond Market Association
                            February 8, 2005

    Thank you, Chairman Shelby, for the opportunity to testify today on 
credit rating agencies. My name is Micah S. Green and I am the 
President of The Bond Market Association. As you know, the Association 
represents securities firms and banks that underwrite, distribute, and 
trade debt securities in the United States and internationally--a 
global market estimated at $44 trillion today. The Association speaks 
for the bond industry worldwide, advocating its positions and 
representing its interests in New York, Washington, London, and 
elsewhere. The Association also works with bond issuers--companies, 
governments, and others who borrow in the capital markets--and 
investors in fixed-income products from across the globe.
    Our members account for approximately 95 percent of U.S. municipal 
bond underwriting and trading activity. The membership also includes 
all primary dealers in U.S. Government securities, as recognized by the 
Federal Reserve Bank of New York, and all major dealers in U.S. agency 
securities, mortgage- and asset-backed securities and corporate bonds, 
as well as money market and funding instruments. In recent years, the 
Association has sponsored both the American and the European 
Securitization Forums. These are affiliated organizations that focus on 
the rapidly growing securitization markets in the United States and 
Europe. Another Association-sponsored organization, the Asset Managers 
Forum, brings together institutions that are active in the bond market 
as investors to address major operational, accounting, public policy, 
and market practice initiatives. The comments here reflect the 
collective views of the Association and our forums.
    The Bond Market Association is deeply involved in investor 
education. Although most bond markets are dominated by large, 
sophisticated institutional investors, it is our strong belief that 
retail investors must have sufficient background and data to not only 
make informed investment decisions but also to realize that allocating 
their assets in a diversified manner is an important investment 
strategy. Last week, the Association launched an updated version of our 
award winning investor education website, Investinginbonds.com. The 
site provides investors with background, news, data, and commentary on 
the bond markets in addition to bond prices. Included in this 
information is the very important credit rating that is attached to 
most fixed-income investments.
    We welcome the opportunity to testify here today on the role of 
credit rating agencies in the capital markets. The past 15 years have 
seen dramatic growth in the number of issuers and the range and 
complexity of fixed-income securities. The importance of credit ratings 
to investors and other securities market participants has increased 
proportionally. The role of rating agencies is critical to the 
efficient functioning of the fixed-income markets. It is both important 
and useful for this Committee to focus on an industry that plays such a 
vital role in the capital markets.

Credit Rating Agencies and the Fixed-Income Markets
    All investments involve risk. One important type of risk associated 
with certain bonds and other fixed-income investments is credit risk--
the chance that a bond will default, or the issuer will fail to make 
all interest and principal payments under the bond's terms. A credit 
rating is essentially an opinion offered by a rating agency on the 
credit risk of a bond. The credit rating process employs both 
quantitative tools and subjective judgment. In addition to analyzing a 
company's balance sheet, for example, credit ratings may also take into 
account subjective forecasts of the issuer's ability to generate 
revenue in the future. An investor can determine objective factors such 
as a security's coupon, maturity, call features, and covenants from the 
issuer's mandated disclosure. Analysis of an issuer's credit quality, 
however, involves individual judgments about a variety of complex 
financial and other information. A credit rating is a valuable 
complement to an investor's own credit analysis precisely because it is 
both expert and independent. Credit ratings also guide the market's 
pricing decisions. Bonds with lower ratings are viewed as riskier than 
higher-rated bonds by investors who demand a yield premium as 
compensation for this risk. Conversely, higher-rated bonds will offer a 
relatively lower yield as a reflection of their stronger credit 
standing. In addition, ratings play an important role in market 
regulation.
    Rating agencies in general, and certainly the more established 
agencies, approach the rating process in similar ways. Rating analysts 
are grouped by market, such as corporate, asset-backed, or municipal 
bonds, and industry or sector, such as financial services or 
transportation and rating decisions are made by committee. As part of 
the process of gathering information, rating agency personnel maintain 
regular contact with issuers and also rely on regulatory filings, news, 
and industry reports, among other information. Nonpublic information, 
such as proprietary business forecasts, also may be available to rating 
agencies under promises of confidentiality and under an exemption from 
the Securities and Exchange Commission's (SEC) Regulation FD. The 
Association strongly supports maintaining this exemption.
    Rating agencies generally inform issuers and investors of their 
rating methodologies for particular asset classes. These are detailed 
descriptions that provide useful information to issuers and investors, 
and also help the rating agencies ensure the consistency of their 
ratings even when different rating analysts are involved.
    Once ratings are published, they are available to all market 
participants and the public. To receive a detailed analysis of the 
rationale for the rating decision, however, generally requires a fee-
based subscription. These subscription fees and the fees paid by the 
issuer for the rating itself are the principal revenue sources for most 
rating agencies. The ratings assigned by the three major firms by 
category are shown in the chart below.



    Capital market participants make use of rating information and 
interact with rating agencies differently depending on their role in 
the market. For issuers of fixed-income securities, credit ratings 
typically have a direct effect on the rate at which they can borrow in 
the capital markets. As noted above, investors will assign a risk 
premium on lower-rated securities to reflect the higher chance of 
default. The premium translates into a higher interest rate on the 
issuer's debt, or an increase in the cost of capital.
    To better appreciate the relationship between ratings and yields it 
is important to consider how the market prices bonds. With few 
exceptions, prices for fixed-income products are quoted as a number of 
basis points \1\ over a benchmark such as U.S. Treasury securities of a 
comparable maturity, the London Interbank Offered Rate (LIBOR), the 
rate on interest rate swaps of comparable duration or some other 
benchmark that represents an investment perceived to be free of credit 
risk. The amount that the return on a given investment exceeds the 
return on the benchmark--a bond's ``credit spread''--represents the 
risk premium investors receive as a result of the degree of risk, 
principally credit risk, the investment carries. Higher rated bonds 
have a smaller spread than lower-rated bonds of the same maturity. As 
the chart below shows, the correlation between rating and spread is 
historically consistent. It is a trusted metric that promotes market 
efficiency as it allows a participant to commoditize partially what are 
disparate assets. A bond dealer asked for a quote on a corporate or 
municipal security, for example, will look not only at any recent 
trades for the same security but also at the current yield on similar 
bonds that have a similar credit rating.
---------------------------------------------------------------------------
    \1\ One basis point equals 1/100th of a percentage point.
---------------------------------------------------------------------------
    Bond investors are overwhelmingly comprised of mutual funds, 
pension funds, endowments and asset management firms, and other 
institutions that employ sophisticated, professional money managers.\2\ 
As of the end of 2003, less than 10 percent of all bonds outstanding in 
the United Stataes were held directly by individual investors, although 
in the tax-exempt municipal bond market that figure is about 35 
percent. Institutional investors often conduct their own credit 
analysis of issuers but also rely on credit ratings as part of their 
overall risk analysis.
---------------------------------------------------------------------------
    \2\ A majority of outstanding municipal debt is beneficially owned 
by individuals through mutual funds and individual holdings, but 
investment decisions for a majority of outstanding municipal bonds are 
made by professional money managers.



    It is common for some institutional investors to have in-house 
rules limiting investment in any fixed-income security that does not 
have at least an investment grade rating.\3\ Similarly, most States 
have laws dictating the permitted investments of insurance companies on 
the basis of credit rating. Some States require two ratings. The 
National Association of Insurance Commissioners (NAIC) maintains a list 
of rating agencies whose ratings are acceptable for this purpose.
---------------------------------------------------------------------------
    \3\ An investment grade rating is defined as at least a BBB rating 
offered by Fitch Ratings or Standard and Poor's or a Baa rating offered 
by Moody's. A sub-investment grade rating, also known as high-yield or 
speculative grade, is defined as any rating below investment grade. 
Some institutional investors purchase a mix of investment grade and 
sub-investment grade bonds and some specialize in sub-investment grade 
exclusively.
---------------------------------------------------------------------------
    Broker-dealers also use credit ratings to supplement proprietary 
credit analysis. They also advise issuers of the effect of ratings on 
the cost of capital. Credit ratings, of course, are also important to 
investors with whom broker-dealers interact in the marketplace. In 
September 2004, the Corporate Debt Market Panel sponsored by the 
National Association of Securities Dealers (NASD) released a report 
recommending the disclosure of credit ratings immediately prior to an 
investor's decision to buy or sell a bond as well as upon confirmation 
of a trade.
    Credit ratings are also used in the regulation of broker-dealers 
and different types of institutional investors. One notable example is 
the Securities and Exchange Commission's net capital rule, which 
requires broker-dealers to maintain specified minimum capital levels to 
support their assets or customer liabilities. Since 1975, the net 
capital rule has imposed different capital charges for assets depending 
upon whether (and at what level) the assets are rated by what the SEC 
defined as a ``Nationally Recognized Statistical Rating Organization'' 
or NRSRO. Higher-rated securities receive a lower capital charge than 
lower-rated securities. Similarly, SEC-registered money market funds 
are permitted to invest in short-term debt securities that receive one 
of the two highest NRSRO ratings. Investment grade ratings can also 
provide an issuer with the option of short-form SEC registration in 
some cases.
    The Bank for International Settlement's Committee on Banking 
Regulation stipulates the use of credit ratings in assessing the 
capital charges for banks under the new Basel Capital Accord, Basel II. 
Basel II articulates a set of criteria a firm must satisfy in order to 
qualify as an External Credit Assessment Institution (ECAI) which allow 
its ratings to be used in this calculation.\4\
---------------------------------------------------------------------------
    \4\ International Convergence of Capital Measurement and Capital 
Standards, Basel Committee on Banking Supervision, June 2004. Page 35. 
The six criteria include objectivity, independence, transparency, 
disclosure, resources, and credibility.
---------------------------------------------------------------------------
TBMA Response to United States and European Regulatory Proposals
    Recently, regulators in the United States and Europe have stepped 
up their focus on rating agencies and raised the prospect of changes in 
the current approach to regulatory oversight. The Association's view on 
the regulation of credit rating agencies is simple:

 We believe that the criteria adopted by regulators for 
    approving NRSRO's or ECAI's should be flexible enough to allow 
    increased competition between a larger number of entities, while 
    ensuring that designated rating agencies have the expertise to 
    produce accurate ratings. In the United States, this means 
    eliminating the current requirement that a rating agency be widely 
    recognized, rather than accepted in a defined sector of the market.
 We believe credit rating agencies should have policies and 
    procedures to ensure the independence of the credit rating process.
 We believe credit rating agencies should publish their rating 
    methodologies for various types of securities, so that both issuers 
    and users will understand the agencies' requirements and standards, 
    and so that different rating analysts in the same agency will 
    produce consistent ratings.
 We do not believe that regulation of the credit rating process 
    is necessary or desirable, since Government regulation would tend 
    to result in less diversity of opinion and would be less responsive 
    to new product developments.
 We believe issuers should be given an opportunity to correct 
    factual misstate-ments in rating agency reports, but not to appeal 
    rating designations outside the rating agency.
 We believe rating agencies should publish information on the 
    historical accuracy of their rating assessments.

    As the capital markets develop and mature globally, the need for a 
measured approach by regulators toward the conduct of rating agencies 
grows in importance. The Association does support those actions by 
regulators--such as modifying the criteria for NRSRO designation--that 
we believe will help enhance competition among rating agencies. We do 
not support steps that would limit the independence of rating agencies 
to determine their opinions of the creditworthiness of issuers.
    For more than a decade, the SEC has contemplated a rulemaking to 
address the credit rating industry, the role it plays in the securities 
market and how it should be regulated. A 1994 concept release led to a 
proposed rule in 1997 that would have set new criteria for NRSRO 
status. The SEC did not act on the proposal but in 2003 issued a report 
\5\ in accordance with the Sarbanes-Oxley Act followed by a concept 
release. The concept release addressed questions of NRSRO regulation, 
potential conflicts of interest between rating agencies and issuers and 
competition within the industry. (The Association's 2003 response to 
the concept release is attached in appendix 1.) *
---------------------------------------------------------------------------
    \5\ Report on the Role and Function of Credit Rating Agencies in 
the Operation of the Securities Markets, U.S. Securities and Exchange 
Commission, January, 2003. Rating Agencies and the Use of Credit 
Ratings Under the Federal Securities Laws, S.E.C. Concept Release June 
2003.
    * Held in Committee files.
---------------------------------------------------------------------------
    In response to the concept release, the Association filed a comment 
letter endorsing the NRSRO designation with some clarification to 
address competition and other issues. Generally speaking, the 
Association acknowledges the important role rating agencies play in the 
capital markets. All market participants--investors, dealers, issuers 
(and their advisors), and regulators--count on rating agencies as 
reliable sources of analysis whose judgments are sound. A number of 
statistical studies show a correlation between strong ratings and a low 
probability of default. At the same time, rating agencies cannot be 
expected to evaluate risk perfectly. Their analysis relies on the 
integrity of an issuer's disclosure.
    In 2004, the International Organization of Securities Commissions 
(IOSCO), of which the SEC is a member, proposed a code of conduct for 
rating agencies, which was followed by a request from the European 
Commission for public input on how the code of conduct should be 
implemented. In response, the Committee of European Securities 
Regulators (CESR) produced a consultative paper suggesting a range of 
regulatory approaches based on the IOSCO principles. In our comments to 
CESR, The Association's position on the regulatory proposals dealing 
with the credit rating process in the United States and Europe is 
centered on the fundamental issues of competition and market conduct. 
(The Association's response to both IOSCO and CESR can be found in 
appendix 2.) *

Competition
    Some observers have questioned whether the credit rating industry 
is as competitive as it should or could be and suggest that 
inappropriate barriers to entry exist. In the United States, the nature 
of the NRSRO designation is often brought up as a factor in this 
debate. The Association supports the retention of this designation. We 
have also called for greater clarity in the SEC's approval policy and 
the elimination of the requirement that a rating agency be ``widely 
accepted'' in order to gain the designation. The Association certainly 
welcomes additional entrants to the marketplace from any part of the 
globe. Increasing competition among qualified rating agencies could 
only benefit issuers, investors, and the market generally.
    The Association responded to the 2003 concept release with 
suggestions for improving the transparency of the designation process. 
Increased transparency will aid public understanding of the process and 
improve the ability of other rating agencies to gain the NRSRO 
designation leading to enhanced competition in the industry. The SEC 
should adopt a formal and standardized application process. 
Applications should be public and the subject of public comment. 
Applicants likely to receive an adverse decision should have the option 
to withdraw their applications to prevent the release of proprietary 
information. The SEC's reasons for accepting or rejecting an 
application should be explicitly stated and existing NRSRO's should 
also complete the application process to ensure uniform treatment.
    At present, the SEC primarily considers whether an agency is 
``widely accepted'' when deciding whether to grant NRSRO status. Other 
factors such as an agency's financial resources, staff experience, 
independence, and rating procedures are also considered. The 
Association believes the ``widely accepted'' standard should be relaxed 
in the cases where a rating agency meets all other criteria but happens 
to specialize in only a single market or industry or geographic sector. 
The NRSRO status of such a rating agency could be limited to its area 
of expertise. This will reduce barriers to entry and enhance 
competition. An obvious way to increase the number of agencies whose 
ratings are widely accepted is to approve niche credit raters which can 
then--after gaining experience and market acceptance--expand to cover a 
broader range of industries and securities.
    In Europe, CESR has listed barriers to entry that exist in the 
credit rating field and asked how regulators should address them. The 
credit rating industry is difficult to penetrate for new firms. Much of 
the value the market assigns to credit ratings is based on reputation 
and track record, something new entrants necessarily lack. This 
dynamic, however, is not unique to the rating industry and CESR itself 
has described barriers as ``natural.'' It also has not created a market 
failure or a condition in which a segment of issuers goes without 
service. The flexibility of an IOSCO-type code-of-conduct approach, as 
opposed to detailed regulation of rating agency business practices, 
will facilitate the entrance and expansion of new credit rating 
agencies in the market.
    The NRSRO designation serves a unique purpose in SEC regulations 
for which a substitute is either not available or not practical. Using 
credit spreads or internal credit ratings as alternatives to NRSRO 
ratings for computing net capital requirements is possible, for 
example, but would add significant costs. In addition, in the case of 
internal ratings it could result in the nonuniform treatment of the 
same assets by different firms.

Rules of Conduct
    The day-to-day operations of rating agencies should never be 
controlled by regulation. With respect to both the United States and 
Europe, specific rating methodologies and standards of due diligence 
should not be mandated by regulators. The 
rating process is subjective in some respects and cannot be evaluated 
for appropriateness by a Government agency. The Association does 
believe it would be appropriate for rating agencies to disclose 
internal statistics on the accuracy of their ratings. Government 
mandates of rating methodology, however, could be construed as a 
Government approval of securities that receive high ratings from 
designated rating agencies. It would also effectively eliminate 
differences in the analysis of competing rating agencies and undermine 
the value of independent credit analysis.
    Similarly, while conflicts of interest between rating agencies, 
issuers, and subscribers may exist, it would not be appropriate for 
regulators to prescribe specific methods for dealing with the issue. A 
more favorable approach--and one the IOSCO code now requires--would be 
for rating agencies to adopt policies and procedures to address and 
disclose potential conflicts of interest, such as issuer and subscriber 
influence and the potential misuse of public information. It is the 
view of some institutional investors--particularly with respect to 
structured finance products--that such policies and procedures should 
be designed to discourage participation in the practice known as 
``ratings shopping,'' a situation in which an issuer employs a rating 
agency based on real or perceived differences in methodology that could 
result in more favorable ratings.

Conclusion
    The Association is pleased to offer the above comments on credit 
rating agencies. As we have noted, the credit rating industry plays an 
important and unique role in the capital markets. It is also an 
industry whose integrity is effectively ensured by market discipline. 
Rating agencies that appear biased or corrupt or supply dishonest 
analyses would find their services without value. Regulators can best 
ensure the credit rating industry remains robust and independent by 
endorsing a principles-based approach to industry oversight, like the 
IOSCO Code, that supports competition but does not dictate specific 
methodologies or other rules of conduct. Regulators need to address the 
barriers to entry by clarifying the criteria for designating NRSRO's 
and changing the ``widely recognized'' requirement so niche players can 
enter the market.

                               ----------

                 PREPARED STATEMENT OF YASUHIRO HARADA
   Executive Vice President, Rating and Investment Information, Inc.
                            February 8, 2005

    Thank you, Chairman Shelby, Ranking Member Sarbanes, and Members of 
the Senate Banking Committee for your kind invitation to present 
testimony at today's hearing entitled ``Examining the Role of Credit 
Rating Agencies in the Capital Markets.''
    We are very pleased to offer our thoughts on this topic as well as 
some more specific information about the challenges faced by our firm, 
Rating and Investment Information, Inc. (R&I), a credit rating agency 
headquartered in Tokyo, as we have sought to clear the hurdles 
necessary to become an effective new competitor in the United States 
market. Even though R&I is the most recognized credit rating agency in 
Japan and the broader Asian markets, obtaining designation in the U.S. 
as a ``Nationally Recognized Statistical Rating Organization'' (NRSRO) 
has been an exercise in delay and disappointment.

Background Regarding Credit Rating Agencies as NRSRO's
    Investors and market professionals historically have used 
securities ratings issued by credit rating agencies to gauge the 
creditworthiness of a particular issue. The SEC significantly expanded 
the traditional use of ratings in 1975 when it adopted Rule 15c3-1 (the 
Net Capital Rule) under the Securities Exchange Act of 1934 (Exchange 
Act). The Net Capital Rule incorporated credit ratings by NRSRO's in 
certain of its provisions. Rather than use securities ratings as a 
measure of creditworthiness, the Net Capital Rule created the NRSRO 
concept to measure liquidity. Currently, there are four rating agencies 
designated by the SEC as NRSRO's for purposes of the Net Capital Rule.
    Since 1975, however, the use of NRSRO ratings in the Federal 
securities laws and regulations has expanded considerably beyond a 
measure of a security's liquidity, as has reliance on those ratings by 
investors and the marketplace. The term ``NRSRO'' remains undefined in 
SEC regulations, and the informal process for determining who is an 
NRSRO remains unchanged--a credit rating agency seeking NRSRO status 
must ``apply'' to the SEC's Division of Market Regulation for a no-
action letter. Meanwhile, both Congress and the SEC have on numerous 
occasions incorporated the NRSRO concept for other purposes, primarily 
as indicia of a security's creditworthiness--the historical and 
predominant use of securities ratings.
    Congress, for example, employed the term NRSRO when it defined 
``mortgage related security.'' \1\ However, Congressional reliance on 
the term used in SEC rules is significant because it reflects a 
recognition that the ``term has acquired currency as a term of art.'' 
\2\ The SEC also has incorporated the term ``NRSRO'' in various 
rulemakings under the Securities Act of 1933, the Exchange Act, the 
Investment Company Act of 1940, and the Investment Advisers Act of 1940 
for purposes well beyond those originally intended under the Net 
Capital Rule.\3\
---------------------------------------------------------------------------
    \1\ Section 3(a)(41) of the Exchange Act was added by the Secondary 
Mortgage Market Enhancement Act of 1984, Pub. L. No. 98-440,  101, 98 
Stat. 1689, 1689 (1984).
    \2\ H.R. Rep. No. 994, 98th Cong., 2d Sess. 46 (1984) (appending 
Statement of Charles C. Cox, Commissioner, Securities and Exchange 
Commission, to the Subcommittee on Telecommunications, Consumer 
Protection, and Finance of the House Committee on Energy and Commerce, 
Mar. 14, 1984).
    \3\ The SEC currently employs the NRSRO concept in the following 
rules: 17 CFR 228.10(e), 229.10(c), 230.134(a)(14), 230.436(g), 239.12, 
239.33, 240.3a1-1(b)(3), 2401.10b-10(a)(8), 240.15c3-1(c)(2)(vi)(E), 
(F), and (H), 240.15c3-1a(b)(1)(i)(C), 240.15c3-1f(d), 242.101(c)(2), 
242.102(d), 242.300(k)(3) and (1)(3), 270.2a-7(a)(10), 270.3a-7(a)(10), 
270.3a-7(a)(2), 270.5b-3(c), and 270.10f-3(a)(3).
---------------------------------------------------------------------------
Flaws in the NRSRO Process
    In order to compete effectively in the U.S. market, a designation 
by the SEC as an NRSRO is a critical factor in the industry. In 
addition to the NRSRO application process having little regulatory 
guidance and/or an established timetable for agency decisionmaking, the 
specific entry barrier for R&I and other companies is the SEC 
requirement that a new NRSRO be ``nationally recognized.'' In essence, 
this means that the rating agency must be ``widely accepted in the 
United States'' as an issuer of credible ratings by predominant users 
of such ratings before it can gain such a designation to enter the U.S. 
market. As can be seen, this is a circular test. It was precisely this 
circular standard which the Antitrust Division of the U.S. Department 
of Justice singled out in 1998 as likely to preclude new competitors in 
this credit rating market.\4\ Moreover, concern about the lack of new 
competitors in this market led the Justice Department to recommend to 
the SEC in 1998 that NRSRO designation be specifically awarded to some 
foreign rating agencies.
---------------------------------------------------------------------------
    \4\ Letter from Antitrust Division of the U.S. Department of 
Justice in the matter of File No. S7-33-97 Proposed Amendments to Rule 
15c3-1 under the Securities Exchange Act of 1934 (Mar. 6, 1998).
---------------------------------------------------------------------------
R&I's NRSRO Application
    As noted, R&I is the largest and most recognized Asian rating 
agency. It is headquartered in Japan, the second largest economy in the 
world. R&I is a respected independent source of financial information 
for the overwhelming majority of United States broker-dealers and 
financial institutions that conduct operations in Japan, and provides a 
variety of ratings services to United States and foreign companies. 
Market participants particularly appreciate that R&I calculates and 
publishes a ``broad-definition default ratio'' based on a 27-year 
record which indicates the probability that an issuer that has been 
given a publicly released rating will fall into default within that 
given period of time. R&I's ratings are regularly announced and 
published by the leading financial electronic and print media in Japan, 
and in the United States as well.
    In regard to your Committee's specific request for a discussion of 
our agencies' internal ratings process we present the following 
overview of the R&I rating team's procedures. The rating team is 
responsible for reviewing financial information regarding the issuer 
and the terms of the instrument to be issued. The team reviews both 
publicly available information and confidential information obtained 
from the issuer. Teams generally review the financials of the issuer 
from the prior 5 years, as well as forecasts for the next 3 years.
    R&I staff, including at least one senior analyst, will visit the 
senior management of the issuer as part of a detailed due diligence 
exam of the issuer. This on-site due diligence examination typically 
lasts several days. During the visit, the team meets with the chief 
executive officer of the issuer, holds various meetings with senior 
executives in the areas of finance, planning and development, 
production, sales, and, where applicable, may schedule an inspection of 
plants and/or other facilities. The meetings include both issuer 
presentations and detailed, extensive interview sessions with senior 
management. Particular attention is focused on the issuer's cashflow 
and overall financial stability. Each rating team considers industry 
trends, sector volatility, and any relevant geopolitical or economic 
risk. The rating team also conducts intercompany comparisons, taking 
into consideration any relevant geopolitical, currency, or economic 
risk.
    Once the initial analysis is complete, each team's written report 
is scrutinized in R&I's intensive committee review process. The team's 
report and recommendation initially is submitted to the Rating 
Committee. R&I has three classifications of Ratings Committees: The 
Plenary Committee, the Standing Committee, and the Subcommittee. The 
Plenary Committee is the most senior committee and serves as an 
``appellate'' body for the other committees, addressing any 
controversial or novel rating that is under consideration by the other 
committees. The Standing Committee evaluates the majority of the 
proposed ratings, and the Subcommittee reviews ratings that are less 
likely to change than other ratings, such as ongoing ratings of 
previously rated issues or issuers. R&I management is generally 
prohibited from participating in the Rating Committee. In exceptional 
circumstances, and only with express authorization of R&I's Board of 
Directors, R&I senior executives may observe the Rating Committee 
meetings, but cannot vote on any matter discussed by the Rating 
Committee.
    For over a decade, R&I and its predecessors have engaged the SEC in 
an effort to receive NRSRO designation. This began in October 1990, 
when the Japan Bond Research Institute (JBRI) submitted a letter to the 
SEC requesting designation as an NRSRO. In January 1991, Nippon 
Investors Services, Inc. (NIS) submitted its request for NRSRO 
designation. While there was some interaction with the SEC following 
these applications neither entity received a formal response from the 
SEC.
    On April 1, 1998, NIS and JBRI merged to form R&I and in July 1998, 
R&I submitted a follow-up letter to the SEC requesting that R&I be 
designated as an NRSRO. This led to some discussion with the SEC staff 
after which R&I submitted an amended request for NRSRO designation in 
January 2002. The 2002 request was limited in scope in that R&I sought 
to be recognized as an NRSRO solely with respect to yen-denominated 
securities. R&I's expertise in yen-denominated securities is recognized 
throughout the world's financial markets and by the leading financial 
institutions in the United States. There is past precedent for the SEC 
to designate limited-purpose NRSRO's including the designation of two 
agencies, in particular, IBCA and Thompson BankWatch, Inc., as NRSRO's 
for limited purposes. Such recognition on a limited-basis was 
considered appropriate if a rating agency could demonstrate that it 
possesses unique expertise in rating particular securities, or 
securities of particular currency denomination. As a practical matter, 
investors and the marketplace will be significantly deprived of the 
full benefit of this expertise unless the rating agency is recognized 
as a NRSRO, at least with respect to those securities issues in which 
the rating agency has expertise.

Recent Developments
    In early 2002, the Senate Committee on Government Affairs held a 
series of hearings into the collapse of Enron. In a follow-up staff 
report on Enron, hearings 
focused, among other things, on the fact that there were only three 
major NRSRO operating in the United States.\5\--a situation which 
continues to this day. As this Committee is aware, the Sarbanes-Oxley 
Act of 2002 required that the SEC then conduct a study of the role of 
credit rating agencies in the U.S. securities markets and submit a 
report regarding its study to the President and Congress.
---------------------------------------------------------------------------
    \5\ Press Statement, ``Financial Oversight of Enron: The SEC and 
Private-Sector Watchdogs,'' Chairman Joe Lieberman, October 7, 2002.
---------------------------------------------------------------------------
    In November 2002, as part of its study, the SEC held 2 full-days of 
hearings attended by a variety of academics, credit rating agencies, 
and consumers of ratings reports such as investment companies. R&I 
submitted written comments to the SEC prior to these hearings. 
Additionally, I participated in the SEC Roundtable forum on November 
21, 2002. In January 2003, the SEC issued its report which included its 
plans to issue a concept release within 60 days of the report to seek 
comment on issues that would form the basis of proposed rules with 
respect to credit rating agencies. In February 2003, shortly after 
issuing its report, the SEC approved a fourth credit rating agency as a 
new NRSRO. In June 2003, the SEC issued a concept release on credit 
rating agencies and the administration of the NRSRO application 
process. R&I promptly submitted its comments on the concept release. 
Since publication of the SEC's concept release, there has been 
additional public action with respect to credit rating agencies 
including two additional hearings in the House Financial Services 
Committee,\6\ a three-part series in The Washington Post that focused 
mainly on the lack of competition in the credit rating industry which 
appeared in November 2004, and most recently a white paper on the 
subject published by the American Enterprise Institute.\7\
---------------------------------------------------------------------------
    \6\ House Committee on Financial Services, Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises, ``Rating the 
Rating Agencies: the State of Transparency and Competition,'' hearing 
on April 2, 2003, and ``The Ratings Game: Improving Transparency and 
Competition Among the Credit Ratings Agencies,'' held on September 14, 
2004.
    \7\ ``End the Government-Sponsored Cartel in Credit Ratings'' by 
Alex Pollock, AEI Financial Services Outlook, January 2005.
---------------------------------------------------------------------------
Action Sought with Respect to R&I's Application
    It is essential that additional qualified credit rating agencies be 
recognized as NRSRO's to increase the quality of the oversight function 
that such credit rating agencies play in the U.S. securities markets. 
Each additional NRSRO will benefit investors and the financial markets 
by improving the availability of important financial information and 
analysis. Considering the pace and uncertainty of any regulatory 
change, pending NRSRO applications, including R&I's application, should 
receive prompt attention.
    Despite the increased interest and attention directed at credit 
rating agencies since the submission of R&I's January 2002 NRSRO 
request, there has been no appreciable progress with respect to R&I's 
application. Eight leading Wall Street investment-banking firms and two 
major U.S. insurance companies have written to the SEC to support R&I's 
NRSRO designation. R&I understands that the future regulation of credit 
rating agencies and the use of the NRSRO designation is in transition, 
particularly in light of the concept release and continuing 
Congressional hearings; however, without such designation, we operate 
at a competitive disadvantage every day under the current regulatory 
scheme. R&I is well-qualified to contribute to the flow of information 
and expert analysis so valuable to U.S. investors and issuers. 
Therefore, the lack of progress on R&I's application harms both R&I and 
investors. If allowed to enter the market, U.S. investors, especially 
institutional investors such as insurance companies, would benefit from 
having an additional source of proven credit analyses and U.S. issuers 
benefit from having more providers of rating services in the Samurai 
bond market. Until such time as a new regulatory scheme is implemented 
with respect to credit rating agencies (which could be years away, if 
ever), we respectfully suggest the SEC should be focusing on approving 
qualified NRSRO's. We encourage the Committee to advise the SEC not to 
neglect pending NRSRO applications nor require such applicants to await 
further rulemaking prior to approval.

Appropriate Type of Regulatory Oversight for Credit Rating Agencies
    It would be appropriate and fair to regularly check if rating 
agencies recognized as NRSRO's have been maintaining their original 
qualification criteria. This can be accomplished by requiring NRSRO's 
to submit reports to the SEC indicating past performance and continuing 
qualification. Such submissions should be disclosed to the public. If 
the SEC determines that a particular NRSRO fails to satisfy all of the 
necessary criteria, such rating agency should be required to 
immediately rectify the situation. If, after one year's probation 
period, such an NRSRO still fails to all of the criteria, the NRSRO 
recognition should be revoked.
    The SEC should review an NRSRO's continuing compliance with the 
original qualification criteria. If there is any reason to believe that 
an NRSRO has failed to meet any of the original qualification criteria 
at any time, the SEC should be able to conduct a review of the 
particular NRSRO in question. The evaluation of the overall quality and 
performance of NRSRO's generally should be deferred to market 
participants.
    If the Committee has any questions regarding R&I, its operations, 
or its application with the SEC for NRSRO status, we would be glad to 
respond to any requests for information. We earnestly seek a timely 
review and a speedy determination regarding R&I's NRSRO application. 
Thank you for the opportunity to present these views.

                               ----------

                 PREPARED STATEMENT OF STEPHEN W. JOYNT
          President and Chief Executive Officer, Fitch Ratings
                            February 8, 2005

Introduction
    Fitch Ratings traces it roots to the Fitch Publishing Company 
established in 1913. In the 1920's, Fitch introduced the now familiar 
``AAA'' to ``D'' rating scale. Fitch was one of the three rating 
agencies (together with Standard & Poor's (S&P) and Moody's Investors 
Service (Moody's)) first recognized as a Nationally Recognized 
Statistical Rating Organization (a so-called ``NRSRO'') by the 
Securities and Exchanges Commission (SEC) in 1975.
    Since 1989 when a new management team recapitalized Fitch, Fitch 
has experienced dramatic growth. Throughout the 1990's, Fitch 
especially grew in the new area of structured finance by providing 
investors with original research, clear explanations of complex credits 
and more rigorous surveillance than the other rating agencies.
    In 1997, Fitch merged with IBCA Limited, another NRSRO 
headquartered in London, significantly increasing Fitch's worldwide 
presence and coverage in banking, financial institutions, and 
sovereigns. Through the merger with IBCA, Fitch became owned by 
Fimalac, a holding company that acquired IBCA in 1992. The merger of 
Fitch and IBCA represented the first step in our plan to respond to 
investors' needs for an alternative global, full-service rating agency 
capable of successfully competing with Moody's and S&P across all 
products and market segments.
    Our next step in building Fitch into a global competitor was our 
acquisition of Duff & Phelps Credit Rating Co., an NRSRO headquartered 
in Chicago, in April 2000 followed by the acquisition later that year 
of the rating business of Thomson BankWatch. These acquisitions 
strengthened our coverage in the corporate, financial institution, 
insurance, and structured finance sectors, as well as adding a 
significant number of international offices and affiliates.
    As a result of this growth and acquisitions, Fitch today has 
approximately 1,600 employees, including over 750 analysts, in over 49 
offices and affiliates worldwide. Fitch currently covers over 4,400 
corporations, banks and financial institutions, 86 sovereigns, and 
40,000 municipal offerings in the United States. In addition, we cover 
over 7,500 issues in structured finance, which remains our traditional 
strength.
    Fitch is in the business of publishing research and independent 
ratings and credit analysis of securities issued around the world. A 
rating is our published opinion as to the creditworthiness of a 
security, distilled into a simple, easy to use grading system (AAA to 
DDD). Fitch typically provides explanatory information with each 
rating.
    Rating agencies gather and analyze a variety of financial, 
industry, market, and economic information, synthesize that 
information, and publish independent, credible assessments of the 
creditworthiness of securities and issuers, thereby providing a 
convenient way for investors to judge the credit quality of various 
alternative investment options. Rating agencies also publish 
considerable independent research on credit markets, industry trends, 
and economic issues of general interest to the investing public.
    By focusing on credit analysis and research, rating agencies 
provide independent, credible and professional analysis for investors 
more efficiently than investors could perform on their own.
    We currently have hundreds of institutional investors, financial 
institutions, and Government agencies subscribing to our research and 
ratings, and thousands of investors and other interested parties that 
access our research and ratings through our free website and other 
published sources and wire services such as Bloomberg, Business Wire, 
Dow Jones, Reuters, and The Wall Street Journal.
    A diverse mix of both short-term and long-term investors uses our 
ratings as a common benchmark to grade the credit risk of various 
securities.
    In addition to their ease of use, efficiency and widespread 
availability, we believe that credit ratings are most useful to 
investors because they allow for reliable comparisons of credit risk 
across diverse investment opportunities.
    Credit ratings can accurately assess credit risk in the 
overwhelming majority of cases and have proven to be a reliable 
indicator for assessing the likelihood that a security will default. 
Fitch's most recent corporate bond and structured finance default 
studies are summarized below.



    The performance of ratings by the three major rating agencies is 
quite similar. We believe this similarity results from the common 
reliance on fundamental credit analysis and the similar methodology and 
criteria supporting ratings.
    Through the years, NRSRO ratings also have been increasingly used 
in safety and soundness and eligible investment regulations for banks, 
insurance companies, and other financial institutions. While the use of 
ratings in regulations has not been without controversy, we believe 
that regulators rely on ratings for the same reason that investors do: 
Ease of use, widespread availability, and proven performance over time.
    Although one can use other methods to assess the creditworthiness 
of a security, such as the use of yield spreads and price volatility, 
we believe that such methods, while valuable, lack the simplicity, 
stability, and track record of performance to supplant ratings as the 
preferred method used by investors to assess creditworthiness.
    However, we also believe that the market is the best judge of the 
value of ratings. We believe that if ratings begin to disappoint 
investors they will stop using them as a tool to assess credit risk and 
the ensuing market demand for a better way to access credit risk will 
rapidly facilitate the development of new tools to replace ratings and 
rating agencies.

Regulatory Review of Rating Agencies
    Beginning in 2002, the SEC began a thorough study of rating 
agencies that included informal discussions with Fitch and the other 
rating agencies, a formal examination of our practices and procedures, 
and two full days of public hearings in November 2002 in which we 
participated. Following the passage of the Sarbanes-Oxley Act of 2002, 
the SEC issued its Report on the Role and Function of Credit Rating 
Agencies in the Operation of the Securities Market in January 2003. In 
June 2003, the SEC issued a concept release, Rating Agencies and the 
Use of Credit Ratings under the Federal Securities Laws, soliciting 
public comment on a variety of issues concerning credit rating 
agencies.
    In the international arena, in the summer of 2003, a working group 
of the International Organization of Securities Commissions (IOSCO), 
under the leadership of SEC Commissioner Roel Campos, began its study 
of the credit rating agencies. Fitch was an active participant in the 
IOSCO process that ultimately led to the publication by IOSCO of the 
Statement of Principles Regarding the Activities of the Credit Rating 
Agencies in September 2003 and the Code of Conduct Fundamentals for 
Credit Rating Agencies at the end of last year.
    Given the importance of credit ratings in the financial market, we 
agree that there is a strong need for credit rating agencies to 
maintain high standards. For that reason, throughout the past 3 years 
Fitch has participated actively in the dialogue at the SEC, IOSCO, and 
on a local level throughout the world about the role and function of 
the rating agencies in the worldwide capital markets.
    Fitch supports the four high-level principles outlined by IOSCO as 
announced in it Principles in September 2003, which the IOSCO Code 
complements. These four principles include transparency and symmetry of 
information to all market participants, independence, and freedom from 
conflict of interest. We are supportive of the IOSCO Code and we 
believe that our present operating policies and practices exemplify the 
principles of the IOSCO Code and will continue to work with all capital 
markets participants to refine ``best practices'' for the ratings 
industry. We plan to publish our formal code of conduct, together with 
our existing policies that complement it, by the end of the first 
quarter of this year.

Testimony
    Set forth below is a summary of our views on the issues we 
understand the Committee on Banking, Housing, and Urban Affairs intends 
to explore at its hearing ``Examining the Role of Credit Rating 
Agencies in the Capital Markets.''

NRSRO Recognition Process And Criteria
    We believe that the SEC should formalize the process by which it 
recognizes rating organizations. The application process, specific 
recognition criteria, and time frames for action on all applications 
should be specified in appropriate regulations. We believe public 
comment should be solicited on applications and an appropriate appeal 
process should be put in place.
    The criteria for recognition should include an evaluation of the 
organization's resources, its policies to avoid conflicts of interest 
and prevent insider trading and the extent to which market participants 
use the organization's ratings. Most importantly, however, recognition 
should be based upon the organization demonstrating the performance of 
their ratings over time by publication of actual default rates 
experienced in rating categories and transition studies showing the 
actual movement of ratings over time. When considering a rating 
organization for possible recognition, we believe the SEC should 
evaluate the default and transition experience of each organization's 
ratings against a benchmark reflecting the aggregate, historical 
default, and transition rates of all ratings issued by rating agencies 
in the market. Ultimately, we believe that recognition should be 
reserved for those organizations that prove the performance of their 
ratings over time relative to the performance of other rating systems.
    We also believe that the SEC should continue the practice of 
limited recognition that acknowledges the special expertise of smaller 
organizations in selected areas of specialty or geographic regions such 
as the prior recognition afforded to IBCA and BankWatch for their 
expertise in financial institution analysis.
    Fitch does not believe that a criterion for recognition should be 
adherence to generally accepted industry standards. In fact, such 
industry standards do not exist in the case of credit rating agencies 
and we believe that it would be detrimental to introduce them. Ratings 
are opinions, and as such are based on differing criteria, qualitative 
and quantitative, in each agency. The market benefits from this 
diversity of opinion, and demands it. Requiring that a rating agency 
abide by strict standards would create a situation in which each agency 
would produce the same result on each credit and there would be no need 
for competing agencies or any benefit from competing agencies.

Examination and Oversight of NRSROS
    Fitch acknowledges the Commission's right to revoke the recognition 
of any NRSRO that no longer meets the criteria for recognition. Given 
the importance of credit ratings in the financial markets, we believe 
this is an important need. As we discussed in connection with the 
criteria for recognition, we also believe that the examination and 
oversight of NRSRO's should be principally focused on the performance 
of a rating organization's ratings over time relative to the 
performance of other rating systems. Accordingly, we believe that the 
Commission's principal oversight function should be to evaluate 
regularly the default and transition experience of each organization's 
ratings against an aggregate benchmark. Additionally, we also 
acknowledge the importance of our adherence to policies designed to 
prevent the misuse of inside information and the need of the Commission 
to ensure compliance with these important policies.
    In addition, we believe that any oversight should be narrowly 
tailored to recognize the constitutional rights of the rating agencies, 
which function as journalists and thus should be afforded the high 
level of protection guaranteed by the First Amendment. An excessive 
amount of interference with the business of rating agencies would both 
violate the First Amendment rights of the agencies and remove some of 
the flexibility in the ratings process that is critical to objective 
and timely ratings.
    Within this framework, a narrowly tailored oversight scheme 
specific to rating agencies should be developed. While the rating 
agencies currently file voluntarily under the Investment Advisor's Act, 
this is not a ``good fit,'' as our agencies function as journalists, 
providing analysis and opinion, and not as investment advisers. As the 
Supreme Court recognized in Lowe, Congress ``did not seek to regulate 
the press through the licensing of nonpersonalized publishing 
activities'' when it enacted the Investment Advisors Act, but rather 
was ``primarily interested in regulating the business of rendering 
personalized investment advice.'' Lowe v. SEC, 472 U.S. 181, 204 
(1985). Fitch does not provide any personalized investment advice; 
indeed, even Fitch's nonpersonalized ratings do not make any 
recommendations to buy or sell particular securities, but rather simply 
analyze the creditworthiness of a security, a point noted by the SEC 
staff in its June 4, 2003 response to questions from Congressman 
Richard H. Baker. Fitch is therefore not an ``investment advisory 
business'' within the meaning of the Investment Advisors Act and to try 
to make the Investment Advisors Act apply to Fitch and other rating 
agencies would not be productive.
    In the same vein, it would be unsound to seek to impose a diligence 
requirement on rating agencies either for purposes of creating a 
private right of action or for oversight purposes. Even putting aside 
the significant and in our view insurmountable issues of statutory 
authority and constitutionality, rating agencies do not now audit or 
verify the information on which they rely, and to impose such a 
requirement would duplicate the work of the various professionals 
(auditors, lawyers, investment bankers, and fiduciaries) upon whom the 
law does place certain obligations of diligence and due care.

Conflicts of Interest
    Over the years, there has been considerable discussion about the 
fact that the current NRSRO's derive a significant portion of their 
revenue from the ratings fees charged to issuers of rated securities. 
Fitch does not believe that the fact that issuers generally pay the 
rating agencies' fees creates an actual conflict of interest, that is, 
a conflict that impairs the objectivity of the rating agencies' 
judgment about creditworthiness reflected in ratings. Rather, it is 
more appropriately classified as a potential conflict of interest, that 
is, something that should be disclosed and managed to ensure that it 
does not become an actual conflict. We believe the measures that Fitch 
uses to manage the potential conflict adequately prevent an actual 
conflict of interest from arising.
    Charging a fee to the issuer for the analysis done in connection 
with a rating, dates back to the late 1960's. Investors, who are the 
ultimate consumers of the rating agency product, are quite aware of 
this.
    By way of context, Fitch's revenue comes from two principal 
sources: The sale of subscriptions for our research, and fees paid by 
issuers for the analysis we conduct with respect to ratings. In this we 
are similar to other members of the media who derive revenue from 
subscribers and advertisers that include companies that they cover. 
Like other journalists, we emphasize independence and objectivity 
because our independent, unbiased coverage of the companies and 
securities we rate is important to our research subscribers and the 
marketplace in general.
    Fitch goes to great lengths to ensure that our receipt of fees from 
issuers does not affect our editorial independence. We have a separate 
sales and marketing team that works independently of the analysts that 
cover the issuers. In corporate finance ratings, analysts generally are 
not involved in fee discussions. Although structured finance analysts 
may be involved in fee discussions, they are only the most senior 
analysts who understand the need to manage any potential conflict of 
interest.
    We also manage the potential conflict through our compensation 
philosophy. The revenue Fitch receives from issuers covered by an 
analyst is not a factor in that analyst's compensation. Instead, an 
analyst's performance, such as the quality and timeliness of research, 
and Fitch's overall financial performance determine an analyst's 
compensation. Similarly, an analyst's performance relative to his or 
her peers and the overall profitability of Fitch are what determine an 
analyst's bonus. The financial performance of an analyst's sector or 
group does not factor into their bonuses.
    Fitch does not have an advisory relationship with the companies it 
rates. It always maintains full independence. Unlike an investment 
bank, our fees are not based on the success of a bond issue or tied to 
the level of the rating issued. The fee charged an issuer does not go 
up or down depending on the ratings assigned or the successful 
completion of a bond offering.
    Our fee is determined in advance of the determination of the rating 
and we do not charge a fee for a rating unless the issuer agrees in 
advance to pay the fee. While we do assign ratings on an unsolicited 
basis, we do not send bills for unsolicited ratings. Any issuer may 
terminate its fee arrangement with Fitch without fear that its rating 
will be lowered, although we do reserve the right to withdraw a rating 
for which we are not paid or if there is insufficient investor interest 
in the rating to justify continuing effort to maintain it.
    As noted above, Fitch believes that the disclosure of the 
arrangement by which an issuer pay fees to Fitch in connection with 
Fitch's ratings of the issuer is appropriate. Accordingly, Fitch 
currently discloses that it receives fees from issuers in connection 
with our ratings as well as the range of fees paid. This has been our 
practice for sometime.
    Another concern discussed by the SEC in the Concept Release is that 
subscribers have preferential access to rating analysts and may obtain 
information about a rating action before it is available to the general 
public. This concern is completely unwarranted in the case of Fitch. 
Fitch takes great efforts to ensure that all members of the public have 
access to our ratings and may discuss those ratings with our analysts, 
whether or not those interested parties are subscribers.
    All public ratings and rating actions are widely disseminated 
through our web sites and international wire services. Except for prior 
notification to the issuer of a rating or rating action, Fitch never 
selectively discloses ratings and rating actions to any subscriber or 
any other party. Fitch's ratings and related publications, including 
those detailing rating actions, are widely available through our public 
websites and wire services free-of-charge and there are no prior 
communications of rating actions to subscribers.
    Fitch analysts do regularly conduct informal conversations with 
investors, other members of the financial media, and interested parties 
discussing our analysis and commentary, but as a matter of policy, 
those conversations can never go beyond the scope of our published 
analysis or communicate any nonpublic information. We believe that 
making our analysts available to anyone interested in discussing our 
analysis is a valuable service to investors and the capital markets at 
large. The contact information for the principal analysts and other key 
contact people at Fitch is included in every item we publish for the 
purpose of facilitating interested parties posing questions to our 
analysts. Anyone can call our analysts free-of-charge and discuss our 
analysis with them, whether or not the person is a subscriber to our 
subscription services.
    From time to time, we also hold free telephone conferences that are 
available to anyone interested, at which our analysts will discuss our 
published analysis and criteria and take questions from the 
participants. These telephone conferences are publicly announced in the 
same manner our ratings and rating actions are disseminated.
    We also sponsor conferences throughout the world, as well as 
participate in conferences sponsored by others (which may sometimes 
require payment of a registration fee) at which our analysts will 
discuss our published analysis and criteria. Fitch publicly advertises 
these conferences and all are welcome.
    In addition, we firmly believe that existing antifraud remedies are 
sufficient to deter any inappropriate disclosures by rating agencies to 
subscribers or any other parties.
    Concern has also been raised about the potential conflicts of 
interest that may arise when rating agencies develop ancillary fee-
based businesses. Over the years, revenue derived by Fitch from 
nonrating sources, including consulting and advisory services has been 
minimal. Historically, the bulk of such services related to providing 
customized ratings, performance, or scoring measures and were usually 
provided to subscribers of our subscription products, which were not 
necessarily entities that we rate.
    In the fourth quarter of 2001, Fitch Group, Fitch Ratings' parent 
company established Fitch Risk Management, Inc. (FRM), a newly formed 
company offering risk management services, databases, and credit models 
to help financial institutions and other companies manage both credit 
and operational risk. Fitch Ratings and FRM are subject to a ``fire 
wall'' policy and FRM has its own employees, offices, and marketing 
staff. Fitch Group recently acquired Algorithmics, a leading provider 
of enterprise risk management solutions. Algorithmics, part of FRM, is 
subject to the same ``firewall'' policies.
    Based on the above-described procedures regarding issuer payment of 
fees, selective disclosure and ancillary services, Fitch believes that 
it adequately addresses any potential conflict of interest. In fact, we 
believe that the suggestions proposed in both the SEC Concept Release 
and the provisions of the IOSCO Code to protect against conflicts of 
interest have already been in large part adopted by Fitch. However, 
Fitch would not oppose narrowly tailored conditions to SEC recognition 
that ensure that these standards continue.

Transparency
    We believe quite strongly that the process and procedure that 
rating agencies use should be transparent. Accordingly, at Fitch, there 
are hundreds of criteria reports published highlighting the methodology 
we use to rate various types of entities and securities, together with 
detailed sector analysis on a broad array of sectors, companies, and 
issues, all available free on our website (www.fitchratings.com). Fitch 
has also been a leader in publishing presale reports in the areas of 
structured finance, global power, project finance, and public finance, 
where our published analysis of various transactions of interest to the 
market is made available free of charge on our website prior to the 
pricing of the transaction. In addition, Fitch makes available free of 
charge on our website all of our outstanding ratings. We also 
distributes announcements of rating actions through a variety of wire 
services as mentioned above.
    However, certain of our publications and data are only available to 
our paid subscribers. We commit extensive time and resources to 
producing our publications and data and we believe they are valuable to 
anyone interested in objective credit analysis. In this practice, we 
are no different from other members of the financial media, such as 
Bloomberg, Dow Jones, Thomson Financial, and others that charge 
subscribers for access to their publications and data services.
    While we believe that for the most part credit rating agencies have 
adequate access to the information they need to form an independent and 
objective opinion about the creditworthiness of an issuer, Fitch would 
welcome improved disclosure by issuers. As we found in our various 
published studies of the use of credit derivatives in the global 
market, financial reporting and disclosure with respect to areas such 
as credit derivatives, off-balance sheet financing, and other forms of 
contingencies vary greatly by sector, and comparability is further 
obscured by differences in international reporting and accounting 
standards.
    As the SEC noted in their report, issuers provide rating agencies 
with nonpublic information as part of the rating process. The nature 
and level of nonpublic information provided to Fitch varies widely by 
company, industry, and country. Nonpublic information frequently 
includes budgets and forecasts, as well as advance notification of 
major corporate events such as a merger. Nonpublic information may also 
include more detailed financial reporting.
    While access to nonpublic information and senior levels of 
management at an issuer is beneficial, Fitch can form an objective 
opinion about the creditworthiness of an issuer based solely on public 
information in many jurisdictions. Typically, it is not the value of 
any particular piece of nonpublic information that is important to the 
rating process, but that access to such information and to senior 
management that assists us in forming a qualitative judgment about a 
company's management and prospects.
    Another factor critical to the adequate flow of information to and 
from the rating agencies is the understanding that information can be 
provided to a rating agency without necessitating an intrusive and 
expensive verification process that would largely if not entirely 
duplicate the work of other professionals in the issuance of 
securities. Thus, as noted by the SEC Report, rating agencies do not 
perform due diligence or conduct audits, but do assume the accuracy of 
the information provided to them by issuers and their advisors. Since 
rating agencies are part of the financial media, we believe that our 
ability to operate on this assumption, and to exercise discretion in 
deciding how to perform our analysis and what to publish, is protected 
by the First Amendment.

                               ----------

                  PREPARED STATEMENT OF JAMES A. KAITZ
     President and CEO, The Association for Financial Professionals
                            February 8, 2005

    Good morning, Chairman Shelby, Ranking Member Sarbanes, and Members 
of the Committee. I am Jim Kaitz, President and CEO of the Association 
for Financial Professionals. AFP welcomes the opportunity to 
participate in today's hearing on the role of credit rating agencies in 
the capital markets.
    The Association for Financial Professionals (AFP) represents more 
than 14,000 finance and treasury professionals representing more than 
5,000 organizations. Organizations represented by our members are drawn 
generally from the Fortune 1,000 and the largest of the middle-market 
companies from a wide variety of industries. Many of our members are 
responsible for issuing short- and long-term debt and managing 
corporate cash and pension assets for their organizations. In these 
capacities, our members are significant users of the information 
provided by credit rating agencies. Acting as both issuers of debt and 
investors, our members have a balanced view of the credit rating 
process, and have a significant stake in the outcome of the examination 
of rating agency practices and their regulation.
    AFP believes that the credit rating agencies and investor 
confidence in the ratings they issue are vital to the efficient 
operation of global capital markets. Before outlining the consequences 
of inaction, it is useful to provide some background on how we got to 
where we are today and summarize AFP's research on this important 
issue.

Background
    For nearly 100 years, rating agencies have been providing opinions 
on the creditworthiness of issuers of debt to assist investors. The 
Securities and Exchange Commission (SEC) and banking regulators also 
rely on ratings from rating agencies. In 1975, the SEC recognized 
Moody's, Standard & Poor's, and Fitch, the three major rating agencies 
in existence at that time, as the first Nationally Recognized 
Statistical Rating Organizations (NRSRO). The SEC and other regulators 
use the ratings from the NRSRO's to determine whether certain regulated 
investment portfolios, including those of mutual funds, insurance 
companies, and banks, meet established credit quality standards. As a 
result, companies that hope to have their debt purchased by these 
portfolios must have a rating from an NRSRO. From 1975 to 1992, the SEC 
recognized four other rating agencies, but each of these entrants 
consequently merged with Fitch. The SEC did not recognize any new 
agencies from 1992 until April 2003, when Dominion Bond Rating Service 
received recognition from the SEC, becoming the fourth NRSRO.
    Some market participants have argued that the NRSRO's did not 
adequately warn investors of the impending failure of Enron, WorldCom, 
Parmalat, and other companies. For example, in 2001, the rating 
agencies continued to rate the debt of Enron as ``investment grade'' 
days before the company filed for bankruptcy. These failures occurred 
despite the fact that credit rating agencies (CRA's) have access to 
nonpublic information because of their exemption from Regulation Fair 
Disclosure (Reg FD). As a result of the corporate scandals of 2001, 
Congress, in the Sarbanes-Oxley Act required the Securities and 
Exchange Commission (SEC) to conduct a study on credit rating agencies 
examining the role of rating agencies in evaluating debt issuers, the 
importance of that role to investors and any impediments to accurate 
appraisal by credit rating agencies. Sarbanes-Oxley also required the 
study to determine whether there are any barriers to entry into the 
credit rating market and whether there are conflicts of interest that 
hinder the performance of the rating agencies.
    In January 2003, the SEC released the Sarbanes-Oxley required 
study, which identified five major issues that the SEC stated it would 
examine further: Information flow, potential conflicts of interest, 
alleged anticompetitive or unfair practices, reducing potential 
barriers to entry, and ongoing oversight. Following the study, the SEC 
issued, for public comment, a concept release exploring these issues on 
June 4, 2003. As of this hearing, the SEC has not issued any proposed 
rules.
    In September 2002, AFP surveyed senior level corporate 
practitioners and financial industry service providers on their views 
regarding the quality of the NRSROs' ratings, the role the SEC should 
take in regulating the agencies, and the impact additional competition 
may have on the marketplace for ratings information. In that survey, 
many financial professionals indicated that the ratings generated by 
the NRSRO's were neither accurate nor timely.
    In September 2004, AFP once again surveyed senior level financial 
professionals regarding the accuracy and timeliness of the NRSROs' 
analyses and on the potential role regulators may have in promoting 
competition among credit rating agencies.\1\
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    \1\ For complete copies of both survey results visit the AFP 
website at www.AFPOnline.org.
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    Key findings of the 2004 AFP Rating Agency Survey include:

 Eighty-seven percent of responding organizations with debt 
    indicate that credit providers require them to obtain and maintain 
    a rating from at least one of the four NRSRO's.
 Many financial professionals believe that the ratings of their 
    organizations are either inaccurate or are not updated on a timely 
    basis.
 A third of corporate practitioners believe the ratings on 
    their organization's debt are inaccurate.
 Fifty-two percent of financial professionals indicate that the 
    cost of credit ratings has increased by at least 11 percent over 
    the past 3 years, including 19 percent that indicate that costs 
    have increased at least 25 percent over that time period.
 While many responding organizations are confident in the 
    accuracy of the ratings they use for investments, they are less 
    confident in the timeliness of the same ratings.
 Financial professionals believe the Securities and Exchange 
    Commission (SEC) should take a greater role in overseeing the 
    credit rating agencies along with encouraging greater competition 
    in the field.

    Recently, other organizations have taken steps to address credit 
rating agency reform issues. The International Organization of 
Securities Commissions (IOSCO) in September 2003 issued a Statement of 
Principles regarding the manner in which rating agency activities are 
conducted. In December 2004, IOSCO released Code of Conduct 
Fundamentals for Credit Rating Agencies.
    In July 2004, the Committee of European Securities Regulators 
(CESR), at the request of the European Commission, issued a call for 
evidence on possible measures concerning credit rating agencies. The 
Committee intends to approve and publish its final advice to the 
European Commission in March 2005.

Consequences of Inaction
    Why is reforming the credit rating system so important? Along with 
the SEC and other regulators that have incorporated the NRSRO 
designation into their rules, institutional and individual investors 
have long relied on credit ratings when purchasing individual corporate 
and municipal bonds. Further, nearly every mutual fund manager that 
individuals and institutional investors have entrusted with over $8 
trillion relies to some degree on the ratings of nationally recognized 
agencies. Rating actions on corporate debt also have an indirect but 
sizeable impact on the stock prices of rated companies.
    Debt issuers rely on the credit rating agencies to understand the 
company's finances, strategic plans, competitive environment, and any 
other relevant information about the company in order to issue ratings 
that accurately reflect the company's creditworthiness. These ratings 
determine the conditions under which a company can raise capital to 
maintain and grow their business. Credit ratings also allow others that 
deal with the issuer to make an informed assessment of the issuer as a 
potential trading partner, and are a valuable part of the issuer's 
external communications with the market.
    While credit rating agencies have long played a significant role in 
the operation of capital markets, the Administration's recent single-
employer pension reform proposal would further increase the importance 
of the NRSRO's and their impact on Americans. The proposal would tie 
pension funding and Pension Benefit Guaranty Corporation (PBGC) 
premiums to a plan sponsor's financial condition as determined by 
existing credit ratings. In some cases, plan sponsors would be 
prohibited from increasing benefits or making lump sum payments based 
on their credit rating and funded status. Such a proposal would further 
codify the NRSRO designation and even further empower the rating 
agencies.
    Despite the increasing reliance on credit ratings, even after more 
than 10 years of examining the role and regulation of credit rating 
agencies, the Securities and Exchange Commission has not has not taken 
any meaningful action to address the concerns of issuers and investors. 
These concerns include questions about the credibility and reliability 
of credit ratings and conflicts of interest and abusive practices in 
the rating process. Chairman Shelby and Members of the Committee, these 
issues are far too important for the SEC to remain silent while the 
world waits for it to take action.
    As I noted earlier, the credit rating agencies and investor 
confidence in the ratings they issue are vital to the operation of 
global capital markets. As evidenced in AFP's research, confidence in 
rating agencies and their ratings has diminished over the past few 
years. Addressing issues such as the lack of a defined process by which 
an agency can become an NRSRO, eliminating potential conflicts of 
interest, and effective marketplace competition will begin to restore 
the much-needed confidence in the credit ratings system.
    When the SEC recognized the first Nationally Recognized Statistical 
Rating Organization (NRSRO) in 1975 without enumerating the criteria by 
which others could be recognized, it created an artificial barrier to 
entry to the credit ratings market. This barrier has led to a 
concentration of market power with the recognized rating agencies and a 
lack of competition and innovation in the credit ratings market. Only 
the SEC can remove the artificial barrier to competition it has 
created. Therefore, AFP strongly recommends that the SEC maintain the 
NRSRO designation and clearly articulate the process by which qualified 
credit rating agencies can attain the NRSRO designation.
    Not only has the SEC bestowed a significant competitive advantage, 
but it has also failed to exercise any meaningful oversight of the 
recognized agencies. In nearly 30 years since creating the NRSRO 
designation, there has been no review of the ongoing credibility and 
reliability of the ratings issued by the NRSRO's. The SEC must improve 
its ongoing oversight of the rating agencies to ensure that they 
continue to merit NRSRO status.
    The SEC further empowered the rating agencies when it exempted them 
from Regulation Fair Disclosure (FD). Through this exemption, the 
rating agencies have access to nonpublic information about the 
companies they rate. Again, the Commission has done nothing to ensure 
that those who are granted this powerful exemption do not use the 
nonpublic information inappropriately. The SEC must require that 
NRSRO's have policies in place to protect this valuable and privileged 
information. Again, this should be part of the SEC's ongoing oversight 
of the rating agencies.
    As highlighted in recent media reports, rating agencies continue to 
promulgate unsolicited ratings of debt issuers. Because unsolicited 
ratings are issued without the benefit of access to company management 
or nonpublic information about the issuer, the resulting ratings are 
often not an accurate reflection of an organization's financials 
condition. Credit ratings are critical to an organization's ability to 
issue debt and issuers often feel compelled to participate in the 
rating process and pay for the rating that was never solicited. The 
potential for abuse of these unsolicited ratings by the rating agencies 
must be addressed by the SEC.
    Finally, an NRSRO is also in a position to compel companies to 
purchase ancillary services. These ancillary services include ratings 
evaluations and corporate governance reviews. Further, the revenue 
derived from these services has the potential to taint the objectivity 
of the ratings. You need look no further than the equity research and 
audit professions to understand why these potential abusive practices 
and conflicts of interest must be addressed by the SEC.

Recommendations
    To address many of the questions raised by the SEC and market 
participants, the Association for Financial Professionals, along with 
treasury associations from the United Kingdom and France, released a 
Code of Standard Practices for Participants in the Credit Rating 
Process.
    A copy of the Code is attached to my testimony.* Importantly, the 
Code contains recommendations for regulators, as well as rating 
agencies and issuers. To be clear, the Code is a private sector 
response intended to complement rather than replace regulation
---------------------------------------------------------------------------
    * Held in Committee files.
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    Earlier in my testimony, I touched upon many of the regulatory 
recommendations contained in the Code. I would like to take this 
opportunity to provide more detailed regulatory recommendations. 
Specifically, we recommend establishing transparent recognition 
criteria based on whether a credit rating agency can consistently 
produce credible and reliable ratings over the long-term. Establishing 
clearly defined recognition criteria is a crucial step to removing 
barriers to entry and enhancing competition in the credit ratings 
market.
    In the Code, we also urge regulators to require that rating 
agencies document internal controls that protect against conflicts of 
interest and anticompetitive and abusive practices, and ensure against 
the inappropriate use of nonpublic information to which the rating 
agencies are privy because of their exemption from Regulation FD. 
Regulatory recommendations also include improving ongoing oversight of 
approved rating agencies to ensure that NRSRO's continue to meet the 
recognition criteria.
    For rating agencies, the Code includes suggestions to improve the 
transparency of the rating process, protect nonpublic information 
provided by issuers, protect against conflicts of interest, address the 
issue of unsolicited ratings, and improve communication with issuers 
and other market participants.
    Finally, recognizing that the credibility and reliability of credit 
ratings is heavily dependent on issuers providing accurate and adequate 
information to the rating agencies, the Code of Standard Practices 
outlines issuer obligations in the credit rating process. These 
obligations are intended to improve the quality of the information 
available to the rating agencies during the initial rating process and 
on an ongoing basis, and to ensure that issuers respond appropriately 
to communications received from rating agencies.
    A reasonable regulatory framework that minimizes barriers to entry 
and is flexible enough to allow innovation and creativity will foster 
competition among existing NRSRO's and those that may later be 
recognized and restore investor confidence in the rating agencies and 
global capital markets. Rather than excessively prescriptive regulatory 
regimes, innovation and private sector solutions, such as AFP's Code of 
Standard Practices, are the appropriate responses to many of the 
questions that have been raised about credit ratings.
    Restoring issuer and investor confidence in the credit ratings 
process is critical to global capital markets. Chairman Shelby and 
Members of the Committee, we strongly recommend that you hold the SEC 
accountable by demanding immediate action on the issues that have been 
raised here today. If the SEC does not act immediately to aggressively 
address each of the concerns we have outlined, we urge you act to 
restore investor confidence in the credit ratings process through 
action by this Committee. We commend you, Mr. Chairman, and the 
Committee for recognizing the importance of this issue to investors and 
global capital markets and hope that this hearing will compel the SEC 
to act.

                               ----------

             PREPARED STATEMENT OF RAYMOND W. MCDANIEL, JR.
President and Chief Operating Officer, Moody's Investors Services, Inc.
                            February 8, 2005

    Good morning. I am Ray McDaniel, President of Moody's Investors 
Service. Let me begin by thanking Chairman Shelby, Senator Sarbanes, 
and the Members of the Committee on Banking, Housing, and Urban Affairs 
(the Committee) for inviting Moody's to participate in this hearing.
    Today, I will briefly discuss Moody's background, the role and the 
use of our ratings in the market, our rating process and enhancements 
we have made to that process, the competitive landscape in which we 
operate, some global developments in our industry, and finally the 
regulatory environment in the United States.

Background about Moody's
    Rating agencies occupy a niche in the investment information 
industry. Our role in that market is to disseminate information about 
the relative creditworthiness of, among other things, corporations, 
governmental entities, and pools of assets collected in securitized or 
``structured finance'' transactions. Moody's is the oldest bond rating 
agency in the world. We have been rating bonds since 1909. Today, we 
have more than 1,000 analysts in 18 countries around the world. Our 
products include our familiar credit rating opinions, which are 
publicly disseminated via press release and made freely available on 
our website, as well as research and special 
reports about debt issuers and their industries that reach more than 
3,000 institutions and 22,000 subscribers around the globe.
    Moody's integrity and performance track record have earned it the 
trust of capital market participants worldwide. Our ratings and 
analysis track more than $30 trillion of debt issued in domestic and 
international markets, covering approximately 10,000 corporations and 
financial institutions, more than 20,000 municipal debt issuers, over 
12,000 structured finance transactions, and 100 sovereign issuers.

What Moody's Ratings Measure
    Moody's ratings are expressed according to a simple system of 
letters and numbers. Ratings forecast the relative likelihood that debt 
obligations or issuers of debt will meet future payment obligations in 
a timely manner. Company ratings are formulated utilizing the 
traditional techniques of fundamental credit analysis and are thus 
based primarily on an independent assessment of a company's published 
financial statements.
    Moody's bond rating system, which we have used for 96 years, has 21 
categories, ranging from Aaa to C. Investment-grade ratings include 
ratings of Aaa, Aa, A, and Baa. Ratings below Baa are considered 
speculative-grade. Moody's ratings are opinions regarding relative 
expected loss, which reflects an assessment of both the probability 
that a debt instrument will default and the severity of loss in the 
event of default. The lowest expected credit loss is at the Aaa level, 
with a higher expected loss rate at the Aa level, a yet higher expected 
loss rate at the A level, and so on down through the rating scale. In 
other words, the rating system is not a ``pass-fail'' system; rather, 
it is a probabilistic system in which the forecasted probability of 
future loss rises as the rating level declines.
    Moody's rating system has over the years extended to other aspects 
of an issuer's creditworthiness, thereby disaggregating the various 
elements of our analysis and providing the market with our opinions on 
those specific characteristics. Two such examples are:

 short-term ratings--which measure the likelihood that an 
    issuer will be able to meet its short-term liabilities; and,
 financial strength ratings--which measure the stand alone 
    financial strength of an entity, excluding any implied or 
    guaranteed third party support

Role and Usage of Ratings
    Moody's believes that the most important function of credit ratings 
is to contribute to fair and efficient capital markets. Our ratings are 
one means of communicating relevant information about a bond to 
potential investors in that bond. At the same time, the broad, public 
distribution of ratings by Moody's helps assure that our credit 
opinions are freely and simultaneously available to all investors, 
regardless of whether they purchase products or services from Moody's.
    Our ratings have 3 intrinsic qualities that have made them useful 
for a variety of purposes. First, as I have mentioned, our ratings are 
publicly and simultaneously available to all market participants; 
second, our rating opinions are independently formed; and third, and 
possibly most important, Moody's rating performance:

 can be tested,
 is regularly tested, and
 has been consistently shown to have predictive content.

    As a result, ratings have been employed by a diverse collection of 
investors, issuers, financial institutions, and regulatory bodies, 
which have a variety of objectives in their use of ratings. For 
example:

 Investors use ratings when making investment decisions to help 
    assess a bond's relative creditworthiness;
 Debt issuers use ratings to broaden the marketability of their 
    securities and thereby to improve their access to the capital 
    markets;
 Portfolio managers employ ratings for performance benchmarking 
    and portfolio composition rules (commitments to specific portfolio 
    investment strategies); and
 Regulators of banks, securities firms, and insurers use 
    ratings to determine investment suitability, measure capital 
    adequacy, and promote market stability.

Moody's Management of the Rating System
    The market utility of a credit rating system is highest when 
ratings effectively distinguish riskier credits from those that are 
less risky, when they do so on a comparable basis across a wide range 
of issuers, and when the ratings are widely disseminated. Stability of 
ratings is also valued in the market, and Moody's manages its ratings 
so that they are changed only in response to changes in relative credit 
risk that we believe will endure, rather than in response to transitory 
events or shifts in market sentiment.
    Having said that, our ratings should not be any more stable than 
our perception of fundamental creditworthiness warrants. Moreover, in 
an effort to provide greater transparency around possible future 
changes in ratings, we have developed a series of additional public 
signals, called ``watchlists'' and ``outlooks,'' through which we 
communicate our opinion on possible trends in future creditworthiness 
and the likely direction of ratings that are under review. A rating 
outlook, expressed as positive, stable, negative, or developing, 
provides an opinion as to the likely direction of any medium-term 
rating actions, typically based on a 12-18 month horizon. Most 
investment grade companies have a rating outlook assigned to them.
    If changing circumstances contradict the assumptions or data 
supporting a current rating, we may place the rating on our watchlist. 
The watchlist highlights issuers (or debt obligations) whose rating is 
formally on review for possible change. At the conclusion of a review, 
typically within 90 days of placement on the watchlist, we will assess 
whether the issuer's credit risk is still consistent with the assigned 
rating. Although the watchlist is not a guarantee or commitment to 
change ratings over a certain time horizon, or even to change them at 
all, historically about 66 percent of all ratings have been changed in 
the same direction (and rarely in the opposite direction) as indicated 
by their watchlist status.
    Through our overall management of the rating system, we believe we 
have achieved the balance demanded by the marketplace for a relatively 
stable product that also is capable of providing timely public 
information about possible future movements in creditworthiness.

Moody's Rating Process
    Let me now describe how we go about rating debt securities issued 
by corporations. Our ratings and research are produced by our credit 
professionals generally located in the region of the issuing entity. 
Our rating process begins when an issuer or its representative requests 
a rating. A managing director responsible for the issuer's industry 
sector will assign the analysis of the corporation to a lead analyst 
and back-up analyst. The lead analyst is responsible for compiling 
relevant information on the issuer. Moody's analysts rely heavily on 
publicly available information, including regulatory filings and 
audited financial statements. The remainder of the information comes 
from macroeconomic analysis, industry-specific knowledge, and the 
issuer's responses to any requests for additional information from the 
credit analyst. Although issuers may choose to volunteer nonpublic 
information to inform our deliberations, they are not required to do so 
as part of the rating process. In instances where, in Moody's' view, 
there is insufficient information to form a rating opinion, we will 
either not rate the entity or withdraw an already published rating.
    Once information has been gathered, the lead analyst will analyze 
the company, which incorporates an evaluation of, among other things: 
Franchise value, financial statement analysis, liquidity analysis, 
management quality, and the regulatory environment of the industry in 
which the company operates. Depending on the complexity of the 
transaction, the analyst may include the expertise of some of our 
specialist teams, which I will discuss in more detail later. Based on 
this assessment, the lead analyst will draft a rating memorandum. That 
memorandum is then distributed and discussed in a rating committee, 
which ultimately is responsible for taking a rating decision on a 
majority-vote basis.
    The rating committee is typically comprised of the rating committee 
chair; the lead analyst, who has researched the company; the back-up 
analyst; junior support analysts; and possibly additional analysts or 
managing directors who have expertise relevant to the rating decision. 
During the committee meeting, the lead analyst presents his or her 
views and discusses the underlying reasoning and assumptions. The 
committee then challenges and debates the various points, and after 
vetting the various issues, it votes.\1\
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    \1\ Junior support analysts typically do not vote. They are however 
encouraged to fully participate in the discussion as the process is an 
effective means of training.
---------------------------------------------------------------------------
    When the committee concludes, the issuer is contacted and informed 
of Moody's rating decision. If the issuer has new information which is 
important and relevant, the issuer may appeal the rating. Otherwise, 
Moody's provides the issuer with a copy of the draft press release 
announcing the rating decision. The draft press release will include 
the rating action and our reasoning. The issuer then has an opportunity 
to review the draft press release prior to its dissemination,\2\ for 
the purpose of verifying that it does not contain any inaccurate or 
nonpublic information. Once final, the rating is released to the news-
wires and made available on our website. The entire rating process 
generally takes from 4 to 6 weeks, and sometimes longer if the credit 
is particularly complex.
---------------------------------------------------------------------------
    \2\ If an issuer has no rated debt outstanding in the market, it 
may request that the timing of the press release coincide with its 
contemplated debt issuance.
---------------------------------------------------------------------------
    Once a rating has been published, Moody's monitors the credit 
quality of that outstanding debt issuance and will alter the rating--
through the same rating committee process--should our perception of the 
issuance's creditworthiness change.

Issuer Pays Model
    Most of Moody's revenues are generated from issuer fees. Issuers 
request and pay for ratings from us because of the broad marketability 
of bonds that ratings facilitate. Ratings facilitate this marketability 
in part because many U.S. institutional investors have prudential 
investment guidelines that rely in part upon ratings as a measure of 
desired portfolio quality. While both issuers and investors rely on our 
ratings, issuers are more motivated to pay for ratings than investors 
because of two attributes of ratings:
    First, there is a substantial difference between issuers and 
investors in their need for a rating on any single debt instrument. 
While ratings promote broad marketability of bonds, investors can 
select from a wide range of investment alternatives and are, therefore, 
more interested in the general existence and application of ratings 
than in any individual rating. If, for example, a rating is not 
assigned to a particular bond, in most cases an investor's motivation 
to request and pay for a rating on that bond is low. There are many 
other rated bonds or investment opportunities that the investor can 
choose among.
    This relative indifference to individual ratings means that 
investors would only be motivated to pay fees for ratings that are 
delivered on an aggregate, comparative basis. Such a service, which 
would have to operate as a subscription service to generate fees, is 
impractical because of the second principle: The expectation that 
ratings of public debt will be made simultaneously available to all 
investors through public dissemination.
    Because ratings are publicly disseminated, investors do not need to 
purchase ratings, as they are freely available. Public availability, 
when combined with the relative indifference of investors versus issuers 
toward any single rating, allows investors to benefit from ratings as 
a ``free good'' by consuming them without a compelling need to support 
the cost base that produces them. An issuer does not have the same 
tolerance as an investor for a missing rating on its bond. It does not 
have the same range of choices in accessing capital that an investor has 
in deploying capital. In order for an issuer to facilitate broad 
marketability of its bond, it will likely choose to have a rating on 
that specific bond.

Conflicts of Interest
    The issuer-pays business model has conflicts of interest, as does 
the investor-subscription business model, and so we have taken 
important steps to effectively manage and disclose those risks. Issuer 
fees were introduced over three decades ago. Since that time, we 
believe we have successfully managed the conflicts of interest and have 
provided the market with objective, independent, and unbiased credit 
opinions. To foster and demonstrate objectivity, Moody's has adopted 
and disclosed publicly certain Fundamental Principles of Moody's 
ratings management. Among them are:

 Policies and procedures which require that analysts 
    participating in a committee be fully independent from the company 
    they rate--for example, analysts are prohibited from owning 
    securities in institutions which they rate (except through holdings 
    in diversified mutual funds);
 Analyst compensation is unconnected with either the ratings of 
    the issuers the analyst covers or fees received from those issuers;
 Rating decisions are taken by a rating committee and not by an 
    individual rating analyst;
 Rating actions reflect judicious consideration of all 
    circumstances believed to influence an issuer's creditworthiness;
 Moody's will not refrain from taking a rating action 
    regardless of the potential effect of the action on Moody's or an 
    issuer; and
 Moody's does not create investment products, or buy, sell, or 
    recommend securities to users of our ratings and research.\3\
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    \3\ Moody's parent company, Moody's Corporation, invests excess 
cash in highly rated short-term debt securities. All investment 
decisions are made at the parent company level.

    The integrity and objectivity of our rating process is of utmost 
importance to us. Our continued reputation for objective ratings, as a 
recent Federal Reserve \4\ study indicated, is essential to our role in 
the marketplace.
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    \4\ Daniel M. Covits, Paul Harrison, ``Testing Conflicts of 
Interest at Bond Ratings Agencies with Market Anticipation: Evidence 
that Reputation Incentives Dominate,'' Federal Reserve Board, December 
2003.
---------------------------------------------------------------------------
Track Record of Predictive Content
    Perhaps the most important litmus test, however, for whether 
conflicts of interest are being properly managed is the performance of 
our ratings. As I said earlier, ratings performance can be and is 
regularly tested according to measures that are 
subject to third party verification. This testing has repeatedly 
demonstrated the predictive content of our ratings over time. Moody's 
and independent academics have published studies on the relationship 
between our ratings and credit risk.\5\ Our annual ``default study'' 
consistently shows that higher-rated bonds default at a lower rate than 
lower-rated bonds, and that the proportion of defaults varies with the 
credit cycle. Moreover, since 2003, Moody's has been publishing a 
quarterly ``report card'' of our rating quality performance utilizing a 
range of accuracy and stability metrics.
---------------------------------------------------------------------------
    \5\ See generally, Rober W. Holthausen and Richard W. Leftwich, 
``The Effect of Bond Rating Changes on Common Stock Prices,'' Journal 
of Financial Economics 17 (1986) 57-89; Edward I. Altman, Herbert A. 
Rijken, ``How Rating Agencies Achieve Rating Stability'', Journal of 
Banking & Finance 28 (2004) 2679-2714; William Perraudin, Alex P. 
Taylor, ``On the Consistency of Ratings and Bond Market Yields,'' 
Journal of Banking & Finance 28 (2004) 2769-2788; Gunter Loffler, 
``Ratings Versus Market-Based Measures of Default Risk in Portfolio 
Governance,'' Journal of Banking & Finance, February 28 (2004), 2715-
2746; Credit Ratings and Complementary Sources of Credit Quality 
Information, by a working group led by Arturo Estrella, Basel Committee 
on Banking Supervision Working Papers, No. 3, August 2000; Default & 
Loss Rates of Structured Finance Securities: 1003-2003, Moody's Special 
comment, September 2004; Default and Recovery Rates of Corporate Bond 
Issuers, 1920-2004, Moody's Special Comment, January 2005; The 
Performance of Moody's Corporate Bond Ratings: December 2004 Quarterly 
Update, Moody's Special Comment, January 2005; Measuring the 
Performance of Corporate Bond Ratings, Moody's Special Comment, April 
2003.
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Enhancements to the Rating Process
    The ultimate value of a rating agency's contribution to market 
fairness and efficiency depends on its ability to offer predictive 
opinions about the relative credit risk of rated entities. However, I 
caution that our ratings should not be construed as investment advice, 
as performance guarantees, or as a means of auditing for fraud. 
Further, the quality of the opinions we provide to the market is in 
large part a function of the quality of information to which we have 
access when formulating our opinions. As a result, the role rating 
agencies play in any market is either augmented or hindered by the 
quality and completeness of the financial information published by debt 
issuers.
    As high profile corporate frauds in recent years have demonstrated, 
if issuers abandon the principles of transparency, truthfulness, and 
completeness in disclosure, neither rating agencies nor any other 
market participants--including regulatory authorities--can properly 
fulfill their roles. As one of the largest consumers of issuers' 
financial disclosure, Moody's has supported the efforts of this 
Committee and the Congress to require truthful financial disclosure.
    Nevertheless, while our processes are not intended to 
systematically detect fraud nor reaudit financial statements, we 
recognize that in order to fulfill our role in the market, our 
methodologies must evolve with the market and our analysts must stay 
abreast of market developments. For almost 100 years, we have been 
committed to providing the highest quality credit assessments available 
in the global markets, which means that we must continue to learn both 
from our successes and our mistakes. In this spirit, we have undertaken 
substantial internal initiatives to enhance the quality of our analysis 
and the reliability of our credit ratings. These initiatives include:

 Analytical specialist teams: We have added over 40 
    professionals specializing in accounting and financial disclosure, 
    off-balance sheet risk, corporate governance, and risk management 
    assessment. These professionals work alongside our analytical teams 
    and do not have direct rating responsibilities. As such, they are 
    able to devote full attention to their areas of concentration and 
    bring their expertise to credits that are more complex and which 
    need greater scrutiny.
 Analyst professional development program: Moody's company 
    analysts must annually complete 40 hours of course work that covers 
    a range of substantive disciplines, including accounting, 
    securitization and risk transfer, liquidity analysis, and ethics.
 Greater use of market information: Moody's has developed 
    market-based monitoring tools to help analysts maintain close 
    scrutiny over their portfolios.
 Global realignment: Moody's has restructured organizationally 
    along lines of business, rather than regions, to allow analysts 
    covering the same industry to share information and expertise more 
    easily across borders.
 Reinforced centralized credit policy function: The credit 
    policy function at Moody's has been augmented to help ensure that 
    credit policies and procedures are efficiently communicated 
    throughout Moody's and the market, and are uniformly implemented.
 Chief credit officers: We have appointed chief credit 
    officers, charged with helping to ensure rating quality, in our 
    United States and European corporate finance groups and in 
    structured finance.
 Performance metrics: As part of our commitment to predictive 
    ratings, we publish a quarterly report card on the accuracy and 
    stability of our corporate bond ratings. We publish numerous 
    studies and measurement statistics, which have shown that overall 
    our ratings, as forward looking opinions, effectively distinguish 
    bonds with higher credit risk from bonds with lower credit risk.

Level of Competition in the Industry
    There are numerous types of credit assessment providers, which 
compete vigorously for the trust of the market. They include, for 
example, traditional credit 
ratings, subscription-based rating providers, statistically derived 
ratings that rely solely on market-based or other financial data, bond 
research provided by brokerage firms, credit research performed by 
banks and other financial firms, and trade credit reporting agencies.
    The combination of the public nature of credit ratings and natural 
barriers to entry \6\ may imply that only a limited number of 
traditional rating agencies will be able to operate and thrive under an 
issuer-pays model. It is possible that only a limited number of 
agencies (though potentially a shifting group) will attain an issuer's 
business, regardless of the aggregate number of competitors. Therefore, 
while there are numerous types of credit assessment providers, the 
number of large traditional rating agencies has always been few.
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    \6\ Natural barriers to entry in the traditional credit rating 
agency industry where ratings are publicly and freely provided are:

     The Costly Nature of Executive Time--Debt issuers have a 
limited use for more than a few ratings because fundamental credit 
analysis, and therefore each agency relationship, requires the issuer's 
time and executive resource commitments. This includes preparing and 
presenting information, and maintaining that flow of information and 
communication on a periodic basis.
     Network Externalities--Investors desire consistency and 
comparability in credit opinions. The more widely an agency's ratings 
are used/accepted by market participants the greater the utility of its 
ratings to investors, and therefore to issuers.
     Broad Coverage--Investors place greater value on an 
agency's ratings the broader its rating coverage and the more widely 
its ratings are used.
     Track Record--Investors have more confidence in ratings 
that are assigned by agencies with publicly established track records 
of predictive ratings over a period of time. Due to the relatively 
small number of defaults in the public capital markets, it is difficult 
to establish quickly a performance track record.
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Oversight of Credit Rating Agencies--Developments in the International
Community
    As the Committee is aware, over the past 3 years much regulatory 
and legislative attention has been focused on the global financial 
services industry. Credit rating agencies have been included in this 
examination process.
    A global cooperative effort over the past 2 years led by the 
International Organization of Securities Commissions (IOSCO)--a 
committee comprised of approximately 100 of the world's securities 
regulatory authorities, importantly including the U.S. Securities and 
Exchange Commission (SEC)--produced and published a code of conduct 
(the Code) for the credit rating agency industry. The Code addresses:

 The quality and integrity of the rating process;
 Credit rating agency independence and the avoidance of 
    conflicts of interest; and,
 Credit rating agency responsibilities to the investing public 
    and issuers.

    Under each broad section, the Code enumerates specific provisions. 
While spearheaded by the SEC, the Code was drafted jointly by global 
regulators, who consulted with issuers, investors, intermediaries, and 
rating agencies in their respective jurisdictions. The Code is to be 
implemented through a ``comply or explain'' mechanism. Specifically, 
rating agencies are to voluntarily adopt the Code, and then publish 
their compliance with it or explain why they are unable to satisfy 
specific provisions. Moody's has announced that we intend to adopt the 
IOSCO Code and periodically disclose our compliance with it. Our 
disclosure would naturally address our ratings activity in the United 
States, as well as all other jurisdictions in which we operate.
    In Moody's view, the Code provides a comprehensive framework for 
rating agency disclosure that will better equip the market to assess 
rating agency reliability. Moody's is committed to supporting the IOSCO 
process and to implementing the Code. We believe that it fosters 
greater market transparency and delivers accountability, while 
simultaneously encouraging a competitive marketplace and information 
flow. Such an outcome should serve market integrity and investor 
confidence without unduly increasing the financial or administrative 
cost of business for rating agencies or users of ratings.

Regulatory Landscape in the United States
    The Nationally Recognized Statistical Rating Organization (NRSRO) 
designation in the United States--which allows regulated entities to 
use ratings provided by credit rating agencies that have been so 
designated--is administered and overseen by the SEC. To the extent that 
the NRSRO designation is seen to limit competition, Moody's is on 
record as not opposing its discontinuance.\7\ We do not believe that 
our business depends upon the continuance of the NRSRO system.
---------------------------------------------------------------------------
    \7\ Moody's Response to the U.S. SEC Concept Release, July 28, 
2003.
---------------------------------------------------------------------------
    By way of background, the use of ratings in U.S. regulation and 
legislation has been an evolutionary process. In the 1930's, bank 
regulators began using credit ratings in bank investment guidelines. 
State laws and regulations soon adopted similar standards for State 
banks, pension funds, and insurance companies, and additional Federal 
regulation followed. In 1975, the SEC introduced credit ratings into 
its net capital rule for broker-dealers.
    Informally called the ``haircut'' rule, the net capital rule 
requires broker-dealers to take a larger discount on speculative-grade 
corporate bonds--a ``haircut''--when calculating their assets for the 
purposes of the net capital requirements than for investment-grade 
bonds. This rule specified the ratings must come from NRSRO's. While 
the term was not defined, rating agencies which had established a 
presence at the time were so designated; among them was Moody's. Over 
time, the use of NRSRO ratings has spread into various legislative and 
regulatory frameworks, including those for the banking, insurance, 
educational, and housing industries.
    It is our view that the use of ratings in regulation and the 
subsequent necessity of recognizing or regulating rating agencies 
should neither alter the rating product nor increase barriers to 
competition. Moody's supports allowing natural economic forces to guide 
competition in the rating agency industry. We believe that a healthy 
industry structure is one in which the role of natural economic forces 
is conspicuous, and where competition is based on performance quality 
to promote the objectives of market efficiency and investor protection.
    In responding to regulatory authorities globally, Moody's has 
consistently supported eliminating barriers to entry caused by, for 
example, vague or difficult to achieve recognition standards. More 
generally, we have supported competition in the rating agency industry. 
Increased competition may augment the number and diversity of opinions 
available to the financial markets; and encourage rating agencies to 
improve their methodological approach and better respond to market 
demands.
    On behalf of my colleagues at Moody's, I greatly appreciate the 
Committee's invitation to participate in this important hearing. The 
obligation to assure that the U.S. financial market remains among the 
fairest and most transparent in the world is one that all market 
participants should share. I look forward to answering any questions 
the Committee has in pursuit of this important goal.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY 
                       FROM SEAN J. EGAN

Q.1. Financial Executives International submitted a comment 
letter on the SEC's Concept Release about credit rating 
agencies in which it recommended: Every 3 to 5 years, the NRSRO 
should be subject to an intensive audit to determine whether it 
remains qualified for such recognition, and to ensure that it 
is abiding by its certifications and documented procedures. The 
Commission should have the authority to penalize an NRSRO for 
``failing'' an audit and those penalties should range from 
fines to ``disbarment.''
    What is your view on the benefits and costs of the 
recommendation?

A.1. We are in favor of such a review and have been and 
continue to be supportive of the efforts of the Association for 
Financial Professionals and its international affiliates as 
reflected in their Code of Standard Practices for Participants 
in the Credit Rating Process. Such a review should assist in 
evaluating potential conflicts in interest, abusive practices, 
and protection of nonpublic information.

      RESPONSE TO A WRITTEN QUESTION FROM SENATOR SHELBY 
                      FROM MICAH S. GREEN

Q.1. Financial Executives International submitted a comment 
letter on the SEC's Concept Release about credit rating 
agencies in which it recommended: Every 3 to 5 years, the NRSRO 
should be subject to an intensive audit to determine whether it 
remains qualified for such recognition, and to ensure that it 
is abiding by its certifications and documented procedures. The 
Commission should have the authority to penalize an NRSRO for 
``failing'' and audit, and those penalties should range from 
fines to ``disbarment.''
    What is your view on the benefits and costs of the 
recommendation?

A.1. We are in substantial agreement with this recommendation. 
As noted in our comment letter, dated July 28, 2003, on the 
SEC's Concept Release on credit rating agencies, we believe an 
NRSRO should make an annual certification that it continues to 
meet the standards that have been set for recognition as an 
NRSRO.
    We also support the December 2004 IOSCO ``Code of Conduct 
Fundamentals for Credit Rating Agencies,'' which requires each 
NRSRO to publish and comply with a Code of Conduct covering 
such areas as the quality and integrity of the rating process, 
the independence of each NRSRO and the avoidance of conflicts 
of interest, the transparency and timeliness of ratings 
disclosure, and the treatment of confidential issuer 
information. We believe an NRSRO's annual certification should 
include a certification that it complied during the previous 
year in all material respects with its Code of Conduct (or an 
explanation of the reasons for any variation from such Code).
    Our July 28, 2003, comment letter also states that we do 
not believe that NRSRO's need to be subject to significant 
additional ongoing examination or oversight, as it is unclear 
what the purpose of such examinations would be. In the event 
periodic examinations of each NRSRO are undertaken, we do not 
believe such examinations should involve reviewing individual 
rating determinations, but instead should involve a review of 
(1) the process by which rating methodologies are developed, 
(2) adherence to, or amendment of, rating methodologies, (3) 
the results of the NRSRO's back-testing of the accuracy of 
ratings, (4) the NRSRO's training program, and (5) the NRSRO's 
procedures for ensuring compliance with its Code of Conduct, 
including its procedures for identifying and managing conflicts 
of interest. We believe it is important for ratings to be 
objectively determined, but equally important to ensure that 
the SEC does not mandate any particular rating methodology.
    The principal question about the costs and benefits of this 
system is whether the costs to the SEC of conducting periodic 
examinations of NRSRO are warranted by the scope of the 
problem, or whether the same benefits (in terms of compliance 
with the NRSRO designation criteria and the NRSRO's Code of 
Conduct) could be obtained by relying on a certification by the 
NRSRO's Chief Executive and Chief Compliance Officer, with 
review by its Board of Directors. We do not believe it would be 
necessary or cost-justified for the SEC to engage in an 
intensive audit of all aspects of the NRSRO's business.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY 
                      FROM YASUHIRO HARADA

Q.1. Financial Executives International submitted a comment 
letter on the SEC's Concept Release about credit rating 
agencies in which it recommended: Every 3 to 5 years, the NRSRO 
should be subject to an intensive audit to determine whether it 
remains qualified for such recognition, and to ensure that it 
is abiding by its certifications and documented procedures. The 
Commission should have the authority to penalize an NRSRO for 
``failing'' an audit and those penalties should range from 
fines to ``disbarment.''
    What is your view on the benefit and costs of the 
recommendation?

A.1. As a preliminary matter, R&I believes in order to maintain 
credibility and public trust in NRSRO's, a certain degree of 
oversight and review of NRSRO's is necessary. However, it would 
have negative consequences on the activities of rating agencies 
if the Commission were to adopt strict and detailed standards 
on the way rating agencies should provide their services. 
Strict and inflexible regulatory standards would discourage 
creative development of new rating and risk analysis methods 
and technology. Setting rigid regulatory standards for purposes 
of oversight and inspection would be detrimental to the healthy 
development of the capital market and should be avoided. The 
question as to who should bear the burden of the cost 
associated with strict and detailed oversight must be carefully 
examined.
     In this regard, an intensive audit to determine the 
qualifications for a NRSRO and to ensure compliance with 
certifications and documented procedure is inappropriate and 
unnecessary. An onsight examination of the soundness of a 
bank's assets is different from auditing the qualifications and 
compliance of rating agencies as the latter would be difficult 
to conduct in a unified and unique manner.
     Therefore, regularly checking the qualification criteria 
can be accomplished by requiring NRSRO's to submit reports to 
the Commission indicating past performance and continuing 
qualification. Such submissions should be disclosed to the 
public. If the Commission determines that a particular NRSRO 
fails to satisfy all of the necessary criteria, then such 
rating agency should be required to immediately rectify the 
situation. If, after one year's probation period, such an NRSRO 
still fails to satisfy all of the criteria, then NRSRO 
recognition should be revoked.

       RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY 
                      FROM JAMES A. KAITZ

Q.1. Financial Executives International submitted a comment 
letter on the SEC's Concept Release about credit rating 
agencies in which it recommended: Every 3 to 5 years, the NRSRO 
should be subject to an intensive audit to determine whether it 
remains qualified for such recognition, and to ensure that it 
is abiding by its certifications and documented procedures. The 
Commission should have the authority to penalize an NRSRO for 
``failing'' an audit, and those penalties should range from 
fines to ``disbarment.''
    What is your view on the benefits and costs of the 
recommendation?

A.1. Prudent SEC oversight, including the ability to take 
enforcement action against recognized credit rating agencies, 
must be a component of any reform effort. To that end, 
conducting a periodic review of whether a recognized rating 
agency continues to meet the established recognition criteria 
must be an integral part of SEC oversight. As we stated in our 
comment letter on the SEC's 2003 concept release, ``[t]he SEC 
should revoke NRSRO status for those rating agencies that fail 
continually to meet the same criteria used to determine whether 
to grant an agency initial NRSRO status.'' Additionally, we 
recommended that the SEC review each NRSRO no less frequently 
than every 5 years.
    In our comment letter, we also stated that the recognition 
criteria should be based on whether an agency can consistently 
produce credible and reliable ratings, not on methodology. 
Also, the SEC should require that a credit rating agency 
seeking the NRSRO designation document its internal controls 
designed to protect against conflicts of interest and 
anticompetitive and abusive practices and to ensure against the 
inappropriate use of all nonpublic information to which rating 
agencies are privy.
    Conducting a periodic review of whether a NRSRO continues 
to produce credible, reliable ratings and meet the recognition 
criteria will help restore confidence in the credit rating 
agencies and the ratings they provide. As with the recognition 
process, the SEC must clearly define the revocation or 
nonrenewal process. Withdrawal of NRSRO status would have a 
material impact on a rating agency and the value of all 
securities it rates. The markets are best-served if it is 
clearly known why the SEC took such an action.
    On behalf of AFP's members, I thank you for your commitment 
to our Nation's capital markets. For your information, I am 
enclosing a copy of AFP's entire comment letter on the SEC's 
Concept Release.* Please do not hesitate to contact me if I can 
be of further assistance.
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    * Held in Committee files.

    
    
    
                       STATEMENT OF KENT WIDEMAN
         Executive Vice President, Dominion Bond Rating Service
                            February 8, 2005

    My name is Kent Wideman, Executive Vice President of Dominion Bond 
Rating Service (DBRS). I am pleased to submit these views on behalf of 
DBRS in connection with this hearing on the role of credit rating 
agencies in the capital markets. Because credit ratings have become 
such an integral part of the global financial markets, it is imperative 
that there be a clear understanding of how rating agencies operate, how 
they compete and how they should be regulated. As the only rating 
agency in the past 13 years to receive an NRSRO designation, DBRS is 
also pleased to share its unique perspective on the SEC's process for 
making such designations.
    Based in Toronto and with offices in New York and Chicago, DBRS was 
founded in 1976 by Walter Schroeder, who remains the company's 
President. DBRS is employee-owned, is not affiliated with any other 
organization, and limits its business to providing credit ratings and 
related research. DBRS is a ``generalist'' rating agency, in that we 
analyze and rate a wide variety of institutions and corporate 
structures, including government bodies, and various structured 
transactions. At this time, we rate over 900 entities worldwide and 
provide credit research on another 200 companies, with most of the 
latter based in the United States. DBRS has a total of 113 employees, 
73 of whom are analysts.
    Since its inception, DBRS has been widely recognized as a provider 
of timely, in-depth and impartial credit analysis. Our opinions are 
conveyed to the marketplace using a familiar, easy-to-use letter grade 
rating scale. These ratings are supported by an extensive research 
product, which includes detailed reports on individual companies, as 
well comprehensive industry studies. This information is disseminated 
through various means, including a proprietary subscription service 
which is used by more than 4,500 institutional investors, financial 
institutions, and government bodies.

Overview
    In order to evaluate the role of credit rating agencies in the 
capital markets, it is necessary to have a clear understanding of what 
a credit rating is and what it is not. A credit rating is an opinion 
regarding the creditworthiness of a company, security, or obligation. 
It is not an absolute predictor of whether a particular debtor will 
default on a particular obligation. Among the many factors DBRS 
considers in issuing a credit rating are: A company's financial risk 
profile, with particular focus on leverage and liquidity; the 
complexion of the industry in which the company operates and its 
position in that sector; quality of management; core profitability and 
cashflow; and other issues which may affect the creditworthiness of the 
issuer or instrument in question.
    As part of the process, we maintain an ongoing dialogue with the 
managements of the companies we rate. Oftentimes, they provide us with 
information that may not be publicly available, and we use this 
information strictly for the purposes of arriving at an accurate rating 
decision. Prior to finalizing our decisions, we discuss our preliminary 
views with the company, and we allow them to review any releases prior 
to public dissemination to assure that our comments are accurate and 
that we have thoroughly considered all relevant facts. Ratings are 
reviewed constantly and changes are made whenever we are of the opinion 
that the relative creditworthiness has changed, positively or 
negatively.
    Credit ratings are a critical assessment tool for investors in 
fixed-income securities or other debt instruments, as well as for 
issuers seeking access to the capital markets. In addition, over the 
past 30 years, the SEC and other State and Federal regulators have used 
the credit ratings issued by market-recognized credible agencies to 
distinguish among grades of creditworthiness of various instruments and 
to help monitor the risk of investments held by regulated entities. As 
the debt markets have grown more complex and more volatile, investors, 
issuers, and regulators have grown increasingly reliant on the 
impartial and independent ratings and credit analyses that the NRSRO's 
supply.
    The confidence the marketplace and the regulators have placed in 
these rating agencies is well-deserved. Academic and industry studies 
uniformly show a strong correlation between credit ratings and the 
likelihood of default over time. We respectfully submit that a few 
headline-grabbing corporate failures should be seen for what they are: 
Aberrations caused by spectacular issuer dishonesty and not signs of 
structural defects in the ratings industry or the regulation thereof. 
Indeed, the scrutiny to which credit rating agencies have been 
subjected over the past 3 years has not uncovered any systemic flaws in 
the way NRSRO's operate. There is no need to dismantle a system that 
has served the capital markets so well for so long.
    With this background in mind we address the specific questions the 
Committee has raised: (1) the transparency of the ratings process, (2) 
conflicts of interest, (3) NRSRO designation, and (4) appropriate 
regulatory oversight of rating agencies.

Transparency
    DBRS considers transparency to be a key factor in the ratings 
process. In order to ensure that those who use our ratings understand 
the bases for our opinions, we back up each of our ratings with 
detailed reports. on individual companies and industries. These reports 
openly convey DBRS' views on both current ratings and the direction of 
ratings. We also hold regular seminars, investor meetings, and 
conference calls, all of which allow for an open and informative 
dialogue with the investment community.
    Although DBRS believes that it is possible to accurately assess an 
issuer's creditworthiness using only publicly available information, it 
is our practice to identify any reports produced without issuer 
involvement, in order to provide context to subscribers and the public. 
Where we have ceased to rate or follow an issuer, we disclose the fact 
that our ratings are not current.
    While DBRS is committed to disseminating its ratings and concise 
explanations for its reasons and methodologies publicly, we also 
believe that credit rating agencies should be entitled to provide more 
in-depth coverage and analysis to investors on a subscription basis. In 
order to ensure that this practice does not harm the financial markets, 
DBRS has adopted effective controls to prevent the selective disclosure 
of ratings, rating actions, and other nonpublic information to its 
subscribers.

Conflicts of Interest
    Like the other NRSRO's, DBRS derives most of its revenue from fees 
charged to issuers and also receives fees from investors who subscribe 
to its credit analyses and reports. Questions have been raised as to 
whether this fee structure compromises the objectivity of credit 
ratings; in particular, whether the receipt of fees from issuers 
presents the potential for rating inflation.
    In exploring this topic, it is important to note that the current 
industry fee structure is the result of the complexity of the debt 
markets and the desire to have credit ratings broadly disseminated to 
the investing public. Performing high-quality credit analysis is a 
costly process, and although the public wants access to credit ratings, 
they do not necessarily want to pay for it.\1\ The only way rating 
agencies can afford to provide initial valuations and ongoing credit 
monitoring to the public is to charge the issuers whose securities they 
rate.
---------------------------------------------------------------------------
    \1\ Testimony of Frank A. Fernandez, Senior Vice President, Chief 
Economist and Director of Research, The Securities Industry 
Association, SEC Hearings on the Current Role and Function of Credit 
Rating Agencies in the Operation of the Securities Markets, Transcript 
of November 15, 2002 Session (SEC Hearings Transcript) at 110; 
Testimony of Glen Reynolds, CEO, CreditSights, Inc., Id. at 143.
---------------------------------------------------------------------------
    It is also important to recognize that eliminating fees from 
issuers would not necessarily eliminate rating agency conflicts of 
interest. Potential conflicts can arise from any number of 
relationships, including those with government bodies, regulators, 
investors, prospects, and financial institutions. For example, 
accepting fees only from investors might still compromise the 
objectivity of rating agencies since investors have a strong interest 
in maintaining high ratings on the securities in their portfolios. 
Moving to an exclusively subscriber-funded business model would also 
diminish the fairness of the markets, since only those who pay for 
credit ratings would have access to them. Eliminating public 
dissemination of ratings could cause market confusion by exposing 
investors to rumors of rating actions and the like.
    We also note that although the current industry fee structure has 
been in place for decades, there is no evidence that it has had a 
deleterious effect on the quality of credit ratings. There are a number 
of reasons why this is so. Perhaps most important is the fact that 
rating agencies live and die by the quality of their ratings and their 
reputation for objectivity. The fact that credit rating agencies derive 
substantial fees from issuers is widely known. If an agency were seen 
to appease any issuer by supplying an inflated rating, the marketplace 
would discount that agency's opinions across its ratings universe. Such 
a discount would be an economic catastrophe for the rating agency. 
Moreover, a rating agency cannot avoid the reputational impact of any 
conflict of interest by concealing the reasons for its ratings, since 
ratings have to be transparent in order to be deemed valuable by market 
participants.
    To safeguard their reputations and ensure the objectivity of their 
ratings, DBRS and the other NRSRO's have developed a range of internal 
controls to manage potential conflicts of interest. DBRS is 
independently owned; engages in no business other than producing credit 
ratings and related research; and no one issuer accounts for a 
significant percentage of the company's total revenues. Furthermore, 
all rating decisions at DBRS are determined by a committee comprised of 
the firm's most senior staff with input from analyst teams that produce 
initial rating recommendations and the rationales therefor. This 
collaborative process effectively neutralizes any positive or negative 
bias on the part of anyone individual and supports the goal of ensuring 
that ratings are comparable across a wide range of different sectors. 
In order to further eliminate an analyst's or rating committee member's 
individual interest in a credit analysis or valuation, DBRS prohibits 
its employees from purchasing any security issued by companies that it 
rates or otherwise follows. The company likewise refrains from buying 
such securities for its own account. Finally, DBRS does not compensate 
its analysts on the basis of any particular ratings or the amount of 
revenue generated from issuers within the analysts' respective areas. 
Rather, analyst compensation depends on the experience, skill, and 
quality of the analyst's work, as well as on the company's general 
revenues. DBRS believes that these internal policies effectively 
address the potential conflicts posed by the current credit rating 
agency fee structure.

NRSRO Designation
    The SEC introduced the concept of ``Nationally Recognized 
Statistical Rating Organization'' or ``NRSRO'' in 1975, as a means of 
identifying ratings of market-recognized credible agencies for purposes 
of applying the broker-dealer net capital rule. From that modest 
beginning, the NRSRO concept has spread to other areas of Federal 
securities regulation, as well as Federal banking regulation, and 
various Federal and State laws. NRSRO ratings have become so firmly 
embedded in the U.S. capital markets that eliminating the NRSRO 
designation at this point would be enormously disruptive. That is not 
to say, however, that there is no room for improvement in the 
designation process.
    DBRS was designated as an NRSRO in 2003, the first and only rating 
agency to receive such a designation since 1992.\2\ In order to receive 
its NRSRO designation, DBRS demonstrated that it is widely accepted in 
the United States as an issuer of credible and reliable ratings by 
users of securities ratings. It also established that it has adequate 
staffing, financial resources, and organizational structure to ensure 
that it can issue credible and reliable ratings of the debt of issuers, 
including a sufficient number of qualified staff members and the 
ability to operate independently of economic pressures or control by 
the companies it rates. In addition, DBRS demonstrated that it uses 
systematic rating procedures designed to ensure credible and accurate 
ratings; and that it has and enforces internal procedures to prevent 
conflicts of interest and the misuse of nonpublic information.
---------------------------------------------------------------------------
    \2\ The recipient of the 1992 designation subsequently merged with 
Fitch Ratings.
---------------------------------------------------------------------------
    Because DBRS believes that the marketplace is the best judge of 
what constitutes a reliable credit rating, DBRS also believes that 
market acceptance is a critical test for determining whether a rating 
agency should be designated as an NRSRO. DBRS further believes that the 
SEC should continue to examine whether an agency seeking NRSRO 
designation maintains policies and procedures reasonably designed to 
avoid conflicts of interest and to prevent the misuse of material, 
nonpublic information, and to evaluate whether a rating agency has 
adequate resources or other safeguards to maintain its independence 
from the issuers it rates. It would also be 
appropriate, in DBRS' view, for the Commission to evaluate an agency's 
commitment to transparency, by assessing the degree to which it makes 
its ratings publicly available and discloses the reasons for its 
ratings.
    Although we generally support the criteria the SEC uses to 
designate new NRSRO's, we believe that the current practice of 
designating such agencies through a no-action letter process is 
unnecessarily cumbersome and insufficiently transparent. In lieu of the 
current procedure, DBRS recommends that the SEC adopt a formal 
application process that provides clearly articulated standards and 
allows for notice and the opportunity for public comment. Applicants 
who are not granted an NRSRO designation within a reasonable period of 
time should be notified of the reasons for their rejection so that they 
may improve their operations in the specified areas and increase their 
chances of submitting a successful application in the future. DBRS 
believes that these measures will greatly increase the transparency of 
the designation process and enhance investor confidence.

Appropriate Regulatory Oversight
    Given the benefit to the financial markets of continuing to have 
designated NRSRO's, DBRS recognizes the need for some form of 
regulatory oversight on an ongoing basis. It is critical, however, that 
such oversight not interfere with the process by which a credit 
analysis is performed or a rating is issued. Whether credit opinions 
are produced though traditional methods or statistical models, 
regulators should neither dictate how a rating is done nor define how 
the quality of a rating should be evaluated. Credible, reliable rating 
agencies may utilize different methodologies, adopt varying outlooks 
and reach different conclusions regarding the creditworthiness of an 
issuer or obligation. This richness of opinion contributes to the 
safety and soundness of the markets and would be lost if every NRSRO 
were obliged to follow the same script. Indeed, ratings diversity 
increases the ``watchdog'' function credit rating agencies play, and 
their ability to function independently helps to disperse their power. 
Furthermore, mandatory standardization of the ratings process would 
ossify credit risk practice and theory, thereby impeding rating 
agencies' ability to evolve with the natural evolution of the 
marketplace. Credit ratings are under constant scrutiny by market 
participants; the regulators should allow the market to determine 
whether or not an agency's credit opinions have value.
    DBRS supports the recent efforts of the International Organization 
of Securities Commissions (IOSCO)--of which the SEC is a member--to 
articulate a set of high-level objectives that rating agencies, 
regulators, issuers, and other market participants should strive toward 
in order to improve investor protection and the fairness, efficiency 
and transparency of the securities markets, while reducing systemic 
risk.\3\ In furtherance of these objectives, in December of last year, 
the IOSCO Technical Committee published a Code of Conduct Fundamentals 
for Credit Rating Agencies.\4\ These Code Fundamentals address many of 
the same issues addressed in the NRSRO designation process. Most 
importantly, the Code Fundamentals are not rigid or formalistic; rather 
they are designed to afford credit rating agencies the flexibility to 
incorporate these measures into their internal codes of conduct 
according to their own business models and market circumstances.
---------------------------------------------------------------------------
    \3\ IOSCO Technical Committee, Statement of Principles Regarding 
the Activities of Credit Rating Agencies (September 2003). This 
document can be downloaded from IOSCO's On-Line Library at 
www.iosco.orq (IOSCOPD151).
    \4\ IOSCO's On-Line Library.
---------------------------------------------------------------------------
    DBRS believes that a sensible regulatory approach might include a 
requirement that NRSRO's adopt codes of conduct along the lines of the 
IOSCO Code Fundamentals. It might also be appropriate to institute some 
form of periodic self-assessment and/or self-certification process 
under which NRSRO's attest that they maintain these internal codes and 
that they continue to meet the NRSRO designation criteria. Such a 
regulatory regime would safeguard the integrity of the credit rating 
process and promote investor protection without having a chilling 
effect on the development of new credit analysis techniques and 
practices.

Conclusion
    Overall, DBRS believes that the credit rating system as it exists 
today works well and has helped foster the growth of the financial 
markets globally. Improving the transparency of the NRSRO designation 
process and implementing an internal conduct code-based regulatory 
scheme would help ensure the continued success of this system. We 
appreciate having the opportunity to share our views with this 
Committee.

        Credit Raters' Power Leads to Abuses, Some Borrowers Say
              by Alec Klein, Washington Post Staff Writer
                           November 24, 2004

    Last of three articles
    The letter was entirely polite and businesslike, but something 
about it chilled Wilhelm Zeller, chairman of one of the world's largest 
insurance companies.
    Moody's Investors Service wanted to inform Zeller's firm--the giant 
German insurer Hannover Re--that it had decided to rate its financial 
health at no charge. But the letter went on to suggest that Moody's 
looked forward to the day Hannover would be willing to pay.
    In the margin of the letter, Zeller scribbled an urgent note to his 
finance chief: ``Hier besteht Handlungsbedarf.''
    We need to act.
    Hannover, which was already writing six-figure checks annually to 
two other rating companies, told Moody's it did not see the value in 
paying for another rating.
    Moody's began evaluating Hannover anyway, giving it weaker marks 
over successive years and publishing the results while seeking 
Hannover's business. Still, the insurer refused to pay. Then last year, 
even as other credit raters continued to give Hannover a clean bill of 
health, Moody's cut Hannover's debt to junk status. Shareholders 
worldwide, alarmed by the downgrade, dumped the insurer's stock, 
lowering its market value by about $175 million within hours.
    What happened to Hannover begins to explain why many corporations, 
municipalities and foreign governments have grown wary of the big three 
credit-rating companies--Moody's, Standard & Poor's and Fitch Ratings--
as they have expanded into global powers without formal oversight.
    The rating companies are free to set their own rules and practices, 
which sometimes leads to abuse, according to many people inside and 
outside the industry. At times, credit raters have gone to great 
lengths to convince a corporation that it needs their ratings--even 
rating it against its wishes, as in the Hannover case. In other cases, 
the credit raters have strong-armed clients by threatening to withdraw 
their ratings--a move that can raise a borrower's interest payments.
    And one of the firms, Moody's, sometimes has used its leverage to 
ratchet up its fees without negotiating with clients. That is what 
Compuware Corp., a Detroit-based business software maker, said happened 
at the end of 1999.
    Compuware, borrowing about $500 million, had followed custom by 
seeking two ratings. Standard & Poor's charged an initial $90,000, plus 
an annual $25,000 fee, said Laura Fournier, Compuware's chief financial 
officer. Moody's billed $225,000 for an initial assessment, but did not 
tack on an annual fee.
    Less than a year later, Moody's notified Compuware of a new annual 
fee--$5,000, which would triple if the company did not issue another 
security during the year to create another Moody's payment. Fournier 
said Moody's did not do anything extra to earn the fee. But the company 
paid it anyway--$5,000 in 2001; $15,000 a year later.
    ``They can pretty much charge the fees they want to,'' she said. 
``You have no choice but to pay it.''
    Moody's declined to comment on Compuware, but the firm said it now 
charges an annual flat fee of $20,000 for monitoring a corporate 
borrower to remove any confusion.
    Dessa Bokides, a former Wall Street banker who founded a ratings 
advisory group at Deutsche Bank AG, said rating firms are continually 
finding new circumstances to extract fees. Frequently, she said, they 
charge clients for many different securities, even if the ratings all 
amount to the same thing: an assessment of a company's finances.
    ``They are rating every [bond issue] and charging for each [bond 
issue], but in reality, they are only rating the corporate'' health, 
Bokides said. ``It is a great business if you can get it.''
    For Moody's, the numbers add up: It rates more than 150,000 
securities from about 23,000 borrowers, whose debt amounts to more than 
$30 trillion. Its revenue more than doubled in 4 years, to $1.25 
billion in 2003, while its profit jumped 134 percent in that time.
    The company said a rating costs between $50,000 and $300,000 for 
corporate borrowers. Moody's declined to provide a fee schedule, but 
according to a list obtained by The Washington Post, if it is the 
applicant's first rating in the past 12 months, there is an additional 
$33,000 fee. Then there is the monitoring fee ($20,000), a ``rapid 
turnaround fee'' ($20,000) and a cancellation fee (at least $33,000). 
For $50,000 more, a client can get an initial confidential rating.
    S&P's fees are similar, according to a price list obtained by The 
Post.
    The former finance chief of a major telecommunications firm was 
stunned when Moody's and S&P sent their initial bills. Each was six 
figures, not counting the annual maintenance fee. ``I remember thinking 
their fees were outrageous,'' said the former executive, who spoke on 
the condition of anonymity for fear of angering the rating firms. When 
he asked his banker about the fees, the banker said, ``You have to pay 
S&P and Moody's.''
    So he paid.
    ``Yeah, it is expensive for a few phone calls and a little 
analysis,'' the former executive said. ``But guess what? Especially 
when you are a public company, your options are limited. Really, you 
have only got S&P and Moody's.''
    Many schools and cities take the same view. The credit companies 
rate their debt as well, but charge much less, typically in the 
thousands or tens of thousands, depending on the size of the bond 
offering. Still, every fee seems to count.
    Louis J. Verdelli Jr., a financial adviser to school districts and 
other localities, knows as much. A municipality dissatisfied with a 
credit rater can have a difficult time getting rid of it, said 
Verdelli, a managing director of Public Financial Management Inc. of 
Philadelphia.
    If, for example, a municipality stops paying a rating fee, the 
credit company may remove its ratings on previous bonds, which could 
raise questions in investors' minds and make it harder for the 
municipality to sell new bonds.
    One investment banker in the Southwest said he encountered such a 
situation. Several years ago, he began representing a cash-strapped 
school district. Things had gotten so bad, the district raised the 
price of school meals.
    To save money, the banker suggested that the district drop one of 
its two credit ratings. That would save less than $10,000, but would be 
better than cutting textbooks. Moody's fee was lower, so the banker 
decided to drop S&P. That is, until he heard from S&P. The credit rater 
gave him an option: Pay $5,000 for S&P's service, or it would pull all 
of its ratings.
    The investment banker said he had no choice: He decided to pay for 
both ratings, which the school district continues to do. ``We are just 
paying off Standard & Poor's, and we are costing taxpayers an 
additional $5,000, because we are concerned that the negative 
association of their pulling the rating would cost more than $5,000,'' 
he said. He spoke on the condition of anonymity, declining to identify 
the school district for fear of angering the credit raters.
    Vickie A. Tillman, S&P's executive vice president, said, ``We 
reserve the right to withdraw our opinion'' when the firm does not have 
enough information to reach a conclusion, and S&P would never 
``compromise its objectivity and reputation'' by withdrawing it for any 
other reason.
    Some U.S. lawmakers have raised another area of concern: The credit 
raters have a privilege but little responsibility under a government 
rule that gives them access to confidential information from a company 
being rated.
    The rating companies say they need such inside data. But when they 
miss financial meltdowns such as Enron Corp., WorldCom Inc. and the 
Italian dairy company Parmalat Finanziaria SpA, the raters argue that 
despite having had insider access in many cases, they cannot be blamed 
for investor losses because they cannot detect fraud. ``The job of 
insuring the accuracy of those source materials belongs to auditors and 
regulators,'' said Frances G. Laserson, a Moody's spokeswoman.
    Rating companies sometimes give yet another perspective about 
inside information. When rating a company without its cooperation, the 
credit raters occasionally say they do not need non-public information. 
They call such ratings ``unsolicited;'' others in the industry call it 
a hostile rating.
    Moody's estimates that less than 1 percent of its ratings are 
unsolicited. Tillman said S&P rarely does unsolicited ratings, and 
generally only if a company borrows more than $50 million, explaining 
that the credit rater considers it a public service to rate major 
offerings. James Jockle, a Fitch spokesman, said that more than 95 
percent of the companies it rates ``agreed to pay our fees.''
    However, corporate officials, investment bankers and others 
familiar with the rating firms' strategies say there is a reason 
unsolicited ratings do not appear common: Companies approached that way 
by credit raters usually agree to pay a fee rather than risk a weak 
rating made without their cooperation.
    An S&P executive, who spoke on the condition of anonymity because 
the firm hadn't authorized her to comment, said that S&P maintains a 
sales force--what it calls an ``origination team''--whose goal is to 
improve revenue by finding companies to rate and charge a fee. ``Some 
of it is cold calling,'' she said.
    Northern Trust Corp., the big Chicago-based bank, said in a recent 
letter to the SEC that it ``has been sent bills by rating agencies for 
ratings that were not requested by Northern, and for which Northern had 
not previously agreed to pay.'' In his letter, James I. Kaplan, then 
the bank's associate general counsel, continued, ``On occasion, we have 
paid such invoices in order to preserve goodwill with the rating 
agency, but we feel that this practice is prone to abuse.'' Northern 
Trust declined to elaborate.
    In 1996, the Justice Department looked into similar unsolicited 
practices by Moody's. At about the same time, a Colorado school 
district sued Moody's, claiming it got an unsolicited negative rating--
a hostile rating--because the district had refused to buy the Moody's 
service. The Colorado case was dismissed in 1997, after a judge ruled 
the rating firm's statements about the school district were opinions 
protected by the First Amendment. Justice took no action, but did fine 
Moody's $195,000 in 2001 for obstructing justice by destroying 
documents during its investigation.
    Fitch also has been criticized for unsolicited ratings. In the late 
1990's, after being dropped as a paid credit rater of Simon Property 
Group Inc., the largest U.S. owner of regional shopping malls, Fitch 
did an unsolicited rating of the company. Some mall company officials 
were dismayed that Fitch did not announce that its rating was done 
without Simon's cooperation.
    Fitch said any requirement that it disclose unsolicited ratings 
would ``inappropriately interfere in the editorial process of the 
rating agencies.''
    When asked by The Post about unsolicited ratings, S&P's Tillman 
said her firm is ``in the process'' of changing its policies so 
investors will be able to tell whether they are looking at a rating 
done with a borrower's cooperation. Moody's said the last time it 
issued an unsolicited rating without identifying it as such was in 
2000. And in October, the company began to publicly identify 
unsolicited ratings.
    Greg Root, a former official of the Canadian rater Dominion Bond 
Rating Service Ltd. who also worked at S&P and Fitch, said that making 
such disclosure is important because, ``when a rating agency does a 
rating, there is the impression there is a formal due diligence and 
that they get non-public information. Investors assume there is a 
strong ongoing dialogue.''
    Whether an unsolicited rating is a form of coercion to earn fees is 
another matter, Root said: ``It is always a fine line.''
    Moody's danced along that line when it began its push into Europe 
in the late 1980's, according to former company officials. It began 
writing letters to European companies, saying it was planning to rate 
them. Moody's invited the companies to participate in the ratings 
process; however, if they did not, the credit rater said it felt it had 
adequate public information to do a rating anyway.
    ``That was the hook. That is where we were trying to get into the 
door and send them the bill,'' said W. Bruce Jones, now a managing 
director at Egan-Jones Ratings Co., a small rival of Moody's. ``The 
implied threat was there.''
    Moody's took a similar approach in mid-1998 when it approached 
Hannover, the big German insurance company that provides insurance for 
other insurance companies, helping to spread the risk in the event of a 
major catastrophe.
    Hannover had become one of the largest reinsurers in the world, 
with about half of its business in the United States. Insurers must be 
able to demonstrate to outsiders that they have the financial strength 
to make good on their policies. Hannover was already paying fees for 
that purpose to S&P and A.M. Best Co., a leader in the insurance rating 
industry. They had both given Hannover high ratings.
    ``So we told Moody's, `Thank you very much for the offer, we really 
appreciate it. However, we do not see any added value,' '' said Herbert 
K. Haas, Hannover's chief financial officer at the time.
    As Haas recalls it, a Moody's official told him that if Hannover 
paid for a rating, it ``could have a positive impact'' on the grade.
    Haas, now chief financial officer at Hannover's parent company, 
Talanx AG, laughed at the recollection. ``My first reaction was, `This 
is pure blackmail.' '' Then he concluded that, for Moody's, it was just 
business. S&P was already making headway in Germany and throughout 
Europe in rating the insurance business. Moody's was lagging behind. 
And, Haas thought, Hannover represented a fast way for the credit rater 
to play catch-up.
    Within weeks, Moody's issued an unsolicited rating on Hannover, 
giving it a financial strength rating of ``Aa2,'' one notch below that 
given by S&P. Haas sighed with relief. Nowhere in the press release did 
Moody's mention that it did the rating without Hannover's cooperation. 
But, Haas thought, it could have been worse.
    Then it got worse. In July 2000, Moody's dropped Hannover's ratings 
outlook from ``stable'' to ``negative.'' About 6 months later, Moody's 
downgraded Hannover a notch to ``Aa3.'' Meanwhile, Moody's kept trying 
to sell Hannover its rating service. In the fall of 2001, Zeller, 
Hannover's chairman, said he bumped into a Moody's official at an 
industry conference in Monte Carlo and arranged a meeting for the next 
day at the Cafe de Paris. There, the Moody's official pressed his case, 
pointing out that the analyst who had been covering Hannover--a man 
whom the insurer disliked--had left Moody's. Zeller still declined 
Moody's services.
    Two months later, Moody's cut the insurer's rating by two more 
notches to ``A2.'' In December 2002, the rating firm put Hannover on 
review for another possible downgrade. Somewhere along the way, Haas 
appealed to his boss to yield.
    ``I said, `Ultimately, you cannot win against the rating agency. 
Let's bite the bullet and pay,' '' Haas recalled. ``But for Willie 
[Zeller], it was a matter of principle. He said, `I am not going to pay 
these guys.' ''
    In March 2003, Moody's downgraded Hannover's financial strength 
rating by two notches and lowered its debt by three notches to junk 
status, sparking a 10 percent drop in the insurer's stock. S&P and A.M. 
Best, both of which were privy to the German insurer's confidential 
data, continued to give Hannover a high rating.
    Industry analysts were confounded. ``The scale of the Moody's 
downgrade was a surprise,'' said Damien Regent, an analyst at UBS AG, 
in a research report at the time. ``There was no new information in the 
public domain to justify a three-notch downgrade.''
    Larry Mayewski, A.M. Best's executive vice president, said he 
thinks Moody's has been using unsolicited ratings to get companies like 
Hannover to buy its services.
    Moody's declined to comment for this article about Hannover, but in 
its reports on the insurer, it said it was concerned that the German 
company had ``high levels of financial and operational leverage'' and a 
``high level of reinsurance recoverables'' due to it. Since then, 
Moody's has softened its stance, raising Hannover's outlook from 
``negative'' to ``positive.'' But it still rates Hannover's debt as 
junk.
    Zeller called the latest downgrade ``ridiculous.'' But when his 
company's stock dropped sharply, he began to wonder whether he had any 
recourse.
    As in the United States, lawmakers in Germany and elsewhere in 
Europe have taken a look at credit raters. But there has been no 
action. And Zeller is not optimistic about the prospects of change.
    ``They have built up such a franchise,'' he said, ``it is 
difficult, if not impossible, to do anything against it.''
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