[Senate Hearing 109-997]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-997

 
                  ASSESSING THE CURRENT OVERSIGHT AND
                  OPERATIONS OF CREDIT RATING AGENCIES

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

                                HEARING

                               before the

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

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

     THE CURRENT OVERSIGHT AND OPERATION OF CREDIT RATING AGENCIES

                               __________

                             MARCH 7, 2006

                               __________

  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

                         Mark Oesterle, Counsel

                          Justin Daly, 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, MARCH 7, 2006

                                                                   Page

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

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     3
    Senator Hagel................................................     4
    Senator Carper...............................................     4
    Senator Sununu...............................................     4
    Senator Menendez.............................................     5

                               WITNESSES

Paul Schott Stevens, President, Investment Company Institute.....     5
    Prepared statement...........................................    28
Glenn L. Reynolds, Chief Executive Officer, CreditSights, Inc....     8
    Prepared statement...........................................    31
Vickie A. Tillman, Executive Vice President, Credit Market 
  Services, Standard & Poor's....................................    10
    Prepared statement...........................................    41
Frank Partnoy, Professor of Law, University of San Diego School 
  of Law.........................................................    11
    Prepared statement...........................................    48
Colleen S. Cunningham, President and Chief Executive Officer, 
  Financial Executives International.............................    13
    Prepared statement...........................................    50
Damon A. Silvers, Associate General Counsel, American Federation 
  of Labor and Congress of Industrial Organizations..............    15
    Prepared statement...........................................    53
Jeffrey J. Diermeier, CFA, President and Chief Executive Officer, 
  CFA Institute..................................................    17
    Prepared statement...........................................    55
Alex J. Pollock, Resident Fellow, American Enterprise Institute..    21
    Prepared statement...........................................    58

                                 (iii)


    ASSESSING THE CURRENT OVERSIGHT AND OPERATIONS OF CREDIT RATING 
                                AGENCIES

                              ----------                              


                         TUESDAY, MARCH 7, 2006

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

    The Committee met at 10:03 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 will come to order.
    Good morning to everyone. Today, the Banking Committee 
continues its review of credit rating agencies. These entities 
wield extraordinary power in their role as gatekeepers to the 
bond markets. Although the rating business has existed for 
almost a century, recently there has been a renewed interest in 
how the industry operates and how it is regulated due to its 
increased importance in today's markets and because of the 
well-publicized failures to warn investors about the 
bankruptcies at Enron, WorldCom, and other companies.
    The modern rating industry was established in 1975 when 
staff of the Securities and Exchange Commission first issued 
no-action letters, essentially regulatory license to a select 
number of rating firms. With the addition of only a few more 
firms, these nationally recognized statistical rating 
organizations, or NRSRO's, have since provided almost all of 
the ratings used in the markets.
    While their market share has remained steady at 99 percent, 
the industry has grown considerably as regulatory changes have 
consistently increased the need for ratings issued by firms 
with the NRSRO designation. It is almost impossible for a 
rating firm to compete in this industry without the 
designation. I believe it is important for us to consider the 
manner in which the designation is awarded.
    The single most important factor in the SEC staff 's NRSRO 
process is the national recognition requirement. As many 
commentators have noted, this presents an obvious dilemma for 
firms seeking to do business in this industry. To receive the 
license, a firm must be nationally recognized, but it cannot 
become nationally recognized without first having the license.
    There are other key questions with respect to the NRSRO 
regime. For example, what is the SEC staff 's definition of the 
term ``NRSRO''? There are no objective standards. What 
constitutes the application process? What is the time frame 
involved for a decision? Once a firm is approved, is there any 
way for the investors to know an NRSRO continues to meet the 
requirements necessary for the designation? What amount of 
ongoing oversight by the SEC occurs? There is no transparency, 
I believe, in the process.
    The Commission has studied ways to improve and to clarify 
the NRSRO system for more than a decade, but has failed to act 
in spite of two concept releases. Two proposed rules--a 
comprehensive report mandated by the Sarbanes-Oxley Act, 2 days 
of public hearings, and an investigation of the NRSRO's 
triggered by the Enron scandal that revealed numerous problems 
at the then-three NRSRO's, including potential illegal 
activity.
    Considering the artificial barriers erected by the NRSRO 
system, it is not surprising that the rating system is highly 
concentrated. It is even more concentrated than the accounting 
profession, which is controlled by four firms. Here, only two 
companies dominate the business. The Big Two--Standard & Poor's 
and Moody's--generate unusual high operating profits for their 
publicly traded parent corporations. The profit margins are 
among the highest in the corporate world.
    Some describe the market penetration of these companies as 
remarkable, even astonishing. Both S&P and Moody's rate more 
than 99 percent of the debt obligations and preferred stock 
issues publicly traded in the United States. Given their profit 
margins and market penetration, it is understandable why the 
Big Two have been called a shared monopoly, a partner monopoly, 
and a duopoly. Their 99-percent market share suggests that they 
do not actually compete with each other, particularly in the 
corporate bond market.
    These conditions raise questions regarding the impact of 
the NRSRO system on investors and the markets. Has the absence 
of competition affected the quality of ratings, as some have 
suggested? Were NRSRO failures to downgrade Enron, WorldCom, 
and others in a timely manner a result of the current system's 
fundamental weaknesses?
    The existing regime also raises critical questions 
regarding the treatment of conflicts of interest. In addition 
to the inherent conflict of debt issuers paying rating agencies 
for ratings, there have been suggestions that the NRSRO's are 
marketing ancillary, fee-based consulting services to their 
issuer clients. This practice, if true, raises questions about 
the independence and objectivity of the rating agencies.
    Of course, it is difficult to assess some of these 
criticisms of NRSRO's because they are so lightly regulated and 
they conduct a great deal of their activities with minimal 
scrutiny.
    For example, information with respect to rating fees is 
limited. We do not know whether and to what extent NRSRO's are 
marketing additional services, such as consulting, to their 
issuer clients or engaging in anticompetitive practices, such 
as notching.
    We do not know whether the firms are complying with their 
procedures and ethics codes. We do not know any of these things 
because the SEC does not conduct periodic inspections of the 
NRSRO's.
    Three decades after granting a few firms privileged status 
with protection from competition, senior SEC staff recently 
questioned whether the Commission even has the statutory 
authority to oversee NRSRO's. It is quite clear that the U.S. 
Congress has a decision to make regarding this essentially 
self-regulated yet noncompetitive industry with duopoly 
profits.
    This morning, the Committee welcomes the distinguished 
panel of witnesses. From left to right, we will hear from Mr. 
Paul Schott Stevens, President, Investment Company Institute; 
Mr. Glenn Reynolds, Chief Executive Officer, CreditSights, 
Inc.; Ms. Vickie Tillman, Executive Vice President for Credit 
Market Services, Standard & Poor's; Mr. Frank Partnoy, 
Professor of Law, University of San Diego School of Law; Ms. 
Colleen Cunningham, President and Chief Executive Officer, 
Financial Executives International; Mr. Damon Silvers, 
Associate General Counsel, AFL-CIO; Mr. Jeffrey Diermeier, 
President and Chief Executive Officer, CFA Institute; and Mr. 
Alex Pollock, Resident Fellow, American Enterprise Institute. 
We welcome all of you to the Committee.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Mr. Chairman, thank you very much for 
holding this hearing on assessing the current oversight and 
operations of the credit rating agencies. Credit rating 
agencies play a very important role in the capital markets by 
providing opinions to investors on the ability and the 
willingness of issuers to make timely payments on debt 
instruments. These ratings issued by the agencies can have very 
significant impacts. The Washington Post, in an article in 
November 2004, wrote, ``They can, with the stroke of a pen, 
effectively add or subtract millions from a company's bottom 
line, rattle a city budget, shock the stock and bond markets, 
and reroute international investment.''
    Investors rely upon the agencies' impartiality, and they 
rely upon their ratings. The SEC created the designation of 
nationally recognized statistical rating organization, NRSRO, 
which is currently applies to five agencies, and many 
institutional investors buy debt only if it has been rated by 
an NRSRO.
    A Reuters article last month, February 2006, stated, ``The 
SEC designation gives these firms a major advantage in 
competing for business against other firms.''
    In recent years, concerns have been raised about the 
industry. In late 2001, the largest credit rating agencies 
maintained an investment grade rating on Enron debt after its 
major financial restatements and until 4 days before Enron 
declared bankruptcy. As a result, as BusinessWeek reported, 
there was a barrage of criticism that raters should have 
uncovered the problem sooner at Enron, WorldCom, and other 
corporate disasters.
    Today's hearing will provide us with the opportunity to 
hear testimony on issues that have been raised about the credit 
rating industry, issues such as: Competition in the credit 
rating industry and barriers to entry; the regulatory process 
for recognizing NRSRO's; the SEC's legislative authority to 
regulate, exam, or impose requirements on rating agencies; 
conflicts of interest that may arise under several 
circumstances, such as when rating agencies are paid by the 
issuers they rate; sell consulting services or have affiliates 
that sell services or products to issuers which they rate; or 
have a director who also holds an executive position for an 
issuer that is rated--alleged anticompetitive processes such as 
those former SEC Chairman Bill Donaldson identified, ``tying 
arrangements, solicitation of payments for unsolicited ratings, 
and threats to modify ratings based on payment for related 
services.''
    The testimony today will add to the Committee's record from 
the hearings in February of last year when witnesses 
representing rating agencies, the bond market, and financial 
professionals testified on the role of credit rating agencies 
in the capital markets, and in March of last year when then-SEC 
Chairman Bill Donaldson testified on the Commission's rule 
proposal to define the term ``NRSRO,'' and on staff discussion 
with the NRSRO's about a possible voluntary oversight 
framework.
    Mr. Chairman, I commend your ongoing interest in this area. 
I look forward to working with you on addressing the many 
issues involved. I join you in welcoming the distinguished 
panel of witnesses, and I look forward to hearing their 
testimony.
    Chairman Shelby. Thank you, Senator Sarbanes.
    Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you. I, too, appreciate 
very much your attention to this issue and look forward to our 
witnesses' testimony this morning.
    Chairman Shelby. Thank you.
    Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    I want to welcome our witnesses. I used to be a Governor, 
and I used to meet with rating agencies on a fairly regular 
basis. Before that, I was State Treasurer and a bond issuing 
officer, so I have a special appreciation for the work that you 
do and just a great appreciation. One of the happiest days of 
my life as 8 years as Governor was the 3 days that we got 
upgrades to AAA from Moody's, S&P, and Fitch. I will always 
remember those days. And whenever I am having a bad day, I just 
get out those press clips and read them all over again.
    [Laughter.]
    I am going to be in and out today. I look forward to your 
testimony. We are just delighted that you are here. This is an 
important hearing. Thank you for being with us.
    Chairman Shelby. Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman. I think you 
covered most of the critical points in your opening statement. 
I do not have any formal remarks, but I do think this is an 
area that deserves our attention. My concern and I think my 
caution is that we make sure whatever solution we proposes, it 
addresses the problem. And I do not see the problem as being 
one of a lack of regulation or need for additional regulation 
in the area of particular business practices as much as it is a 
question of a lack of competition. And I think that competition 
is lacking in part because there are a number of barriers to 
entry, and one of the most significant barriers to entry are 
regulations, and they are the barriers that have been created 
by--unintended, but have been created by some of the existing 
regulations, and we need to look carefully at those.
    We have sophisticated financial markets. We want to make 
sure we have good disclosure, good standards for certification, 
but at the same time, if you look just at the market share 
data, which I think the Chairman quoted in his opening 
testimony, you see one of the most concentrated markets in the 
entire country, one of the most concentrated market share 
profiles in the entire country, and it is an industry that 
currently acts as an oligopoly, and that can create a lot of 
bad behavior and a lot of pricing problems. And that is not 
necessarily the case or the fault of the participants. Again, 
we get back to the question of whether we have a regulatory 
structure that is actually discouraging competition. No one 
wants that to happen, but it could well be the effect of some 
of the existing rules.
    So this is a critical issue. We have the ability to make, I 
think, modest changes that will result in greater competition, 
greater pricing, greater range of choices for both investors 
and companies that seek to get rated by one of these important 
firms.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Menendez.

              STATEMENT OF SENATOR ROBERT MENENDEZ

    Senator Menendez. Thank you, Mr. Chairman. I look forward 
to the witnesses' testimony, and I hope that we will hear part 
of the concerns that many of us have expressed about the 
timeliness of the essence of the ratings and the nature of, 
particularly at State and local governments, timely basis of 
financial troubles that may exist. And while I have been on the 
other side of this equation, as Senator Carper has, in 
receiving ratings, as a former mayor and being in the State 
legislature as well, I am increasingly concerned about finding 
out too late in the process and what that means both for the 
public when it is a public entity and what it means for 
employees when it is a private entity.
    So, I look forward to the testimony.
    Chairman Shelby. Thank you, Senator.
    All of your written testimony will be made part of the 
hearing record, if you will--it is a large panel--briefly sum 
up your remarks.
    Mr. Stevens, we will start with you.

                STATEMENT OF PAUL SCHOTT STEVENS

            PRESIDENT, INVESTMENT COMPANY INSTITUTE

    Mr. Stevens. Thank you, Mr. Chairman. Good morning.
    As you have noted, I am President of the Investment Company 
Institute, the national association of U.S. investment 
companies. Our members include mutual funds, closed-end funds, 
exchange-traded funds, and sponsors of unit investment trusts. 
ICI members manage a total of approximately $9.6 trillion.
    This is my first opportunity as President of the ICI to 
testify before the Committee, so ably led by you, Chairman 
Shelby. Under your leadership and that of Ranking Member 
Sarbanes, the Committee has been very active on critically 
important issues affecting all aspects of our capital markets. 
I do commend you for holding this hearing to examine the 
current oversight and operation of credit rating agencies. The 
institute welcomes the opportunity to provide its views on 
these issues and others before the Committee.
    Credit rating agencies play a significant role in the U.S. 
securities markets generally and vis-a-vis mutual funds in 
particular. Mutual funds employ credit ratings in a variety of 
ways: To help make investment decisions, to define investment 
strategies, to communicate with their shareholders about credit 
risk, and to inform the process for valuing securities.
    The most significant influence of credit ratings on the 
fund industry is on the $2 trillion invested in money market 
mutual funds. Money market funds are a remarkable chapter in 
U.S. financial history. For many years, retail and 
institutional investors alike have relied on money market funds 
as an indispensable tool for cash management because of the 
high degree of liquidity, stability in principal value, and 
current yield that they offer. ICI estimates that between 1980 
and 2004, roughly $100 trillion flowed into, and the same 
amount out of, money market funds.
    If money market funds are an industry success story, they 
also most certainly are an SEC success story. Since 1983, money 
market funds have been governed very effectively by Rule 2a-7 
under the Investment Company Act of 1940.
    Rule 2a-7 limits the types of securities in which money 
market funds can invest in order to help them achieve the 
objective of maintaining a stable net asset value of $1 per 
share. Credit ratings form an integral part of these 
limitations.
    Chairman Shelby. Explain further what you mean there, their 
limit on what you can invest.
    Mr. Stevens. Money market funds may invest only in 
securities that are rated by an NRSRO in one of its two highest 
short-term rating categories, or if the securities are unrated, 
they have to be determined by the fund's board to be of a 
comparable quality. So it is a restriction on the way that we 
can invest our assets. It is written into the regulations, yes, 
Mr. Chairman.
    Now, it is important to note that no governmental entity 
ensures money market funds. Nevertheless, despite this 
estimated $200 trillion flowing into and out of these funds 
over the past 25 years, through some of the most volatile 
markets in our history, only once has such a fund failed to 
repay the full principal amount of its shareholders' 
investments. In that case, a very small institutional money 
fund ``broke the buck''--the $1 per share value--due to 
extensive derivatives-related holdings.
    Now, we believe the record of success achieved under Rule 
2a-7 must continue for the benefit of money market fund 
investors. And this, in turn, depends on the ratings issued by 
NRSRO's providing credible indications of the risk 
characteristics of those instruments in which money market 
funds invest.
    To promote the integrity and quality of the credit ratings 
process and, in turn, serve the interests of investors who 
utilize credit ratings, we believe it is timely and appropriate 
for Congress to consider legislation to advance several 
objectives.
    First, the NRSRO designation process should be reformed to 
facilitate the recognition of more rating agencies and thereby 
introduce much needed competition in the credit rating 
industry. The mutual fund sector is one in which intense 
competition has brought unparalleled benefits to investors. I 
firmly believe that robust competition can do the same for the 
credit ratings industry and is the best way to promote the 
continued integrity and reliability of credit ratings.
    Unfortunately, the current SEC process for designation 
credit rating agencies does not promote but, in fact, retards 
competition. That process involving the issuance of no-action 
letters utilizing a vague ``national recognition standard'' has 
not worked effectively. In place of the process, the institute 
recommends the implementation of a mandatory, expedited NRSRO 
registration process with the Commission.
    Second, there should be appropriate regulatory oversight by 
the SEC over NRSRO's to ensure the credibility and reliability 
of their ratings. We believe this can be achieved through a 
combination of: One, periodic filings with the SEC; and, two, 
appropriate inspection authority for the SEC, coupled with 
adequate enforcement powers.
    Specifically, credit rating agencies should be required to 
provide key information to the SEC upon registration, including 
information relating to conflicts of interest, the procedures 
used in determining ratings, ratings performance measurement 
statistics, and procedures to prevent the misuse of nonpublic 
information. NRSRO's should be required to the report to the 
SEC on an annual basis that no material changes have occurred 
in these areas. Similarly, they should be required to report 
any material changes that do occur on a timely basis, and this 
information should be made available promptly to investors who 
rely on their ratings. Such disclosures should be accompanied 
by an appropriate SEC inspection process, tailored to the 
nature of credit rating agencies' specific business activities.
    Third, investors should have regular and timely access to 
information about NRSRO's to provide them a continuing 
opportunity to evaluate the ratings that they produce. It is 
important to our members as investors that they have access to 
information about an NRSRO's policies, procedures, and other 
practices relating to credit rating decisions. In particular, 
it would be helpful for credit rating agencies to disclose to 
their investors their policies and procedures addressing 
conflicts of interest, as well as the conflicts themselves, and 
periodically to disclose information sufficient for investors 
to evaluate whether they have the necessary staffing, 
resources, structure, internal procedures, and issuer contacts 
to serve as NRSRO's.
    Finally, they should have some accountability for their 
ratings in order to provide them with incentive to analyze 
information critically and to challenge an issuer's 
representations. Any reforms to the credit rating process 
should, at a minimum, make the agencies accountable for ratings 
issued in contravention of their own disclosed procedures and 
standards. Surely, the First Amendment does not prevent 
Congress from requiring credit rating agencies to make truthful 
disclosures to the SEC and to the investing public. Increased 
competition, appropriate SEC oversight, greater transparency, 
and heightened accountability--these are the right objectives 
for reform of the credit rating industry from the perspective 
of mutual funds, other investment companies, other investors, 
and the securities markets as a whole.
    I very much appreciate the opportunity to share the 
institute's views with you today. I look forward to working 
with the Committee on these and other issues and would be 
delighted to take your questions.
    Chairman Shelby. Thank you.
    Mr. Reynolds.

                 STATEMENT OF GLENN L. REYNOLDS

          CHIEF EXECUTIVE OFFICER, CREDITSIGHTS, INC.

    Mr. Reynolds. Thank you, Mr. Chairman and Members of the 
Committee. I am happy to have this opportunity to express our 
views on this very important subject.
    I would just like to clarify that we are an independent 
research firm. We have never applied to be an NRSRO and have no 
plans to in the immediate future.
    What we would like to say up front is that the timing could 
not be better for productive change in the credit ratings 
industry, especially given the trends in the global markets, 
how information and research is delivered, and who will be 
delivering it in coming years.
    The incumbent NRSRO's will look to represent this current 
process as being about burdensome regulation and oversight. It 
is really about lowering barriers and removing structural 
impediments to competition. The agencies will wave the flag of 
letting the markets work when, in fact, they are promoting the 
exact opposite.
    Lowering barriers will still mean raising the bar for 
product quality and innovation, and that point often gets lost 
in all the angling in the reform process.
    New market entrants will need to deliver high-quality 
products to generate a meaningful revenue stream. The market 
will get very competitive among the new entrants looking to 
establish a foothold, and that is not a bad thing at all for 
quality.
    It will take more time for Moody's and S&P to feel any 
meaningful competitive pressure, but we need to start 
somewhere. Moody's and S&P have done a good job pushing back 
the start date of all of this, but the inevitable is on the 
way.
    In our discussions on this topic, we always remind people 
that business reality, the need to develop quality products, 
build brand power, and develop distribution capabilities all 
entails a lot of costs and takes literally many millions of 
dollars even for small firms.
    Individuals do not invest in or work at firms where the 
product cannot generate cash to grow. Analysts cost money, 
websites cost money, and opening offices costs money. As 
Moody's and S&P probably can attest, lawyers and lobbyists most 
likely also cost a lot of money.
    The business reality has always been a very compelling 
gatekeeper, and always will be. That will be the case with 
market entrants into the credit ratings industry.
    Innovation in the credit markets has always been heavily 
due to growing competition in the banking and brokerage 
industry. There were predictions of doom by the securities 
industry well over a decade ago when the commercial banks 
started their concerted moves into the traditional underwriting 
businesses.
    The investment banks were playing an old but transparent 
game of hyping the fear of the unknown. The incumbent 
securities firms were looking to stave off competition and 
thought predictions of chaos and trouble might strike a nerve.
    The opposite effect came true. Now investors and issuers 
have much more choice of who they want to deal with, pricing is 
more competitive, the markets are more efficient, and despite 
some bumps, the system is stronger and better capitalized.
    Innovation in such areas as securitization and risk 
management have served the U.S. corporate sector well. It is in 
no small part due to the evolution of the banking and 
underwriting industry from a small group of a half-dozen bulge 
bracket investment banks to a global bulge bracket of a few 
dozen major integrated financial services operations.
    The evolution of the credit markets was about letting 
competitors compete and seeing the market benefit from 
innovation and choice.
    Along the way, Moody's and S&P have been able to hitch a 
ride to the sweeping benefits that came with this intensified 
competition. Unfortunately for the market, new ratings firms 
were essentially blocked by a regulatory system that kept 
market entrants out, while banking sector innovation fed the 
rating agencies a steady diet of new business.
    All in all, it was a very sweet deal. Wall Street, the 
investment banks, and the securities firms invent it and engage 
in brutal competition to market it. Then Moody's and S&P come 
in and rate it and reap the benefits of inelastic pricing and 
no choice.
    Now Moody's and S&P wave the same red flags around market 
disruptions. Their take is that hidden risks lurk around the 
corner that will create problems in the markets. It sounds a 
lot like what the investment banks were crying about with the 
commercial banks and non-U.S. banks came into their space. It 
is an old ploy.
    In the case of the banks and brokerage houses, the system 
in the end benefited, and innovation was everywhere. Not 
coincidentally, Moody's and S&P cashed in on the value of 
someone else's competitive excellence.
    There is a reason that Moody's pretax profit margins 
significantly outdistance those of Microsoft and dwarf Exxon 
Mobil.
    That is all well and good. Now it is time to let more high-
quality institutions in to compete and push the incumbents to 
do a better job rather than reap profits tied in part to the 
market being a price taker by regulatory dictate.
    Competition makes an analyst want to know it better than 
the next guy, write it up faster than the next guy, and look to 
establish himself and his firm in the market. Quality only 
benefits from that. Plus if you want to take on these 
behemoths, you better have a good product, if not some major 
backing.
    We are all in favor of profit maximization, but we also 
favor fair play and truly competitive markets.
    New competition will not be disruptive or undermine 
quality. That is a ruse. The rating agencies' performance 
during the scandal years with their Reg FD exemptions and 
absolute market power does not leave room for them to hype 
quality fears. After all, we have already seen the downside of 
quality problems that come with no competition.
    We address some of the quality worries we have heard in our 
formally filed testimony, but do not buy the lie that quality 
will suffer and information flows will not improve.
    In the end, Moody's and S&P may just have to settle for 
enormously profitable, high-margin growth under the rules of 
fair competition and open markets that the rest of the 
underwriting chain has to adhere to. They will somehow bear up 
under the strain. In the meantime, issuers will have choices as 
will investors.
    Thank you for your time and this opportunity.
    Senator Sununu. [Presiding.] Thank you, Mr. Reynolds.
    Ms. Tillman.

                 STATEMENT OF VICKIE A. TILLMAN

       EXECUTIVE VICE PRESIDENT, CREDIT MARKET SERVICES,

                       STANDARD & POOR'S

    Ms. Tillman. Mr. Chairman, Members of the Committee, good 
morning. I am Vickie Tillman. I am the head of ratings at 
Standard & Poor's, and I have been in the business for about 30 
years. Let me start by saying that S&P strongly supports the 
lowering of barriers to entry in our industry and the resulting 
designation of additional NRSRO's. Over the years, Congress and 
other regulators have used their NRSRO recognition as a means 
to provide a quality check for investors. By way of example, 
the Federal Deposit Insurance Act includes a provision that 
generally prohibits savings and loans associations from holding 
securities unless they are deemed investment grade by an NRSRO.
    To abandon the NRSRO system would be to abandon this 
quality check. The result would be a regulatory vacuum that 
could expose to unwarranted risk the very investors Congress 
and these regulators have determined to protect.
    In our view and in the view of the market, as reflected in 
an SEC study, a more effective and significantly less 
disruptive approach is to improve on the existing system. The 
groundwork for this approach is already in place. The SEC has 
drafted, published, and received extensive comments on a 
proposed rule that should lead to a streamlined NRSRO 
designation process, and more NRSRO's, all of which would 
promoted competition.
    Unfortunately, despite receiving broad support for the 
proposed rule, the SEC has taken no step, since the close of 
comments last June, toward finalizing it. We urge Congress to 
press the SEC to move forward on the proposed rule. The 
financial markets have accepted the longstanding global 
practice of S&P and other rating agencies of charging fees to 
rated issuers.
    Despite this broad acceptance, concerns have been raised 
about potential conflicts of interest arising from this 
practice. These concerns are unfounded. There is no evidence 
that the ``issuer pays'' model compromises the independence and 
objectivity of ratings. Quite the contrary. Studies have found 
that any potential conflicts of interest have either not 
materialized or have been effectively managed. On the other 
hand, ``issuer pays'' models have benefits not available under 
other models. For example, it allows rating agencies to make 
their ratings available to the entire market without cost. S&P 
does this by, among other things, posting our rating actions on 
our free website. In this way our ratings are subject to 
constant market scrutiny. The ``issuer pays'' approach also 
allows for the ongoing monitoring of ratings and the rated 
issuers.
    Put simply, effective ways exist to increase competition 
and manage potential conflicts of interest in our industry 
without drastically overhauling a system that has worked for 
decades. We believe that legislation, therefore, is unnecessary 
at this time. It could also be harmful to the quality of 
ratings. Ratings are opinions, and analysts must be free to 
form their opinions without fears of being second guessed or 
subjected to sanctions for ratings others might feel are too 
high or too low. Substantive SEC oversight or legislation of 
the analytical process would necessarily involve such second 
guessing, and we believe, cause analysts to be unduly tentative 
or conservative in their analysis so as to avoid later 
criticism.
    In our view, a better approach is one that was recently 
adopted by the European Commission following an intensive stud 
of the issues. The EC determined that oversight of rating 
agencies is more appropriately accomplished through the 
establishment of codes of conduct, such as the S&P code of 
conduct that I have attached to my testimony.
    To that end, we have been working diligently with the SEC 
and the other NRSRO's toward the adoption of an oversight 
framework. Each NRSRO would adopt, as S&P already has, a code 
of conduct, and would establish an independent internal audit 
mechanism by which to test annually compliance with that code. 
The audit results would be shared and discussed with members of 
the SEC staff. We have met with the SEC on many occasions, and 
are now close to final agreement on the framework. Not only 
would such an approach avoid the public policy pitfalls of more 
intrusive Government oversight, but it would also avoid 
infringing the well-established First Amendment rights of S&P 
and other rating agencies.
    Thank you, I would be happy to answer any of your 
questions.
    Chairman Shelby. Thank you.
    Professor Partnoy.

         STATEMENT OF FRANK PARTNOY, PROFESSOR OF LAW,

             UNIVERSITY OF SAN DIEGO SCHOOL OF LAW

    Mr. Partnoy. Thank you, Chairman Shelby, Ranking Members 
Sarbanes, and Members of this Committee, for the opportunity to 
testify today. I am a Law Professor at the University of San 
Diego, where I have spent much of the past 9 years studying the 
credit ratings industry.
    First, a bit of historical perspective. When I wrote my 
first academic article on credit rating agencies, Moody's was 
not a public company, and S&P was a relatively small line item 
at McGraw-Hill. I argued that the companies had an unfair 
oligopoly because of legal rules that required the use of NRSRO 
ratings. I also set forth evidence showing that ratings often 
are ``too little, too late,'' because they generate little 
information and lag the market by months.
    I did not expect much of a response--academic articles 
rarely receive much of a response. But the NRSRO's sent 
representatives to meet with me in San Diego and to discuss my 
findings at an academic conference. They also began a lobbying 
effort aimed at influencing opinion in the area. Moody's funded 
an academic research and advisory committee, and even hired 
academics who had been examining NRSRO's.
    Not much changed until Enron collapsed in late 2001. As 
evidence emerged that the NRSRO's had played an important role, 
the U.S. Senate decided to examine the NRSRO process. When 
Senator Joseph Lieberman's staff invited me to testify before 
the Senate Committee on Governmental Affairs in January 2002, 
more than 4 years ago, Senators from both parties asked 
detailed questions about the serious problems and dangers in 
the credit rating industry.
    Shortly thereafter, Moody's went public, with shares worth 
just about $4 billion, about one-seventh of the value of 
General Motors, and less than half the value of major financial 
firms such as Bear Stearns. Congress ultimately included, as 
part of the Sarbanes-Oxley legislation, a provision requiring 
that the SEC reexamine the NRSRO designation, and I thank the 
Members of this body, particularly Ranking Member Sarbanes, for 
doing so.
    Today, we have the results of that investigation and the 
evidence against credit rating agencies is damning. The 
problems I addressed in 1999 have multiplied exponentially. 
Moody's and S&P are more powerful and profitable than ever, and 
the dangers associated with the NRSRO system are much greater 
than they were in 2002. Moody's shares are now worth $20 
billion more than those of either General Motors or Bear 
Stearns. Moody's shares have increased in value by more than 
500 percent since they were issued, when the rest of the market 
was down.
    Moody's and S&P say they are merely publishing companies, 
and that they distribute their ratings to the public for free. 
But if that is right, why have they become so much more 
profitable?
    Even a simple financial analysis shows that the NRSRO's are 
not in the publishing business. For example, Moody's shares are 
worth more than the combined value of Dow Jones, publisher of 
The Wall Street Journal, The New York Times, The Washington 
Post and Knight-Ridder, which owns dozens of publications. But 
Moody's has only a fraction of those firms' employees, and 
provides far less information.
    And credit ratings certainly are not free. The cost of 
ratings are passed to investors who buy rated securities, which 
are more expensive than they otherwise would be, by billions of 
dollars, because issuers are effectively required to pay for 
ratings.
    The NRSRO's increasing oligopoly profits are a dangerous 
sign, a symptom of an infection spreading through the financial 
markets. Because regulators make NRSRO ratings so important, 
investors have incentives to engage in dysfunctional behavior 
to try to obtain high ratings, and they pay very high fees to 
do so. The rating agencies are conflicted, not only because 
issuers pay for ratings, but they also provide consulting 
services and threaten unsolicited ratings. The multitrillion 
dollar credit derivatives industry, which is driven by NRSRO 
ratings, and generates a large share of NRSRO profits, is 
opaque, volatile, and downright frightening.
    Overall, the NRSRO regime poses a serious threat to the 
financial system. It is no coincidence that NRSRO ratings 
played a central role in the bankruptcy of Orange County, the 
collapse of Enron, and numerous other scandals.
    In my view, the ideal solution would be to replace the 
entire NRSRO regime with one based on market measures. Every 
day, every hour, even every second, the markets provide 
information about the risks of particular securities. Indeed, 
the NRSRO's use these very measures, albeit not very well, in 
determining ratings. Congress might simply replace NRSRO 
ratings with reasonable market ranges.
    Alternatively, I believe, H.R. 2990 is a fair compromise. 
It would increase competition and create incentives for rating 
companies to use market-based measures and/or receive fees from 
investors rather than issuers, and pressure from competition 
will vastly improve quality in the credit rating industry. To 
the extent there are market-based constraints, they should 
eliminate any ``race to the bottom.'' I have not see evidence 
that opening markets to competition would be disruptive or lead 
to rate shopping. Instead, it is the conflicts of interest and 
perverse incentives associated with the current NRSRO system 
that pose the greatest concerns. Indeed, it is possible that 
S&P and Moody's will continue to dominate the industry after 
reform, but if they do so, it will be because of high-quality 
ratings and not because of a regulatory oligopoly.
    Let me conclude just very briefly by mentioning three 
issues related to NRSRO accountability, which I believe should 
be part of the discussion. First, Federal law currently exempts 
NRSRO's for Federal securities fraud. It should not.
    Second, Moody's and S&P have claimed that their ratings are 
merely opinions that are protected as free speech. In my 
opinion, that argument is laughable. H.R. 2990 is not 
unconstitutional. If it were, much of the Federal securities 
law system would be subject to challenges based on the First 
Amendment.
    And third, the NRSRO's have argued they can take care of 
any industry problems on a voluntary basis, perhaps with the 
help of the SEC, but both the NRSRO's and the SEC have 
demonstrated during the past three decades that they cannot be 
trusted to reform the credit rating business.
    Our financial markets are the strongest in the world, in 
large part because Congress has intervened at critical moments 
to reshape the financial landscape. When the stock market 
collapsed in 1929, Congress responded with important 
legislation, not just once, but several times over a period of 
years. In 2002, Congress offered its first response to the wave 
of corporate scandals with the Sarbanes-Oxley legislation. In 
my view, now is the time for Congress to continue that response 
by acting on this crucially important issue of credit ratings.
    Thank you again for the opportunity to give you my 
thoughts.
    Chairman Shelby. Thank you.
    Ms. Cunningham.

               STATEMENT OF COLLEEN S. CUNNINGHAM

             PRESIDENT AND CHIEF EXECUTIVE OFFICER,

               FINANCIAL EXECUTIVES INTERNATIONAL

    Ms. Cunningham. Thank you, Chairman Shelby, and Members of 
the Committee, for this opportunity to appear before you today. 
I am the President and Chief Executive Officer of Financial 
Executives International. FEI is a leading advocate for the 
views of senior financial executives representing 15,000 CFO's, 
treasurers, controllers in the United States and Canada.
    I am pleased to have the opportunity to share our views 
with you today on the important issue of credit agency 
operations and oversight.
    There are more than 100 CRA's operation worldwide, but only 
five are designated as nationally recognized statistical rating 
organizations by the Securities and Exchange Commission. These 
five enjoy a competitive advantage over their peers because the 
guidelines for many government, mutual fund, and other 
institutional investment portfolios not only specify minimum 
credit ratings for their securities, but also require that the 
ratings come from NRSRO's. The absence of competition and the 
ambiguity surrounding the designation criteria have left these 
incumbent NRSRO's with a distinct competitive advantage.
    The most effective way to increase competition in the 
credit agency market would be to eliminate the no-action 
process the SEC uses to recognize NRSRO's, and to replace it 
with transparent registration requirements, which any CRA can 
understand and aim for.
    Additionally, there is no mechanism in place in the current 
system to ensure that NRSRO's continue to satisfy the criteria 
necessary to maintain their designation. Once a rating agency 
has been designated, it is only required to notify the SEC when 
it experiences material changes that may affect its ability to 
meet these criteria. Given the enormous financial impact that a 
loss of designation would have on a rating agency, I believe it 
is unrealistic to expect them to police themselves. For this 
reason, I urge Congress to increase accountability through 
regular performance audits to ensure that registered CRA's 
continue to satisfy this criteria.
    I also believe the CRA's should be required to disclose 
additional information about their operations as part of their 
registration application with the SEC. These disclosures could 
address such items as the CRA's policies and procedures for 
protecting nonpublic information, and for handling conflicts of 
interest. The training and experience of those individuals 
tasked with developing the ratings, and the extent to which the 
CRA staff met with an issuer's management prior to developing 
its rating. This information would help investors differentiate 
between or among registered CRA's and might help issuers decide 
which rating agency to retain for rating purposes.
    Yet another flaw in the current system is that it fails to 
address the important issue of conflicts of interest. For 
example, some have sold fee-based advisory services to their 
rated-A clients in areas such as risk management, corporate 
governance, shareholder disputes, and data analysis. The 
NRSRO's offering these services have assured policymakers that 
they have erected adequate firewalls between their rating 
service and advisory service operation. While this may be true, 
issuers may, nevertheless, feel pressure to purchase advisory 
services to enhance the likelihood of receiving a good rating.
    I believe that a simple rule, similar to the restrictions 
included in Title II of the Sarbanes-Oxley legislation, as the 
Members of this Committee know well, would solve this problem. 
Title II of the Sarbanes-Oxley Act addressed the issue of 
auditor independence, and listed specific activities which 
registered audit firms could no longer perform for their audit 
clients. I believe a similar line should be drawn here. Rating 
agencies should not be permitted to provide both fee-based 
advisory services and rating services to the same issuer. This 
bifurcation of rating services and advisory services would help 
ensure that credit ratings are developed based solely on the 
company's creditworthiness, and not on any unrelated matters.
    In closing, I would like to urge Congress to introduce 
legislation that addresses the three concerns I have raised, 
the need to increase competition in the marketplace, the need 
to increase accountability and credit agency operations, and 
the need to eliminate conflicts of interest.
    That concludes my remarks. I want to thank the Chairman and 
the Members of the Committee for inviting FEI to participate in 
today's hearings, and I would be pleased to answer any 
questions.
    Chairman Shelby. Thank you.
    Mr. Silvers.

                 STATEMENT OF DAMON A. SILVERS

                   ASSOCIATE GENERAL COUNSEL,

                AMERICAN FEDERATION OF LABOR AND

              CONGRESS OF INDUSTRIAL ORGANIZATIONS

    Mr. Silvers. Thank you, Chairman Shelby and Member. I 
appreciate Senator Sarbanes' leadership in this as well.
    The AFL-CIO appreciates the opportunity to discuss the 
credit rating agencies and the role they play in the debt 
markets from the perspective of America's working families, who 
look to the credit markets to finance their employers, support 
their communities, and to fund their retirement and their 
children's education.
    Union-sponsored benefit funds have over $400 billion in 
assets, and union members participate in benefit funds with 
over $5 trillion in assets. Most defined benefit funds have 
between 40 and 60 percent of their assets invested in fixed-
income investments. Our funds rely on credit rating agencies to 
help price these assets, and when the agencies get it wrong, as 
they did in Enron, our funds paid the price. The AFL-CIO 
called, in 2001, 1 week after the bankruptcy of Enron, for the 
SEC and Congress to address conflicts of interest and quality 
issues at the rating agencies, and we are very pleased to see, 
Mr. Chairman, you are taking up that task at this time, as you 
have for some time.
    Credit rating agencies are a vital part of the functioning 
of our capital markets. As one Moody's spokesperson has said, 
``Our ratings are essentially a public good.'' The public good 
here is the provision of reliable, easily analyzed credit 
quality data to all credit market investors that enable 
investors to quickly and efficiently make investment decisions 
without each investor having to determine for themselves the 
degree of risk involved in a given financial instrument.
    However, this system is vulnerable to structural problems 
in particular, because the credit rating business is an 
effective duopoly, as the Chairman noted, with the 
Congressional Research Service estimating that Moody's and S&P 
together have 80 percent of the market.
    Many have expressed concern about the level of 
concentration and the business of auditing public companies. 
Obviously, the degree of concentration in the credit rating 
business is substantially greater, with two dominant firms and 
one subordinate firm, compared to four comparably sized major 
public audit firms and a substantial number of minor ones.
    While there are benefits to having a limited number of 
well-regarded credit rating firms, information, economics 
benefits to investors and other market participants, the 
current degree of concentration appears to us to be excessive. 
However, greater competition by itself is unlikely to be a 
sufficient solution to the structural problems with the credit 
rating business. There are two reasons for this.
    First, the scale and prominence of the existing firms are 
going to be a formidable barrier to entry, regardless of the 
regulatory changes that have been discussed here this morning.
    Second, and I believe more critically, there is a 
structural principal agent problem here that is unlikely to go 
away because the real customers are not doing the buying. It is 
hard to see how the real customers, the investors, and other 
people making investment credit quality decisions, are going to 
be able to do the buying without substantially detracting from 
the liquidity of the credit markets and the general 
availability of information.
    In this respect, as in many others, the credit rating 
business has similarities to the business of public company 
auditing, and for this reason, this business is not--there are 
risks in this business in looking to competition to be the sole 
solution because there is an interest on the part of both the 
rating agencies and the purchasers of their services to 
collude, and in particular to collude in areas, such as a 
previous witness mentioned, where the public interest is very 
much at stake, like in the area of what securities, S&L's, and 
other regulated entities buy.
    We have seen in both the Washington Post coverage of the 
rating agencies and in the SEC's examination of the same 
allegations, evidence of exactly the abuse one would expect to 
see in an unregulated monopoly providing a public good: Alleged 
differential treatment of firms, depending on whether they paid 
rating agency fees, agencies engaging in consulting businesses 
that parallel their core rating businesses, and extracting 
essentially concessions from the companies they rate, and lax 
treatment of major issuers like Enron with devastating 
consequences.
    We believe that there must be, as a result, public 
oversight of the rating agencies. I think you will find that my 
views on this parallel those of the FEI, and of the ICI, which 
is a new experience for me in certain instances.
    [Laughter.]
    This oversight must focus on three areas: Monitoring the 
seriousness of agency reviews of issuers, preventing abuse of 
business practices like coercing payments through bad ratings, 
and putting an end to conflicts of interest that lead rating 
agencies to become too cozy with the companies they rate. 
Again, this is analogous to the bar and most auditor-consulting 
services contained within the Sarbanes-Oxley Act and expanded 
on by the PCAOB.
    We find the need for regulation particularly compelling in 
light of the--extensively discussed here today--existence of 
the NRSRO concept in our securities laws. The NRSRO concept 
though is helpful in dealing with information cost to 
investors, Government agencies, and a wide variety of financial 
market actors. Replacing it with a mere registration process 
without substantive oversight, in light of the principal agent 
problem I discussed a moment ago, as some have suggested and is 
embodied in legislation introduced in the House, will be 
harmful to investors and ultimately to the functioning of our 
credit markets.
    However, the NRSRO system today should be more transparent 
and open so that firms that wish to become NRSRO's know what 
that entails, and so that existing NRSRO's can be held 
accountable to clear standards. Obviously, it also should be 
possible for firms that are not NRSRO's to become one, and that 
the process ought not to be Catch-22.
    For these reasons, we would favor the regulation of the 
rating agencies either by the SEC directly or by a PCAOB-like 
body with the powers to set specific criteria for being 
recognized as an NRSRO, powers to oversee agency practices, set 
positive standards, and prescribe abusive practices. This 
direction was embodied in the recommendations of the Senate 
Governmental Affairs Committee's October 2002 report following 
the collapse of Enron, and was raised and addressed extensively 
by the SEC in its June 2003 concept release, but as has been 
noted by prior witnesses, the Commission has not taken final 
action on any of these items, even the rather modest reforms in 
the NRSRO application process from the June rulemaking.
    This Committee can be very proud of its work in crafting 
the Sarbanes-Oxley Act of 2002. That Act contains within the 
principles that should be applied to the credit rating 
agencies, real independent oversight and an end to conflicts of 
interest. Credit rating agency regulation is part of the 
unfinished agenda of corporate reform, like the reform of 
executive compensation that the SEC is now attempting, and the 
continuing need to reform public company board elections that 
remains today unaddressed.
    The AFL-CIO commends this Committee for taking up this 
issue, and hopes that this unfinished agenda item can be 
finished. We appreciate very much the opportunity to appear 
before the Committee.
    Mr. Chairman, we appreciate your leadership in this area, 
and we look forward to working with you as you move forward.
    Chairman Shelby. Thank you.
    Mr. Diermeier.

               STATEMENT OF JEFFREY J. DIERMEIER

      PRESIDENT AND CHIEF EXECUTIVE OFFICER, CFA INSTITUTE

    Mr. Diermeier. Good morning. I am Jeff Diermeier, and I am 
President and Chief Executive Officer of CFA Institute. Up 
until about 14 months ago, I was a 29-year veteran of the 
institutional investment management wars, most recently as 
Global Chief Investment Officer of UBS Global Asset Management.
    I would certainly like to thank Senator Shelby, Senator 
Sarbanes, and other Members of the Committee for the 
opportunity to speak to you this morning on this important 
topic.
    First, some background about CFA Institute. CFA Institute 
is a nonprofit membership organization made up of individuals, 
investment professionals with a lofty mission of leading the 
investment profession globally by setting the highest standards 
of ethics, education, and professional excellence. CFA 
Institute is most widely recognized as the organization that 
administers the CFA examination and awards the CFA designation, 
a designation that I share with nearly 68,000 investment 
professionals worldwide. We also fund and support the CFA 
Center for Financial Markets Integrity, which promotes high 
standards of ethics and integrity.
    A common denominator for anyone involved with our 
organization is adherence to a code of ethics that I am 
comfortable calling the highest ethical standard that exists 
for investment professionals. CFA Institute is also a staunch 
proponent of self-regulation. This approach is embodied not 
just in our own code of ethics, but also in a number of 
additional guidelines and standards we have established in 
areas such as issuer-paid research and objectivity of analyst 
research.
    A necessary prerequisite to self-regulation is that it must 
be embraced by the market participants whose activities it 
attempts to standardize. Such appears not to be the case with 
credit rating agencies that have been reluctant to embrace any 
type of regulation over the services they provide to the 
investment community. This, despite the fact, from our 
viewpoint, that their business model appears to have 
significant conflicts. In a business that relies upon public 
trust for its existence, credit rating agencies should be held 
to the highest standards of transparency, disclosure, and 
professional conduct. Instead, there are no standards, there is 
no oversight.
    We are pleased to see that the Committee has listed, as a 
priority for the second session of Congress, the need to 
address conflict of interest and competition concerns that have 
been raised about credit rating agencies, as Senator Shelby 
announced on January 31.
    Were credit rating agencies operating within an environment 
of openness and transparency of business practices, free from 
substantial conflicts of interest, your Committee might have 
been advised to leave them alone. Such is not the case. Their 
problems notwithstanding, if credit rating agencies were 
willing to engage with regulators to address a variety of 
serious issues facing their businesses, it would have been 
reasonable for your Committee to let those discussions run 
their course. Such is not the case. Or if credit rating 
agencies were eager to avoid regulation, but began serious 
dialogue about a self-regulatory system, there would be no need 
for this Committee to focus its attention on these issues. Such 
is not the case.
    What we hear from rating agencies, when prompted, on the 
idea of reform does not help matters. They state that theirs is 
not a product intended for use by investors and that their work 
should be protected under the First Amendment as journalist 
product. These viewpoints, I understand, may perform well in a 
court of law, but they are not in alignment with the reality 
that investors do indeed rely on their services as an important 
tool in verifying the legitimacy of debt securities.
    Chief among the issues are conflicts of interest that 
appear to exist, notably that rating agencies rely on revenues 
provided from the issuers that they rate. These conflicts are 
exacerbated by rating agencies pitching ancillary services to 
issuers, such as prerating assessments and corporate 
consulting. In these relationships, the rated companies hold 
the cards, meaning they have the power to end the contract if 
and when the rating agency offers anything other than glowing 
review. Rating agencies are under constant pressure to issue 
favorable reviews in order to retain a particular book of 
business. Further, agencies are under no obligation whatsoever 
to publish their findings. Negative reviews, therefore, never 
make their way to the investing public.
    Under ordinary circumstances, competitive market forces 
might be capable of solving this problem. Those with 
reputations of full disclosure and investor focus could be 
expected to rise to the top. But, ironically, the one bit of 
authority the SEC does have is to require issuers of publicly 
trade debt securities to receive credit ratings from NRSRO's. 
This has the unintended consequence of reducing competition, 
since the threshold for a new entrant in the marketplace to 
achieve nationally recognized status is practically 
insurmountable. As a result, only five agencies hold this 
coveted status. In other words, even though rating agencies are 
not beholden to regulators, they nonetheless are beneficiaries 
of the rules that are in place for issuers.
    It is our belief that the standoff between rating agencies 
and the SEC is likely to remain unless Congress decides either 
to expand the SEC's oversight powers and/or to mandate rating 
agencies to submit to either involuntary regulation or 
voluntary self-regulation. Given the impasse that appears to 
exist between the SEC and rating agencies, we have a number of 
suggestions that we believe your Committee should consider as 
it determines how to address the current situation.
    First, the NRSRO definition is antiquated and must be 
revised. The initial hurdle to become nationally recognized is 
high and has had the unintended consequence of reducing the 
ability of new entrants into the marketplace, placing an 
emphasis on recognition versus an emphasis on competence.
    Second, regulatory oversight for credit rating agencies 
should be assigned to the SEC and rating agencies should be 
subject to periodic SEC review. Without adequate authority 
assigned to the SEC, any changes that the agencies make, either 
voluntary or by regulation, cannot be quantified or verified.
    Third, I believe the situation we are talking about here 
with credit rating agencies is materially similar to a 
situation we have dealt with in the area of issuer-paid 
research. In this case, small companies that are not covered by 
Wall Street analysts pay firms to provide equity research. To 
address these conflicts, the CFA Institute and the National 
Investor Relations Institute partnered to develop best practice 
guidelines for managing the relationship between corporations 
and financial analysts. I believe these guidelines, entitled 
``Best Practice Guidelines Governing Analyst-Corporate Issuer 
Relations,'' could serve as a model if and when standards for 
better managing the relationships between corporations and 
credit rating agencies are developed. We will provide a copy of 
the guidelines with my written remarks.
    Another relevant situation of the recent past is the well-
documented conflict that has existed between the investment 
banking and research departments at brokerage firms. This, of 
course, has had a multitude of consequences, most notably that 
analysts received pressure from both inside and outside their 
firms to issue favorable recommendations on the stock of 
current and potential investment banking clients.
    In this case, CFA Institute developed research objectivity 
standards to address the conflicts in the research process 
which are not limited to equity research, but extend to fixed-
income research as well. The same disclosures and restrictions 
should be required of credit rating agencies.
    Fourth, an industry-wide standard of professional conduct 
should be developed that clearly defines standards of 
independence, appropriate relations between agencies and 
issuers, and duties to the investing public. Analysts and 
supervisors should be required to attest annually of their 
adherence to the standard. In many cases, simply identifying 
the areas of conflict and processes to eliminate or manage 
those conflicts would be a big step forward, but annual 
attestation of adherence moves us to a higher standard.
    This code of conduct should require rating agencies to 
explain in their written reports what analyses were performed 
in arriving at a particular rating and what factors were 
considered in preparing the rating. The current lack of 
transparency that is endemic among rating agencies must be 
address. No NRSRO standards currently exist for defining what 
minimal analysis should be performed.
    This code of conduct should also require NRSRO's to adhere 
to standards that govern the analysis performed. One of the 
simplest approaches would be to require that policies and 
procedures be established and verified to ensure compliance. 
These could include requiring documentation in support of the 
analyses, as well as a periodic supervisory view of the 
documentation and ratings. Last, the code of conduct should 
establish minimum competency requirements within rating 
agencies for those who analyze securities and assign their 
ratings.
    As I stated earlier, CFA Institute is a proponent whenever 
possible for self-regulation over government-mandated 
regulation. Nonetheless, we recognize that self-regulation has 
its limitations and there comes a time when a full-fledged 
regulation may be the only course of action. Of all the 
directions this Committee has at its disposal, we believe the 
one direction it absolutely should avoid is the status quo.
    The code of ethics I mentioned earlier which all of our 
80,000 members must abide by requires them above all else to 
place the interests of investors first. And we believe that 
this Committee, the SEC, and rating agencies, if they are to 
follow that same basic principle, will ultimately find the 
right solution. CFA Institute is committed to providing our 
perspective and any type of assistance we may give the 
Committee.
    Thank you very much.
    Senator Bennett. [Presiding] Thank you.
    Mr. Pollock.

                  STATEMENT OF ALEX J. POLLOCK

         RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

    Mr. Pollock. Thank you, Senator, and I would like to thank 
the Chairman, Ranking Member Sarbanes, and Members of the 
Committee for the opportunity to be here today. These are my 
personal views on the need to reform the credit rating agency 
sector.
    I think it is both important and also quite timely for 
Congress to address this issue now, since the actual result of 
the SEC's actions, and in recent years its notable inaction, as 
various other panelists have pointed out, has been to create 
and sustain a Government-sponsored cartel, or the term you 
used, Mr. Chairman, a Government-sponsored shared monopoly.
    A few weeks ago, Barron's magazine had this to say, 
``Moody's and Standard and Poor's are among the world's great 
businesses. The firms amount to a duopoly and they have enjoyed 
huge growth in revenue and profits. Moody's has a lush 
operating profit margin of 55 percent, S&P of 42 percent.'' And 
I have to say if I were a manager of such a firm, I would try 
very hard to maintain the status quo.
    One securities analyst recommending purchase of Moody's 
shares wrote, ``Thanks to the fact that the credit ratings 
market is heavily regulated by the Federal Government,'' rating 
agencies enjoy what he called ``a wide economic moat''; in 
other words, protection. It is my recommendation that Congress 
should remove this Government-created protection or economic 
moat and instead promote a truly competitive credit rating 
agency sector, and that will bring all the advantages of 
competition to the customers of ratings.
    It is my view that the time has come for legislation to 
achieve this. Instead of allowing the SEC to protect the 
dominant firms, which it does, in fact, although I do not 
believe it does so on purpose, it is my view that Congress 
should mandate an approach in legislation to end the 
Government-sponsored cartel and credit ratings. As part of 
this, you obviously have to think about this NRSRO issue, as 
many others have discussed and you have covered quite well in 
your opening comments, Mr. Chairman.
    I think the nub of the matter is that a competitive market 
test, not a bureaucratic process, should determine which credit 
rating agencies end up earning the market's view that they are 
the worthwhile, recognized agencies, so competition can provide 
its normal benefits of higher quality and lower costs. I will 
note this is completely different from the approach taken in 
proposals by the SEC staff on the NRSRO issue, and these 
proposals, in my opinion, are unsatisfactory.
    On the other hand, I believe that very much in the right 
direction is the bill which has been mentioned before 
introduced into the House by Congressman Fitzpatrick, H.R. 
2990. What this bill does is directly address a really big, 
practical problem with the NRSRO issue, which is that this 
NRSRO designation over the three decades of its life has become 
enshrined in a very large and complex web of regulations and 
statutes which all interlock and interact with each other and 
pose a serious question of how could you ever untangle this web 
which affects thousands of financial actors, basically all of 
the regulated parts of the financial system, which is most of 
the financial system.
    H.R. 2990 does this in what I believe is an elegant fashion 
by keeping the abbreviation ``NRSRO,'' but completely changing 
what it means. As you know, it does that by changing the first 
``R'' from ``Recognized'' to ``Registered,'' so you have 
nationally registered credit ratings organizations. This change 
would move us from an anticompetitive designation regime, which 
is what we have now, to a procompetitive disclosure regime. 
Many of the other members of the panel have mentioned the need 
for operating on a disclosure basis.
    I believe that registration in such a system should be 
voluntary, and if any rating agency, such as apparently Mr. 
Reynolds' firm, does not want to be an NRSRO, it should not 
have to be. But if it wants to be an NRSRO, the way is plain 
and clear what you do to get there. If you do not want to be an 
NRSRO, then your ratings cannot be used for regulatory 
purposes. And if you are happy with that, we should be happy 
with you, but if you want entry into this regulated part of the 
system, then you should have to register as a nationally 
registered rating agency. This voluntary approach, in my view, 
entirely removes any First Amendment objections which can be 
made.
    A very important advantage of a voluntary registration 
system is it would allow multiple pricing models for the credit 
rating agency business. As has been discussed, the model of the 
dominant agencies is that securities issuers pay for credit 
ratings, which arguably creates a conflict of interest which 
needs to be closely managed.
    The alternative is, of course, having investors purchase 
the credit ratings directly, and this seems to create a 
superior incentive structure. If the investors pay, it 
obviously removes any potential conflict. I am not suggesting 
that regulation should require one or the other, just that both 
should be available in the market. This contrasts to the SEC 
staff proposal which would enshrine the issuer-paying model in 
the regulation.
    I do not believe we should have actual regulation of credit 
ratings by the SEC or the process of forming credit ratings. I 
think that would be a worse regime that we have now, but we do 
need a competitive system. I do not think there is any doubt 
that a fully competitive rating agency market would perform 
better, but it will not happen all at once. This would be an 
evolutionary process and the desirable transition, given the 
natural conservatism of risk policies and financial actors, 
will be gradual.
    In my view, any concern about disrupting the fixed-income 
markets is entirely misplaced. Having worked in banking and 
dealt with bond and derivatives markets for a good long time, I 
see no chance of any market disruption from these changes, no 
chance at all. Also, having dealt with numerous financial 
regulators over many years, I see no chance of what one 
panelist called a regulatory vacuum. I do not think that will 
happen at all.
    A final thought on timing. The NRSRO issue has been a 
regulatory issue and discussion for a decade in what seems to 
me a quite dilatory fashion, and I think the time would be very 
appropriate for Congress now to settle this issue of 
competition versus cartel in this key financial sector. In my 
view, this will bring, as the evolution proceeds, better 
customer service, more innovation, more customer alternatives, 
and reduce duopoly profits. Also, it will bring higher-quality 
credit ratings.
    I think there is a certain analogy to publishing and the 
press in rating agencies, and we all know the more reporters 
you have working, the more likely the story is to come out. In 
the same way, in my view, the more credit rating agencies we 
have working on risk assessments, ideas, analysis, and looking 
at firms, out of this vibrant competition we are going to get 
better risk assessments.
    Thanks again, Mr. Chairman, for the chance to be here.
    Chairman Shelby. I thank all of you.
    The regulation of rating agencies begins and ends when the 
SEC staff issues the NRSRO license. Was the Department of 
Justice's Antitrust Division correct when it asserted that the 
NRSRO regime established, ``a nearly insurmountable barrier to 
competition for new entrants?''
    Mr. Pollock.
    Mr. Pollock. I think the Department of Justice, Mr. 
Chairman, was absolutely correct in that opinion.
    Chairman Shelby. Mr. Partnoy.
    Mr. Partnoy. I agree. I think we have seen evidence of 
insurmountable barriers, and we will continue to see that 
unless we have action.
    Chairman Shelby. Mr. Stevens.
    Mr. Stevens. I think the circumstances speak for 
themselves. If it did not, there would be presumably many more 
NRSRO's than there are today.
    Chairman Shelby. Once the SEC staff issues the NRSRO 
license, what is the level of Commission oversight?
    Ms. Cunningham.
    Ms. Cunningham. None; very little.
    Chairman Shelby. Mr. Stevens.
    Mr. Stevens. You mean currently, Mr. Chairman?
    Chairman Shelby. Yes, sir.
    Mr. Stevens. I think it is slim to none.
    Chairman Shelby. Slim to none?
    Mr. Stevens. Probably more to the ``none'' side.
    Chairman Shelby. Mr. Pollock, do you agree with that?
    Mr. Pollock. That is my understanding, as well, Mr. 
Chairman.
    Chairman Shelby. Would SEC oversight benefit investors and 
the markets?
    Mr. Silvers.
    Mr. Silvers. Oh, I think undoubtedly. I think that is the 
main problem here. We have granted an unregulated monopoly in 
something where such harm can be done that to have substantive 
SEC oversight would be of huge benefit to working people in the 
markets.
    Chairman Shelby. Given that S&P and Moody's both have 99 
percent, from what we have been told, of the corporate bond 
market and profit margins that exceed 40 and even 50 percent, 
how would you assess the level of competition in the rating 
industry? Do the Big Two actually compete with each other or is 
it a duopoly or partner monopoly, as some economists have 
asserted?
    Mr. Partnoy.
    Mr. Partnoy. I think you have heard consensus today, and 
the literature suggests that we have a duopoly, that this is 
not a market that is working well. It would be hard to find a 
market that is working worse where you had higher operating 
margins and greater oligopoly profit.
    Ms. Tillman. If I may, Mr. Chairman?
    Chairman Shelby. Go ahead, Ms. Tillman.
    Ms. Tillman. Being that I seem to be in the minority here, 
I would like to mention a couple of things that we believe need 
to be said. First of all, we believe that the NRSRO framework 
that was put in place did, in fact, have unintended 
consequences. Certainly, all you have to do is figure out how 
many years it has been in place and say that there are only 
five NRSRO's and that, in fact, it has limited the designation.
    However, what we do believe is that there is a system in 
place or there are a number of actions that can be taken that 
would simply and effectively increase the level of competition, 
and for that matter allow the NRSRO's and any additional 
NRSRO's to review their processes and procedures on an annual 
basis, reporting back to the SEC and allowing the SEC to have 
discussions with them.
    Chairman Shelby. Mr. Reynolds, are investors in the markets 
disadvantaged by the absence of any real competition among the 
Big Two? In other words, what is the impact of all of this? Do 
they have unlimited pricing power?
    Mr. Reynolds. Well, there are multiple levels. The first 
immediate one is when you have two firms dominating a market, 
it creates severe market disruptions. Market access, cost of 
capital, the ability to expand--it all wags on basically what I 
would argue would be one opinion rather than two, given the 
fact that the two very often operate in lock-step.
    A comparable situation would be having only two investment 
banks can make over-the-counter markets in debt securities. If 
one changes their mind and the other one has a history of 
following, there is no second and third opinion, and people 
need a second and third opinion. And because they are issuer-
based models, not investor-based, at the end of the day you do 
not get paid for having the best opinion by the investor. You 
get paid by the issuer for just providing those ratings, or I 
should say for not withholding ratings.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman. I know we have a 
vote on. I am going to put just a couple of questions because I 
am not going to be able to return if you continue the hearing.
    I want to address something that may appear tangential, but 
I mean I think the basic arrangement needs to be examined 
carefully along the lines of the Chairman's questioning. Last 
year, The Economist wrote, ``There are unsettling parallels to 
the disgraced auditing industry. The rating agencies are 
started up consulting businesses which advise on matters that 
might affect an issuer's ratings.''
    The Washington Post, in an editorial entitled ``Rating and 
Raters,'' said ``It is also troubling that the rating agencies 
are starting to sell consulting services. To secure contracts, 
the raters may be tempted to inflate grades for consulting 
clients. An acute version of this conflict of interest used to 
bedevil accounting firms.''
    Why should the rating agencies engage in these consulting 
services? Shouldn't an appropriate arrangement be that they are 
a rating agency, pure and simple? And you avoid the conflicts 
of interest that are associated with going into the consulting 
business for people that they are then going to rate?
    Mr. Diermeier. Senator Sarbanes, I would definitely agree. 
It is not just a competition issue. This conflict in terms of 
consulting and ancillary services does create pressure. And 
since businesses and people that work in businesses understand 
how those pressures can manifest themselves, unless you have a 
clear, cut-and-dry rating process that is free from those 
conflicts, we are going to continue to have these kinds of 
problems. So, I think that the parallel is an excellent one.
    Senator Sarbanes. Ms. Cunningham, and then, Ms. Tillman, we 
will certainly give you an opportunity.
    Ms. Cunningham. I could not agree with you more, and I 
think we have seen that the audit example is a perfect example 
of where even the self-policing just did not work. It is a bit 
like putting the fox in the hen house.
    Senator Sarbanes. Ms. Tillman.
    Ms. Tillman. I would just like to state that Standard and 
Poor's rating services does not offer any consulting business, 
nor are any of its analysts involved in any consulting 
business.
    Senator Sarbanes. And you do that in order to avoid this 
charge of a conflict of interest?
    Ms. Tillman. Well, not just because of that. It is because 
they are separate businesses and our code of conduct that we 
have in place does not permit analysts to be involved in any 
consulting business. And as I said earlier, the ratings 
services do not offer any consulting business.
    Mr. Partnoy. Senator, could I just point out----
    Senator Sarbanes. We have a lot of takers here. Real quick, 
because we have a vote.
    Mr. Partnoy. It might not be called consulting, but 
Standard and Poor's and Moody's offer services to issuers. For 
example, if an issuer wants to come to the agency to find out 
how a particular transaction might affect their rating, they 
can do so. So there certainly are these kinds of services being 
offered. They might not be called consulting, but they are 
consulting by any other name.
    Ms. Tillman. If I could reply to Mr.----
    Senator Sarbanes. I will come back to you in a minute.
    Ms. Tillman. Thank you.
    Chairman Shelby. Mr. Silvers.
    Mr. Silvers. Thank you, Senator Sarbanes. Two quick points. 
First, there is not a lot of data, at least not that I could 
find, that really gets at the question of how much consulting 
is going on not just by the silo that the firms will tell you 
about, but by all of their affiliates and all the things that 
are not called consulting, but might be consulting.
    Second, I think it is really worth the Committee's 
attention to the fact that these issues of conflicts and the 
quality of ratings dwarf the issues around pricing. The 
collapse of Enron literally wiped out in debt more value than 
the entire market has placed on Moody's, which is the market's 
value of essentially all of the bad pricing that other 
witnesses have been talking about. But one catastrophe bred by 
conflicts is of greater consequence than all of that, which is 
frankly why my testimony focused on managing those.
    Senator Sarbanes. Mr. Stevens.
    Mr. Stevens. Senator, it seems to me we need more 
participants in the market and we need to know a lot more about 
all of those participants so that people who use these ratings 
can judge them. And if we have conflict of interest disclosure 
that is detailed enough and that is current enough, then the 
users of ratings can determine whether the rating is worth it 
or not.
    Senator Sarbanes. Ms. Tillman, you wanted to add something?
    Ms. Tillman. Yes, just a couple of points.
    Senator Sarbanes. The last word, I think.
    Ms. Tillman. One, we agree that Enron was a tragic 
situation and certainly hurt and was harmful to many people. 
But we were also victimized. As was stated in a plea agreement, 
the rating agencies were purposefully deceived. Literally, the 
executives of Enron sat down and put a plan in place to deceive 
the rating agencies so that they would not lower the ratings.
    On conflicts of interest, the weight of opinion by market 
participants is that the issuer-paid model does not compromise 
the objectivity of the rating. In numerous surveys, responses, 
and comments to regulators both here and abroad, they have 
found no occurrence of conflicts of ratings, or if there is, 
they have been well-managed.
    Therefore, you know, I believe that the issuer-paid model 
also offers something that we do not talk about, and that is 
the benefits of disseminating information for free, 
disseminating media analysis, disseminating the reasons and 
rationale for those ratings.
    One other clarification. We are paid to do analysis. We are 
not paid to publish it, and we freely publish it so that the 
investing public is aware of what the creditworthiness is of 
the issuers and the securities in the market.
    Senator Sarbanes. Let me ask one quick question. What is 
the view of panelists on whether the director of a rating 
agency--let me put it the other way--that the chief executive 
officer or director of a company that is being rated should 
also be the director of the rating agency? Is that a problem? 
It seems to me if it is, it is pretty easy to fix.
    Mr. Silvers. Senator, I think that the ideal governance of 
a rating agency would be that the board would be composed of 
individuals who did not have an economic interest in any way in 
the ratings that were being done. That being said, it is fairly 
easy to wall off that particular conflict, but the real 
question, I think, is why is that conflict necessary? There 
does not seem to me to be a good reason why you have to have 
that conflict in the first place.
    Senator Sarbanes. Thank you.
    Chairman Shelby. We appreciate you coming. We are 
controlled by the floor, as you know, and we have a big vote on 
the floor now. I have a number of questions to ask all of you 
and I would like to do that for the record. It will be part of 
this hearing record. We will follow up with all of you and go 
from there. We appreciate your participation here today.
    I would just like to sum up with one thought. What is wrong 
with competition? What is wrong with transparency, competition, 
and healthy oversight?
    Mr. Pollock, you have been here many times.
    Mr. Pollock. Absolutely nothing, Mr. Chairman.
    Chairman Shelby. We preach competition, do we not?
    Mr. Pollock. You have just said it all.
    Chairman Shelby. Thank you so much.
    The hearing is adjourned.
    [Whereupon, at 11:26 a.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
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