[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
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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
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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:]