[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
MUNICIPAL BOND TURMOIL: IMPACT
ON CITIES, TOWNS, AND STATES
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
MARCH 12, 2008
__________
Printed for the use of the Committee on Financial Services
Serial No. 110-99
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41-730 PDF WASHINGTON DC: 2008
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California DEBORAH PRYCE, Ohio
CAROLYN B. MALONEY, New York MICHAEL N. CASTLE, Delaware
LUIS V. GUTIERREZ, Illinois PETER T. KING, New York
NYDIA M. VELAZQUEZ, New York EDWARD R. ROYCE, California
MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma
GARY L. ACKERMAN, New York RON PAUL, Texas
BRAD SHERMAN, California STEVEN C. LaTOURETTE, Ohio
GREGORY W. MEEKS, New York DONALD A. MANZULLO, Illinois
DENNIS MOORE, Kansas WALTER B. JONES, Jr., North
MICHAEL E. CAPUANO, Massachusetts Carolina
RUBEN HINOJOSA, Texas JUDY BIGGERT, Illinois
WM. LACY CLAY, Missouri CHRISTOPHER SHAYS, Connecticut
CAROLYN McCARTHY, New York GARY G. MILLER, California
JOE BACA, California SHELLEY MOORE CAPITO, West
STEPHEN F. LYNCH, Massachusetts Virginia
BRAD MILLER, North Carolina TOM FEENEY, Florida
DAVID SCOTT, Georgia JEB HENSARLING, Texas
AL GREEN, Texas SCOTT GARRETT, New Jersey
EMANUEL CLEAVER, Missouri GINNY BROWN-WAITE, Florida
MELISSA L. BEAN, Illinois J. GRESHAM BARRETT, South Carolina
GWEN MOORE, Wisconsin, JIM GERLACH, Pennsylvania
LINCOLN DAVIS, Tennessee STEVAN PEARCE, New Mexico
PAUL W. HODES, New Hampshire RANDY NEUGEBAUER, Texas
KEITH ELLISON, Minnesota TOM PRICE, Georgia
RON KLEIN, Florida GEOFF DAVIS, Kentucky
TIM MAHONEY, Florida PATRICK T. McHENRY, North Carolina
CHARLES WILSON, Ohio JOHN CAMPBELL, California
ED PERLMUTTER, Colorado ADAM PUTNAM, Florida
CHRISTOPHER S. MURPHY, Connecticut MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana PETER J. ROSKAM, Illinois
ROBERT WEXLER, Florida KENNY MARCHANT, Texas
JIM MARSHALL, Georgia THADDEUS G. McCOTTER, Michigan
DAN BOREN, Oklahoma KEVIN McCARTHY, California
DEAN HELLER, Nevada
Jeanne M. Roslanowick, Staff Director and Chief Counsel
C O N T E N T S
----------
Page
Hearing held on:
March 12, 2008............................................... 1
Appendix:
March 12, 2008............................................... 91
WITNESSES
Wednesday, March 12, 2008
Blumenthal, Hon. Richard, Attorney General, State of Connecticut. 17
Dillon, Terry, Chief Executive Officer, Atlas Excavating, on
behalf of the National Utility Contractors Association......... 52
Dinallo, Hon. Eric R., Superintendent of Insurance, Department of
Insurance, State of New York................................... 16
Jain, Ajit, Chairman, Berkshire Hathaway Assurance Corporation... 65
Levenstein, Laura, Senior Managing Director, Global Public,
Project and Infrastructure Finance Group, Moody's Investors
Service........................................................ 69
Lockyer, Hon. Bill, Treasurer, State of California............... 43
McCarthy, Sean W., President and Chief Operating Officer,
Financial Security Assurance, on behalf of the Association of
Financial Guaranty Insurers.................................... 67
Newton, Mark, President and Chief Executive Officer, Swedish
Covenant Hospital.............................................. 50
Reeves, Hon. Tate, Treasurer, State of Mississippi............... 48
Sirri, Erik R., Director, Division of Trading and Markets, U.S.
Securities and Exchange Commission............................. 11
Vogtsberger, Martin, Managing Director and Head of Institutional
Brokerage, Fifth Third Securities, Inc., on behalf of the
Regional Bond Dealers Association.............................. 71
Wiessmann, Hon. Robin L., Treasurer, State of Pennsylvania....... 45
APPENDIX
Prepared statements:
DeLauro, Hon. Rosa L......................................... 92
Blumenthal, Hon. Richard..................................... 94
Dillon, Terry................................................ 98
Dinallo, Hon. Eric R......................................... 103
Jain, Ajit................................................... 109
Levenstein, Laura............................................ 115
Lockyer, Hon. Bill........................................... 132
McCarthy, Sean W............................................. 140
Newton, Mark................................................. 195
Reeves, Hon. Tate............................................ 198
Sirri, Erik R................................................ 202
Vogtsberger, Martin.......................................... 210
Wiessmann, Hon. Robin L...................................... 217
Additional Material Submitted for the Record
Frank, Hon. Barney:
Chart entitled, ``Sectoral Breakdown of Moody's-Rated Issuers
and Defaulters: 1970-2000.................................. 224
Washington Post article, ``Tax-Exempt Funds Yield a
Surprise,'' dated March 11, 2008........................... 225
Bachus, Hon. Spencer:
Statement of the Municipal Securities Rulemaking Board....... 227
Kanjorski, Hon. Paul E.:
Letter from the Government Finance Officers Association, the
National Association of Counties, the National Association
of State Auditors, Comptrollers and Treasurers, the
National Association of State Treasurers, the National
League of Cities, and the U.S. Conference of Mayors, dated
March 11, 2008............................................. 244
Letter to the House Ways and Means Committee from various
Members of Congress........................................ 253
Shays, Hon. Christopher:
Letter to former SEC Chairman Christopher Cox from Hon.
Spencer Bachus, dated January 23, 2007..................... 258
MUNICIPAL BOND TURMOIL: IMPACT
ON CITIES, TOWNS, AND STATES
----------
Wednesday, March 12, 2008
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 10:04 a.m., in
room 2128, Rayburn House Office Building, Hon. Barney Frank
[chairman of the committee] presiding.
Members present: Representatives Frank, Kanjorski, Waters,
Watt, Sherman, Moore of Kansas, Capuano, McCarthy of New York,
Lynch, Scott, Green, Cleaver, Moore of Wisconsin, Perlmutter;
Bachus, Royce, Shays, Feeney, Hensarling, and Campbell.
The Chairman. The Committee on Financial Services will come
to order.
I am pleased to see that the representative of the
Securities and Exchange Commission passed security. I don't
know about your exchanges, but you're okay on security.
And this is as important a hearing as we are going to have.
Earlier this year, when we began to talk about a stimulus
package, there was a lot of pressure on Speaker Pelosi, who had
been one of the leaders in the recognition of the need for a
stimulus, to get into infrastructure, and it's a very widely
supported goal among Members of both parties, especially many
Democrats.
The speaker quite courageously, and I think thoughtfully,
said no, we're going to do something that can be spent quickly
and infrastructure doesn't meet that, but she gave her
commitment that we would be working on improving infrastructure
financing, because there is an admitted need in this country
for bridges and highways and schools and sewer facilities,
etc., all of which have to be paid for by the public sector.
Today, we are here playing defense because due to grievous
misjudgments made by elements in the private sector, the public
sector in this country now faces unfair excessive costs as they
try to meet those infrastructure needs.
We are all, in America, capitalists today. We understand
the value of the free market system. People on this committee
understand the importance of the financial system as
intermediaries in our system.
But those who have argued that the private sector should be
left essentially alone, and that public sector intervention
would do more harm than good, have nowhere been more decisively
refuted than in the situation in which the municipalities and
the States find themselves.
In yesterday's Washington Post, and I ask unanimous consent
to put this into the record, Alan Sloane notes that he
discovered to his surprise that a tax exempt money market
mutual fund is now paying a higher absolute rate than a
Treasury fund, even though the one paying the higher rate is
taxable and the Treasury fund is tax exempt.
Here is the situation: Municipalities have been unfairly
treated by the private sector for some time. I will be giving
out this chart, ``Sectoral Breakdown of Moody's Rated Issuers
and Defaulters: 1970 to 2000.'' Under ``General Obligation,''
there it is. Number of Issuers: 14,775. Number of Defaults: 0.
Despite that, there has been pressure on issuers to buy
insurance.
Now, to begin, the insurance for full faith and credit
general obligation bonds has been unnecessary.
Requiring general obligation issuers of full faith and
credit bonds, where the taxing power of the entity stands
behind them, requiring them to buy insurance is, as I said
yesterday--it occurred to me, and I was fond of it, so I will
say it again--like asking a vampire to buy life insurance,
because nobody is going to ever have to pay off.
The problem is that in this situation, the bloodsucking
seemed to have gone in the opposite direction, because the
vital substance of these municipalities has been sucked away,
and what happened?
Mr. Callen from Ambac had an interview in the Wall Street
Journal, and he said, well, the premiums paid by the
municipalities were golden. They were AAA and better sources of
revenue, but it was kind of slow growth.
So what some of these insurance companies did was, they
took the insurance premiums from issuers that shouldn't have
had to pay premiums in the first place, and invested them in
sophisticated instruments, and did it badly, and as Mr. Callen
said, when we got into CDO squared, we were a little beyond
what we understood.
What happened? These private investments went bad. And who
is paying the price? Among others, the municipalities.
It is an odd situation in which issuers are now being
charged higher interest because they are hurt by their
insurers. They are better propositions than their insurers.
We have had problems with rating agencies. There have been
two scales. Rating agencies have had a separate scale for
municipalities than for corporates.
Why? Because if you rated municipalities, and again, I'm
talking particularly about general obligations, although you
can see it's a pretty good ratio with some of others as well,
if you rated municipals the same way you rated corporates, it
would be boring, because everybody would get super duper triple
A. And how do you make a business out of saying everything is
perfect? So they get subjected to this separate rating system.
This is not a minor technical matter. The cost of schools
and highways and sewer treatment facilities and bridges and a
number of other important facilities now costs the public more.
There are areas where we have made mistakes in the public
sector. This is an area where the private sector, left to its
own, has made the great bulk of mistakes and the public sector
is paying the price.
So I want to send a message very clearly from myself as
well as, I believe, the majority of this committee, and I have
also had some bipartisan conversations on this. This has to be
fixed.
We cannot tolerate a situation in which elected officials
trying to build schools and comply with mandates from the
Federal Government to improve the treatment of sewage, to build
highways, and to do other important things are charged much
more than they should be charged, partly because of an initial
undervaluing of their credit, and then compounded, adding
injury to injury, by the fact that people took their premiums,
and since they never had to pay any of those claims, had all
the money to go invest, invested it badly, and inflicted damage
on the public sector.
I have to say, I mean, I am not one of those who invokes
religion in the public sector. People are free to do that, but
it is not something that I generally do. But for me, it is the
time of year when we celebrate the exodus from Egypt, and I
have to say now as an elected official who is a partner in
governance with the cities and States, I want to say to the
private sector that has enmeshed them in this set of
circumstances in which they're being unfairly penalized when
they sell bonds, ``Let my people go.'' This is a time to cut
them loose. And if we have to part the ``red ink sea,'' we will
do that.
But I do not think we can tolerate, as a society, this
situation where people are being required to pay so much.
Now, this has not been a traditional Federal role.
Insurance has been State regulated. That is why we have one
Federal regulator here and two very able State regulators. But
that is not going to continue. I think the Federal Government
has to be a partner with regulators such as we have here who
have been stepping forward.
And we intend to listen today, but I am submitting an
invitation now: Give us solutions to this. We are determined, I
believe the majority of this committee, and I think the whole
Congress, to deal with this.
Let me make one other statement, now. It's a personal
statement. But we spent a lot of time on the ethics rules
yesterday, and it was very controversial.
I will say this. I intend fully to comply with the ethics
rules, so let me take this occasion to tell everybody, no, I'm
sorry, I can't have dinner with you and we can't have
breakfast, and if you see me sitting there, you have to leave
me alone to read the paper and not buy me a cup of coffee, and
that's the new ethics rules, and I can live with them.
But I plan today to buy some municipal bonds from the State
of Massachusetts. I wish they weren't being forced to pay such
a high rate, given that they are for me double tax exempt, but
given that they are, me as well as anybody else ought to buy
them, and I really say that, my advice to people, I don't
usually do this, you get a great buy in municipal bonds right
now.
I didn't want to say this before the hearing. I don't want
to be accused of sort of influencing, you know, and buying
beforehand.
But this is an intolerable situation. Some things are more
complex than others. This one is clearcut.
We have to have a situation in which those numbers--I'm
told there has been since 2000 one default in a general
obligation. It was a default where they were not in full
compliance with the covenants, and in fact nobody lost any
money, everybody got paid off. So we have to restore some
rationality here.
And this is one where the market has got it wrong. The
market is a wonderful instrument, and it creates a lot of
wealth, but it's not a perfect instrument, and this is a case
where if this doesn't get corrected, we will have to intervene.
The gentleman from Alabama.
Mr. Bachus. Thank you, Mr. Chairman. I appreciate you
holding today's hearing on the ongoing turmoil in the bond
markets and the problems that cities and counties are facing in
trying to issue, refinance, and price their municipal debt.
This is the committee's first hearing on the $2.6 trillion
municipal securities market. We did have a hearing on bond
insurers, at which time Mr. Dinallo testified, and I'd like to
acknowledge at this time both the difficult and important work
that you're doing with the monoline bond insurers in preserving
liquidity, which is very important to our municipal bond
market, as we all know.
Our hearing unfortunately comes at a time when that market,
which I think the chairman, by his chart showed, has
traditionally been known for its safety, security, and rate of
return, presently is under severe stress.
Constituents in my congressional district are being
particularly hard hit by the crisis. In my home county of
Jefferson County, Alabama, the breakdown of the secondary bond
markets has forced the county's interest rate payments on local
sewer bonds to skyrocket from 3 to 10 percent, a more than
triple increase.
Most of these are revenue bonds, and these higher costs
will ultimately have to come out of the pockets of the users,
the water and sewer system there, or there will have to be a
reduction of services, or, as I said higher fees.
We need to act swiftly and responsibly to determine whether
there's anything we can do as a Congress to get these markets
on track before too much more damage is done, although at the
same time, I'm not sure what that will be, other than perhaps
the SEC's proposal.
I would respond to the chairman that I'm not as convinced
as he is about not having a need for bond insurance.
I could see that, on occasions when you have an entity like
maybe the port authority or you had a well-known entity, a
State, but when you are dealing with particularly local
governments or water boards that investors know nothing about,
I would think that the insurance would almost be necessary to
market the bonds.
Local governments across the country are facing a hostile
environment in which to raise funds, with new issues plummeting
and many municipalities forced to pay significantly higher
interest rates to attract investors.
The downgrading of bond insurers and the constriction of
the credit markets as results of the subprime mortgage problems
have forced banks and hedge funds to dramatically reduce their
municipal debt risk exposure.
I think this reduction of risk we're seeing in our economy,
of people not willing to take as much risk, is probably a good
thing. There has been too much risk in the past, and people are
repricing that risk, and I don't think there's anything
unnatural about that.
The extent of its impact on the municipal bond market, the
municipal securities market, is however a problem, which I am
still hopeful may be transitory.
As the economy picks up and liquidity improves, I think
we'll see a lot of improvements in this regard, although I'm
not sure we'll ever see the auction rate securities come back.
But the resulting collapse of the secondary bond markets
has further impaired the ability of local governments to manage
their debt exposure, and this is a serious problem.
Until the recent crisis, the secondary bond markets had
ample liquidity, but auctions have been failing since the end
of last year as the investment markets pulled back.
On March the 5th, Bloomberg reported 536 unsuccessful
auctions in the market for floating rate securities. That is a
failure rate of 68 percent of all auctions.
According to Bank of America, the rate of failures reached
87 percent on February the 14th, and has since ranged from 61
to 69 percent. These are sobering statistics.
Fortunately, this committee does have possible solutions
available to better protect both local governments and
investors.
SEC Chairman Cox presented a vision last year for
increasing integrity, transparency, and accountability in the
municipal securities market. Chairman Cox's initiative would
require meaningful public disclosures that are current and
understandable with a full accounting of all material
information at the time of a new municipal bond issuance.
Chairman Frank has agreed, at my urging, to invite Chairman
Cox to appear before the committee later this year to formally
consider his proposal.
In addition to considering Chairman Cox's proposal for
greater disclosure and transparency, the committee will also
need to examine the dual credit rating scale used by the rating
agencies that appears to arbitrarily assign municipalities a
higher risk rating than other debt issuers.
This creation of risk perception has forced many
municipalities to purchase insurance that, as the chairman
said, may not have been otherwise necessary.
More business is created for the rating agencies who
analyze the bond insurers' offerings, but it's the local
taxpayers who end up paying the increased cost.
Not surprisingly, it has been the non-municipal debt that
rating agencies severely under-assessed for risk, with
investors in secondary markets absorbing huge losses as the
result of a fundamentally flawed system of risk analysis.
In conclusion, Mr. Chairman, the municipal bond markets, as
you said, finance the development of roads, bridges, sewer and
water systems, hospitals, universities, and other critical
infrastructure upon which local residents rely.
Efficient and liquid municipal finance markets are critical
to keeping our economy moving forward and must be restored to
working order as promptly as possible.
Thank you.
The Chairman. We have a vote; I believe it is to table the
notion of requesting a privilege. But I think we can get some
more opening statements in, and it usually takes about 20
minutes. So I apologize, but I think that will be the only vote
for a while.
The gentlewoman from California, the chairwoman of the
Housing Subcommittee.
Ms. Waters. Thank you very much, Mr. Chairman.
The need to hold this hearing reflects the growing impact
of the subprime and home mortgage loan market crises across the
domestic and global economy.
Hedge funds, along with large commercial and investment
banks, continue to take hits to their balance sheets as a
result of their substantial investments in mortgage-backed
securities of uncertain or clearly declining value.
As a result, they have been flooding the market with bonds
in a rush to sell assets. This has had a dual effect.
First, demand for bonds has dropped over the past few
weeks, putting upward pressure on yields and the cost of
borrowing for bond issuers such as municipalities.
Second, it has meant that large commercial and investment
banks have not been willing to step into their traditional role
as a backstop in the municipal auction rate securities market
when these auctions have begun to fail.
This has, of course, had disastrous results for municipal
bond insurers, which have seen their costs of borrowing
skyrocket.
Simultaneously, the municipal bond market has been
operating under the spectre that one of the bond insurance
agencies could face a ratings downgrade.
Currently, many municipal bond issuers purchase bond
insurance primarily to take advantage of the higher rating the
insurance confers on their bonds, even though the risk of
default, even on municipal bonds rated below AAA, is
statistically insignificant.
Without access to bond insurance or revisions to the
municipal bond, we need a way out of this bind if the
absolutely essential $2.6 trillion tax exempt municipal bond
market is to return to smooth functioning.
I look forward to hearing from today's witnesses, including
my former colleague, now the treasurer of the State of
California, Mr. Bill Lockyer, about potential solutions to this
dilemma.
I yield back the balance of my time.
The Chairman. The gentleman from Alabama has a unanimous
consent request.
Mr. Bachus. Thank you, Mr. Chairman. I ask unanimous
consent to submit for the record a statement from the Municipal
Securities Rulemaking Board.
The Chairman. Without objection, it is so ordered.
The gentleman from California, Mr. Campbell, is now
recognized.
Mr. Campbell. Thank you, Mr. Chairman.
I agree with many of the comments the chairman made in
opening this hearing, but I think there's another factor at
work here, which I hope we, in all three panels today, will
discuss, and I hope the chairman would consider, as well.
Clearly, the risk premiums that exist now on municipal
bonds, and I have personally taken some of the same actions in
my home State of California that the chairman just described in
his of Massachusetts, that risk premium appears to be
unjustified at the moment.
But I do believe that there are risks out there which we
can't tell what they are, and that's part of what is driving
this.
In my home State, there have been several bankruptcies of
governmental units, including my home county of Orange, in the
last couple of decades, and there is at least one city
municipal bankruptcy being threatened in California today.
And these bankruptcies and these fiscal problems usually
occur from one of two things. Either they take their investment
funds and invest them in risky investments which then don't
turn out, and the municipality or civic organization loses
money, or, and this is the great threat, I think, going
forward, there is substantial, in many cases, unrecorded and
unfunded liabilities largely for pension and health care and
other union obligations, which are out there, which appear to
be completely unsustainable, but they're not shown on the
books.
So I'm a CPA, and this kind of stuff, as you can imagine,
drives me nuts, and so one of the things I think we need to
look at in this whole process is transparency, so that
investors and potential bond insurers can see what is really
going on in that municipality.
If there are substantial pension obligations, they first of
all shouldn't be unrecorded, and they probably shouldn't be
unfunded, but they absolutely should be disclosed and discussed
and put in as part of the risk factor.
And my concern is that we do have potential failings of
municipalities down the road if we don't start exposing and
dealing with all these things now.
And so I do think that that is a part of the equation that
I hope this panel and the subsequent panels will discuss and
that we will have a part of the conversation, Mr. Chairman.
The Chairman. Thank you.
We have 5 minutes left, so we are going to break and vote.
When we come back, we will have an opening statement from the
former mayor of the city of Somerville, my colleague from
Massachusetts, Mr. Capuano, and then we will get to the
witnesses.
[Recess]
The Chairman. Please be seated. We want to move as quickly
as we can.
Please be seated.
We will resume, and we will now turn to the gentleman from
Connecticut for 3 minutes for an opening statement.
Mr. Shays. Thank you very much, Mr. Chairman.
I want to align myself with the basic thrust of your
comments. I might take off a little of the rough edges, because
you're pretty emphatic about it. But I do buy into your
comments.
And I do want to say, in particular, I want to welcome the
attorney general from Connecticut, Richard Blumenthal. I read
his entire statement, and I agree with it almost in its
entirety. I commend it to all the members to read.
And I just, I am ending up, for me, what I wrestle with is
why shouldn't--why not just have the Federal Government insure
municipalities?
Because in the end, it's really going to be the same
taxpayers, and it does seems to me, however, small the fee is,
the premium is, it seems like a premium that one should not
have to pay, number one.
And number two, given that the insurance companies are the
ones that have gotten themselves in trouble, it seems unfair
to, basically, the taxpayers, that they have to pay the
penalty.
I almost feel like municipalities should insure insurance
companies, rather than insurance companies insure
municipalities.
I thank you for the time, and I welcome all our witnesses,
but particularly my colleague from Connecticut.
The Chairman. Thank you. And from time to time, we in
Massachusetts are glad we have our suburban neighbors to clean
up our act a little bit. As long as we're in general agreement,
it's okay.
The former mayor of the city of Somerville, the gentleman
from Massachusetts, Mr. Capuano.
Mr. Capuano. Thank you, Mr. Chairman.
Mr. Chairman, I want to start my remarks by stating right
from the outset that I do not enter this issue as a neutral
observer. I am a former mayor. I am not neutral on this issue.
I have very strong opinions. And I think what I'm about to say
is on behalf of every single mayor and governor and government
official who currently serves and doesn't have the freedom to
say what I'm about to say.
The monolines started to back up some questionable
municipalities. They're no longer monolines. They're now bond
insurers. And they really use the municipal and State bonds to
shore up their other risky investments. They're completely
upside down.
But I don't want to blame them alone. They're in business
to make money. They can't do it alone.
Even though the State municipal bonds are the safest
investments in bonds you can make, they need the help of the
credit rating agencies to basically hold hostage cities and
towns and States across this country until they pay them a
ransom.
Now, they call those ransoms nice little things, like fees
or bond enhancements, but it's still a ransom: ``Until you pay
us, we're not going to rate you in the way you deserve, the way
your taxpayers deserve, and when we do, we're still going to
shake you down, because we're going to make you get bond
insurance that you don't need.''
To me, as I've said before, and I will continue to say,
this is nothing more than legalized extortion.
But even they didn't do it alone. They had the help, or the
acquiescence, if not the active help, the benign neglect of
most Federal regulators, and many State regulators. They sat by
and said, ``Well, what's the big deal?''
This fell particularly heavily on poorer cities and towns
who didn't have the negotiating power of some of the larger
bond issuers.
The rating agencies, the bond insurers, and those compliant
regulators effectively, in my opinion, stole billions, if not
trillions of taxpayers' dollars to put in their pocket.
When people in my position, my former position, were not
able to hire police, firemen, teachers, or sanitation workers,
or to improve their cities and towns, we had to pay them their
ransom, their extortion. And I will tell you that,
unfortunately, I'm not--there are mixed emotions.
I'm not happy we're here today, because my friends who are
still at the city and town level are still being held hostage
and are being hurt even more today because of the neglect and
the malfeasance and misfeasance of people who have been doing
this for years.
I can't tell you how much I will do to do my utmost to make
this legalized extortion stop, to give the cities and towns and
States their due, to let their taxpayers have their money back,
and to stop this stealing from people whose money you don't
deserve to have.
Mr. Chairman, I yield back whatever time I might have,
unless you want to give me another 5 minutes.
The Chairman. No, because it's going to take 3 minutes for
Mr. Shays comment on you now. But that's fine.
Mr. Shays. I would align myself with my colleague--[off
microphone]--rough edges.
[Laughter]
Mr. Capuano. Mr. Chairman, without the rough edges, they
don't hear it.
The Chairman. And you wouldn't be yourself.
[Laughter]
The Chairman. The gentleman from Pennsylvania, the chairman
of the Subcommittee on Financial Institutions, who has been
taking the lead for us in dealing with some of the related
issues here, such as the rating agencies, and who had a related
hearing on this, Mr. Kanjorski.
Mr. Kanjorski. Thank you very much, Mr. Chairman.
Mr. Chairman, I want to congratulate you for convening this
hearing of the full committee on this important subject,
because certainly it is a major part of what I think is a
crisis of confidence in the credit markets of not only the
United States, but indeed, the world.
We must recognize the seriousness of the problem and the
need for fast, pragmatic solutions. Even though some of these
solutions will not always work, they must be tried, because the
failure to try and the failure to stem the whirlpool that is
occurring out there in the credit world could be catastrophic
for the American economy and the world economy.
I think it is so important in the bond insurance market to
see the ramifications of what can happen when there is a
disqualifier of losing a certain rating that is necessary and
required of trustees of various funds who are purchasers of
municipal bonds, that it can destabilize. Although a very small
part of the premium world of insurance, the municipal bond
market is a $2.6 trillion market, and it could be tremendously
destabilized by the credit crunch that is prevailing today.
But I may say, it does not only apply to the municipal bond
market. It applies to the student loan bond market. It is now
starting to spread into so many other fields. So we have a
metastasizing that is occurring in the credit markets of the
world.
So this committee has the chief jurisdiction to put the
effort forward to make the stops, and for that, I am pleased to
see that we are going to have the treasurer of the Commonwealth
of Pennsylvania, Robin Wiessmann, as one of our witnesses. I
look forward to her testimony.
And I look forward to what we are going to turn out here as
a product, eventually.
I ask, Mr. Chairman, that two letters, one to the Ways and
Means Committee and the second letter from the Governor of
Finance Officers Association, the National League of Cities,
and the National Association of State Treasurers, the National
Association of State Auditors, Comptrollers, and Treasurers,
the National Association of Counties, and the U.S. Conference
of Mayors be submitted and entered in the record with
suggestions of some of the things that can be done.
Thank you, Mr. Chairman.
The Chairman. Without objection.
And with the consent of the committee, I'm going to go to
one more speaker, because we have another former mayor of one
of our large cities, and we did want to get his input, the
gentleman from Missouri, Mr. Cleaver, and then we'll go to our
witnesses.
Mr. Cleaver. Thank you, Mr. Chairman.
I want to associate myself with the statements of Mayor
Capuano, both in tone and content.
I served as the mayor of the largest city in the State of
Missouri, and in the State of Missouri, State law prohibits any
city or municipality from spending into the red, which means
that every city in the State, at the end of its fiscal year, is
debt free with regard to overspending. There's no deficit
spending.
And so we don't have either a debt, other than the bonds
that we are paying on, but we have no debt, and no deficit.
And in spite of that, we end up getting the roughest
treatment from the bond insurance companies, and yes, the
roughest treatment comes to the cities, even if they have the
highest rating possible.
We can't get a AAA bond rating in Kansas City, Missouri, in
spite of the fact that we have AAA status.
Now, the State can get it, the State of Missouri can get
it, but the municipalities--neither St. Louis nor Kansas City
can get it, and we don't have any deficit spending.
Wilbur Ross, the billionaire, just bought $1 billion in
municipal bonds. This is not some stupid guy playing the stock
market. He knows what he's doing.
And if we can invest in municipal bonds $1 billion, and
then have J.P. Morgan and Chase Company and Lehman Brothers
recommend that debt, it seems to me that it's safe.
We have had one little piece of a default in almost 4
decades, 4 decades, and then we still get ripped off.
And so I'm here today--and I'm not going to leave--because
I want to hear every single word that comes out of your mouths
with regard to what is happening to cities, because I want to
be able to translate this, not only to my home of Kansas City,
but to the U.S. Conference of Mayors and the National
Conference of Black Mayors, with whom I used to be affiliated.
Thank you, Mr. Chairman.
The Chairman. Thank you.
I would point out that there are some seats there. I know
they say ``staff,'' but if staff comes, you can get up. If
people want to sit, they should sit.
We will now go to the witnesses, and we will begin, and as
I said, this is an area--we have to vote, but we'll get in one
statement, and I think that we'll be okay after this for a
while.
Historically, this has been State regulated, but there is a
Federal role, as well. So we will begin with Erik Sirri, the
Director of the Division of Trading and Markets of the SEC. He
is a regular witness, and we appreciate, Mr. Sirri, your
continued cooperation with us.
Please go ahead.
STATEMENT OF ERIK R. SIRRI, DIRECTOR, DIVISION OF TRADING AND
MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION
Mr. Sirri. Chairman Frank, Ranking Member Bachus, and
members of the committee, thank you for inviting me here to
testify on behalf of the Securities and Exchange Commission
about the current turmoil in the municipal bond markets, its
impact on cities, towns, and States, and the Commission's
responses.
There's no question that the recent dislocations in the
muni bond market have created unanticipated hardships for
municipal issuers, and in some cases, have dramatically
increased borrowing costs.
Today, I'd like to discuss some of the current problems in
the bond markets, with particular attention to problems that
have developed in the market for certain short-term municipal
securities known as auction rate securities.
Auction rate securities are municipal bonds, preferred
stocks, and other instruments with interest rates or dividend
yields that are periodically reset through auctions, typically
every 7 to 35 days.
Auction rate bonds are usually issued with maturities of 30
years, but maturities can range from 5 years to perpetuity.
Auction rate securities were first developed in 1984, and
the market has grown to over $325 billion of securities, with
State and local governments accounting for about $160 billion
of the outstanding auction rate debt.
As you know, hundreds of auctions for auction rate
securities issued by municipal issuers recently have failed to
obtain sufficient bids to establish a clearing rate.
Consequently, issuers who decided to use this type of
financing to obtain favorable short-term interest rates are
instead paying what are known as ``penalty'' interest rates,
which can be as high as 20 percent, at least until the next
auction. In addition, investors cannot sell their holdings
through the auction process until the next successful auction.
The Commission has received many requests to address this
market dislocation from municipal issuers, conduit borrowers,
dealers, and investors.
For a variety of reasons, including the current lack of
dealer support for auctions and frequent auction failures, many
holders of auction rate securities now want to sell them.
Recent downgrades of bond insurers have caused many holders to
desire to sell bonds insured by companies who recently have
been downgraded or soon may be.
In addition, many holders of bonds insured or supported by
the credit of insurers whose ratings have not been threatened
may now also wish to sell, which may be due to a general loss
of confidence in the muni auction rate market.
As a result of these factors, among others, we understand
that sellers of muni auction rate securities have often far
exceeded buyers in auctions, resulting in auction failures.
Estimates of the value of recent failures for auctions of
muni auction rate securities exceed $80 billion.
Prior to the current disruption in the auction rate market,
participating dealers retained to solicit bids for the auctions
generally supported the liquidity of the auction rate
securities by placing proprietary bids as necessary in order
that the auctions not ``fail,'' and disclosed the fact that
they might do so.
However, in recent weeks, for a variety of reasons,
including liquidity concerns and uncertainty surrounding the
monoline insurers, participating dealers have ceased to
intervene proprietarily in auctions, with the result that
hundreds of auctions have failed.
Due to these failures, and the resulting higher borrowing
costs, we understand that some muni issuers and conduit
borrowers would like to, and in many cases have begun the
process to convert their auction rate bonds into variable rate
bonds backed by letters of credit or other type of credit
enhancement or fixed rate bonds.
However, the ability to convert auction rate securities may
be slowed due to heavy demand for such substitute instruments
and further overall concerns about the credit markets.
We also understand that certain participating dealers may
be unwilling to accept bids from issuers in an auction because
of questions about the scope of a settlement in a past
enforcement action.
The Commission has received several requests to consider
ways to assist issuers with an orderly exit from current market
conditions.
On February 28th, the leadership of this committee asked
the Commission to clarify for the market as quickly as possible
that issuers can, within the bounds of applicable laws and
regulation, participate in auctions for their own securities.
The staff is developing approaches to providing further
guidance in this area in light of market developments and the
settlement.
Due to the severity and immediacy of the auction rate
market decline, and the implication for investors, Commission
staff is developing appropriate guidance to facilitate orderly
markets and continue to protect investors.
This guidance would be designed to clarify that, with
appropriate disclosures and compliance with certain other
conditions, municipal issuers can provide liquidity to
investors that want to sell their auction rate securities
without triggering market manipulation concerns.
This may also have the secondary effect of easing the
substantial financial burden on muni issuers and conduit
borrowers from unusually high interest rates.
It should also facilitate an orderly exit from this market
by municipal issuers and conduit borrowers who seek to do so.
We hope to have such relief prepared by the end of this
week.
The Chairman. Mr. Sirri, I'm going to interrupt, just
because this is a very important subject.
When you use the phrase ``municipal'' there, is that in the
broadest sense of the other tax exempts, as well?
Mr. Sirri. Yes.
The Chairman. Thank you.
Mr. Sirri. Enhanced transparency would be a key component
of this guidance, as it is to the auction process.
For example, if municipal issuers or conduit borrowers want
to bid in auctions, they must disclose, among other things,
certain facts related to price and to quantity.
Of course, issuers have to comply with their disclosure
obligations under the Securities Act of 1933 and the Securities
Exchange Act of 1934, as applicable.
Staff anticipates that this guidance should remove any
hesitancy on the part of broker-dealers and auction agents to
allow municipal issuers to bid at auction.
Of course, this guidance cannot modify the terms of
contracts between buyers and sellers or contracts between
issuers and bondholders, and so municipal issuer bidding could
only take place if consistent with the terms of the auction
rate securities as reflected in their respective indentures and
governing instruments.
The guidance does not address the amendment of the terms of
any auction rate securities in accordance with their governing
instruments.
I also should note that the Commission staff is closely
monitoring the potential effects of the developments in the
muni auction rate securities markets on mutual funds, including
money market funds, and on closed-end funds.
Tax-exempt money market funds, with $465 billion under
management, are key investors in muni securities and part of
the $3.3 trillion money market industry. Money market funds
typically have as their investment objective the generation of
income and the preservation of capital.
To help meet this objective, they are required by Rule 2a-7
under the Investment Company Act of 1940 to limit securities in
which they invest to high-grade, short-term instruments that
the funds' advisers determine also involve minimal credit
risks.
As part of this rule, Rule 2a-7 employs NRSRO ratings to
determine whether funds may purchase a security.
As much as 30 percent of the muni securities currently held
by tax-exempt money market funds are supported by bond
insurance issued by monoline insurance companies. Some of the
securities may be eligible for investment by money market funds
because of the insurance that monoline insurers provide.
Given the importance of money market funds as investors in
muni securities, some have raised questions regarding the
effect of credit rating conditions in Rule 2a-7 on the funds'
ability to purchase and hold muni securities affected by
downgrades of monoline insurers.
The Commission staff recognizes that a significant
downgrade in a monoline insurer's rating could result in the
securities becoming ineligible under Rule 2a-7 for investment
by money market funds.
The credit rating conditions only create a ``floor'' below
which funds may not invest, however, and constitute one among
several risk-limiting conditions of Rule 2-a7.
Since its adoption in 1982, this rule has continued to
serve the purposes that the Commission intended. It is notable
that, despite the current liquidity crisis, money market funds
and their sponsors have not asked the Commission for any
changes to the risk-limiting conditions of Rule 2a-7, including
the credit rating floor.
The Chairman. Mr. Sirri, I'm going to stop you here. We're
going to come back to you. This is a very important subject. I
don't usually do this, but I don't want you to be rushed. This
is very important, so we are going to go vote, and then we will
come back.
I have nothing to do until 3 o'clock. I hope the rest of
you don't, either, because we're going to do this hearing. It's
as important a subject as we get.
I appreciate the clarifications you have already given on
this. We will be back as soon as we can.
[Recess]
The Chairman. Let's take our seats.
Sit down, please.
We will resume, and Mr. Sirri, I apologize for interrupting
you, but this is a hearing where we don't want anyone to feel
rushed, so please continue where you left off, and would other
people please take their seats and be quiet.
Mr. Sirri, go ahead.
Mr. Sirri. I believe we were talking about Rule 2a-7, so
let me continue.
The Chairman. Yes.
Mr. Sirri. There are also some other possible effects that
a significant downgrade in a monoline insurer's rating could
have on money market funds. The municipal securities they hold
include variable rate demand notes and tender option bonds that
typically have liquidity backstops, or puts, that are provided
by a financial institution.
The Chairman. Excuse me. Hold on.
All right, let's get in here in a hurry or get out. I'm
sorry for this, but we're not going to add to the inescapable
problem of the votes, so people, either stand or sit.
Mr. Sirri, I apologize. Please continue.
Mr. Sirri. These liquidity features serve to provide a
source of cash to satisfy redemptions by fund shareholders, and
also to shorten the muni bonds' maturities and make them
eligible investments for a money market fund.
A significant downgrade could terminate the put, and thus
result in money market funds holding long-term securities that
would be inappropriate for funds maintaining a stable net asset
value.
The Commission staff has been in regular contact with fund
management companies, which are aware of these risks and have
taken steps intended to protect funds, and thus fund investors,
from the loss of these puts.
Now that I've discussed mutual funds and other investment
companies as investors in municipal auction rate securities,
it's important to also understand that closed-end funds are
also issuers of a particular type of auction rate security,
called an auction rate preferred security. The general loss of
confidence in the auction rate market has spilled over into
this market, and many of these auctions have failed, as well.
There are important differences in how auction failures
have affected municipal and closed-end fund issuers.
Although closed-end funds also issue auction rate
securities to obtain financing, they use the financing to
leverage their investment in portfolio companies in order to
seek higher dividends for the funds' common shareholders.
Also, although the funds have been paying penalty rates to
their preferred shareholders to compensate them for the
illiquidity, the rates generally are much lower than those paid
by muni issuers.
One effect of the respectively lower penalty rates is that
the rates are generally not as detrimental to fund issuers.
As long as the amount they pay to their preferred
shareholders through penalty rates is less than the returns
they generate from converting the proceeds of the financing,
the underlying mechanics continue to work as intended and the
funds have positive carry.
This does not mean that the current status of auction rate
preferred securities will continue, however.
Although the closed-end funds pay the preferred
shareholders the penalty rate, failed auctions mean that these
shareholders may have to continue to hold the securities, which
are perpetual, or attempt to sell them in a secondary market at
what may be a heavy discount.
Preferred shareholders have pressured closed-end fund
companies to find solutions to the failed auctions, and the
companies have recently begun to contact the SEC's Division of
Investment Management for guidance.
Due to the special issues raised by the auction failures in
the auction rate preferred securities market, such as those
raised by the fiduciary duties owed by funds to both preferred
shareholders and common shareholders, the staff guidance in the
muni auction rate securities market may not extend to the
closed-end funds issuers.
The Division of Investment Management continues to asses
requests for guidance, however, and to monitor the developments
in this area closely.
Thank you for the opportunity to testify in front of you
today. I'd be happy to answer any questions you may have.
[The prepared statement of Mr. Sirri can be found on page
202 of the appendix.]
The Chairman. Thank you, Mr. Sirri. That was very useful,
and we will get back to it.
Next, we will hear from Eric Dinallo, who is the
superintendent of insurance for the State of New York.
Mr. Dinallo.
STATEMENT OF THE HONORABLE ERIC R. DINALLO, SUPERINTENDENT OF
INSURANCE, DEPARTMENT OF INSURANCE, STATE OF NEW YORK
Mr. Dinallo. Thank you, Chairman Frank.
It's good to be back before you. It's an honor to testify.
And I thought I would take a few minutes and update this
committee on what has gone on since I testified in front of the
subcommittee just about a month ago.
I think substantial progress has been made in seeking
company solutions in the monoline or bond insurance industry in
helping facilitate market stabilization and beginning to define
the future regulatory landscape for these activities.
I hope our role reflects a proactive approach by the
regulator here. I think that's the proper approach here. I
think we need to be facilitators, we need to be catalysts when
we see something that has to be jump-started.
I think doing nothing here would have been a grave error,
and although we took some risk by getting involved, I think
prudential risk in times of what has been described as a crisis
is better than doing nothing, which is still a choice of doing
something, you're just not actually doing anything, you're
instead accepting the status quo.
We began a three point plan in the fall. The three point
plan consisted of:
Number one, bringing new capital and capacity into the
monoline insurance area;
Number two, to begin to begin to deal with and prepare for
chronically distressed bond insurers; and
Number three, to begin to rewrite the rules of the road and
develop new regulations and statutes in this area.
I thought I would just take a minute and go over where we
are in those three areas, and that will be a description of at
least what our role has been to date.
First, in the area of capacity and capitalization, we have
created or facilitated conditions that have attracted
approximately $7 billion of capital injections and a total
overall capacity, including the Berkshire Hathaway offer of $12
billion in total that have helped insure the ratings of the two
publicly traded companies, kept the market fairly competitive,
and helped to stabilize that market.
Those activities include inviting Ajit Jain of Berkshire
Hathaway into the industry and helping facilitate the licensing
of Berkshire Assurance Corporation in record time, and working
with the other States in facilitating the licensing by 30
States in approximately a month, also receiving a bid on the
municipal book for FJIC, Ambac, and MBIA from Berkshire.
Second, we approved and facilitated MBIA's capital raising,
which led to $2- to $3 billion of additional capital into that
company.
And as you're well aware from when I was here last time, we
fostered and helped create the consortium behind Ambac that
resulted in the capital raise that occurred just about a week
ago.
We worked with Wilbur Ross and spent a lot of time speaking
with private equity, and between his purchases of bonds and
injection in Assured, there's a billion into the system, and we
will be seeking out other capital, including other private
equity on investors' sovereign wealth, and some bulge bracket
investment banks have sought licensing through the Department
of Insurance.
In the second category, concerning dealing with distressed
companies, we have done the capital raising activities that we
just discussed--
The Chairman. Mr. Dinallo, we're going to run out of time,
and that's in your written statement. If you could get to some
of the forward-looking things, I think that might be more
useful.
Mr. Dinallo. Okay.
The forward-looking ideas here are to facilitate
reinsurance and support of the markets, to engage in the
possibility of a rehabilitation or restructuring of the
companies that would be done by the government, including the
good book/bad book scenarios that have been talked about, the
Citibank concept of an optionality built into such a situation.
I have also spoken to this committee about the potential
for a Federal backstop, which we could discuss, and I would
explain what that would look like, if you have questions about
that.
The third category is around new regulations. We have done
a serious research and discussion with experts of what new
regulations would look like. We have drafts of those.
Basically, we're considering the requiring of more capital
to be engaged in this industry, the elimination of certain
guarantees of structured products, such as CDO squares, which
you have discussed, the possible segregation of the businesses
of structured municipal and possibly project finance, and
finally, the prohibition of insuring credit default swaps and
other instruments that cause events of default or acceleration,
which is generally not regarded as a good thing for insurance
book, because you can't manage the claims if the worst-case
scenario arises.
And on the reinsurance, the Federal backstop, because I
know that you're seeking solutions that Congress could
facilitate, my view is that a lot of the offers that we have
received from private equity and from Mr. Buffett are
essentially reinsurance transactions, and it seems to me that
the Federal Government could rather inexpensively, in a certain
sense, guarantee and reinsure the municipal sides of these
books.
That would actually, ironically, free up capital to put the
structured side in the best possible position going forward, so
their policyholders were as protected as possible, and for the
Federal Government, it would at least be just a backstop. It
would be simply a guarantee against the book that, as your
statistics showed, was already proven to be a fairly safe bet.
[The prepared statement of Superintendent Dinallo can be
found on page 103 of the appendix.]
The Chairman. Thank you, Mr. Dinallo, and we're going to
pursue some of these. That's exactly what we were hoping for.
Next, we will hear from Attorney General Blumenthal.
STATEMENT OF THE HONORABLE RICHARD BLUMENTHAL, ATTORNEY
GENERAL, STATE OF CONNECTICUT
Mr. Blumenthal. Thank you, Mr. Chairman, and members of the
committee.
Thank you, first of all, Mr. Chairman, for having this
hearing, and I want to join in saying how important it is, and
say how pleased I am to be here with Superintendent Dinallo,
who is doing great work, as the regulator in New York, in
attempting to address many of these problems, and working very
closely with the folks at Berkshire Hathaway Assurance
Corporation.
I am also pleased to be here with them, and particularly
with Ajit Jain, and want to say that I'm going to try to avoid
the rough edges, but I feel as deeply as anyone in this room
about the cost of this system on the towns and cities and
States around the country.
The cost of insuring these bonds per year is about $2.3
billion. That's money paid by everybody in this room and the
people whom you represent.
They are costs that are unnecessary and avoidable. They
fall directly on taxpayers, and they inhibit infrastructure
improvement and upgrading. That is exactly what the chairman
mentioned at the outset of this proceeding.
The cost is not just on them, but it's also on investors,
because the current dual system, the double standard that
disadvantages municipalities and inhibits their use of public
debt, is one that also confuses investors. It makes the market
less transparent, and it restricts competition.
I have an investigation ongoing into potential violations
of law. This system is not just unfair and unwise as a matter
of public policy; it is also, in how it has been perpetuated
and sustained, quite possibly illegal under our Federal and
State antitrust laws.
My investigation is ongoing and active. It focuses on how
this system started and how it was perpetuated, and I will say
to you that our findings so far are very, very deeply
troubling.
We know there was a concerted effort among supposed
competitors to maintain the dual rating system and kill
attempts at reform.
There were discussions among bond insurers aimed at
retaining this dual rating system, when at least one of the
rating agencies suggested modifying or eliminating it.
And the net effect of these activities was clearly to
maintain prices and prop up the market for bond insurance.
This misuse of market power and restraint of competition is
plainly anti-competitive and anti-taxpayer, causing direct harm
to municipal and State customers--
The Chairman. Mr. Blumenthal, hang on one second.
That is another motion to adjourn. I do not plan to make
that vote. I would advise other members, if you want to go and
come back to do so, but I am going to keep going.
Go ahead, Mr. Blumenthal.
Mr. Blumenthal. Thank you. I will be brief, and I would ask
that my full remarks be included in the record, but just to
summarize--
The Chairman. Don't feel rushed. This is too important. You
know, the chicken scratchings can go on without us.
Go ahead.
Mr. Blumenthal. Thank you.
We have found no legitimate business reason for this dual
standard by itself. Just as one example, a triple B municipal
bond, according to Moody's ratings, is one-fourth as likely to
default as a triple A corporate bond. A municipality in that
situation either has to buy bond insurance--and as I have
described, we have documented how discussions perpetuated this
system, involving the bond insurers as well as the rating
agency--or a municipality has to pay higher interest rates for
the debt that is issued.
Either way, taxpayers and citizens pay more, $2.3 billion
more every year to insure that debt than they would otherwise.
And this dual rating system, so far as we know, has no
justification. I will be interested in whether any is presented
later in the day when you have at least some of the rating
agency representatives before you, and I would suggest, with
all due respect, that you put this question to them and request
them to justify how the dual system can possibly be justified.
Let me just close by saying that I am here to urge you to
abolish it and prohibit it. It should have been prohibited in
the 2006 Act, the Federal Credit Rating Agency Reform Act. In
my view, arguably, it was prohibited because it is an unfair
and anticompetitive practice. But, obviously it should be
specifically prohibited under law, and I would ask that the
United States Congress do that. It may well result, in any
event, from voluntary actions by the rating agencies themselves
because it is so contrary to the globalization of our credit
markets that eventually it will probably fall of its own
weight. But in the meantime, we are paying billions of dollars
in unnecessary and unwise cost.
Thank you, Mr. Chairman.
[The prepared statement of Attorney General Blumenthal can
be found on page 94 of the appendix.]
The Chairman. Thank you. This has been very useful and very
much in point. Mr. Sirri, let me express my appreciation, and
please convey to the Chairman and the other members of the
Commission, few though they may be these days, that what you
have done has been very responsive, and the way you have
explained it has been very helpful.
On Rule 2a-7, I guess what you're saying is that nobody has
raised that of course. What we would hope to do is fix the
ratings, or have the ratings fixed so that it wouldn't come
into play, that people would not be--and I agree with you. I
don't want to accommodate an inequitable and inaccurate rating
system.
Mr. Dinallo, you listed some very useful things we could do
in terms of the regulations that would apply. Obviously under
the current system in America, those are within the
jurisdiction of the States. But would there be any
Constitutional obstacle to our also doing them under Federal
jurisdiction? I know many of us are reluctant to have
preemption, but in some cases, there is some argument for
uniformity. We could do a kind of regulation that would not
preempt the State's ability to go beyond that.
And Attorney General Blumenthal, I would ask you as well.
Would there be any Constitutional or other obstacles to our
doing some of those things as a floor, for example, on the
national level? Mr. Dinallo?
Mr. Dinallo. I don't think there would be any
Constitutional objection to it. I am not such a staunch
objector to a Federal regulatory system for insurance. But I
would point out that I am fairly against an optional Federal
charter, because I think you end up with a regulatory arbitrage
situation.
The Chairman. We're not talking about that.
Mr. Dinallo. But I think you could have--here you could
have sort of a Federal floor on this. It is true, as
Congressman Kanjorski said, that it was sort of shock and
surprise at how much of the national and the global financial
system was hung off of this small part of the market.
The Chairman. This is separate from the optional Federal
charter. I mean, that's--
Mr. Dinallo. I think it's a place where the Federal
Government should inquire, because it turns out that a big part
of the economy is driven by this kind of insurance, which--
The Chairman. You know, and there's direct context,
connection here. We talk about--and we have all acknowledged
State and local spending on various infrastructure projects is
impacted. As you know, there is an intermix of Federal and
State and local funding there. So, Federal transportation
policy can be frustrated by excessive charges at that level.
Attorney General?
Mr. Blumenthal. I see no Constitutional objection. I think
that preemption, as you know, Mr. Chairman, is very, very
frequently used. I think as a State law enforcer, I would
object to any preemption of State enforcement authority if
there are--
The Chairman. That's a very good point.
Mr. Blumenthal. --criminal or even civil prohibition.
The Chairman. Well, in fact, let me just underline that.
Yes. It would be a grave error for us to try to do that because
even if we were to promulgate some rules, we have no Federal
enforcement entity for insurance, and it would be--that's a
very good point that you would have them work together.
Mr. Blumenthal. Exactly, Mr. Chairman. And I think that for
all the reasons that Mr. Dinallo has stated so well, there
might be an argument that more of the bond insurer or that
aspect of the insurance industry might be federalized so far as
rules of--
The Chairman. Let me ask one last question here, and that
is on the backstop. I would say, the gentleman from
Connecticut, Mr. Shays, had mentioned that, and others had. And
I know--and Mr. Buffet has also talked about doing that, and we
are very pleased to have Mr. Jain here and we have talked to
Mr. Buffet, and we will deal with that later. And there may be
a context in which Mr. Buffet and the Federal Government are
equally attractive alternatives, or maybe these days he might
have the edge in the minds of some in terms of financial
stability.
But what about--what are your initial reactions, the two of
you, to a Federal financial reinsurance?
Mr. Dinallo. I think I'll just tell you what I learned
along the way that would maybe inform. When we explored the
possibility that the investment banks would engage in a
consortium, one of the very first ideas was whether it would
just be a line of credit, essentially a backstop. And I thought
the rating agencies would give it very high credit without
actual capital being put up. I assume that the Federal
Government's guarantee would be even more highly rated.
And so what you do is you put in place a reinsurance
situation where you essentially guarantee a certain amount of
capital in case there are defaults. What that does is it lets
the insurance company release a lot of capital that it was
otherwise holding to cover on the municipal side. And that
would go towards a situation that would elevate the ratings
across the board, including on the structured side.
But if you were in a situation where you wanted to not have
to do damage to other policies or establish the worst-case
scenario of a good bank, a bad bank, that would be
extraordinarily helpful to releasing capital and coming out of
what looks like a liquidity crunch situation.
The Chairman. Attorney General?
Mr. Blumenthal. I support it strongly, and the reason is
very simply that it represents the best hope for achieving the
goal that you stated at the start of the season, to let our
people go, to free the towns and cities from a tax, a secret
tax, that is now imposed by Wall Street. Let's face the facts.
Except for Orange County and a couple of other aberrations, no
towns and cities and certainly no States cease to exist. They
continue in business. They almost never default, and the
Federal Government as a backstop would eliminate the tax that
currently towns, cities, and States have to pay.
The Chairman. Well, I appreciate that. I am going to finish
with this, but it strikes me that as you talk, you mention
Orange County. There have been a couple of bumps. But in every
case, it seems to me it was because the issuer got cute and
tried to get into investments that were over its head, and
there would be nothing stopping us if we were to do this from
saying, here, we are the backstop for full faith and credit,
general obligation, plain vanilla. And if you start getting
fancy, then you're out of our loop. And I think that might save
a lot of grief as well.
Mr. Blumenthal. Mr. Chairman, if I can just add, there is
another aspect of this whole issue legally, which is that right
now, the States often function as backstop for the towns and
cities.
The Chairman. Yes.
Mr. Blumenthal. In fact, one of the first actions I did as
Attorney General was to go to bankruptcy court and prevent the
city of Bridgeport from declaring bankruptcy and defaulting on
its bonds. So the States will not let--
The Chairman. Right. Because of the negative effect it
would have had on everybody else, and in fact the bondholders
were held harmless, and that may be another problem.
Mr. Blumenthal. Exactly.
The Chairman. I would just--we have been joined by our
colleague from Connecticut, and I just wanted to tell him we
have been talking about his--the idea he and I had talked
about, about the backstop, and we will be pursuing that
further.
The gentleman from Alabama.
Mr. Bachus. I thank the chairman. When it comes to the
municipal securities market, we have functional regulators and
they focus on different things. The Fed focuses on one part,
and the insurance commissioners focus on another. You have all
this, you know, obviously the SEC on broker-dealer matters. But
are there gaps in that regulation, or is there a need for
some--for better coordination?
Mr. Sirri. Well, Congressman Bachus, I think our chairman
has gone on the record and said that he feels that disclosure,
in particular in the municipal area, could be stronger. I think
when you compare disclosure in the municipal area to, say,
disclosure in the corporate area, some immediate gaps arise.
And Chairman Cox has stated very clearly, I think he sent
material up to the Hill that details this very precisely, that
disclosure could be improved both in its accuracy, its
completeness, and its timeliness.
I think issues like accounting, accounting protocols, and
the independence of certain accounting standard setters, could
also be improved, so as to bring disclosure and the quality of
information that investors get more in line with the standards
we have in the corporate area.
Mr. Bachus. Okay. Attorney General Blumenthal, you proposed
prohibiting different rating standards for the corporate
municipal bonds. Would you--what about municipalities that may
not be able to pay? I mean, how do you--and would you run
through that? And you may--exactly how that would work?
Mr. Blumenthal. Well, I think that goes to the heart of the
idea, and is obviously a very profoundly significant question.
I'm not proposing that every municipality be rated triple A,
but simply that the criteria and the standard be the same for
the municipality as it would be for the corporation. And there
are a lot of corporations that don't deserve triple A ratings
also.
So, if a municipality has insufficient reserves, is not
taxing enough, in fact is uncreditworthy for some reason, then
it should be judged accordingly, but it should be judged by the
same standard, not a dual standard, but a single, unified
standard known either as a global standard or the corporate
standard, call it what you will, it should basically be the
same for corporations as it is for municipalities, but not give
either of them a break.
Mr. Dinallo. May I comment for just a second on the triple
A rating issue? I think that it's important to note what I
think the bond insurers did here, because I heard the words
``extortion,'' etc., and I do think that there is a serious
issue that has to be looked into. But they did perform one
important function for small municipalities, water authorities,
school boards, and hospitals. They essentially commoditized
their bonds such that they could be traded in and out of triple
A rated situations.
Now we know that money markets, Fidelity, even hedge funds
have triple A tranches that have to be filled with a triple A
rating. So what I think they essentially did was they took sort
of a statistical gamble, which has paid off, in that they did
not in fact examine every one of those authorities. And the
rating agencies themselves did not rate every one of those
authorities.
I think I would just challenge a bit that it would be a
very difficult and inefficient and expensive system that would
have every single municipality, authority, school board,
hospital, or museum rated by the rating agencies, or, in fact,
examined by the insurers. But across the whole board, as
Chairman Frank showed, the gamble is a good, safe gamble, it
seems. And I think that was the system.
I don't want to comment on the investigations, but it seems
to me that approach was a way to let all municipalities come to
market and be commoditized in a positive way so they could be
held as they deserve statistically triple A rated. If you begin
to pluck, cherry-pick out of that system, and I'm sure it's
perfectly appropriate for Florida and California to want to do
this, you will create a situation where the lesser
municipalities, so to speak, which still statistically are good
bets, will find it much more difficult to come to market. So
the system will have to change dramatically.
Mr. Bachus. It does appear to me at least that there has
been a double standard or there have been harsher ratings on
the municipal securities, when as you say, they have
historically been much safer. So, you know, I have not
understood that.
Let me ask you this. What about the difference--we talked
about general obligation bonds. What about revenue bonds? Is
there a different approach to them? Since the revenue bond is a
dedicated source. And Mr. Sirri or--well, anyone who would like
to--
Mr. Dinallo. I would say that one thing you'll learn this
afternoon is I would seek answers from the rating agencies
about how they would go about doing the ratings. I know it
sounds kind of tautological, but the point is, I think that
what municipalities do doesn't necessarily fit well into sort
of the box checking that the rating agencies usually look for.
They don't have a revenue stream. They don't have a return of
equity. They don't have capital. It's a very different way of
judging. What they have is a very secure promise on a risk, on
an obligation. And I agree with those who have commented it may
be the most secure of all.
But in fact I would urge the rating agencies not to
necessarily rate them the same as corporates, because they're
not going to be able to be rated the same as corporates. They
don't have the same structure. But they need to be
statistically brought in line with corporates under their own
system. And I think the SEC will work, I assume, with rating
agencies to try to produce that and get better standardization.
Mr. Blumenthal. And I would just add, if I may, sir, that
there are ways to minimize the tasks of the rating agencies in
looking at either revenue bonds or the school boards and the
resource recovery agencies or all of the municipal agencies and
simply say or ask, are there backstops, for example, State
guarantees? And in many instances, it will be found that the
reason why their default rates are so low is the State will not
let them default, period. End of story. And so why are they
paying insurance? Well, they're paying insurance because they
have been bludgeoned and intimidated into doing it by the
markets and by the powers that be.
Mr. Bachus. Mr. Sirri. Thank you.
Mr. Sirri. I would just point out that there is a
difference between general obligation and revenue bonds.
General obligations are backed generally by the taxing, full
faith taxing authority of the municipality, whereas with
revenue bonds, the payments are secured by some particular
project, whatever it is.
Much that we have been talking about today about the strong
credit performance of municipal securities is related to
general obligation instruments. When it comes to revenue
instruments, the picture becomes somewhat more cloudy. Not all
revenue bonds are insured. They're not all wrapped. And in some
cases, there have been performance issues. And in those cases,
because the performance is secured by a particular project, you
can't bring in general taxing authority.
Mr. Bachus. Yes. And there is some political pressure on
not raising rates or not raising charges. And sometimes a
Federal judge has to intervene.
The Chairman. Thank you. The gentleman from Massachusetts.
Mr. Capuano. Mr. Chairman, I just want to assure the
gentlemen at the table that though I wasn't here, I was
watching from a secure location.
[Laughter]
Mr. Capuano. First of all, Mr. Sirri--
The Chairman. Excuse me, but that's because he was the
author of the ethics bill. It has nothing to do with you.
That's why he had to be hidden.
Mr. Capuano. Mr. Sirri, I want to thank you and the SEC for
the report you have done. I haven't read the whole thing yet,
but what I have seen of it, I like, and what I have heard of
it, I like.
However, it's only a portion of the problem that I'm
interested in. Honestly, I cannot believe that anybody is going
to look me in the eye and tell me that most GOs have to go to
auction at all. Most of them don't. Most of them--and those who
do only go to auction because they're bundled with something
that's junk. And so--I understand what you're saying and I
don't disagree with you about the ARS. That's a problem. It's a
serious problem for the country, and I'm glad you're addressing
it--finally--but you're addressing it. At the same, it's only a
portion of the problem.
Mr. Blumenthal, thank you for being smoother than me, but I
heard you say almost the exact same stuff I said, just nicer.
And I would encourage you not--
Mr. Shays. Much nicer.
Mr. Capuano. And I would encourage you, though, not to wait
too long for Congress to act. We tend not to act until way too
late on almost everything. And if we don't do it, I'm begging
you to please do it and gather your other attorneys general to
do it. And I'm also asking you, you know, you have all kinds of
laws. You have RICO laws, you have all kinds of laws you can
use on cabals that extort people. Basically, that's illegal,
and it shouldn't be allowed, and if I can help you in any way,
that's fine.
I do have some comments, though, Mr. Dinallo, about some of
the things you just said. I will tell you that in
Massachusetts, it's exactly as Mr. Blumenthal said, cities and
towns have gone bankrupt, but not a single bondholder has been
unpaid because the State steps in and pays directly. Not one.
And according to--this was just handed to me this morning.
This is from Moody's. Source: Moody's Investors. GOs, since
1970, 14,775, not one default. Not my numbers. Moody's. Not one
default. They didn't say the big ones, the small ones, the tiny
ones, the ones that don't matter. You could also have things
like pooling of issuances. If you have some small community
that needs a fire truck, you pool it with five other
communities and issue that bond.
And if the State of New York doesn't want to step in
behind, fine, then the State of New York should know that their
cities and towns are going to pay higher rates. But for those
States that have the foresight and the wisdom and the desire to
provide the backup for the municipalities, they should be
allowed to do so.
Now, I understand that. And I'm not--I'm hoping that some
of your commentary is not based on the fact that most of these
people are there. I also want to make one particular point.
When I asked the credit agencies to rate my city, I paid for
that. They didn't come in and say, ``Oh, Mike, we're good guys.
We're just going to do it for you.'' Not only did I pay for it,
I wined them, I dined them, I bused them around, I begged them,
I treated them nice. And I had to keep my mouth shut the entire
time. I don't have to do that any more.
[Laughter]
Mr. Capuano. So let's not pretend that they're doing us a
favor. And by the way, I also want to be very clear. The dual
system is a problem, but it is not the only problem. If we had
a unified system, they would still rate me, my poor city, lower
than somebody else who is just as likely to pay back their
bonds. Corporations go bankrupt every day and walk away. Most
municipalities don't, particularly those who have States that
back them up. We're not going anywhere.
So even with a unified rating system, that's all well and
good, but it is only one step towards the final process. The
final process is to treat all bond issuers the same, only
looking at the likelihood of the bondholders being paid back,
and that is a fair and reasonable standard. Other than that,
it's extortion, especially when you have only a handful of
people making those judgments. I guess I must--I don't know if
I have a question in there somewhere, but they can--
The Chairman. Let me just, if the gentleman would yield
briefly, let me just underline what's been said. Several of us
here were State legislators, my colleague from Massachusetts,
and were mayors. Here is the point: No State, no State
legislators, no governor, can allow any one of its
municipalities to default because then every other municipality
would pay through the nose. So that is why this is not just
some charity here; this is self-defense.
The particular municipality, you might pity the municipal
workers there. Services may get cut back. Maybe the trash won't
get picked up. But we can guarantee you, we have all been
there, you can't do that. Because if any one municipality
falters, every municipality in that State would pay, and there
isn't a State governor and legislature in the country who
doesn't understand that, and that's why the State guarantee is
such a good one.
I'm sorry.
Mr. Dinallo. No. But if that's the absolute truth, which I
don't dispute, then you could essentially federalize the rating
systems for municipalities. It wouldn't be an outrageous
concept to either socialize the rating agencies completely and
take out the conflict that the Congressman just recited. That's
not--
Mr. Capuano. Sign me up.
Mr. Dinallo. That has been discussed. You could, on the
municipal side, essentially federalize that rating system and
say that the U.S. Government through the States, through the
municipalities will stand behind all those obligations, and I
assume it would immediately get the equivalent of a triple A
rating in those asset management situations that I described
before. I mean, these are not insane ideas. You just described
a situation where you're essentially saying, as the chairman of
the Financial Services Committee, that we just don't let those
fail, which is probably a good situation for the reasons you
say, you could change the system.
The Chairman. The gentleman from Connecticut.
Mr. Shays. I thank you again, all three of you, for being
here. I was waiting for that vote that never happened, so I
didn't hear your statement. I did read yours, Mr. Blumenthal,
and thought it was again quite excellent.
I'm struck with a number of different reactions. One is,
again, it seems to me that local municipalities are better off
than the insurance companies that were rating them. And I just
find that, you know, rather curious. And we all have stated
that you're not going to see defaults, which is fairly obvious.
I moved to the City of Bridgeport that previously had attempted
to go bankrupt, and the local community rose up in arms, and
the State said no way are you going to go bankrupt.
The only value I see--and then I'm struck by this reaction,
that, particularly with subprime, the rating agencies have lost
their brand. They are meaningless, because they have been so
wrong. They were wrong about Enron. They were wrong about other
companies, but in particular, they were wrong about the
subprime market. And so I'm even questioning the value of
rating agencies now.
The only thing I am struck with is that there is value in
having a mayor or governor in fact, have to be held--be given a
grade as to how they're managing the city. But other than that,
if I was an investor, I'm struck by the fact that the ratings
are almost meaningless. Tell me why the ratings aren't
meaningless. Tell me why a businessman or woman in this day and
age who is investing would pay much attention to rating
agencies.
Mr. Dinallo. I'll just say, I'll just give a general
response and defer to Mr. Sirri. I think the credit markets
need some efficient commoditization that they can rely on. You
cannot take away all ratings. It would I think result in sort
of credit market chaos. I think that the municipalities are
potentially a separate situation. But once again, we're dealing
with thousands and thousands of companies, and it is impossible
for credit providers, loan givers and investors to make all of
those individual distinctions, especially when they're running
a large asset base.
Mr. Shays. I hear that, and yet they have been so wrong.
Mr. Dinallo. They have had some--well to be fair, they have
had some dramatic wrongnesses, there is no doubt. But I bet if
we look at it statistically, you would actually give them a
higher grade than just based on some of their largest so to
speak mistakes. To be fair. I think that they need to stand up
on those. They need to get over this inference of a conflict of
interest, but I don't know that I know a better system. That's
all that I'm saying.
Mr. Blumenthal. I would just add that I agree, Congressman
Shays, and I want to thank you, by the way, for your work on
behalf of Connecticut's towns and cities in infrastructure and
credit and so forth.
Mr. Shays. This is called the quid pro quo that we have
developed. Thank you, Dick.
Mr. Blumenthal. But I would agree that--I would agree with
Mr. Dinallo that in theory there is a need for some objective,
dispassionate, disinterested agency that evaluates whether
investors will be paid back. In other words, the likelihood of
default, the creditworthiness of a corporate bond. In the
municipal situation where there is the kind of State
guarantee--
Mr. Shays. See, that's the irony. That's why I wonder what
is the value of the rating, because they're going to be paid
back. They can say that a town is well-run or not well-run, but
in the end, it's almost irrelevant.
Mr. Blumenthal. And the problem is that they have no
business telling Bridgeport or Stamford or Boston or any other
city whether it is being run well. That's for voters to decide.
All they should be deciding is will somebody who buys the bond
receive his or her money. And in the case of most cities,
there's no question that they should be getting triple A
ratings, and that's why in my view, a single, unified standard
would accord many of the towns and cities, and States
obviously, a triple A rating because of those legal guarantees,
but also because they're not going anywhere, as Mr. Capuano
said more eloquently than I could. They're going to be in
business, and they are not going to default when they have to
go into the market again and again and again in the future.
Mr. Shays. Mr. Sirri? Thank you, Dick.
Mr. Sirri. I think it is interesting to realize how credit
rating agencies came about. Historically, they came about over
100 years ago when investors sought to understand the credits
of, at the time, railroad bonds. At that time, people couldn't
distinguish between the credits, so they looked at credit
rating agencies to help them with that. So in that context,
they were a point of efficiency.
Fast forward to today, I think you have pointed out quite
correctly some issues with credit rating agencies, whether it's
Enron or certain issues in the subprime area. But in some ways,
this has partially been addressed with the Credit Rating Agency
Reform Act of 2006. To my reading of that Act, what Congress
thought to point out to us was that we should let the
competitive markets determine how useful credit ratings are.
So to what we're talking about there, a few things have
happened. We have seen new credit rating agencies enter the
market that weren't there before. We now have nine credit
rating agencies where we used to have five. If it's the case
that these credit ratings aren't useful, then one of two things
will happen, I believe, in the long run: (a) if they don't
improve, investors will ignore credit ratings. They'll start to
be written out of the process; and (b) the second thing I think
will happen is that credit rating agencies have an incentive,
given this legislative framework, to improve their act. And I
believe they will over the long run.
I think you've seen some steps in that direction. They
won't happen instantly, and there may be a role for entities
like ourselves, the Securities and Exchange Commission, to step
in. Our chairman has indicated that we will engage in some
rulemaking this year I think that's based on some of the things
we've observed. But there is this framework under which credit
rating agencies are governed, and I think this will play out
over time.
Mr. Shays. This may seem like a stupid question, but
wouldn't the best investment be the State that has the worst
credit rating and therefore the highest interest rate?
The Chairman. Yes.
Mr. Shays. Yes. I mean.
Mr. Blumenthal. And--
Mr. Shays. So you really want to find the worst. I'm sorry,
Dick.
Mr. Blumenthal. You know, just to put a footnote on the
point that has been made. You know, the elephant in the room
here--
Mr. Shays. Don't use elephant. You can use donkey.
The Chairman. That's right. We're for diminishing the
number of elephants in the room.
[Laughter]
Mr. Shays. Give him the microphone and you're dead.
Mr. Blumenthal. You know, it may well be that there are a
few more credit rating agencies, but let's face the facts. It's
a highly concentrated market. You have S&P and you have
Moody's, and they dominate the market. It is a highly
concentrated market. And in the long run, Mr. Sirri may be
right, but it's a very long--
The Chairman. Can I just--if I could interject. And there
is also the question--Mr. Sirri is right--we generally like
competition, but there is some question here about where the
competitive effects are pulling you. Who's paying? And I think
there is a question here about how the, you know, where the
competition, in some cases, the way it is now structured, might
have had a countervailing effect, and that's one of the things
I hope will be addressed in the rulemaking.
Mr. Sirri. There is one other point I'd like to make. We
have been focusing on credit ratings, but I think it's also
equally important to focus on market prices, or in this case on
yields. If all municipalities were as we say, and that none of
them were ever to default, then those bonds should all trade at
the same yields, but they don't. The market actually, as it
trades bonds, prices them at different yields. And that's--
The Chairman. That's right. And by the way, the market is
wrong. I mean, it's demonstrably wrong. There would still be
some different yields but probably because you have different
State tax structures. For me, the double tax and triple tax
exemptions would give you one market versus another. But I do
think this is a case where the market clearly doesn't get it
right.
Mr. Sirri. It may be. I mean, it's hard to say. I
appreciate the point you make, since the default rate is so
low. But not only do they trade at different yields, but as
credits change, as municipal credits change, you see yields
widen on those credit--
The Chairman. Yes, but again, isn't it--that's because the
credit rating agencies have been giving different views, and
that may be changing.
The gentleman from Massachusetts, Mr. Lynch.
Mr. Lynch. Thank you, Mr. Chairman. I want to thank the
members of the panel for helping us. Just to pick up on this
last point, I do agree with Mr. Capuano and the attorney
general who have talked about the disconnect between the
corporate bond rating and the municipals. But I think there is
value in the rating system for the--principally for the second
reason that Mr. Sirri raised, which is not all municipalities
are the same. We need that competitive incentive for
municipalities to get their act together, as Mr. Sirri said.
And we don't have to look back very far. The whole change
in GASB 45 where municipalities now had to lay out in their
financials the long-term pension obligations and health care
obligations with respect to their employees over the long term,
we saw some municipalities handle that very well, others not
well at all. And so now it's a huge burden on some older cities
with a lot of public employees.
So I think relative to a measurement between municipalities
and States and towns, I think that that rating is an important
factor for investors to consider. But let me just--aside from
that, would there be a way, rather than this whole tangled mess
that we have right now with the rating agencies, would it not
be possible for the Federal Home Loan banks to step in here?
The chairman has talked about a Federal backstop. Mr. Shays has
talked about a Federal backstop. What about the Federal Home
Loan banks issuing, say, a letter of credit on the bond
rather--in place of I guess or maybe even belt and suspenders,
on the bonds themselves? Is that something that could work or
take the--you know, take this rating agency, and at least the
double standard, mitigate that somewhat?
Mr. Dinallo. Well, I was about to comment that on the $236
billion line of credit that the Fed just created, you could in
a sense take a small sliver of that and stabilize the bond
insurance industry overnight. I mean, the stress amounts that
are at issue there, as I testified to the subcommittee, are
somewhere in the range of $7 to $10 billion. In other words--
Mr. Lynch. Just on that thought, if you did it, you know,
nationally, how do you eliminate the moral hazard of backing up
someone who's not doing the right thing? Unless you do it on a
municipality-by-municipality basis? And say here's the
opportunity. You have to prove yourself.
Mr. Dinallo. Well, the moral--look, the moral hazard
problem is a serious problem. I think that is why I sort of
illuminated that everyone assumes that there really is no
chance of a municipality defaulting on its obligations.
If that is really true, then the moral hazard is already
baked into the system, it seems to me, and you might as well
save all the money on the wrap and the insurance and the
Federal Government should just sort of de-clear it, so you will
have moral hazard, but it seems to me you have just kind of
annunciated today that the moral hazard is already there. The
markets do not seem to believe it.
Mr. Lynch. I appreciate that.
Mr. Dinallo. If you took it away, you would get at a very
wealthy truth, so to speak.
Mr. Lynch. Mr. Blumenthal, any thoughts on that?
Mr. Blumenthal. I think it is an idea that ought to be
explored. Certainly anything that relieves costs--the Home Loan
Bank Board may be a good prospect--should be explored;
absolutely.
Mr. Dinallo. I think that the chairman's point is well
taken. I do have one idea. The way that most municipalities
have gotten into trouble is on their asset liability match and
sort of investing in situations to try to boost their returns
and cover their liabilities.
If you were essentially guaranteeing their backstop and
then prevented them, because they would not have to go into
some of the riskier investments, and sort of take out the moral
hazard of getting into the situations that we described before,
you might be able to take out what is the most difficult moral
hazard, which is the risky investment side.
Mr. Lynch. Mr. Sirri, do you have anything to add to that?
Mr. Sirri. No, not in particular. I would just point out
that any time you issue a guarantee like that, you have to
manage your liability with respect to the guarantee. As people
have said, that can be difficult.
I think the moral hazard issue is a serious one and one
that has to be thought about.
Mr. Lynch. Mr. Chairman, I yield back.
The Chairman. Thank you. Let me just note, by the way, as
my colleague talked about or somebody talked about, the $236
billion in the Fed. Apparently, the Fed is by statute currently
prevented from getting into the longer term municipal bonds,
and we are in the process of writing Chairman Bernanke.
I think what the Fed has done this week has been neutral,
but if they can take AAA mortgage backed securities in the swap
with treasuries, we are talking about something that has a
higher value even than that.
We are going to explore that with the Fed as well. I think
we are all moving in that general direction.
The gentleman from Texas.
Mr. Green. Thank you, Mr. Chairman. I thank the witnesses
for appearing.
Let me start by asking if we are in essence talking about
the auction rate securities and available rate demand notes, is
that the bottom line here that is creating the increase in fees
and costs that we are seeing? Is that where we are?
Mr. Sirri. I think my comments earlier were directed to
relief that we are aiming to providing in the auction rate
securities space.
The variable rate demand obligations space still appears
for the most part to be functioning well, although there have
been some capacity issues there.
Mr. Green. With the monoline insurers, when their credit
rating is downgraded, the cost of their borrowing increases,
correct? This impacts the bond issuer.
It does not impact what we will call the notes that they
already have in place, the debt that is already in place. It
does not impact their debt service payments.
It does impact their payments on new acquisitions going
forward; is that correct?
Mr. Sirri. One place--in general, I think what you are
saying, the answer is yes. One place it can have an important
effect is the relationship in the variable demand space,
variable demand obligations.
If there were to be a sufficient problem with an insurer,
then these bonds could be put back to a backstop provider.
Again, the bonds are issued. I just want to point out there
could be a significant effect there.
Mr. Green. My intelligence indicates that the cost of
borrowing increases greatly when the credit rating is
downgraded. Give me an example of what ``greatly'' really
means, please.
Mr. Dinallo. You can take a look at what happened to the
Port Authority, I guess. One week, they were paying 3 to 4
percent, and when the wraps sort of fell off and the auction
rate market went haywire, they were paying 18, 19, 20 percent.
We are talking about the Port Authority of New York and New
Jersey, which is about as good of a bet as you can reasonably
imagine, as Chairman Frank said earlier.
Mr. Green. Permit me to ask you, if you can, to translate
that into dollars so I can get a more comprehensive
understanding--3 percent in dollars and the 18 to 20 percent in
dollars, please.
Mr. Dinallo. I cannot quite do that for you. I do remember
that the week that they had to pay, that one week was, I
think--it might have been just for the day, it was several
hundred thousand just for that day. I am speculating a little.
Mr. Green. Did you say several hundred thousand?
Mr. Dinallo. Yes, I believe so.
Mr. Green. We have gone from a few thousand dollars to
several hundred thousand dollars?
Mr. Dinallo. If you took what Mr. Sirri said earlier, which
is on the day we were testifying, 600 or so auction rate bonds
failed, I think across that list, you are into--I am going to
speculate--it has to be hundreds of millions of dollars for
that round of bonds.
Mr. Green. I was going to get to that, the failure at an
auction, when you have that, then you have the penalty interest
rate that you have to contend with.
Is the penalty interest rate contained within some codified
agreement? How do we find the penalty interest rate? How does
it get defined in this process?
Mr. Sirri. When the auction rate instrument is set up, it
provides for the eventuality that an auction possibly may not
succeed. When that happens, there is a maximum rate or penalty
rate that is set. It could be particularly high. We were using
the example of 20 percent. It might be lower. It might be 6 or
7 percent. That depends on the design of the instrument.
It is part of the set of documents and contracts, the
auction rate agreements, that constitute the papers supporting
the issue.
Mr. Green. The auction rate fails because the company, the
bonding company, no longer has its AAA rating. All this is no
fault of the municipality?
Mr. Sirri. The failure here is defined as having more
sellers of the bond than buyers. If a group of sellers came and
wanted to sell 100 bonds but there were only 80 bonds that
wanted to be bought, that auction would fail.
Mr. Green. I understand. The reason you do not have the
buyers is because of the ratings the insurer's have; is that
correct?
Mr. Sirri. That may be one of the reasons, but there could
be other reasons, too. Let me give you a concrete example.
When you start to have some failures in this space, you
could also have failures in credits that are otherwise
unaffected, say credits in the student loan space, where the
underlying credits are perfectly fine. There may be explicit or
implicit government supports.
What people anticipate is their auction may fail for
whatever reason. Knowing their auction may fail and given that
people who hold this paper have a very high demand for
liquidity, they view it as a short term money market
substitute. They do not want to be the last person to get out,
so they jump for the exits. If people anticipate folks jumping
for the exits, they all jump for the exits, and thus you see
good credits where there is not a question of a downgrade, you
see in those credits failed auctions.
Mr. Green. Final question. The municipality, in this scheme
that you just gave to me, is not at fault in this process.
Nothing has happened with the municipality. It is still there.
They are still doing the same things they have been doing. It
is the insurer that has the problem.
Mr. Sirri. If I can interpret ``fault'' as saying there has
not been some event at the municipality in terms of its credit
or its ability to--
Mr. Green. Let me ask someone else to respond.
Mr. Dinallo. I think the way to phrase it would be to say
that the underlying creditworthiness of the municipality had
not changed, and that instead, there were two events that were
going on, there was a doubt as to the viability of the
insurance wrap that you are referring to, the AAA wrap, and in
general, at exactly the same time, the credit markets were
starting to withdraw credit and liquidity, so the auction rate
market, I think, was impacted both by the monoline crisis and a
general tightening of credit.
The Chairman. The gentlewoman from California.
Ms. Waters. Thank you very much, Mr. Chairman. I would like
to thank all of our panelists for being here today.
It is very important that we understand what is going on
and see what we can do to assist in dealing with this economic
situation we find ourselves in.
Mr. Dinallo, it strikes me that we have a somewhat odd
situation here. On the one hand, you have bond insurers having
started to insure much riskier bond products, such as mortgage
backed securities. On the other, an entire class of bonds,
municipal bonds, which seem to have to rely on borrowing the
bond insurer's AAA ratings, even though their riskiness is
probably much lower than the municipal bond rating system
reflects.
Am I correct in identifying this duality and if so, how are
you dealing with it at the State level?
Mr. Dinallo. I think you are correct in identifying the
duality and we have spent quite a bit of time talking about it.
At the State level, I think we have gone in to try to both
stabilize the markets and infuse capital to make sure that we
do not at least lose the ratings that were attached to the
municipality on the structured side.
What I find interesting is that as presented to the bond
insurers, the ratings for the structured side were usually
already AAA rated. In other words, it was the super senior
tranches of the CDOs and the banks wanted the equivalent of a
credit default swap to basically assure that no matter how the
value changed, they had a AAA wrap around that.
The municipalities, as we pointed out today, ironically,
many people believe they were woefully underrated or unrated.
If you were a computer just judging risk, the monolines
took a riskier bet in uplifting them from no rating or A or AA
into AAA. It is all very ironic now and clearly not true.
If you were going in and relying purely on the ratings or a
lack of a rating, it was the case that you were essentially
being riskier on the municipality side just from a ratings
point of view.
I think there is going to be a large sorting out, which is
appropriate and should be done quickly, which we are working on
the new regulations to get there, about essentially separating
the businesses potentially going forward, assuring the credit
default swaps are no longer the instruments for securing that
kind of obligation, and probably prohibiting credit CDO
squared, which is the sort of recreation from a BBB into a AAA,
sort of the silk purse out of a sow's ear problem that
exacerbated it.
Mr. Blumenthal. Can I add just an answer as well, please?
Ms. Waters. Yes.
Mr. Blumenthal. I think the thrust of your question is
absolutely right. What happened was a great many of these
instruments, the CDOs, the SIVs, the structured investment
vehicles, the structured finance securities, were overrated,
and the municipalities were underrated.
I ran across a quote. It happens to be from Warren Buffett.
It is not directly quoted, so I apologize if he did not say it
or if I am getting it wrong.
He said: ``It's poetic justice in that the people who
brewed this toxic kool-aid found themselves drinking a lot of
it in the end.''
The folks who brewed the mix are now having to swallow it.
The point is that we need to change this system so it does not
happen again.
Ms. Waters. Mr. Chairman, I thank you very much. Even
though we do not have time to get into it, I would hope that at
some time we can really get into understanding the tranches and
how they were packaged, how it worked, and how they were
determined to be risky or not.
That is one area where I just need more information.
The Chairman. We certainly are going to try hard. I am not
going to promise anybody that by the end of this year, I am
going to understand what the derivative of a collateralized
debt obligation really means. I will just take comfort in the
fact that nobody else seems to know either.
[Laughter]
The Chairman. The gentleman from Pennsylvania, and then the
gentleman from North Carolina.
Mr. Kanjorski. What was it that you did not understand, Mr.
Chairman?
My problem is somewhat related to what Ms. Waters has been
addressing. There are so many bad signs here. I recall about 3
weeks ago meeting with one of the monoline insurance carriers
that did not get into as much difficulty as some of the others.
They showed me a study that they had undertaken of their
competitors. One of them was the pools of securities that were
purchased and insured by their competitors, and it showed that
in one year, in 2007, 18 percent of the first installments on
the mortgage obligations were not paid.
The only thing I can relate to is the prior experience I
had on a board of directors of a small bank that when our
default rate on mortgages went above one percent, everybody
seemed to get into a nervous state and started at least
experiencing the pains that may indicate a heart attack.
How did we get to an area where 18 percent of the mortgages
did not even perform on the first installment and why did not
people know about this? Two, why did it not set off a bell in
any number of places, from the owners of the securities, the
purchasers of the securities, the people that made up the
pools, or for that matter, the insurance carriers that were
putting their resources into the pools?
It seemed to me everybody turned a blind eye and should
have known with even a cursory review of the record that
something was wrong.
I will grant one thing. It is practically impossible to
figure out what is where and what the impact is because there
does not seem to be any inventory that exists in the public
realm anyway that you could find out how these securitized
pools are manipulated and sold off in various configurations.
Certainly, should not a regulator--and maybe I should
direct this to you, Mr. Dinallo--is your inspector or auditor
of these insurance companies able and does he make an in-depth
analysis of the securities held as collateral to know whether
or not they are performing, and if they are not performing,
does he take some action to indicate therefore, they do not
meet the criteria established by the law?
Mr. Dinallo. I think that is a great point. There is a
history here where in fact there is something called the
Securities Evaluation Office of the NAIC, which is a group of
100 people who value securities separately.
We did once, I am told, long before I came onto the scene,
seek to value hybrid securities, hybrid equity securities,
differently than the rating agencies, and it created a brouhaha
because the States in their capacities, regulators, were sort
of daring to question to not create chaos in the marketplace.
I am considering sort of juicing that up. It is located in
New York. I think it is important, but do recall, please,
Congressman, that our first order job is solvency and I think
on solvency of policyholders, we have done quite well, frankly.
People will be paid on their losses it looks like because
the assets of the insurance companies exceed the most
aggressive liability projections or losses by someone say like
Mr. Ackerman.
I think on that, we have done well. On the AAA rating that
comes before the insurance company, I will just tell you that I
have a theory. You asked a question, a rather large macro
question. I will say that the Congressman who has since
departed hit on moral hazard.
There was a day that when you gave a loan as a banker, you
stood behind that loan. You owned the risks of that loan, and
you had a book of business that was built on making good
underwriting, good loan decisions.
Someone then had an idea that we could securitize that book
of business and do good things. We could extend more loans to
people who wanted homes or to buy a car or finance their
children's education, and so it was securitized, and the banker
could do more loans.
That first book of business was excellently built and it
performed rather well. On the fourth or fifth iteration of
that, it became a more dangerous undertaking.
Insurance. We need to be very careful that we do not over
securitize the underwriting that is going on there, and it is
something that I am very worried about.
Mr. Kanjorski. Thank you. You may not be aware that the
Governor of New York announced his resignation. I suspect you
are an appointee of the Governor.
The Chairman. Why are we getting into that?
Mr. Dinallo. I am.
Mr. Kanjorski. I would recommend to the new Governor that--
The Chairman. Let's not get into that. Let's go on.
Are there any further questions?
Mr. Kanjorski. No.
The Chairman. The gentleman from North Carolina.
Mr. Watt. I thank you, Mr. Chairman. Let me first comment,
I left the room after Mr. Capuano because I did not want to go
after him. There was so much passion in his voice. A lot of the
points he was making, the concerns about this resonated, but
there is also a side here that is reflected by the chairman's
comments about lack of understanding here, that may lead to
some slightly different conclusions on how we proceed.
I think the value of this hearing is to expose that there
are a number of irrationalities in this market as we have seen
in virtually every market recently.
The first question I want to ask is, who is the prime
regulator of this market? Whose responsibility as regulator
would it be to step into the void that you all are describing
here?
Mr. Dinallo. I guess that would be me, Congressman, to the
extent that most of the monoline insurers are either located or
domiciled in New York.
Mr. Watt. This is a New York issue, which leads me to one
of the other irrationalities of this. We are dealing with a
national market. This reminds me that the first irrationality I
dealt with in this whole context, in the whole bond issuance
context, was back in the mid to late 1970's when lawyers in the
State of North Carolina could not issue opinions on bonds,
legal opinions on bonds of any kind. It was all done in New
York.
Mr. Dinallo. I may not have answered your question
correctly. If you are asking who is responsible for the rating
agencies and the ratings of bonds, creditworthiness.
Mr. Watt. I am asking if there is some regulator who, if a
problem emerged in this market context, in the bond issuance
context in general, is there a regulator we could point to and
say this person has responsibility for it.
If there is not, then that is the first problem that it
seems to me we have because everybody then will be pointing the
finger at everybody else, the same way that everybody has been
pointing the finger at everybody else on the whole other side
of the credit crisis.
Is there a regulator that has super responsibility for
this? I would have assumed Mr. Sirri would have been the first
person to answer this question, not somebody at the State
level.
I am not trying to influence that. I am just trying to find
out who the regulator is.
Mr. Sirri. I took Mr. Dinallo's answer to be for the bond
insurers, and I think he clearly has responsibility for the
monoline bond insurers there.
With respect to understanding your question, when you talk
about the issuance of the securities, municipal securities are
by and large exempt securities. The Securities and Exchange
Commission, which generally oversees the offering of corporate
securities, not so for municipal securities in the same way
because they are exempt from the 1933 Act.
That said, there is a framework in which there are
various--
Mr. Watt. So, you are telling me there is no regulator. Is
that what you are telling me? Does the Fed have the authority
to step into this and be a super regulator?
Mr. Sirri. I think what I am saying is we are not a super
regulator in the sense that we are all encompassing. We have
various touches on the market, however, with respect to certain
kinds of fraud that may occur. We have authority with respect
to the operations of brokers when they trade--
Mr. Watt. Who would we hold accountable if this thing was
completely out of whack as it is? Who would we hold accountable
for that other than the market?
We all know that the market got out of whack. Was somebody
supervising the market? I thought this was going to be a simple
question. Apparently, it is a lot more difficult than I thought
it was.
Mr. Sirri. I think the best way I can answer it is there
are various pieces that are divided between various entities.
For us, when it comes to credit rating agencies, when it
comes to the work that brokers do in selling these securities,
we have authority there. When it comes to issuance, the
Securities and Exchange Commission does not. When it comes to
the monoline insurers who wrap these securities, we do not.
Mr. Watt. Thank you. I yield back.
The Chairman. The gentleman from Georgia.
Mr. Scott. Thank you, Mr. Chairman. I would like to just
ask a question dealing with something that is happening across
the country, if any of you care to respond.
There are examples where communities across the country are
experiencing incredible interest rate increases. I call to mind
an example, a couple of examples that some of you may be aware
of, where I recently read that Underwood Memorial Hospital in
Woodbury, Pennsylvania, my own alma mater, the University of
Pennsylvania's health system, and the Pennsylvania
Intergovernmental Cooperation Authority all have had
outstanding auction rate securities, and have all experienced
interest rate increases, as much as from 4.5 to 8 percent.
This is happening in various places throughout the country
where people are telling us of similar experiences of
incredible interest rate increases.
I was just wondering if you think that providing additional
sources of credit enhancement, such as that which is provided
by the Federal Home Loan Bank's letters of credit and similar
ideas are of value in addressing the financing needs of these
communities?
Mr. Blumenthal. I would say yes. You hit on a point that I
think is very, very important. Even before this credit crisis,
the cost of those debt issues were rising in terms of interest
and also in terms of insurance. The insurance companies, the
bond insurers, were charging more and more as a percentage of
what the interest savings could be.
That is a means that I think we have discussed today to
reduce or minimize those costs. I think again going back to the
question that was raised before and I was going to raise it
when the Congressman was still in the room, clearly, in this
whole system, there are gaps in terms of regulation. I think
that is an important point that has emerged today.
There are gaps and there are some overlapping
jurisdictions, but there are clearly deficiencies in the law
that need to be corrected. One of them is the absence, in my
view, of a provision that prohibits the dual system that again
disadvantages the health system of your alma mater.
Mr. Scott. Thank you for that. Let me go to another point.
With the initial question being whether we need to worry about
a municipal bond or a muni market melt down, do you believe,
each of you, that this issue is being overblown, or do you feel
we have yet another blow to the economy ahead with bond
insurers?
Do you believe it to be true that more and more insurers
will lose their AAA ratings as Moody's and S&P look as though
they are ready to lower the grades on more insurers, even such
names as Ambac and MBIA?
It appears to be quite worrisome when a firm is downgraded
to AA, it is most difficult for them to do any more municipal
business.
Is this not the case, or is it not the case that many of
these companies are themselves to blame for the mess that they
are in after expanding out into the risky securities that some
say they had no business or experience in insuring?
Will it not be hard to find investment banks who are
willing to bail these guys out and will there even be a bail-
out if necessary, or do you believe that investors will simply
have to take these losses?
Finally, would an industry-wide bail-out be even a
legitimate option as getting banks to agree on how much each
should pitch in to help might prove difficult itself?
Mr. Dinallo. I think, Congressman, that it is a very
difficult set of questions to answer that you have asked. I
think the infusions of capital that you have seen into the bond
insurers have at least for now maintained the AAA ratings of at
least four or five of them, and others are going to shake out
and possibly go to a lower rating.
If I were to be asked whether these were sufficient capital
infusions for the absolute long run, I cannot answer that
because the question is as difficult as answering exactly where
is the economy going to be in fact several years from now.
If mortgage defaults continue at a certain rate, then we
are probably going to be okay, if they are as projected by the
rating agencies, but if they take off into a worse scenario,
then the rating agencies will, I presume, require more capital
as those projections go up.
Likewise, that could also have a serious pull on the
municipal side because if there was a tax base erosion, then
the municipalities could presumably default if permitted to
default at a higher rate than they otherwise have been.
It is a question that is linked to the economy. That is why
I think we should inject capital prudently and it should be
market based solutions and let the assumptions crisis that we
are in and the potential liquidity crisis play out a little
bit.
Mr. Scott. Thank you, Mr. Chairman.
The Chairman. The gentleman from Missouri.
Mr. Cleaver. Thank you, Mr. Chairman.
Mr. Sirri, my city needs about $1 billion to upgrade its
storm water sanitary sewers, combination sewers. I stepped out
a few minutes ago to meet with Mayor Jim Odom, who is the mayor
of one of the suburban communities in Kansas City, Missouri.
His City is Belton. He just told me he needed $2 million to
upgrade their infrastructure.
The National Service Transportation Policy and Revenue
Study Commission says that we need $255 billion a year, a year,
to upgrade the infrastructure around the country. If that is in
fact true and if municipalities are going to do it, they are
going to have to access the debt market to do it. No city has
that kind of money in the city treasury.
When you add the market volatility, then municipalities are
in serious trouble.
Is there something that the SEC can do within its
regulatory authority to correct not a perceived problem but a
very real problem with the bond rating agencies that to a large
degree, and I want to talk to them directly about it, are
causing the problem.
Do you see that the SEC has any responsibility for helping
us out of what I think is a crisis?
Mr. Sirri. I think there are several things we are doing at
the moment. The first is, and I referred to this earlier, that
we are providing some relief to dealers in the auction rate
area so that municipalities, perhaps such as some of the ones
you mentioned, would be able to bid for their bonds at auction,
and be able to have those bids taken.
That should help in the short run. In the longer run, right
now, and you brought up the credit rating agencies, as we speak
right now, we are examining the credit rating agencies for a
number of issues, most of them related to subprime, but that
work will continue.
Our Chairman has asked that we engage in some rulemaking
where appropriate this year to get at some of the issues that
we have talked about. I think that rulemaking is still to be
flushed out as to what it will entail precisely.
I think we do take very seriously our responsibility, our
authority over the credit rating agencies is new. The Act was
promulgated in 2006. It really just came on line in 2007. We
are barely 9 months into our authority here.
I think we do not want to do something untoward, to do
something that is not carefully--
Mr. Cleaver. Do something what?
Mr. Sirri. We want to be careful in our use of authority
here. The Chairman has instructed us to be very measured, to
think very carefully about what kind of rulemaking we engage
in.
The Chairman. That is the Chairman of the SEC.
Mr. Sirri. I am sorry, the Chairman of the SEC. I am sorry.
Very good.
The Chairman. He is more measured than me.
[Laughter]
Mr. Cleaver. I am not suggesting that you do something
irresponsible. I am not sure it sounded like I was saying that.
I am asking that the SEC use the responsibility it has been
given legislatively to deal with the problem. I understand you
have not had that for a long period of time.
What I hope to convey to you is that it is a problem that
is growing daily. It is not getting any better because the
crumbling infrastructure around this country is not going to
stop until we deal with this problem.
Is there something that you can do? Can you tell them to
stop?
Mr. Sirri. I think with regard to a number of things, we do
have authority. For example, if in the process of our exams we
were to find out there was anti-competitive behavior going on,
and we have had some discussions here at the table about the
nature of what that anti-competitive behavior may be, our
authority is very clear there, that we could step in and stop
that.
Mr. Cleaver. Do you not think there is anti-competitive
behavior?
Mr. Sirri. I do not want to jump ahead of where our exams
are. We are looking at--
Mr. Cleaver. We have nine rating agencies--maybe that
suggests something is awry.
Mr. Sirri. It certainly raises that possibility. There are
possibly some other benign explanations for it, but I certainly
take your point.
We started our authority with five. We have had nine come
in. As I said before, I think some of the cures that are
provided by the Act will take some time. I certainly appreciate
there is more urgency there and that we need to be focused on
the here and now as well as a longer term view.
Mr. Cleaver. Mr. Blumenthal, if you could write out a
script for the SEC to address the problem, what would it be,
please?
Mr. Blumenthal. On the credit rating agencies?
Mr. Cleaver. Yes, on credit rating agencies.
Mr. Blumenthal. What I would like to see is that the SEC
would require a single unified standard. In other words, I
believe that under the current statute, it has authority to
mandate that single standard, but it may be a fair issue for
them as to whether they feel the statute does provide
authority, so I am suggesting that there be explicit
congressional action in that regard.
I believe that as part of this rule, they can and should
take that action to make the system fair and eliminate these
disparities. In effect, the system that we have right now puts
municipalities in a lesser category of existence.
I will say to your point about anti-competitive conduct,
that is precisely the focus of my investigation. It is not only
on the dual standard and the way it started and perpetuated and
maintained, but it is a variety of other practices that the
rating agencies have engaged in doing that raise the cost of
those ratings, the so-called notching practices, the basketing
practices.
These terms have meaning and I know this hearing is not
focused on the details of the rating agencies, but there are
very, very profound and significant questions under the
antitrust laws about whether or not they have restrained trade
or otherwise impacted competition.
Mr. Cleaver. Thank you.
The Chairman. The gentleman from Colorado.
Mr. Perlmutter. Thank you, Mr. Chairman. I am sort of with
Mr. Kanjorski and Mr. Frank in not understanding some of the
terminology. I would just like to go to basics for a second.
I represent an area with lots of school districts, and some
health and hospital authorities, and they want to issue a bond.
They have to get some money to build a new hospital or new
school. Those are the guys, if I understand it, that are going
to be affected by these higher interest rates.
Is that right or wrong?
The Chairman. The court reporter is very able, but she is
not good at nods.
Mr. Blumenthal. Yes.
Mr. Dinallo. Yes.
Mr. Perlmutter. Thank you, Chairman.
Let's move the credit enhancement piece aside for a second.
Somebody who is going to invest or buy these bonds will look at
a revenue stream that is generated by the township or the area
of authority or whatever, look at the expenses, and say that
looks like a good buy for me and I will buy it at 5 percent.
That is how I look at the risk of this. Is that right?
Mr. Dinallo. Yes.
Mr. Perlmutter. There are a bunch of these out there. Some
of what we have done, the market has done something to try to
short cut analyzing the revenue stream and whether it is
legitimate and a solid revenue stream or in the instance of
some of my neighborhoods where there are lots of foreclosures
and lots of people who are not paying their property taxes or
sales tax has dropped, the revenue stream is not as solid as it
once was. Still have all those expenses.
Some of these municipalities or authorities then buy down
the risk; right? They buy down the risk by either getting
letters of credit from a bank or they find an insurance company
to buy down the risk, or they get a credit agency, the credit
agency looks at everything and says this is a good risk.
Is that how this is working?
Mr. Sirri. I think you mentioned two different kinds of
risk there. When you cited the letter of credit, you are
talking generally about liquidity risk, that is the idea that
the bond can be re-sold.
When you talked about a monoline insurer wrapping the bond,
you are talking about credit risk, the idea that if the
municipality does not make their timely payments, that someone
will step in and make it for them.
In the third instance, when you talk about the credit
rating agency, you are talking about an opinion of a third
party about the likelihood that they make timely payments.
The three of them interact together in the way you say.
Mr. Perlmutter. To be able to peddle or sell the bond.
Where is it that we are running into trouble?
Is it because we do not have insurance any more or because
the credit agency is saying hey, the markets are very difficult
out there right now, we are going to tighten down on everybody,
just like the appraisers and the accountants are tightening
down, and the regulators are tightening down.
Is that the problem? Or is it because nobody has any money
to buy these things?
Mr. Dinallo. I think Mr. Sirri just helpfully asked me to
answer that question. I think there are several factors that
are contributing to the issue. The rating agencies, I think,
have gotten tougher because they have sensed a certain
scrutiny, and I think it is appropriate for them to tighten up
a bit.
It is the case that the bond insurers that would otherwise
be giving the wrap have been under pressure and their ratings,
which are the wrap that you talk about, have gone down or been
in danger of going down.
The credit markets that are sometimes the way those
municipalities come to market, the variable rate markets, etc.,
are very tight as Wall Street and other liquidity providers are
beginning to worry about their capital requirements and pulling
away from the lending activity that everyone just kind of got
used to and maybe overly used to.
There are several factors that are contributing to it. We
discussed today one other that is kind of at the heart of what
you are saying, which is a belief that the rating agencies
essentially have a two tier system for rating corporate credit
risk versus municipality credit risk, and that the underlying
credit decisions around municipalities should be more liberal,
so to speak, and they should not have to pay as much because
they ought to be starting off from either a higher rating or
any rating at all, which some of them cannot even get rated so
they buy the wrap.
The Chairman. We have a vote. We can finish.
Mr. Perlmutter. As regulators, are you seeing any trouble?
One of the things we have been dealing with is this subprime
mess here and we are seeing lots of foreclosures.
Do you see any problem with the revenue side? That
municipalities really are starting to--
Mr. Dinallo. In a worst-case scenario, I have two concerns.
My immediate concern, which I think is clear to everybody, is
that the mortgage foreclosures and the mortgage defaults will
definitely put a huge pull on the CDO side of the obligations
that the monoline insurers have put out, and that will in turn
put stress on the municipal side of their books.
Likewise, I do believe that if the economy goes abruptly
and more so in the wrong direction, you may have underlying
stress on the municipalities. I think that is where you will
hear Ajit Jain from Berkshire say that it is not quite as safe,
the risk, as everyone seems to be saying, that it is a riskless
investment. I read his testimony.
Mr. Perlmutter. Thank you.
The Chairman. Thank you. I am not going to go vote. It is
an adjournment. I will stay here and we will get to the next
panel. We will finish with the gentlewoman from Wisconsin.
Ms. Moore of Wisconsin. Thank you so much, Mr. Chairman.
I was very fascinated, Mr. Sirri, by your testimony and
others regarding the auction rate securities and specifically
want to know more about the Federal backstops that you might
suggest.
I can see that you think that perhaps there is something
that can be done in the regulatory area. I have heard others
talk about the Federal Home Loan Bank.
As people want to get rid of these bonds and switch them to
variable rate, you said that had been slowed tremendously
because so many people are trying to do it.
I noticed in the footnote in your testimony on page four
that you said some banks have already reached their entire
yearly capacity for writing letters of credit policies.
What more can you do or what role could the Fed provide in
enabling people to make these swaps?
Mr. Sirri. What we have done specifically here is we have
made something clear that had been slightly unclear to the
market. We have a situation where we have issuers of bonds,
municipalities, who are paying particularly high rates because
their auctions have failed.
We have a situation where we have investors in bonds who
normally would be happy to get those high rates. Of course,
that is what they like to do at auction, but they also have a
demand for liquidity. Because the auctions have failed, they
cannot move their paper.
What we are striving to do this week is to issue some
guidance by the staff of the SEC saying that municipal issuers
can bid through dealers at auction and repurchase their paper,
take it off the market. First, that is helpful to them, and
second, by bidding, many of the auctions we hope will not fail.
Once they do not fail, those rates will come down and the
issuers' rates that they pay will be more in line with the
traditional rates they pay for their credits.
We have provided some guidance there to make it clear that
will not be deemed ``manipulation,'' and that is one of the
reasons why dealers have been not willing to accept the bids of
municipalities.
Ms. Moore of Wisconsin. Because there would be a huge
discount to muni's if they bought their paper back?
Mr. Sirri. There was an enforcement settlement in 2006
where there was some actual manipulation by dealers. In the
wake of that settlement, dealers became very conservative. In
our view, perhaps slightly overly conservative, and that is
fine that they do so. They do not want to run afoul of the
securities laws.
We just want to clarify for them that in this instance, and
perhaps generally, that when they bid at auction, if they bid
in a precise way that has good disclosure around it, they will
not be deemed to manipulate the market.
We want to be very, very clear, we are not saying anything
about the contracts around these. There are various private
issues about the contracts, about the agreements between the
parties. The SEC is saying nothing about those whatsoever.
We are just clarifying that the municipalities can place
bids through dealers and neither the auction agents, the
dealers, nor the municipalities will be deemed to have
manipulated under a set of circumstances that has a lot of
disclosure around it.
Ms. Moore of Wisconsin. Thank you for that clarification.
The Chairman. I thank the gentlewoman. I thank the panel.
The panel is dismissed with our thanks. There are a lot of
specific things and we will all be back to this.
We will call our next panel, Mr. Lockyer, Ms. Wiessmann,
Mr. Reeves, Mr. Newton, and Mr. Dillon. Will you all come
forward?
I thank the panel. This is a very important subject, and
while not all of the Members are here, people are watching this
elsewhere, and there are staff members here on both sides, so
we will get right to it.
First, we have Bill Lockyer, the treasurer of the State of
California. Mr. Lockyer, do you want to go ahead? If you need
to be excused after your testimony, feel free. Why don't you
begin?
STATEMENT OF THE HONORABLE BILL LOCKYER, TREASURER, STATE OF
CALIFORNIA
Mr. Lockyer. Thank you very much, Mr. Chairman, and members
of the committee. It is the red eye and Ambien on the plane
that does not seem to work well for me.
The Chairman. We have about 50 Members in California who
will not be sympathetic to that.
[Laughter]
The Chairman. None of them are here, so you go ahead.
Mr. Lockyer. The committee considers upheavals in capital
markets that dramatically affect governments, taxpayers, and
investors across the Nation. I commend you for shedding light
on these issues and appreciate the opportunity to share
perspectives from California, the largest municipal bond issuer
in the United States.
I would like to start by addressing the issue that lies at
the foundation of much of the turmoil that led to this hearing,
the system used by major U.S. rating agencies to grade
municipal bonds.
If you remember back when we were taking tests in school,
what if you had aced every test and still received a grade
lower at the end of the semester than a classmate who failed
four exams. You would with total justification call the
teacher's grading system unfair.
Unfortunately, for American taxpayers, that is exactly the
same situation faced by governmental entities that issue bonds.
The agencies hold municipal issurers to a higher standard
than corporate issuers. There has been considerable comment on
this by the Chair and others, so I simply point out that
disparate treatment results in higher payments and that the
system is fundamentally flawed.
The rating agencies' own studies substantiate these claims.
Municipal bonds rated Baa by Moody's have a default rate of .13
percent while corporate bonds rated Aaa by Moody's have
defaulted at 4 times that rate or .52 percent, and similarly
with the other rating agencies.
S&P, who by the way, of the rating agencies has been the
one most resistant to considering change, published an article
last Friday on muni ratings, and focused on unrated bonds, ones
that do not rely on a government's strength of issuance.
With regard to the rated municipal bonds at issue in this
debate, however, the same article contained updated numbers of
default statistics that support these claims, showing the
disparity between corporate and municipal defaults.
California has never defaulted on its bonds, yet, the
agencies refuse to give the State a AAA rating. It undermines
the functioning of an efficient and transparent market. It
misleads investors by falsely inflating the risk of buying
municipal bonds relative to corporate bonds, and worse from my
perspective as the State's banker, it costs taxpayers billions
of dollars in increased costs and bond insurance premiums.
If the State received the AAA rating it deserved, we could
reduce taxpayers' borrowing costs by hundreds of millions of
dollars over the 30 year term of still to be issued bonds that
have been approved by our voters to finance infrastructure
development. Billions of dollars more could be saved by
municipal issuers across the country.
We have asked the rating agencies to work with us to devise
a unified rating system based on default risk. We believe that
reform would make the market more efficient and transparent and
better serve taxpayers and investors.
A number of other State treasurers and finance officials
have signed those letters or written similar letters of their
own. You will hear from some shortly. That letter is attached,
Mr. Chairman, to my written testimony.
The rating issue flows naturally into the question of bond
insurance. Municipal issuers buy insurance to obtain a AAA
rating that, in many cases, they already deserved, based on the
de minimis risk of default.
Insurers' AAA ratings are then transferred to the issuers'
bonds. Our policy on insurance is similar to most muni issuers.
If by insuring bonds we can save taxpayers more money in
interest than it costs to buy the insurance, we will insure the
bonds.
During the 5 years of 2003 to 2007, California spent $102
million to insure $9.1 billion in GO bonds.
Defenders of the current rating system argue that the
market understands the distinctions between corporate and
municipal rating scales. I would suggest that argument holds no
water.
If investors truly possessed that understanding, our
taxpayers would have had no need to spend $102 million on
insurance. The fact that investors placed value on insurance,
that it is an enhancement of our credit, shows the market does
not understand fully the distinctions between the two ratings.
Even though bond insurers almost never paid out a claim
since muni issurers almost never default, the industry is in
crisis because of risky bonds they insured in other markets.
Some monoline insurers are fighting to save their AAA status
while rating agencies have downgraded others and the AAA rating
of insured bonds purchased by investors has been lost or is in
danger.
The effect of these downgrades on municipal issuers differs
depending on the type of the bond. Most of our State's
outstanding debt is in fixed rate bonds, but downgrades do
affect debt service with respect to other bonds, and you have
talked earlier about auction rate and others.
The Chairman. Mr. Lockyer, we need you to summarize and
finish up, if you can, and then we can get to questions.
Mr. Lockyer. The variable markets have been hit because of
the insurance difficulties.
The States are grateful for the fact that the SEC has
indicated that they may provide rules that will provide
assurance soon to local entities that if they repurchase, that
it does not constitute a default or some manipulation of the
market. Replacing the dual bond system with a unified approach,
Mr. Chairman, is a needed reform, and we hope that you will be
able to assist.
[The prepared statement of Mr. Lockyer can be found on page
132 of the appendix.]
The Chairman. Thank you, Mr. Lockyer. We appreciate the
leadership you have taken. The letter you put together will be
put into the record as well as anything else people want to
submit.
Ms. Wiessmann, please go ahead.
STATEMENT OF THE HONORABLE ROBIN L. WIESSMANN, TREASURER, STATE
OF PENNSYLVANIA
Ms. Wiessmann. Chairman Frank and members of the Financial
Services Committee, thank you for inviting me to testify today
about the current turmoil in the municipal bond marketplace,
and what I have termed the collateral damage that is being
experienced by State and local government entities.
My name is Robin Wiessmann and I am Pennsylvania's
Treasurer. My professional experience that is relevant to
today's hearing includes municipal and State agency
supervision, 24 years as an investment banker, which includes
10 years as an owner of a broker-dealer investment banking
firm, and 15 years of asset management oversight.
Today's financial market problems are very disturbing to
me, especially the failure of many auction rate securities and
the high reset rates on variable rate demand bonds.
They are imposing extraordinary volatility and stress on
all municipalities including States, local governments, other
local political subdivisions, and student loan providers.
This credit crisis is affecting them through no fault of
their own, but due to market disruption unrelated to the
prudent financial management of State and local governments.
Such market disruptions are costing taxpayers in terms of
increased expenditures and constrained budgets. Further, the
potential exists that in an already tenuous financial
situation, it may worsen and disrupt the provision of basic
government services, including the availability of student
loans for the next school year.
The market is in desperate need of some help, and to those
who say let the market correct itself, one must recognize that
the market has been unable to adjust itself.
While I have great faith in the resiliency of the American
economy, the market has demonstrated an inability to self
correct.
While I applaud the Federal Reserve's action yesterday in
announcing the securities lending facility program,
nevertheless, the situation in the municipal markets requires
and demands a more targeted relief for this market.
I want to speak about Pennsylvania for one moment. The
current state of the national economy is very difficult and
challenging, but the real challenge is, as I said, the
challenge in the credit markets.
Nevertheless, we in Pennsylvania are relatively optimistic
about the Commonwealth's economic outlook and debt portfolio.
Due to Pennsylvania's conservative debt policies and
conservative investment policies, we are again relatively well
positioned to weather the current market uncertainties and
challenges.
However, the turmoil does have wide ranging implications
and my concern extends beyond the Commonwealth's direct debt to
the agencies, counties, municipalities and school districts.
I would like to turn now to some very specific
recommendations. I would like to call on the Federal Government
to provide liquidity and confidence to the municipal
marketplace. Encouraging investor confidence in the municipal
bond market, which will bring in more buyers and result in
liquidity, is essential, so that market participants can have
the time to restructure their products, services, and
securities.
In particular, I would call on the Federal Government to
consider temporary actions to provide liquidity such as serving
as a buyer of auction rate and variable rate securities,
providing liquidity which they have provided to the general
market with specific direction to maintain the auction rate and
variable rate market of municipal issuers, and providing short
term credit enhancements for bonds suffering market failure
because of downgrades of their bond insurer, so that the bonds
can resume trading at reasonable interest rates.
There has been much discussion about credit ratings, and
based on my years working on Wall Street, I know firsthand that
the credit of investments is primary. I also know that credit
evaluations of governmental obligations have withstood the test
of time.
However, I do have some observations about the market.
Since municipals are governed by such challenging standards and
are monitored very closely, they are, as we have heard many
times today, seldom in default. Despite the scrutiny and the
reduced likelihood of default, they are often perceived and
priced as inferior credits.
I would corroborate and support many of the statements that
have been made here today.
There should be some mechanism for the true
creditworthiness of governmental debt obligations to be
recognized. That will only happen when some adaptation of the
current rating system is made. A credit rating system that is
analogous to the corporate rating system would serve this
purpose and make bonds comparable. Specific distinctions could
provide the differentiation if necessary among municipal
credits.
Another reason for this is very market driven. Buyers are
now investing across asset classes based on relative value, and
this simpler classification might facilitate this crossover
buying, which in turn will provide greater liquidity and market
demand for municipal credits.
Markets change. Guidelines evolve. We need to adapt.
I would also suggest that there are mechanisms that should
be put into place to support trading, when disruptions in the
market occur, as has occurred recently. Just as triggers were
established in the equity markets, I suggest that the Federal
Reserve or other Federal agencies offer stop gap temporary
measures to support and sustain the municipal markets in times
of psychological or actual crises, such as what we have been
experiencing.
Had measures such as these been available in December or
January, we might not have experienced the cascading effect of
liquidity and credit concerns which are now impacting fixed
rates and unenhanced paper.
Some of the other immediate solutions that I will not go
into detail on have been cited before, raising the bank
qualified debt limit from the current $10 million level to $25
million, permitting an additional advance refunding of bonds,
altering the rating requirement under Rule 2a-7, and permitting
Federal Home Loan Banks to offer letters of credit, and
allowing governments to purchase their own debt.
I would like to speak just one more moment and speak about
looking forward and doing better going forward.
It is clear from our current credit crisis that changes
need to be made in our approach to the marketing and securities
market.
There are three major factors that are necessary in order
to effectively direct our capital markets: First, a principles-
based code of conduct for business operations, a deliberate
conscientious decision making process with consideration of
market ramifications as they relate to consumers, capital
markets and the economy as a whole, not just the business
entity itself; second, transparency and complete disclosure of
financial operations and securities structures; and third, a
regulatory discipline that accurately reflects the realities of
today's marketplace.
Thank you very much for your time.
[The prepared statement of Ms. Wiessmann can be found on
page 217 of the appendix.]
The Chairman. Thank you, Madam Treasurer.
Next, the Treasurer of the State of Mississippi, Mr. Tate
Reeves.
STATEMENT OF THE HONORABLE TATE REEVES, TREASURER, STATE OF
MISSISSIPPI
Mr. Reeves. Thank you, Mr. Chairman, for the opportunity to
be here today. I would ask that my entire statement be entered
into the record.
The Chairman. Anything that anybody wants to put into the
record will be put in, without objection.
Mr. Reeves. For the record, I am serving my second term as
the State Treasurer of Mississippi. I am the immediate past
president of the National Association of State Treasurers, and
I am currently serving at the request of Treasurer Lynn Jenkins
of Kansas, our Association's current president, as the chairman
of the Legislative Regulatory Committee, which has jurisdiction
over issues that relate to the municipal marketplace.
Accessibility and affordability of the capital markets and
the liquidity of those markets is of great importance to your
Nation's State and local governments. The capital we raise in
the municipal marketplace builds our schools, hospitals, roads,
and other vital infrastructure and public projects.
In times of disaster, municipal issuers are often called
upon to use public debt to finance recovery efforts. New York
City's post-9/11 liberty bond program and the Gulf opportunity
zone bond after Hurricane Katrina are two of the most prime
examples in recent years.
My experience as treasurer of a State that bore the brunt
of the largest natural disaster in the history of our country
certainly confirms the advantages of tax exempt borrowing.
Many of the post-Katrina recovery projects in Louisiana,
Alabama and Mississippi have been and are being aided by the
Gulf Opportunity Zone Act of 2005.
The bonds we have been able to issue as a result of
congressional action have greatly benefitted the recovery
efforts and the citizens of the affected regions.
I would be remiss if I did not take this opportunity to
thank the members of the committee as well as every other
Member of Congress for your willingness to help my own home
State in the aftermath of Katrina. Our recovery is far from
complete, but the financial resources through appropriations
and tax law changes approved by Congress make possible what
seemed like a nearly impossible task of rebuilding in late
August of 2005.
It is extremely important to remember that what brings my
colleagues and me before the U.S. House Financial Services
Committee this morning is the current situation in the
municipal marketplace, and it is not a general decline in the
underlying credits of municipal issuers, but a disruption in
the corporate marketplace caused by the collapse of securities
backed by subprime mortgages.
In fact, the current stress in the bond insurance industry
is not at all caused by the consistent highly profitable cash
flow derived from insuring municipal debt.
Instead, the problems with the insurers, and by extension
the public debt they insured, are a direct result of their
decision to insure higher risk ventures in the corporate
securities markets.
The current loss of market liquidity has affected public
issuers across the country. The end result is a failed auction
resulting in dramatic spikes in interest rate costs on bonds
which have little risk of default. In some cases, the rates
have jumped to upwards of 20 percent. Obviously, the taxpayers
foot the bill as the cost of capital increases.
In our State, we have been more fortunate than many with
respect to our exposures in today's unstable market. By
statute, we cannot have greater than 20 percent exposure to
variable rate debt.
In practice, we have a well diversified portfolio that
generally helps position us to weather and even take advantage
of short term aberrations in the market.
Of our $3.2 billion debt portfolio, less than $140 million
currently is held in auction rate mode securities. We have had
one failed auction, but due to the diversification of our
portfolio, this failed auction will only contribute an
additional 2/100 of 1 percent to our overall debt service
payments in the current fiscal year.
The following week, our auction was priced at a level more
in line with our expectations, and although it was and
continues to be trading at a level significantly above the
SIFMA index.
Many of the specific issues that are before the committee
today as it relates to the present market disruption are, in my
opinion, short term aberrations caused by the credit crunch.
Having said that, the issue of bond insurance, liquidity, and
rating agency scales on municipal bonds are longer term issues
that must be addressed.
I am not convinced that Congress necessarily should play a
role in all of these issues, but to the extent you should, I
would recommend consideration of the following:
A traditional role of the Federal Government in past
financial crises has been to provide short term price stability
and liquidity to the market during extremely difficult times,
until the market can find its own footing. Clearly, these are
extraordinary difficult market conditions.
The Department of the Treasury, at the request of the
National Association of State Treasurers and other market
participants, recently released extremely helpful guidance on
re-issuance rules for auction rate securities and variable rate
demand bonds.
This guidance allows many issuers to convert out of auction
rate securities into different products, such as fixed rate
maturity bonds, without having the bond deemed to be re-issued
which can be costly to our governments. This has allowed our
issuers to save taxpayers money and limit their exposure in a
volatile market.
Some tax exempt bond issuers secure letters of credit from
strongly accredited financial institutions to achieve lower
borrowing costs. Letters of credit can be particularly helpful
as a source of liquidity for small issuers who do not have
strong bond ratings or large bond issuances. They are also
useful to issuers of every size as a mechanism to diversify
access to credit markets through large, well known
institutions.
As has been mentioned today, the Federal Home Loan Bank
System is not allowed under current law to offer this AAA
guarantee. Legislation proposed in this Congress would permit
that, and I personally would like to tell you that I appreciate
the support of Chairman Frank, Subcommittee Chairman Kanjorski,
Congressman Bachus, Congresswoman Pryce, and other members of
the committee who have co-sponsored this legislation.
Of course, the fact that we have separate scales on
municipal and corporate debt makes little sense to me and many
of my colleagues.
Moody's has indicated that the default rate on investment
grade municipal bonds from 1970 through 2006 is approximately
.1 percent, far different from the 2.1 percent default rate
among all investment grade corporate securities over the same
period.
Yet, municipal issuers pay a penalty to the market for the
different scales which leads to higher costs of capital that is
borne by the taxpayers.
It may be that the market will resolve this particular
concern. I think it is important that Congress be aware of this
discrepancy, and to the extent that the rating agencies
voluntarily establish a global rating scale that more
accurately reflects relative credit risk, the market will be
better off.
Of course, the Securities and Exchange Commission treats
the two rating scales as equivalent under Rule 2a-7, which
governs qualified investments in money market mutual funds.
This rule effectively requires that States' money market mutual
funds must hold investments rated AA or better.
I believe that a relaxing of Rule 2a-7 requirements would
benefit both issuers and investors.
No single solution exists to solve the current market
turmoil. To the extent possible, Congress, the SEC, and market
participants all have a role in navigating our financial system
through this storm.
The key is to encourage investor confidence in the
municipal marketplace.
I will conclude my prepared remarks by reminding you that
the capital raised through the issuance of debt in the
municipal markets is vital to our great country. Working
together, we can continue to ensure a viable efficient market
which ensures the lowest cost of capital for our State and
local governments, thereby maximizing the benefit to all of our
taxpayers.
Thank you.
[The prepared statement of Mr. Reeves can be found on page
198 of the appendix.]
The Chairman. Thank you. Let me just say to the witnesses
that I am apologetic and I appreciate your staying. If you want
to get something to eat, you have time. There is a cafeteria
right downstairs. I know people have been here all day. We are
going to get to our third panel.
Let me get right to Mr. Newton.
STATEMENT OF MARK NEWTON, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, SWEDISH COVENANT HOSPITAL
Mr. Newton. Good afternoon. Thank you, Chairman Frank. My
name is Mark Newton, and I am the president and chief executive
officer of Swedish Covenant Hospital, located in Chicago.
I offer a ground-level view of this current situation and
crisis. Swedish Covenant Hospital is a 334-bed urban community
hospital. We are the largest remaining independent hospital on
the north side of Chicago, and we serve a very culturally
diverse community. Over 50 languages are spoken--
The Chairman. We have a time problem, so I want to get
right to how--we stipulate that this is a very important
institution--you were affected by this--
Mr. Newton. Well, Swedish Covenant is a Federal
disproportionate share hospital, and as such we represent this
critical safety net for the uninsured and underinsured. And we
consider ourselves your partner in serving these communities.
The cascading nature of this turmoil over the last few
months indicates that there is no predictable fire break on the
horizon. And as the president and CEO of a hospital, I'm no
stranger to responding to these kinds of community health
risks, competitive market changes, malpractice crises, nurse
staffing shortages, and possibilities of revenue stream cuts.
We have been able seemingly to weather each one of these
risks to the healthcare system while trying to expand our
infrastructure, and the key to our ability to respond truly has
been the availability of predictable and efficient capital.
Let me share some details of our story. Since 2000, when I
first joined Swedish Covenant, we have had hospitals close in
our community with over 500 beds removed and 3,000 jobs removed
from the community. Our best response has been to invest in new
facilities, services, and technologies, while others have
downsized and curtailed services. This is not only out of a
sense of mission, but it is also our view that it is important
that we strategically invest in health care facilities for our
community.
We now find ourselves responding to a crisis that requires
us to reinvent our balance sheet and rethink strategies of
capital spending. We are currently in a refinancing process
that is going to cost over $1 million in transaction fees. This
amount is being taken directly from patient care. Our monthly
insurance costs have historically been in the range of $600,000
a month, that has increased by an additional $350,000 a month,
an increase that is directly related to failed auctions and the
result and expectations of bondholders of default rates of
interest between 10 and 15 percent.
The Chairman. We are not talking malpractice insurance
here. You are talking about the bond insurance, correct?
Mr. Newton. Correct.
The Chairman. Yes. I just wanted to be very clear that it
is just the bond insurance. Thank you.
Mr. Newton. All of this turmoil clearly has lessened the
confidence in the financial markets. And what we find is that
we have to be more alert to unintended consequences as we
restructure our balance sheet.
Today our debt is approximately $150,000, with 83 percent
fixed and 17 percent variable, and it is either insured by bond
insurance or supported by bank letter of credit. We are an
underlying Triple-B-plus credit. Our fixed rate now is 4.9
percent. We expect the fixed rate to increase to 6.5 percent.
After refinancing, we will have to increase the percentage
of variable debt to about 60 percent. One unintended
consequence is even greater reliance on bank letters of credit,
which by nature are short-term. The cost of bank credit
enhancement as a replacement for traditional bond insurance has
increased significantly. Credit enhancement capacity has been
reduced as we look forward in the next 3 months to a massive
period of debt refinancing by hospitals such as Swedish
Covenant Hospital. This remains a yet unexplored dimension of
this ongoing crisis.
If this crisis is not resolved, hospitals like Swedish
Covenant will face significant cost increases on our existing
debt and may have very little capacity for access to new
capital in the next few years. We would slow down projects
investments in projects such as implementation of an electronic
medical record; we would postpone expansion and renovations of
core infrastructure; and we would conserve other spending to
maintain needed cash balances as banks tighten other credit
terms such as higher minimum levels of cash on hand.
Perhaps my final observation is that organizations such as
mine truly need a fire break in this current cascading crisis.
As I noted before, as your partner in providing health care
services, we really need and want to get back to the basics of
caring for people. The fabric of an efficient and effective
health care system depends on access to stable and predictable
sources of capital.
I want to thank the committee for the opportunity to
discuss this important issue, and I welcome any questions.
[The prepared statement of Mr. Newton can be found on page
195 of the appendix.]
The Chairman. Thank you. I'm going to go vote, and we are
going to come back. I appreciate your indulgence. People should
feel free, you have 15 or 20 minutes to maybe get lunch. Not
this panel, because we're going to be right back here with the
others. But we will get right back to you. And I thank you. Our
commitment to this issue, I think, justifies all of us doing
this.
[Recess]
The Chairman. On behalf of the National Utility
Contractors' Association, I should note that I spoke with
Chairman Jim Overstar of the Transportation and Public Works
Committee because we did want to make clear what the impact of
this is on services such as health, as we have seen from Mr.
Newton, and infrastructure in general. And Mr. Overstar
strongly recommended that we ask someone from the National
Utility Contractors' Association, so I'm glad that we were able
to arrange that. Mr. Dillon, please go ahead.
STATEMENT OF TERRY DILLON, CHIEF EXECUTIVE OFFICER, ATLAS
EXCAVATING, ON BEHALF OF THE NATIONAL UTILITY CONTRACTORS
ASSOCIATION
Mr. Dillon. We appreciate your letting us testify today,
Mr. Chairman. And I'm going to put a little different kind of
color to your meeting today, so let's see how this thing goes
for you.
My name is Terry Dillon, and I am the owner of Atlas
Excavating in West Lafayette, Indiana. We have 150 employees
who work on sewer, water construction, highway, and road
reconstruction projects throughout the State. My wife and two
sons are partners in my business.
My written statement today supports the need for municipal
bonds and their effect on infrastructure projects. I will leave
the reading of the statement for you and move on to actual
projects these bonds are used for, and try to put some color in
today's testimony. Ten miles south of Lafayette, Indiana, is
the small town of Stockwell, where about 300 residents reside.
Three years ago, you could drive through this town and see
puddling sewage in the streets and in the yards. There was a
bad sewage stench in the air. The local kids would be riding
their bikes through the sewage and playing in it; small
children could be seen playing in the muddy sewage as if
playing in a sandbox.
Stockwell residents took control of this issue, and had a
sewage system designed, financed, and built. Financing was done
through the SRF program, the OC Grants, and municipal bonds.
Today residents are painting the houses. They have cleaned up
their neighborhood, and have taken their community back. It's a
thriving Indiana town again.
My company, Atlas Excavating, has done about 30 such
projects across the State of Indiana. In each one of these
towns that we have gone into, I have found a dilapidated city
and a bad attitude, and once these sewage lines have been
repaired and the city has been cleaned up, the towns thrive
once again.
Next, the City of Indianapolis is under Federal mandate to
clean up its dumping of raw sewage through sewage overflows.
This is at a cost estimate of around $2 billion, of which these
are supposed to be done over the next 20 years. Indianapolis
also has 80,000 septic tanks in the city limits that have to be
replaced with a piped treatment system, and posted all over the
City of Indianapolis at ponds and streams are big red warning
signs where overflow structures dump raw sewage into the
waterways. The signs say, and I quote, ``Caution, sewage
pollution. Keep out of the water. People who swim in, wade in,
or swallow these waters may get sick.'' And it is repeated in
Spanish.
Finally in the City of Lafayette, there is a 42-inch
concrete sewer line that runs from Staley's Corn Syrup Plant 10
miles to the sewage treatment plant in the City of Lafayette.
The sewage line goes through woods, creeks, residential
neighborhoods, back yards, camp grounds, and playgrounds. This
line is in such bad decay that it breaks 2 to 3 times a year,
and in the last 10 years, my company has repaired this line on
most of its breaks. I want you to imagine a 42-inch-diameter
concrete pipe that has 5-inch wall thickness, with a daily flow
of 15 million gallons per day. This 42-inch pipe, which was put
in around 30 years ago, now has paper-thin walls, with a
maximum thickness of about 1 inch left in the 5-inch-thick
concrete walls. This pipe is a disaster waiting to happen.
My most memorable repair to this line was 5 years ago. The
city engineer contacted me, requesting immediate response to a
sewer break. Normally you get a call giving you hours to
respond, but the urgency in her voice sent me driving to the
site immediately. When I got there, it looked like a crime
scene. There were fire trucks and emergency vehicles lining the
roads to get to it, and the site was cordoned off. I ran up to
the failing spot, and found a 20-foot-long, 5-foot-deep, 12-
foot-wide sinkhole. In the hole, raw sewage was running down
the broke and exposed pipes at a very rapid rapid rate,
indicating a high flow and massive surcharging. The swirling of
the water in the hole was eroding the ground conditions. I
immediately had emergency crews who were standing there,
gawking in the hole, get back away from the hole, and at the
last minute, I grabbed a city official who was standing by the
hole by the back of his shirt and pulled him back, and said,
``I said get out of the way.'' At that point in time, the
ground caved in out from underneath his feet; however, he did
not fall into the hole due to my pulling him back. Had he
fallen into that hole, it would have killed him instantly.
While that is scary, it is not the worst of the day. The
reason that the emergency vehicles and the fire department were
there quickly became aware to me when I looked at the
surroundings. We were in a playground, and two small children
were playing on a swing set 100 feet away from us. It would
have been a very bad day if one of those children had fallen
into that hole. If you fell into that particular sinkhole, your
next stop would be the grinder pumps at the treatment plant.
This entire line has now been replaced, largely due to
municipal bonds. Are bonds important to our infrastructure
needs? Yes. It is probably the single most important funding
source that we have, bar none, across the Nation.
Gentlemen, clean water is to me more important than oil.
Without clean water to drink, you won't live more than a week.
We need your help and you need to help take control of this
bond market and the infrastructure across this country and help
be responsible for it. I personally believe that you alone,
with me working in this industry, we are the gatekeepers of our
infrastructure system, and it is the greatest asset that the
United States has.
Thank you for letting me testify today. I will be happy to
answer any questions.
[The prepared statement of Mr. Dillon can be found on page
98 of the appendix.]
The Chairman. Thank you, Mr. Dillon. That's precisely why I
consulted with Mr. Overstar, who is our chief infrastructure
chairman, and why he recommended you. I should note that I
believe we will be joined on this committee within a few days
by the new Member of Congress from Indianapolis, Andre Carson,
who is succeeding his grandmother, and we look forward--
although we regret the circumstances of having him.
I want to note that Deputy Treasurer Paul Rosenstiel has
replaced Treasurer Lockyer on the panel. And I want to move
quickly here. But let me just ask--a number of things that we
have talked about, merging the dual risk, some other things
that are clear--I have been struck--a number of witnesses have
mentioned, Mike--Massachusetts, Mr. Lynch--Federal Home Loan
Bank. We will be looking at all those things. What about the
question of a Federal re-insurance for particularly general
obligation, full faith and credit municipal bonds? Any comment
on that? Let's start with you, Mr. Rosensteil.
Mr. Rosenstiel. Well, I think that is the kind of thing
that can give investors confidence. With the dual rating
structure, unfortunately investors don't think that our ratings
are as strong as we think the risk of State general obligation
and other general obligation and strong revenue bond issues is.
So I think the Federal Government stepping up and saying, you
know, ``This is not risky,'' that's a good idea.
The Chairman. Ms. Wiessmann?
Ms. Wiessmann. I think if the Federal Government steps up
to provide assurance in the marketplace, it is a good thing;
however, actually administering it, there are differences among
credits introduced in the marketplace. And actually managing
and administrating the implementation of that, I think, will be
a challenge.
The Chairman. Are there real differences among full faith
and credit general obligation funds, do you believe? Or should
there be?
Ms. Wiessmann. Credit and markets are continually dynamic.
They change all of the time. It's based on facts and
circumstances at the time. So at different points in times,
yes, there are differences among them.
The Chairman. Among full faith and credit general
obligation? We have the record that none have defaulted, you
know, since 1970. So what are the differences?
Ms. Wiessmann. There are varying degrees of strength. I'm
not disagreeing with the point that they're very, very strong
and very secure. But they are because they have certain
operating requirements, reporting requirements. They have
accounting requirements. And to make sure that the incentive is
still in place for them to achieve good credit ratings and to
not have issues requires some administrative--
The Chairman. Well--the Federal Government could make some
things conditional. But--it's sort of circular. If they don't
have a good credit rating because credit rating agencies don't
give them good credit and because markets undervalue--solidity.
Mr. Reeves?
Mr. Reeves. Thank you, Mr. Chairman. I think that I agree
in general terms with Treasurer Wiessmann. The reality is that
in the municipal marketplace, relative risk is always going to
be important, and it's going to be important either relative to
the way in which rating agencies rate securities, or it's going
to be important relative to the buyers who are actually buying
those securities--
The Chairman. But we are talking about full faith and
credit general obligation bonds. Are there real differences and
risks?
Mr. Reeves. Absolutely. There are real differences in risk.
I mean if you look at the general obligation of the State of
Pennsylvania, which has a very diversified economic situation
within the State or my State and the State of Mississippi
relative to the general obligation of a smaller entity that may
not have the sort of diversified situations. Now, in terms of--
The Chairman. Which has never defaulted.
Mr. Reeves. The default risk is one component of the
overall risk structure--
The Chairman. Well, but that's so fulfilling. Yes, if you
leave it entirely to a market which undervalues the--and to a
credit rating agency with a dual structure, then those
differences are built in. The question is, what would happen if
the Federal Government stepped in and said, ``You know, with
regard to these, there has been a default. We don't think that
the way the rating agencies have treated them reflects
reality.''
Mr. Reeves. Well, I agree that the way in which rating
agencies have treated municipal issuers has not reflected
reality because when I say ``relative risk,'' I think relative
risk means not only amongst general obligation credits of
larger entities and smaller entities. Relative risk also
includes that of the corporate marketplace as well. And that's
where the real distinction has been in the past, in my opinion.
The Chairman. By the way, the record does not show that the
size of the State makes any difference whatsoever. There is
simply no difference with regard to defaults with regard to
State, because they don't default.
Mr. Reeves. I would agree with that, Mr. Chairman, but I
would like to just note that when you talk about the entire
municipal marketplace, you're not just talking about--
The Chairman. I said, Mr. Reeves, full faith and credit
general obligation. I understand that. But that's exactly yes,
there are some differentiations there. But even there, though,
the market--the market undervalues all of this, but in
different levels.
The gentleman from Pennsylvania?
Mr. Kanjorski. Thank you very much, Mr. Chairman. As I
understand it, the question in the municipal bond market is not
that there aren't funds available the people would like to buy
bonds with; it is the problem of getting to a triple-A rating,
which is required by many of the entities that invest in
municipal bonds. So having lost in some instances the value of
the insurance wrap-around, that because the rating agencies
were able to sell their wrap-around, triple-A rating to the
particular municipal bond issuer, these qualified across the
board to all potential buyers. Now that has disappeared, and in
some instances the fiduciary relationship of the pension fund
or whoever buys these bonds is now being forced to divest
themselves of the bonds because they failed to meet the legal
requirement of a the triple-A rating. Is that correct?
We are not talking about having to create an investment
tool process by which the owners or purchasers of these bonds
can continue to exist as they have in the past. And since they
do not know what the rating is, they cannot depend on the
rating right now, and the insurance companies are either
incapable because of their draw-down of equity to issue the
amount of capacity that they had in the past, we no longer have
that clear triple-A rating.
Is that basically--do I have it right or do I have it
wrong?
Ms. Wiessmann. In that segment of the market, yes.
Mr. Kanjorski. Well, so it seems to me that we have about a
$2.6 trillion market. It has probably been working for your
friends and associates in the construction industry and in the
municipalities. It is a question of how do we get back to that
status, so there isn't an interruption, as there has been?
And one of the interruptions would be the insurance
companies. Their equity is being drawn down because they have
wrapped too many high-risk securities that now they have to
come forward and show support for that, and that limits the
amount of equity they have left in their companies to give the
triple-A guarantee to new issues. Is that about the correct
analysis?
Mr. Dillon. But I would like to say, Congressman, there
there has been--construction work is slowing and stopping. It's
being affected immediately right now. And really it just has
happened in our industry in Indiana probably in just the last
three to five--
Mr. Kanjorski. But we could probably cure that if we were
to decide to pass a very limited Federal financing instrument
and say that municipal bonds from this day forward may be
insured by this Federal agency for the next 12 months or until
other insurance in the private market is obtainable for a
reasonable price. And that would then jilt the market right
back to being a very sound triple-A document. Is that correct?
Mr. Dillon. That is my understanding from our local city
engineer.
Mr. Kanjorski. Right. And we should all be in favor of
that, finding a way. So now we are in the darkness, trying to
find the light. The problem that I have is it is quite an
invasion and disruption of the private market. The question
that I pose to you, and perhaps the treasurer from
Pennsylvania: At what point should we worry about invading the
private market? Is it so pervasive the risk to going on with
municipal bonds and public projects, that we ought to just as a
matter of course in good public policy delve into it to solve
the immediate problem of stimulating the market to begin to
operate?
Ms. Wiessmann. Well, that goes to the heart of my
testimony, which is that I do think these are very unusual
circumstances, and that the increases and the expenses and the
stress that is being created on States and municipalities and
entities is something that needs to be obviated. And I have
called for some intervention, both from a liquidity standpoint,
and if the Federal Government were to see to having some from a
insurance standpoint, if the Federal Government found fit to do
that on a temporary basis, I think it would be justified.
Mr. Kanjorski. Well, let me follow that reasoning. It would
take us a considerable length of time to establish a new
municipal bond government guarantee corporation. From my
experience standing here, we are probably talking years,
unfortunately. So that is one of the reasons I came up with the
argument and the idea a number of months ago to use the Federal
Home Loan Banks. If we authorize the issuance of letters of
credit to operate as an insurer of municipal bonds, that could
be implemented almost immediately. We have it all
collateralized, and available in all 12 Federal Home Loan Banks
across the country, and they could be operable almost
immediately, or certainly within 30 days.
Ms. Wiessmann. I think you have three State treasurers here
on the panel, who have all concurred that would be a very good
idea.
Mr. Kanjorski. So we ought to urge our fellow members on
the Ways and Means Committee to move as quickly as possible on
that piece of legislation as a surgical procedure to at least
restart the municipal bond operation to move projects along in
the country, is that correct?
Ms. Wiessmann. In my opinion, yes.
Mr. Kanjorski. Right.
The Chairman. Thank you. Next? The gentleman from
Massachusetts.
Mr. Capuano. Thank you, Mr. Chairman.
I'd like to ask each member of the panel--I notice that
several of you work with treasuries in one hospital and one
independent. I just want to make it clear in my own mind. Are
you all currently, or any of you not currently issuing bonds on
a regular basis, either for the State, or on behalf of cities
and towns, or on behalf of the hospital? Are you not in the
bond market? Oh, you--I'm presuming you are in the bond market.
Mr. Rosenstiel. We are in the bond market today, selling a
billion dollars of revenue bonds because of the fact that they
are not working--
Mr. Capuano. That's--I just want to know if you were in the
market.
Mr. Rosenstiel. Yes.
Ms. Wiessmann. The Commonwealth of Pennsylvania has issued
bonds very recently.
Mr. Capuano. And I assume that you don't issue bonds
directly, you just benefit from them when you can?
Ms. Wiessmann. Correct.
Mr. Capuano. So then it's fair for me to believe that I
have to be a little wary of everything you say, because if
you're in the market, you really don't want to get the credit
rating agencies upset with your State. You really don't want to
get the bond insurers upset with your State. And I don't blame
you. I was hostage for 9 years, I had to very nice and very
professional, so I'd have to tell you that I feel sorry for you
and I look forward to the day that you are released from your
hostage situation, and then can speak freely.
In the meantime, I would like to know, if you can tell me,
if you feel--again, I would never ask you to hurt your State or
municipality, so if you have to couch them or just want to
skip, go right ahead. Does anybody think that the dual-rating
system is good or fair? Does anybody think that the similar
treatment that's required by the SEC or the dual-rating system,
is fair?
Ms. Wiessmann. I made in my comments, I commented that the
origination of the ratings, which of course have a long history
at this point up until now have withstood the test of time. But
our markets have become much more complicated, and when times
call for it, changes should be made.
Mr. Capuano. That strikes me as a very nice and
professional way to say they're not fair, and you know--
[Laughter]
Ms. Wiessmann. Well, I like to approach things
constructively.
Mr. Capuano. That's fair. I can't tell you how good it is
to have some freedom. Believe me, when you get it, it's great.
[Laughter]
Mr. Capuano. I'm just curious. I know you each come from
different States. I assume the three of you can answer; I'm not
sure if the other two can. If you can, I'd appreciate it. Do
your States back up municipal bonds? I know in Massachusetts if
a city or town has trouble, the State will take it from Local
8. And they come in right away and we have had cities go
bankrupt, and not a single bondholder has missed a beat. I'm
just curious, is that true in each of your States?
Mr. Rosenstiel. There is nothing legislatively that
requires it, but in fact when there have been problems, there
has been a history of the State stepping in to--
Mr. Capuano. So there's a history, a recent history of that
happening?
Mr. Rosenstiel. Yes.
Ms. Wiessmann. In Pennsylvania, it also is done on a case-
by-case basis. It's not legislated, but there is often a
considered moral obligation.
Mr. Reeves. We have a specific conduit issuer in
Mississippi, which by the way was very useful in the immediate
aftermath of Katrina. But we do have a specific conduit issuer
that on certain issues when requested does all for the moral
obligation of the State. I will tell you just for the record
that along with that moral obligation comes additional
responsibility by the issuers to satisfy the members of the
board that sits on that conduit issuer, including myself. Yes,
we do have a conduit issuer.
Mr. Capuano. Good. And can you answer me relative to
Illinois? Do you know?
Mr. Newton. I can answer relative to my institution.
Mr. Capuano. Okay. That's fair. What is the answer for your
institution?
Mr. Newton. We're totally dependent on ourselves and our
own performance.
Mr. Capuano. Okay. And do you know--again I don't expect
you to know, but I figured you might--
Mr. Dillon. No, I don't. I don't.
Mr. Capuano. Okay.
Mr. Dillon. If you want to know how to put pipe in the
ground, I'm your guy.
[Laughter]
Mr. Capuano. We're doing that right now in my city. As we
had a brief discussion, my city is currently in the middle of
doing a major sewer project that has been put off for 20 years,
and had I been able to save all the money I had to waste on
bond insurance, I could have done it years ago, and a lot of
people's homes and businesses would not have flooded.
In that case, I appreciate you being here. I don't have any
real questions for you. I can only tell you that if you have
heard us say anything here that you think has been wrong, then
I would suggest if you haven't, then talk to your local cities
and towns, your mayors, and in particular your county
commissioners. Whomever issues the bonds, in particular, GO's
and revenue bonds, and see if they think it's wrong. And again,
when the time comes when you are no longer in the market, I'd
love to have a further discussion with you to see what your
personal experience has been. In the meantime, I would like to
say to the credit rating agencies and the bond insurers in the
market in the room tonight, this afternoon, please don't hold
against them what I have said.
The Chairman. The gentleman--I was sorry but not surprised
to hear your report that this has already begun to affect a
slowdown. Anything that your association wanted to send to us
along those lines, we would be glad to put in the record,
because I think it is important to show that, as I said, we're
not talking about some narrow technical matter, but some real
problems that will slow down the rate of needed physical
improvements.
The gentleman from Texas? Oh, I'm sorry, the gentleman from
Connecticut.
Mr. Shays. Yes. Thank you, Mr. Green, as well. Just on
behalf of Ranking Member Spencer Bachus, I'd like to enter into
the record a letter that Mr. Bachus sent to Securities and
Exchange Commission Chairman Christopher Cox on January 23,
2007, not 2008, more than 14 months ago, long before the issues
in the municipal securities market that we have been discussing
here today. The letter states concerns that Mr. Bachus had
about the oversight of the municipal securities market and the
situation particularly in Jefferson County, Alabama. So if I
could submit--
The Chairman. Without objection, that will be part of the
record.
Mr. Shays. Thank you.
The Chairman. And the gentleman from Texas is recognized.
Mr. Green. Thank you, Mr. Chairman. And I thank the members
of the panel for appearing. It appears to me that we are
talking to a great extent about the monoline market. Is there
anyone who is of the opinion that this market should be
regulated at the Federal level? Or if you're at liberty to say,
and perhaps I should start with Mr. Newton. Mr. Newton, should
this market be regulated?
Mr. Newton. I don't know if I can give you a specific
direct opinion on regulating the monolines. What I can share
with you is that what really precipitated this was the failure
in the auction market. And to the extent that there is
oversight of the auction market, and to the extent that we can
have available to us other options for credit enhancement, that
would be a wonderful thing.
Mr. Green. The failure in the auction market is due in
great part to the way the mono insurers conducted themselves,
is that correct?
Mr. Newton. That's my understanding. Correct.
Mr. Green. So regulating that market would mean that we
would again get back to the monoline market. I don't know how
we get away from that. Maybe you can help me to understand how
we get away from it.
Mr. Newton. Well, what really makes health care work is
having this predictability and capacity of capital. And when we
run up against things that frankly--I, like you, don't
understand all of the arcane science of how these markets may
choose to work, what I would be greatly in favor of is if
transparency and visibility and greater understanding of the
kind of debt instruments that are involved, that would be very
helpful, if that helps clear the market.
But what we're facing is a bolus in the market of this
refinancing, and that to me on a looking forward basis is
really my greater concern. The past is past. I mean I can't
really give some more in-depth conversation about how it really
got this way.
Mr. Green. Well, Mr. Dillon, do you have a comment on it,
please?
Mr. Dillon. No. I really can't advise you on that.
Mr. Green. Do you think that we should, the feds should
regulate the monoline market in any way?
The Chairman. Well, let me just say in fairness to the
witness, he was invited here to give his information about what
the impact of this crisis has been on the industry he
represents. He was not asked to be prepared on the--
Mr. Green. Thank you, Mr. Chairman. I appreciate it. Well,
let me ask this question. Would regulation--and if this is the
wrong panel to ask a question of, my apologies again--but would
regulation have been of benefit, any kind of regulation in the
monoline market have been of benefit to us in terms of
preventing the failures that we're talking about?
Ms. Wiessmann. I would just suggest that the insurance
companies would respond today that they are regulated; they
just happen to be regulated by different States. And one thing
that I have been struck with about this is how different the
different insurance companies are. So I do think it would be
beneficial for there to be some uniformity of standards as it
relates to the marketplace that they're operating in, so that
there is a greater understanding of how they are conducting or
managing their risk relative to this very important market
sector.
Mr. Green. Thank you, Mr. Chairman. I'll yield back.
The Chairman. The gentleman from Missouri.
Mr. Cleaver. Mr. Chairman, I have one question--I'm anxious
for the next panel--uniform standard. I mean insurance
companies, Ms. Wiessmann, you said would argue that they are
regulated--if there is a regulation supposed to be at the State
level. And so I guess I'd like to know if you know of any kind
of regulatory control over an insurance company that has
addressed any of the issues that we're raising today? The dual
standards, student loans. I don't know if Mr. Dillon talked
about the problems with student loans.
Ms. Wiessmann. Well, I think there are a number of factors,
here. The dual standards I think are generally referring to the
rating agencies in terms of all of that.
Mr. Cleaver. Yes.
Ms. Wiessmann. It is a complex mix. It's an interplay of a
number of different factors. When I said that I thought that it
would be useful to have some uniform standards, if there are
particular criteria that Congress or other interested parties
think need to be put into consideration when insuring municipal
bonds, I think you could develop those. So I think there is
something that you can do. I think we do have to do it, to say
wholesale regulation is--I'm not really in a position from a
jurisdictional standpoint to argue that. But I certainly think
that there's a lot to be done to improve the information we
have as well as knowing how the risk is allocated.
So--
Mr. Reeves. I'd like to just touch on that. The regulation
of the insurance industry has been an issue handled by the
States for a long period of time as to whether or not that's
the right approach or not that's not something I should
necessarily comment on, because again, as the treasurer said,
it's not under my jurisdiction.
But what I would like to say, and I think this is extremely
important, is that the fact that the insurers have had the
complications that they've had, and that they've lost their
credit ratings really speaks to--as it relates to the
challenges that we face today, speaks to a larger issue, and
that is the lack of liquidity in the market. The real
challenges that we have in the auction rate securities market
is due to lack of liquidity. The reason that the insurers
losing their triple-A ratings, at one reason, has really
exacerbated the problem is because of the Rule 2a-7
requirements. Okay? So in essence, when the insurers lost their
triple-A ratings, many of these securities were no longer
eligible under Rule 2a-7. The chairman earlier mentioned his
sensitivity to the private marketplace. My opinion is that the
least invasive solution in the short run is actually a relaxing
of the 2a-7 requirements for municipal bonds. Because the
reality is it makes no sense that a 2a-7 fund can purchase a
double-A corporate and not a single-A muni, when in fact the
reality is and the facts show that that single-A muni has less
of a default risk than the double-A corporate. So in my view,
the least invasive solution in the short run is that relaxation
and as the chairman mentioned earlier, secondarily, an
additional possibility which again requires legislation, which
takes time, is the allowance of the Home Loan Bank to offer
letters of credit again, which would infuse liquidity.
Mr. Cleaver. Thank you, Mr. Chairman.
The Chairman. Again, what we stress is the case where the
low rating of the insurance drags down the entity it is
insuring. This is the lead life preserver. You would be better
off without the life preserver and floating on your own.
The gentleman from Colorado?
Mr. Perlmutter. Thanks, Mr. Chairman. And I guess, I have
so many questions, I don't know where to begin but just basic
question to the treasurers: Why do you have to go through
Moody's if you are California or you are Pennsylvania or
Mississippi, why cannot you just go straight to somebody who
buys bonds and not have to go through any of this stuff?
Mr. Reeves. Well, one of the main reasons is that among the
biggest buyers of municipal bonds are mutual funds, and they
require the ratings. That is in their bylaws for each of their
funds, that there have to be generally two ratings.
Mr. Perlmutter. Okay, so the mutual fund before it buys
says we have to have something from Moody's?
Mr. Reeves. That's correct.
Mr. Perlmutter. Or we have to have insurance?
Mr. Reeves. We have to have certain rating levels from
usually at least two rating agencies.
Mr. Perlmutter. Is there anything in the law that says that
they have to have that?
Mr. Reeves. I don't believe so, but I am not an expert on
their law.
Mr. Perlmutter. So if you went to a mutual fund, and I have
represented for instance Pennsylvania Higher Education
Authority, which apparently is struggling to make some loans
because it cannot borrow any money or sell bonds, but your
Pennsylvania Higher Education Authority. And you say, ``But we
are a good credit risk, and we can put on the dog and pony show
to any bond buyer out there and prove to you that we are worth
5 percent interest, and that is a good risk for us. Why don't
you do that?'' They just say, ``Sorry, you have to go through
Moody's,'' or some other?
Mr. Reeves. There is that and there are other buyers who
buy the bonds and then turn them into variable rate bonds and
2a-7 requires the ratings and just in general I think
investors, individual investors, get a sense of security. The
ratings have provided an important function in our market.
Mr. Perlmutter. But, Mr. Treasurer, listening to Mr.
Lockyer, I am going wait a second, California has issued $9
billion worth of whatever, it has paid $100 million to
insurance companies and to the credit rating agencies, you
could have taken that $100 million and gone to Leonard
Perlmutter and say, ``Hey, we are good credit risk, will you
buy $100,000 worth of our bonds?'' Why do you not do that?
Ms. Wiessmann. The short answer is that you rely on the
negotiation of the credit markets, which are far larger than
anything a State or a particular entity could access. When you
talk about Pennsylvania student loans, there are securities on
loans of $7 billion. We would have to find a lot of one-on-one
placement in order to fulfill that type of liquidity
requirement, which it brings us back to the point that it
really does--rating agencies have provided an objective, a
perceived objective standardization in the marketplace, just as
the insurers have been up to this point have been perceived as
creating a marketability for these.
The Chairman. Will the gentleman yield?
Mr. Perlmutter. Certainly, yes.
The Chairman. There is nothing objective. I understand that
you were held hostage by this, but I do not understand why you,
the victims, would defend a rating system that has totally
undervalued you, that has cost you a lot of extra money. There
is just no validity to this. They are drawing distinctions
among bonds that never default. So I understand why you are
forced into it, but frankly now some of them come in, I have to
tell you at this point, and I have said it before, the ratings
agencies worth--I have said about editorial writers, they come
down from the hills after the battle is over and shoot the
wounded. So they are never there to help anybody in advance,
but I do not understand how you can talk about them as being
objective.
Ms. Wiessmann. I just want to qualify, number one, I do not
feel held hostage to them at all. I feel quite independent in
fact, but--and I do not think that what I say here today is
going to affect the credit rating of Pennsylvania.
The Chairman. But I am saying this, as the gentleman from
Colorado said, we have bonds that never default and you were
all held hostage, what you are saying is if you did not go and
subject yourself to the rating agencies and to this insurance,
which is dragging people down because it is lower rated than
you ought to be, you could not sell.
Ms. Wiessmann. I just want to say I mentioned before that
markets change. The sophistication of buyers, the
sophistication in America in terms of what municipal bonds are
is quite different from when rating agencies were first added.
The Chairman. But now you are worse off, is that what you
mean?
Ms. Wiessmann. And they provided market access.
The Chairman. I'm sorry, I want to get back to the
gentleman from Colorado, but I do not think that is the case
because you are now paying more than you used to, so if they
are more sophisticated, that must mean that you are worse than
you used to be as a credit risk, and I don't think you are. The
fact is if they were so sophisticated, you would not be in the
situation of having rates go up when there is no valid reason
for it.
The gentleman from Colorado?
Mr. Perlmutter. And I will just cut it off at this. I can
understand why the hospital authority or something else needs
to go through a middleman, Moody's or have to have some backup
from an insurance company because the marketplace or the Smith
Barneys or the Goldman Sachs or whoever buys these bonds does
not really understand you, but California, Pennsylvania,
Mississippi, for goodness sakes, it really does not make sense
to me how this process works.
Ms. Wiessmann. Unfortunately, we just respond to the
market. We are trying to change the market. We are trying to
educate people that we are better credits, but we are in the
market today with $1 billion worth of bonds, and we bought bond
insurance on them.
Mr. Capuano. Will the gentleman yield for a second?
Mr. Perlmutter. Certainly.
Mr. Capuano. I appreciate your trying to educate them. Why
would they get educated when they make money by being--well,
uneducated?
Ms. Wiessmann. What I mean is the investors.
Mr. Capuano. Why would the investors do it when they get a
higher rate of return?
Ms. Wiessmann. That is a very good point.
Mr. Capuano. If you are telling me that you are going to
educate me, and when I am educated, I am going to get 5 percent
back on my bond as opposed to 8 percent on my bond, guess what?
I will stay stupid.
[Laughter]
Mr. Capuano. So therefore, how can you educate the people
who are making money on the backs of your taxpayers?
Ms. Wiessmann. You are defining part of our problem, but
there are also a lot of investors, especially we had at other
times in the market, as recently as less than a year ago, many
of our bonds were bought by hedge funds. They put in a great
bid for our bonds. They drove our interest rates down, and the
reason they did that is they then put it into trust and they
sold variable rate bonds. They now have had to unwind those
trusts because of the problems of the bond insurers. That has
been one of the problems.
Mr. Capuano. Because they were bundled with risky bonds.
They were not sold individually.
Ms. Wiessmann. They put into the trust insured bonds, and
when the insurers were downgraded, the bonds--
The Chairman. Right, the insurers downgraded because they
went into other things and not your bonds.
Ms. Wiessmann. Yes, that is exactly right.
The Chairman. We are going to have to break now, but we
have Stockholm Syndrome here, where you start thanking the
kidnapper.
[Laughter]
The Chairman. People need to be much less accommodating
intellectually to a system that has just mistreated you. We
have to go and vote.
Mr. Capuano. Mr. Chairman, just one point?
The Chairman. Yes?
Mr. Capuano. Just one point. I need to remind everybody
that even Patty Hearst said good things about her captors.
The Chairman. Yes, they talk about that. Anyway--
Ms. Wiessmann. We would not be on this panel if we did not
think there should be changes to be made.
The Chairman. I understand, but you have to make the
arguments for the changes, not by defending the objectivity of
the existing system. That is not going to help us. I want to
say to the next panel that we will be back. It may take us
about a half-hour. There are a couple of votes. I apologize but
your testimony will be valuable. Let's take a little break. We
will be back in about 45 minutes. If you can stay, I appreciate
it, and we will get to you.
[Recess]
Mr. Cleaver. [presiding] We apologize for how often we have
to leave, and I wish I could tell you that this was unusual,
but we are going to proceed and Chairman Frank will join us
shortly. We are going to move on with the third panel, and we
will begin to receive your testimony. By the time the chairman
returns, hopefully we by then can become ``dialogical.'' We
will begin with Mr. Jain, Berkshire Hathaway Assurance
Corporation. Thank you for being here.
STATEMENT OF AJIT JAIN, CHAIRMAN, BERKSHIRE HATHAWAY ASSURANCE
CORPORATION
Mr. Jain. Thank you to the members of the committee. It is
my privilege to appear before you today. My name is Ajit Jain,
and I am with Berkshire Hathaway. Recognizing the value of your
time, I will get right to the three issues you have asked me to
address, which are: One, the circumstances that prompted us to
form Berkshire Hathaway Assurance Corporation, a new bond
insurer, and the offer we made earlier this year to protect the
municipal bond portfolios of the insurers. Two, the value of
bond insurance to bond insurers and investors. And, three, what
I think the future looks like for the bond insurance industry.
The first issue then is our decision to enter into the bond
insurance industry. This was prompted by a phone call from the
New York Superintendent of Insurance. I confess that when I was
told that a regulator was calling, I was prepared for a
complaint. Instead, he was calling to discuss a business-like
approach to solving a problem, involving us to create New York-
based insurer. Clearly, flattered by the phone call, we wanted
to reciprocate by helping address a problem of national
importance.
At about the time the superintendent called us, we felt
there was a real possibility that the bond insurance industry
would undergo a structural and permanent shift. For almost 20
years, we have been considering entry into this business. With
our triple A ratings and excess capital position, this segment
was always a natural for us. The attractive macro-features
notwithstanding, when we analyzed the risk/reward
characteristics of a typical transaction, we concluded that the
pricing did not adequately compensate the capital provider for
the risk, especially the tail risk. By ``tail risk'' I mean a
black event defined as a random, difficult to predict event, an
event that may have never happened and therefore is unlikely to
happen. But when it does happen, it has a huge impact.
In about October of 2007, with the advent of the subprime
crisis and the increased awareness of the financial losses it
could bring, we hypothesized that risk in general, and
financial credit risk in particular, would no longer be
underappreciated and underpriced. Pricing going forward would
reflect an expectancy of loss plus a reasonable return to the
risk bearer.
In addition, we believe that the franchises of the existing
industry leaders could be mortally wounded by the subprime and
structured finance exposures. Whether or not these companies
would raise additional capital, we believe there is a good
chance that they could no longer maintain their all important
triple A ratings. If that happened, there would be an opening
for us in the business.
As for our offer to reinsure the municipal bond business of
existing insurers, here again the New York superintendent gets
the credit. He forced us to consider how our capital could be
deployed to help alleviate the increasing pressure on the
existing players and their policyholders. A comprehensive
solution, including the structured finance and the municipal
obligation, was everybody's first priority. However, we could
not untangle the complex financial transactions that made up
the structured finance portfolios. While we continued to feel
that historical pricing on the municipal bond business was
inadequate, we could at least take on that risk with a price
adjustment, which we made in our offer to reinsure the
company's municipal bond business.
I would like to briefly explain why we believe the offer
had the merits from several perspectives. First, from the
municipality's perspective, having a solid, triple A insurer
backing their bonds would almost certainly have avoided the
steep increases in interest cost that we have seen in the
variable and auction rate securities. Similarly, for the bond
investors, our protection may well have avoided the steep price
decreases in the value of the bonds that they witnessed 2 weeks
ago. Furthermore, by releasing capital from the municipal side
of the business, the structured finance policyholders could
have had more capital available to pay for their losses.
Finally, the shareholders of these companies, having shared the
30 year municipal bond obligations, the companies could then
negotiate with their counterparties to terminate their
structured financial obligations and ultimately return capital
to the shareholders. This might have been the best outcome for
the shareholders given where the shares of these companies were
trading then and are trading now. Despite these benefits, also
it was clearly not in the best interest of the management of
these companies, whose interest appeared to have trumped the
combined interest of the investors, issuers, policyholders, and
shareholders.
The second issue I have been asked to address is the
benefit of bond insurance to issuers and investors. On this
point, I can add almost nothing to what has already been
spelled out by so many others. Historically speaking, the cost
of a financial guarantee insurance policy was more than
justified by the reduced interest that the municipalities paid
investors for the funds being borrowed. Speaking historically
once again, the rating enhancements of the insurance was good
for investors because it helped maintain a stable and liquid
market for bonds.
Given where we are today then, I can well understand the
committee's interest in the large issue I am to address, which
is where are we going with all of this? What my answer lacks in
helpfulness, it makes up for in honesty: I do not know. There
is a great deal of uncertainty. For our part, we are tiptoeing
into the water and while we are writing business at pricing
levels that are economically attractive to us, I remain very
concerned about the long-term viability of the business in
general and for us particular.
There are several reasons for my concern: First, as is true
in all insurance, the product that is being sold is nothing
more than a future promise to pay. With recent headlines of
municipalities having to pay as much of 20 percent on auction
rate securities and some insured municipal bonds selling at
higher yields than corresponding uninsured bonds, buyers have
every right to question--
Mr. Cleaver. Mr. Jain, I notice you have a couple more
pages, three more pages, if you could summarize that for us.
Mr. Jain. Okay.
Mr. Cleaver. And perhaps during the question and answer
period, you will be able to respond to questions on that.
Mr. Jain. Sure. The buyer has every right to question the
value of the bond insurer's promise to pay. This concern about
the integrity of the product is further reinforced by the
``good bank,'' ``bad bank'' talks that are being discussed
these days.
I will end there given that I have run out of time, and I
want to thank you for giving me the chance to address you.
[The prepared statement of Mr. Jain can be found on page
109 of the appendix.]
Mr. Cleaver. Thank you very kindly.
The next witness is Mr. Sean W. McCarthy, president and
chief operating office, Financial Security Assurance, on behalf
of the Association of Financial Guaranty Insurers.
Mr. McCarthy?
STATEMENT OF SEAN W. MCCARTHY, PRESIDENT AND CHIEF OPERATING
OFFICER, FINANCIAL SECURITY ASSURANCE, ON BEHALF OF THE
ASSOCIATION OF FINANCIAL GUARANTY INSURERS
Mr. McCarthy. Mr. Chairman, Ranking Member Bachus, and
other members of the committee, I am Sean McCarthy, chair of
the Association of Financial Guaranty Insurers, AFGI, and the
president and chief operating officer of Financial Security
Assurance Holdings, Ltd., and its monoline, Financial Security
Assurance, FSA.
AFGI is an association of 11 monoline primary insurers and
re-insurers. Established in 1971, the monoline bond insurance
industry has generally been a triple A-rated industry. It was
initially founded to provide bond insurance to the U.S.
municipal bond sector and today serves the municipal public
infrastructure and asset back markets globally. As monolines,
we provide financial guarantees and related products only. We
do not provide other forms of insurance, such as property and
casualty, life, auto, or health insurance products.
It is a highly regulated and transparent industry with few
exceptions. The monolines are required to be licensed in States
and/or countries in which they operate. For example, the
monolines are regulated by the New York State Insurance
Department and in the UK, by the Financial Service Authority.
Of the six companies providing primary guarantees, three are
public companies and three are privately held. All are subject
to or voluntarily provide disclosure, consistent with the 1934
Act reporting requirements. The rating agencies also require
ongoing information.
The industry's practice is to underwrite at least
investment grade risks, meaning investment grade or better,
with low severity of loss when default does occur. In addition
to providing financial guarantees, monolines also provide
surety bonds and credit derivatives, whose terms exactly mirror
a financial guarantee. All of these policies have pay-as-you-go
settlement terms, and there is no requirement to post
collateral if the underlying credit deteriorates, thus
minimizing liquidity risk.
Over the past 5 years, monolines have insured more than $1
trillion of U.S. funds to fund essential public projects,
almost $82 billion of the funds to fund infrastructure outside
of the United States, and more than $1 trillion of asset-backed
bonds globally to lowering funding costs. The issuers do not
pay more for bond insurance. The premium paid for the guarantee
allows them to lower their overall cost of funding.
Additionally, bond insurance provides for a larger, broader
public finance market because it increases investors' capacity
for individual credits.
For investors, bond insurance provides protection against
default of principal and interest, built in analysis,
surveillance and remediation so that problems can be worked out
before a default. Bond insurers do not guarantee market value.
As a result of conservative underwriting, the industry has up
until now had a low loss record of three basis points on net
debt service. This contrasts with the banking industry's
weighted average annual charge-offs on principal of 60 basis
points from 1992 to 2006.
What has happened lately? The crisis originates from a
specific type of security: collateral debt obligations of
asset-backed securities, referred to as CDOs of ABS, or another
form, CDOs of CDOs. These contain large amounts of U.S.
subprime residential mortgages in concentrated forms. While
home equity lines of credits, securities called HELOCS, and
subprime mortgages may also generate claims for the financial
guarantors, they will not be of the magnitude to imperil the
company's credit ratings. Thus, some companies made a mistake
in a single asset type class. This does not represent a
systemic failure nor does the industry request a Federal
bailout. Going forward, industry members who have been degraded
will do whatever possible to get back to a triple A level. We
also expect the rating agencies to recalibrate their models
with more conservative assumptions on all forms of asset-backed
transactions, including the oversight of the monolines. The
monolines will respond accordingly.
Even if a bond insurer goes into run-off, it can renew its
capital reserves through investment income and freeing up of
reserves if the bonds it has insured mature or are called.
AFGI, as an association, does not take a point of view on how
monolines are structured. I will say from the perspective of my
company, FSA, it does not make sense to require companies to
split into municipal and structured finance units, as the model
works appropriately now if correctly applied with conservative
underwriting.
I would also like to add a perspective on the causes of the
recent option rate failures, which, while due in part to credit
concerns about the bond insurance industry for sure, were also
driven by dealers backing away from an implied obligation to
provide liquidity and to credit liquidity concerns in general.
In most cases, bond insurers will work--we certainly are
working with issuers to convert auction rate to either fixed or
variable rate bonds.
One further point: We believe that unrealized marks that
insurers are required to take through the income statement on
insurance policies issued in a credit default swap form under
US GAAP are obscuring the true performance of the industry.
Absent any claims under the guarantee and given the insurer's
intent to hold these contracts until maturity, decreases or
increases to income due to the marks will sum to zero by the
time each contract has matured, eliminating any economic
impact. These contracts are functionally identical to the
financial guarantee policy and are not inherently more risky.
Therefore, we can submit the fact that CDOs of ABS were insured
in the credit default swap form have nothing to do with the
economic loss that will be taken on these structures, it is the
assets underneath them.
I thank you for taking the time to listen to me, and I
would be happy to answer any questions.
[The prepared statement of Mr. McCarthy can be found on
page 140 of the appendix.]
Mr. Cleaver. Thank you very much, Mr. McCarthy.
We will move now to Ms. Laura Levenstein, the senior
managing director of Global Public, Project & Infrastructure
Finance Group, Moody's Investors Services. Thank you very much
for being here.
STATEMENT OF LAURA LEVENSTEIN, SENIOR MANAGING DIRECTOR, GLOBAL
PUBLIC, PROJECT AND INFRASTRUCTURE FINANCE GROUP, MOODY'S
INVESTORS SERVICE
Ms. Levenstein. Thank you. Good afternoon, Chairman Frank,
and members of the committee. I am pleased to be here on behalf
of my colleagues at Moody's Investor Service to discuss our
rating system for municipal bonds and how that system is
designed to address the attributes of the municipal market. I
will also describe some of the more recent changes we have made
to our municipal rating system as a result of our ongoing
dialogue with issuers, investors, and other market
participants. I should note that more than 35 percent of the
municipal bond issuances are not rated by Moody's or any other
credit rating agency. Therefore, the information contained in
my testimony is based on the securities that Moody's has rated
in the municipal market and our comments should not be
construed as being applicable to the entire universe of
municipal issuance.
Moody's first began rating municipal securities in 1918.
Today, our U.S. municipal rating system is used for rating
securities issued in the U.S. tax-exempt and taxable bond
markets by State and local governments, nonprofit
organizations, and related entities. This system is different
from our global rating system, which is used for rating issuers
and issuances of non-financial and financial institutions,
sovereigns and sub-sovereign issuers outside of the United
States as well as for structured finance obligations.
Our municipal rating system grew out of and reflects the
unique dynamics and needs of the municipal bond market and its
participants. There are two aspects of the municipal bond
market that have historically been particularly important.
First, while it should be noted that the loss experienced from
non-rated municipal issuers has been higher than that for the
rated universe, municipal securities rated by Moody's have had
relatively low credit risk when compared to rated corporate or
structured finance obligations. This low credit risk is
primarily the result of the special powers and the role of
municipalities as public entities. These include their ability
to levy taxes and the likelihood that in the event of financial
distress, municipalities or other public entities will receive
support from a third party, such as a State government. Because
of these and other factors, the municipal market has had
limited default and loss experience and our municipal rating
system reflects that reality.
Second, investors in municipal securities have
traditionally had different perspectives and risk advertised in
corporate bond investors. Municipal investors generally have
been more risk averse and less diversified in their investment
portfolios. They typically have been more concerned about the
liquidity of their investments and, in the case of individuals,
more dependent on debt service payments for income. They have
typically been highly intolerant of seeing their investment
portfolios experience diminished value or reduced liquidity,
which can occur as a result of an issuer's financial distress,
even if the bonds do not ultimately default.
In response to these market characteristics, are municipal
ratings more finely distinguished among municipal securities
than do our corporate ratings? Because the risk and potential
severity of loss is low, our ratings focus primarily on the
risk that an issuer will face financial distress. This can
result in delayed payments and reduced liquidity.
If municipal bonds were rated on a global rating system,
the majority of the ratings would fall between just two
categories: triple A and double A. This would eliminate one of
the primary values municipal investors have historically sought
from our ratings, namely, the ability to differentiate the
relative credit risk among various municipal securities. We
have been told by many investors that not providing that
differentiation would make the market less transparent, more
opaque, and presumably less efficient for both investors and
issuers.
Nonetheless, Moody's recognizes that the municipal bond
market has evolved in recent years, and we have taken steps to
respond to the changing needs of investors and issuers. For
example, in 2002, to accommodate the trend we saw of some
taxable bonds being placed outside the United States, we began
offering entities issuing such securities the opportunity to
request a global rating. We also began providing broad guidance
on how our municipal ratings would translate into global
ratings. In 2006, we conducted extensive surveys of market
participants. As a result of that feedback, in 2007, we
announced that when requested by issuers, we would assign a
global rating to any of their taxable securities regardless of
whether issued within or outside the United States. We also
published a conversion chart that allows the market to estimate
a global rating from a municipal rating.
Finally, since our last formal outreach to market
participants in 2006, we believe that the market has continued
to evolve. As a result, we plan to assign global ratings at an
issuer's request to any tax-exempt bond, including previously
issued securities, as well as new issues beginning in May 2008.
We are also re-evaluating the overall market use and
understanding of our municipal ratings and will be issuing a
request for comment this month.
Moody's has always maintained an active dialogue with
investors and issuers to understand what would help make our
municipal rating system most useful, and we welcome additional
market feedback on measures that would improve the overall
transparency and value of our rating systems.
Thank you.
[The prepared statement of Ms. Levenstein can be found on
page 115 of the appendix.]
STATEMENT OF MARTIN VOGTSBERGER, MANAGING DIRECTOR AND HEAD OF
INSTITUTIONAL BROKERAGE, FIFTH THIRD SECURITIES, INC., ON
BEHALF OF THE REGIONAL BOND DEALERS ASSOCIATION
Mr. Vogtsberger. Good afternoon, Chairman Frank, and
members of the committee. Thank you for the opportunity to be
here today. State and local governments depend on a smoothly
functioning municipal market to finance schools, roads,
hospitals, water and sewer systems, and other vital
infrastructure. This is a timely and important hearing, and I
commend you for your attention to these issues.
My name is Martin Vogtsberger. I am a managing director and
head of institutional brokerage at Fifth Third Securities, a
regional broker-dealer, which underwrites fixed rate municipal
bonds and variable rate demand obligations. Like most regional
broker-dealers, we have not been active in the auction rates
securities market. But I am here today representing the
Regional Bond Dealers Association, of which my firm is a
member. The Regional Bond Dealers Association is a new
association that represents securities firms active in the
municipal bond markets. Many of our members, including my own
firm, are active in the municipal market.
One of the things that makes the municipal market unique is
that it is dominated by many thousands of State and local
entities that issue bonds in relative size issue sizes. In many
cases, these small issuers do not attract the attention of
large global securities firms, so the municipal market depends
on the participation of regional firms to function smoothly.
The disruptions we have recently seen in the municipal
market are the result of a perfect storm of negative events
starting last summer. Sparked by the deterioration in
residential real estate and especially subprime mortgages,
credit markets began to freeze up. Investors retreated from the
credit markets, liquidity dried up, and prices fell. While
municipals were not as affected as other asset classes at the
time, they were not spared. Hedge funds and arbitrage funds,
who have become increasingly active participants in the
municipal market, faced margin calls and began selling assets.
Finally, it became clear that some of the bond insurers who
provide credit enhancement to more than half of the outstanding
municipal bonds were suffering from their exposure to subprime
mortgages, structured credit products and other assets, but
notably not from their municipal bond exposure. These events
together caused stress on the municipal bond market similar to
what other sectors of the credit market experienced last year.
The disruption was felt most in markets for products that are
designed to mimic money market instruments, including auction
rate securities and to a lesser extent, variable rate demand
obligations and tender option bonds.
The most frustrating aspect of the current market
disruption is that it is occurring despite the fact that the
underlying fundamental credit quality of State and local
governments has not eroded over the last several months. To be
sure, the credit ratings of many thousands of bond issues have
been lowered, but that occurred not because of weakening
financial positions of States or localities but because of
downgrades of some of the monolined insurers.
State and local governments have suffered in several ways
as a result of the current market stress. First, some of the
auction rate securities are now paying owners penalty rates on
auction rate securities whose options have failed. Often, these
penalty rates are well above market rates. Many issuers are
trying to refinance out of auction rate securities into more
economical forms of financing. In some cases, however, this is
difficult because of lack of asset to credit enhancement. In
addition, issuers who have come to market with traditional,
long-term, fixed rate bonds have had to pay higher financing
costs than they otherwise would have because of lack of credit
enhancement and a general loss of market liquidity.
One question that has received significant attention in the
context of the current market disruption is the rating scale
used by bond rating agencies from municipal bonds, which
differs significantly from the scale used by other debt
securities. The separating scale of municipal bonds cost State
and local governments money when they issue bonds, either
because they have to issue bonds at a lower rating or because
they have to buy bond insurance to issue at a higher rating. A
strong argument can be made for encouraging rating agencies to
rate municipal bonds on the same scale as other debt
securities.
Although important segments of the municipal market have
experienced significant stress in the last several months, the
core of the market has remained relatively strong. Issuers of
traditional, long-term, fixed rate securities have still been
able to access the market to finance new public investment.
This is attributed to the strength of municipal bonds as an
asset class and is hopefully a sign that the market's distress
will not have long-term negative implications for States and
localities.
Thank you again, Chairman Frank, for the opportunity to be
here. I look forward to your questions.
[The prepared statement of Mr. Vogtsberger can be found on
page 210 of the appendix.]
The Chairman. Thank you. I apologize for being a little
late, but again this is very important, and I appreciate all of
you staying here. Let me start with Mr. Jain. And you
reiterate, and we appreciate, we had a chance to talk with Mr.
Buffer, and we appreciate your being here, you reiterate that
you still think that going into the municipal only insurance
business would be a very good deal?
Mr. Jain. At current pricing levels, we certainly feel
there is an attractive opportunity for us.
The Chairman. Meaning that you could get--there would be a
very low default rate, so a fairly low premium structure and
you could make some money?
Mr. Jain. That is correct.
The Chairman. Well, of course, we are also thinking one
possibility of course--well, I guess two things. There is a
question about whether, and I apologize, I just tried to read
your statement, you have made that offer but no one has taken
you up on it, is that right?
Mr. Jain. On the re-insurance for the existing municipal
bond--
The Chairman. Have you thought about just going to that
business and saying to the municipal issuers, ``Here we are,
come and be insured?''
Mr. Jain. We are doing that as we speak. Over the last 2
months now, we have insured about four billion-plus of
secondary market transactions and have written premiums.
The Chairman. What about primary, have you thought about
doing it for the primary?
Mr. Jain. Absolutely. We are in the process of trying to
get ready, but you need a license in each and every State
before you can write a primary transaction.
The Chairman. Unless the Federal Government were to pass a
statute that licensed this. I can't think of any obstacle to
our doing that constitutionally. It could be a specific
license. The Federal Government could license you to do that
for municipalities only, you know, for municipal bonds. If the
Federal Government were to pass such a license, would that
facilitate your efforts?
Mr. Jain. We are, since we made our application to the
NAIC, through the NAIC to the individual States, we now have 31
licenses already.
The Chairman. All right. I'll tell you how to get 19
licenses in a hurry. We'll file a bill for a Federal license.
You'll get 19 more licenses in about 4 hours.
Mr. Jain. Thank you.
[Laughter]
The Chairman. Now I do want to get to the issue of the
duality. And I understand, Ms. Levenstein, your argument, but
it seems to be somewhat circular. Well, first of all, I was
struck with what Mr. Jain says in his statement. If the rating
agencies had just one rating, there would be little need for a
financial guarantee insurance marketplace because much
municipal debt on a stand-alone basis wouldn't require the
enhancement. So he's arguing against interest, and we
appreciate the honesty of your doing that. But--and then, Mr.
Vogtsberger, as I understand it, you're saying you think
there's a strong argument--let me put it this way. Ms.
Levenstein is, it seems to me, arguing, if I read correctly and
listened to your statement, that the reason for the dual track
is consumer demand; that the people who want to buy municipals
because they are less--they are more risk-averse, they want a
separate rating system. Is that essentially what you are
saying?
Mr. Vogtsberger. Right. I think when you add mutual funds
as proxies to households, roughly 70 percent of the municipal
market--
The Chairman. And they want a separate rating system?
Mr. Vogtsberger. --are households, and they rely on ratings
to--
The Chairman. Well, but, why do they--I understand that.
But that's not the question. Please, let's stipulate. We'll get
to whether or not there should be ratings in entities that
never default. One default that was fully paid off since 1970.
But why two ratings systems? That is, I understand they want
ratings. But why--I mean, what we're being told is this. You
know what? If we rated municipals the way we rated everything
else, they'd always get 100. It would be boring. So, therefore,
it wouldn't be good enough. That's the tail wagging the dog.
That's the cart before the horse. That's all those metaphors. I
mean, our--do investors demand a separate rating system from
municipals because municipals don't fail enough to make the
current--to make it interesting? I mean, let me ask you, Ms.
Levenstein. Do investors in your view demand a separate rating
system?
Mr. Vogtsberger. No. They demand a rating.
The Chairman. All right. Mr. Jain, you say if we had a
separate rating system, it would just show that everybody was
solid. Ms. Levenstein, your argument appears to be that while
you're meeting the needs of investors by a separate rating
system, what's the evidence for that?
Ms. Levenstein. We have been rating based on this scale
since 1920.
The Chairman. No, that's simply that you've been doing it.
But the fact that you've been doing it doesn't mean that
there's an investor demand that you keep doing it. So, what
makes you think--
Ms. Levenstein. But we've queried--we have queried the
market many, many times, and the--
The Chairman. In what sense? You've done a survey? Have
you--
Ms. Levenstein. We've reached out and had one-on-one
meetings. We've had briefings. We've done publications. We've--
The Chairman. And they have told you that they insist on a
separate rating system, even though they know that there's no
default?
Ms. Levenstein. Yes.
The Chairman. All right, I'm going to tell you, I'm
skeptical. Sometimes--I'm sure you're being honest with the
results, but I don't know how these things are done. I mean,
let me put it this way. You say, well, in general, you talk
about likeliness of default, but you're saying that when people
buy municipal bonds, they're not interested in likelihood of
default. They're interested in financial stress on the entity,
even though your own evidence is that financial stress on the
entity appears to be unrelated in any statistically significant
way to default. I mean, is that a rational basis for the market
to do this?
Now, I do understand the argument that, well, no, but
they're not as tradable. Right. They're not as tradable because
of your rating system. It seems to me that's very circular. So
why would people wanting to buy bonds not be influenced by
whether or not they were going to default? And why is that
relevant for corporate and not for municipal?
Ms. Levenstein. Well, I think they are influenced by that.
But ratings have multiple attributes. Ratings don't measure one
aspect or one metric. Ratings are meant to provide relative
rankings as well as--
The Chairman. Well, but relative rankings, one in ten
million versus one in a million? Relative rankings of what?
Ms. Levenstein. Relative ratings of likelihood of default.
The Chairman. Okay. And what is the likelihood--so, why
don't you then put municipals in with everybody else and let
them take the relative ranking of likelihood of default? Why
can't you rate municipals like everybody else on the relative
likelihood of default?
Ms. Levenstein. Well, on a forward basis, as I've stated in
the testimony, we are going to do that. We are going to offer
at the issuer's request to rate both--
The Chairman. I'm sorry. I didn't realize. So from now on,
if an issuer wants to be rated the same was a corporate--
Ms. Levenstein. That's correct.
The Chairman. So the investor demand apparently--
Ms. Levenstein. --of this year.
The Chairman. --wasn't so strong after all?
Ms. Levenstein. I'm sorry. Excuse me?
The Chairman. Do you expect investors now to stop buying
them?
Ms. Levenstein. No, I don't. But I do expect investors to
still want to know what the relative ranking is, as well as the
absolute likelihood of default of default.
The Chairman. Relative ranking of municipals and corporates
together?
Ms. Levenstein. Relative ranking of municipals amongst
municipal securities, and then the likelihood of default across
the whole spectrum.
The Chairman. Well, let me ask you, you are all sort of
market experts. If there is no--do I really care whether it's
one in a million versus 1 in 900,000? I mean, why is that
important information for me to have?
Ms. Levenstein. Because risk premiums are based on relative
rankings, not--
The Chairman. Yes, but, then why--they're not absolute?
They're relative?
Ms. Levenstein. Yes.
The Chairman. Is that rational--I mean, you would pay more
for one in a million than for 1 in 900,000?
Ms. Levenstein. I don't know if those are--
The Chairman. You know, I mean, I've been listening for
years people tell me you politicians, you act emotionally, you
act irrationally. We, the market, are lucid. Based on today,
not so much.
The gentleman from North Carolina.
Mr. Watt. Mr. Jain, you were about to make three points at
the end of your testimony that you didn't get a chance to make.
I'm going to give you the opportunity to make those three
points quickly, if you can do it.
Mr. Jain. The three points I was going to make was in
relation to the outlook of the industry and why I felt the
outlook of the industry was uncertain in general and our role
in particular. And the reasons I have concerns for the outlook
for the industry. Firstly, as we talked about, in insurance,
the product that we are selling is a promise to pay. And buyers
have rightly so have started to question what the value--
Mr. Watt. And when you say industry, are you talking about
the insurance of these bonds, or are you talking about the
bonds themselves?
Mr. Jain. I'm talking about the bond insurance industry.
Mr. Watt. The bond insurance industry, not municipal bonds
in general?
Mr. Jain. No.
Mr. Watt. Okay. So you're talking about the insurance, and
I guess if there weren't two rating systems, a triple A and a
double A, as I understand it, there wouldn't be any insurance
would there?
Mr. Jain. There would be less of a need for bond insurance.
If a number of the--
Mr. Watt. What does that insurance do, other than provide
an absolute guarantee of payment in a market in which there is
a one in one million absolute guarantee of payment anyway?
Mr. Jain. The insurance certainly provides peace of mind to
somebody who cannot really assess what are the true odds of the
loss, to be able to get--
Mr. Watt. But isn't that what the triple A rating, or
that's what the rating would do anyway, isn't it?
Mr. Jain. Right. But--
Mr. Watt. So you are--the insurance adds an extra layer on
top of the rating?
Mr. Jain. Extra layer of protection in the event of
default.
Mr. Watt. But do people understand that there hasn't been
any default anyway?
Mr. Jain. I am not sure--
Mr. Watt. Historically?
Mr. Jain. I am not sure about that. A lot of the product is
sold in the retail market, and I'm not sure if the retail
investors are sophisticated enough to be able to analyze
individual credits. What they do rely upon are the ratings of
the underlying municipality and--
Mr. Watt. That's what Ms. Levenstein does, right?
Mr. Jain. And the bond insurance protection--
Mr. Watt. Which is what you do? So you are--I mean, people
are really paying a premium for both of those things, both of
which do, as I understand it, essentially the same thing.
If you--if you give a triple A rating, Ms. Levenstein,
isn't that a virtual guarantee that there's going to be
payment? Historically, hasn't that been the case?
Ms. Levenstein. Historically, that is the case, but--
Mr. Watt. Okay. All right.
Ms. Levenstein. --I think you could step--
Mr. Watt. And if he gives an insurance premium, then does
that do anything other than charge me an insurance premium to
get the same historical guarantee? But I guess it gives me that
assurance going forward. I'm not relying on history any more.
I'm relying on his policy?
Ms. Levenstein. Can I just provide a little bit of
background that may be helpful?
Mr. Watt. Absolutely.
Ms. Levenstein. I don't think that price or yield is driven
only by the rating. I think it's driven also by the size, name
recognition, amount of disclosure that's available. There are
other factors.
Mr. Watt. Insurance premiums are driven by that, too?
Ms. Levenstein. Insurance premiums. Sean should answer
that.
Mr. Watt. Mr. Jain?
Mr. Jain. The insurance premium is, as far as we are
concerned, is driven first and foremost by what our expectancy
of loss is.
Mr. Watt. Okay. Well, let me ask this question, Mr. Jain.
You say you're getting, if you get these other 20 States or so,
you're going to get into the primary market. Are you going to
require in that primary market, are you going to require
insurance?
Mr. Jain. We are providing the insurance, so, you say will
I require?
Mr. Watt. You'll be playing on both sides, as I understand
it, at that point. You'll be in insurance, and you'll be a
purchaser of the bonds?
Mr. Jain. No. No. We are not talking about us and our role
in terms of purchasing the bonds. We will be the risk bearer
taking on the insurance risk of the default of underlying
bonds.
Mr. Watt. And you will be what else?
Mr. Jain. That's it.
Mr. Watt. Well, what are you now?
Mr. Jain. We are a bond insurer.
Mr. Watt. Okay. And once you get in on the next level after
you get all these licenses, what will you be?
Mr. Jain. We will be a bond insurer.
Mr. McCarthy. I think perhaps the point that he was making
is that right now, Berkshire Hathaway is participating in the
secondary market.
The Chairman. It's secondary and primary. The license is
what is primary. Is that the--
Mr. McCarthy. --I think he's making is that once he obtains
all of the licenses, he will participate in the primary market.
Mr. Watt. Okay. Well, and the question I was asking is,
once you do that, will you require insurance also, or will you
not?
Mr. McCarthy. No. He'll be--
Mr. Jain. We will be--let me explain what I meant by the
role we are playing right now. A number of bonds come into the
market without any insurance whatsoever. These bonds end up
with traders or with retail investors. At some point, these
traders or these retail investors come to us on these uninsured
bonds looking for insurance protection. We write insurance
protection for these bonds on a secondary market basis, as
opposed to negotiating with individual issuers, which is a
primary basis.
Mr. Watt. I think I--
Mr. Jain. So in both cases we are playing the role of an
insurer only.
Mr. Watt. I think you've confused me sufficiently.
Mr. Jain. I'm sorry.
The Chairman. Let me just--I want to go back to Ms.
Levenstein again. Somebody just suggested, and you said, and
I'm glad to hear that, that you're going offer the municipal
issuers the choice. Will there be a price difference in what
they're charged?
Ms. Levenstein. We haven't decided yet, and that's still
under discussion. If there would be any incremental price, it
would be an ongoing monitoring price. I should point out also
that we currently--
The Chairman. You would charge an ongoing monitoring price
to the corporation--I mean, different than--I don't understand
that. Why should they--
Ms. Levenstein. Because there is additional work that we
need to do in order to translate the ratings. But I would like
to--
The Chairman. Well, no, no. So that's really taking back
what it said in your opening--if they're in the same rating
system as the corporations, why should--are they paying twice
for this? I don't--
Ms. Levenstein. No. We're providing a municipal scale
rating or a rating under the municipal system, and we are going
to effectively translate that to the equivalent of a corporate
rating or a--
The Chairman. Why don't you just rate them in the first
place? Oh, so you're going to charge--so a municipality that
wants to be rated as a corporate might have to pay more because
they'll be first rated as a municipal issuer and then they have
to pay a translation fee?
Ms. Levenstein. I think that hasn't been determined yet,
but they will be first rated under the municipal system and
then we will apply the--
The Chairman. Well, what if they just said, I'll skip the
municipal system. Just rate me like anybody else right away?
Ms. Levenstein. That's not what we're planning to do right
now.
The Chairman. I find that, from our public policy
standpoint, unacceptable, and we would certainly try to
legislate against that. To charge them double to be treated
like anybody else--
Ms. Levenstein. No, we're not charging them double.
The Chairman. Yes. That's what you're saying. You'll charge
them to be a municipal--
Ms. Levenstein. No.
The Chairman. You'll charge them for the separate rating
when they don't want a separate rating and then charge them
again to get the same rating as everybody else.
Ms. Levenstein. We're providing a municipal system rating
which will allow for the sort of differentiation and relative
ranking, which is valuable to the market. We're also providing
or will provide upon request, only upon request, a global
scale--
The Chairman. I must say, I misunderstood what you said.
When you said you were going to offer them a choice, what
you're going to offer them is a second item for which you can
charge them. And I think you will be continuing to be abusive
of them in that regard.
Ms. Levenstein. Again, I--
The Chairman. You're going to charge--they have to--get
rated like anybody else, they have to pay for two ratings.
Ms. Levenstein. No. That is incorrect.
The Chairman. You just said that. They're going to be rated
as municipal whether they want to or not, and then if they also
want the global rating, there's an extra charge for that.
Ms. Levenstein. What I said is we hadn't determined it yet.
The Chairman. No, but--well, if you do--if you don't, then
I withdraw my comment. But if you do, then you're charging them
double. And when you suggested to me that they'll have a
choice, yes, I have a choice. I can buy--pay for two or I can
pay for one. But that's not what I usually mean by a choice.
Ms. Levenstein. But the other thing I should point out, it
wouldn't be double. But the one thing I would like to point out
is that we have offered global scale ratings or global system
ratings since 2003 for any taxable issues, and it is
interesting to us that we've only had 18 issuers--
The Chairman. Do they pay extra for that?
Ms. Levenstein. They do.
The Chairman. Okay. Well, surprise, surprise, they don't
want to pay extra for it. Secondly, taxable is different than
tax exempt.
Ms. Levenstein. I don't think that's--
The Chairman. The fact that people may not want to pay
extra doesn't mean that they wouldn't make the choice if they
didn't have to pay extra.
The gentleman from Massachusetts.
Mr. Capuano. Thank you, Mr. Chairman. Mr. Chairman, I beg
to differ with what you said earlier. The investors are very
lucid. Why would they want to do the right thing in order to
get a lower return? They love the system they have now because
they get eight points back when they should be getting five.
They get seven points back when they should be getting four.
Why should they change it? Why would any of these people at
this table change the system when with a good system they'd be
out of business? We wouldn't need you. So I think you're
investors, and you are very lucid. You got it right. You have
them by the short hairs. Keep them screaming. Don't worry about
it.
Mr. McCarthy, I beg to differ when you saved us $40
billion?
Mr. McCarthy. Correct.
Mr. Capuano. That's like the local gang coming into my
little corner store and saying we saved you $100,000 because
your place didn't burn down last week. We gave you protection.
You didn't save anything. You saved it because you have the
system rigged so that cities and towns can't get the ratings
they deserve due to their default rates, their lower default
rates. You didn't save anything.
How can you possibly be shocked that they're now attempting
to pretend to do the right thing and going to charge us for it?
But I'm supposed to say thank you? When I was a mayor, I would
say thank you. Have another croissant. I don't have to say that
anymore. Getting double charged for doing what you should be
doing in the first place, I don't have to say thank you. I can
call it what I've said it is. It's extortion. All I see is the
rate for extortion is going up.
I do want to ask one thing. On the historic default rates,
am I wrong? Is my information incorrect that corporate double A
bonds that are rated by Moody's have defaulted at a rate 43
times higher than double A rated munis?
Ms. Levenstein. No, I don't believe you're wrong.
Mr. Capuano. Yet they get a better rating. How is that
defensible? If you're going to do this, then stick with the
dual system. Just change how they get done. Why? Keep the dual
system. Give the munis a better rate. They're a better deal,
according to your own dual system. And I understand fully well
that somehow I must be mistaken here in the documents you gave
and the written testimony you said that you used analytical
methodologies. Okay. That sounds very complicated, very
mathematical, very precise. But then I just heard you say the
reputation or the name recognition of the community. So if you
don't know where my community is, though my community has never
defaulted, just because you don't know where it is, I have to
pay more?
Ms. Levenstein. No. That wasn't--
Mr. Capuano. That's obscene. That's offensive.
Ms. Levenstein. That wasn't what I was saying. What I was
saying is the way the market prices things sometime depend--
Mr. Capuano. If the market knew that I was going to pay
them back, they would price--I have no problem with ratings. I
just want to be rated on a fair and equal footing. I have no
problems with ratings, and I do understand that rateds is
different than unrateds. I understand that within rateds--I
accept all that. That doesn't bother me.
But put me in the category, put us in the category that we
have earned. You didn't give it to us. We earned it by paying
our bills. We've done what we were asked to do. We have done it
better than corporations, and yet you still punish us because
we have been silent. I'm not being silent today. And I don't
expect to be silent ever again because I now have this new
freedom that I am finding very good.
Simply treat us fairly, and there would be no problems. You
can continue making a few bucks. You can continue insuring
those issuances that need insurance. Everybody goes on.
Everybody's happy, everybody makes a few dollars. The cities
and towns get to do what they need to do. My sewers get fixed.
My cops get hired, and you're still in business. Stop sticking
it to us because you can. Otherwise, we will find ways to stop
you.
Mr. Chairman, I yield back.
The Chairman. I thank the gentleman. I would note Mr.
Jain's comment that if in fact the municipal issuances, the
municipal bonds were rated the same as any other, there
wouldn't be any insurance business because they would all do
well. Mr. McCarthy?
Mr. McCarthy. Just one point. I think--
The Chairman. Your microphone is not on.
Mr. McCarthy. I'm sorry, Mr. Chairman. One of the functions
of the insurance business in the municipal area is that we
quote a bid in the market for every particular bond, and there
are thousands and thousands of municipal credits. We have a
very, very large staff that analyzes municipal bonds, and
really the value we're bringing to, as an industry, to the
municipal investor is that first we're putting our capital up
so that to the extent that something does happen, whether
there's a payment shortfall or something else, we stand by
that.
I think the chart that the chairman produced earlier is a
Moody's chart that actually excludes defaults that might be
taken by the model lines. So the model line--
The Chairman. No. No.
Mr. McCarthy. It's not?
The Chairman. No. There were just no defaults. These
weren't defaults that were paid by somebody else.
Mr. Capuano. Mr. Chairman, I want to be clear. I don't
think that you have no role in the marketplace. I think you do
have a role. But I want you to market my bonds on the basis of
the likelihood of me paying them back. And you can't do that
without Moody's giving me an appropriate rating.
Mr. McCarthy. Right. We're not the arbiter of whether we
get used or not.
Mr. Capuano. Oh, I understand that.
The Chairman. But I also would have to add--
Mr. Capuano. Because you're the beneficiary of it.
The Chairman. I would also add while that's a nice model,
in fact the way it's worked out for many municipal issuers,
they have been carrying their insurers. They have in fact been
rated higher than their insurers, and the insurers have dragged
them down, and they have had to pay more money because of the
low rating of their insurers, who improvidently invested the
money.
Mr. McCarthy. Well, some--in the model line insurance
industry--
The Chairman. Yes.
Mr. McCarthy. --there are several companies, thank
goodness, FSA, which I represent--have maintained their triple
A's from all three rating agencies in our State.
The Chairman. But let me say this. I don't know anybody who
had to pay more for his car because his car suddenly became
worth more than his insurance agency. You're saying it only
happened with some insurance agencies--
Mr. McCarthy. No, no.
The Chairman. Some insurers and not others.
Mr. McCarthy. No.
The Chairman. Where the lousy performance of their insurers
cost them money.
Mr. McCarthy. Well, the financial wellbeing of the
companies, if you think of it this way, as I said in the
testimony, if you look at the CDOs of ABS, different model line
companies were exposed to a single asset class which have very
large losses and severe losses, and that single asset class--
The Chairman. Which asset class is that?
Mr. McCarthy. CDOs--
The Chairman. Okay. Excuse me. You say were exposed to. Now
does that mean they were walking down the street and it wafted
in and they caught it like pneumonia?
Mr. McCarthy. No.
The Chairman. They didn't--they weren't exposed to it. They
took the profits from the municipals and went out and bought
it. They weren't exposed to it.
Mr. McCarthy. No, I don't that's--I think the way it
actually works is that each company has capital--
The Chairman. Excuse me, Mr. Callen said in the Wall Street
Journal from Ambac, we took the profits, which were very good
and very secure, and we went and invested in things, and we
invested in things we didn't fully understand, CDOs. He wasn't
exposed to it. He jumped in.
Mr. McCarthy. I would speak--
The Chairman. Well, but, that's one of the big companies.
Mr. McCarthy. I can speak for the industry generally, I can
speak for FSA specifically.
The Chairman. Well, then, don't talk about it, but the fact
is--
Mr. McCarthy. But Mr. Callen I can't speak for.
The Chairman. But you weren't exposed to it. These other--
Mr. McCarthy. No. We didn't underwrite that--
The Chairman. I understand that. But the point I'm making
is, you know, the passive voice probably ought to be banned
from the English language. It's the great excuser. Oh, we were
exposed to it. No, they weren't exposed to it. They tried to
make some money and made a bad guess.
Mr. McCarthy. Well, they underwrote it, meaning that those
transactions that with a triple A--
The Chairman. But they volunteered to go and underwrite it
because they thought they'd make money.
Mr. McCarthy. That's correct.
The Chairman. They were--yes. All right.
Mr. McCarthy. That's correct.
Mr. Capuano. Mr. McCarthy, if my city had gotten the rating
I deserved according to these charts, I would have been triple
A from day one and I wouldn't have needed bond insurance, so I
wouldn't have been exposed to anything, because I wouldn't have
had to get bond insurance.
Mr. McCarthy. We would--well, I'm not sure. We will still
quote--
Mr. Capuano. And I would say thank you very much, no thank
you.
Mr. McCarthy. And investors may or may not decide--
Mr. Capuano. And by the way, even when I needed bond
insurance, I was never any lower than a B.
Mr. McCarthy. Right.
Mr. Capuano. And guess what? I didn't want to be put in
with junk bonds.
Mr. McCarthy. Right.
Mr. Capuano. The people who did the CDOs, they chose to
throw me into junk bonds. They were using my good credit to
cover their lousy choices. I didn't get exposed by voluntary. I
didn't ask, oh, gee, please throw me in with the junk bonds.
The Chairman. We're going to move on.
Mr. McCarthy. I think it's important to note that each of
the companies that have experienced distress, MBIN Ambac, for
example, have raised significant amounts of capital.
The Chairman. They didn't experience distress. They made
lousy investment decisions. These were not--you know, they
didn't experience distress. They made bad investment decisions.
Mr. McCarthy. You're exactly right.
The Chairman. Okay. Thank you. The only question I had was,
my colleague from Somerville, I don't know if you know
Massachusetts, but did you go to Cambridge to get those
croissants you were giving people when you were mayor?
[Laughter]
The Chairman. I didn't think they had croissants in
Somerville. All right. I'm sorry. The gentleman from Missouri.
Mr. Cleaver. Thank you. I hope you understand, and I feel
very similar to my colleague. As a former mayor, we have--for 8
years, I had to tiptoe around with the rating organizations--
agencies, because we didn't--you know, the lawyers said, you
know, you can't irritate them, you know. We have a double A
rating with perfect payments with regard to the general
obligation bonds, and so you have to play nice.
And so, like my colleague, I'm irritated, because I don't
have to play nice now. You know, I guess maybe the mayor in
Kansas City is afraid. I'm curious, Mr. Vogtsberger, or you and
Ms. Levenstein, how much money have you had to pay out in
municipal bond defaults in the last 10 years?
Mr. Vogtsberger. As a bond underwriter, we don't pay any
money out for municipal bond defaults. We buy bonds and then
remarket them.
Mr. Cleaver. Well the truth is, nobody pays anybody off in
municipal bonds, because there haven't been any defaults.
Mr. Vogtsberger. There have been defaults in municipal
bonds, not general obligation bonds, but--
Mr. Cleaver. Where?
Mr. Vogtsberger. Hospitals, for example, private colleges,
industrial development revenue bonds. Those are all municipal
bonds that from time to time--
Mr. Cleaver. I'm talking about municipalities.
Mr. Vogtsberger. Municipalities, very few.
Mr. Cleaver. One?
Ms. Levenstein. But that's of the rated Moody's universe.
There may be others that are unrated. I simply don't know.
Mr. Cleaver. Okay. But you can't name one?
Ms. Levenstein. I only know of one that was within our
rated universe, that's correct, of a GO--
Mr. Cleaver. A municipality. I'm not talking about a--
Ms. Levenstein. A general obligation pledge from a
municipality.
Mr. Cleaver. On the full faith and credit of that city?
Ms. Levenstein. Yes. They defaulted. There would have been
others--there were others that were different types of revenue
pledges.
Mr. Cleaver. One out of how many?
Ms. Levenstein. One out of about 28-, or 29,000.
Mr. Cleaver. Don't you think that the cities need a rebate
now? This is a serious question.
Ms. Levenstein. No I don't.
Mr. Cleaver. Why not?
Ms. Levenstein. Because, again, I think we provided to the
market--
Mr. Cleaver. What?
Ms. Levenstein. --what the market wanted, what was usable.
Mr. Cleaver. What did you provide Kansas City?
Ms. Levenstein. We provided ratings that provided relative
ranking.
Mr. Cleaver. I'll tell the people when I go home this
weekend--
Ms. Levenstein. That's what the market told us they--
Mr. Cleaver. --because all they know is that they're having
to pay, that our city is having to pay high insurance, no low
interest, and there's no--there's such a minute change that
we're going to go into default, that it's almost absurd that we
have to do it. And you're saying you don't think anything has
gone wrong there?
Ms. Levenstein. I think the market is pricing what they
perceive to be the risk.
Mr. Cleaver. So everything is fine?
Ms. Levenstein. All we're doing is providing an opinion of
the relative credit ranking, and that's what we have done.
Mr. Cleaver. So everything is fine? You don't see a problem
with--
Ms. Levenstein. What has changed is that there is more of a
crossover market and the market appears to want, as well as the
municipal rating system, the global system. And that's why
we're offering it on a forward basis.
Mr. Cleaver. When did you discover this as the point, I
mean--
Ms. Levenstein. We first started to talk to the market
about this in 2001, and we talked to the market in 2001. We
talked to over 100 participants in the market. The feedback
that we got at that time--
Mr. Cleaver. What--who--
Ms. Levenstein. --that for a certain segment of the market,
global ratings would be helpful.
Mr. Cleaver. Did you talk to the--
Ms. Levenstein. Only that segment.
Mr. Cleaver. --the U.S. Conference of Mayors, the National
Conference of--
Ms. Levenstein. We talked to issuers. We talked to
investors. We talked to intermediaries.
Mr. Cleaver. But you didn't--you never talked to any of the
mayors or the organizations representing mayors?
Ms. Levenstein. We talked to issuers, so we did talk to--
Mr. Cleaver. Who?
Ms. Levenstein. --who were representatives of mayors. I
don't have the list. But we did talk to over 100
representatives.
Mr. Cleaver. And they didn't go off?
Ms. Levenstein. No, they did not.
Mr. Cleaver. Boy, I'd like to see them.
Ms. Levenstein. In fact, the overwhelming opinion was to
keep things the way they were, and that's what we did, except
for the small segment of the market that was taxable issuance
outside of the United States or swap obligations. And so
between 2003 and 2007, we offered global system ratings to that
segment of the market.
Now as I've said earlier, it is clear that there's a
change, and it is clear that there would be value to the market
of global system ratings. So we will provide those on a forward
basis to any issuer who wants them.
Mr. Cleaver. The State government of Missouri has a triple
A rating.
Ms. Levenstein. Yes.
Mr. Cleaver. I think there are only five States with triple
A in the United States. Our creditworthiness is higher than the
State, and we have a double A. How do you explain that?
Ms. Levenstein. Well, I'm not in a position today to
discuss the difference between your city and the State of
Missouri. But certainly we could get back to you if you wanted
to have that discussion.
Mr. Cleaver. I do.
Ms. Levenstein. But clearly, we think on a relative ranked
basis, but that's not the case.
Mr. Cleaver. I'm sorry?
Ms. Levenstein. If you were to relatively rank the city
versus the State, we think the State is stronger. But if you
would like to talk about the specifics of that, we can--
Mr. Cleaver. I want to talk about a rebate. When can we
meet to talk about a rebate?
Ms. Levenstein. I don't think that's warranted.
Mr. Cleaver. I'm sorry?
Ms. Levenstein. I don't think that is warranted.
Mr. Cleaver. If we have a vote, it would be.
Mr. Capuano. Mr. Chairman, if the gentleman would yield for
one minute.
The Chairman. Go ahead.
Mr. Capuano. As I understand it, the people that you were
talking to are the very people who make money at this business.
So you basically ask people, do you want to continue making
more money than you would otherwise make if we make the system
right? And you also talk to maybe a few hostages, people who
didn't have the freedom to tell you what they really wanted. Or
did you talk to anybody who had been a former mayor or a former
issuer of bonds when you asked the market participants?
Ms. Levenstein. I don't know if we did or not.
Mr. Capuano. I mean, my expectation is market participants
means either the people who are making the money, and you
basically ask them, do you want to make less money? And they
said no. And then you might have asked a few people who are
hostages, would you like us to change it so you can save some
money? And they said, oh, no, please don't do that, because if
you do that, you're going to lower our rating. That's not the
market participants that mean anything to me. Those are
hostages, and those are people who are making money on the
backs of my taxpayers. Their interest is no interest.
The Chairman. And I think you have a feedback loop here
between the rated and then people who were asked. But let me
ask you this. You said the State versus the city. What about if
there were other instances--
Ms. Levenstein. There are instances. We do rate a number of
intercept programs and other types of bonds.
The Chairman. Straightforward question.
Ms. Levenstein. Yes?
The Chairman. If the State stands behind the cities, are
there still differences in the ratings?
Ms. Levenstein. It depends on the mechanism that the State
uses to stand behind the city. If the State stood completely
behind the city and it was effectively a guarantee, then there
would be no difference.
The Chairman. Thank you, that was the question.
The gentleman from Colorado.
Mr. Perlmutter. I was never a mayor, and I don't have that
sense or hostility that my two friends have shown, but I have
done Chapter 9 bankruptcies, and so I do recognize that there
are risks. I don't know whether these were Moody rated. I don't
know whether there was a lot of underwriting or bond insurance
behind it, so I recognize something here, but I have just some
very basic questions again. First, who pays Moody's to do a
credit rating, the buyers of the bonds or the issuers of the
bonds?
Ms. Levenstein. The issuer does.
Mr. Perlmutter. The issuer does. Who pays, Mr. Jain, I kind
of heard that it could be an investor wanting to protect the
investment or it could be the issuer could buy the insurance,
the issuer, is that right?
Mr. McCarthy. The issuer in a primary market and an
investor in a secondary market position who owns the bonds
already.
Mr. Perlmutter. Now, I asked the last panel, is there any
law that says State, Federal, that requires Denver Health and
Hospitals, who I spoke to a half-hour ago, to get rated by
Moody's or to buy insurance before they issue bonds and sell
the bonds, is there any law?
Ms. Levenstein. No, there is not.
Mr. McCarthy. No, there is no law.
Mr. Perlmutter. Okay, how many ratings agencies are there?
Ms. Levenstein. There are nine recognized rating agencies.
Mr. Perlmutter. Nine recognized for municipal or government
type--
Ms. Levenstein. Nine recognized by agencies, there are
nine.
Mr. Perlmutter. And not to pick on Moody's but since you
are here, how much of that market, of those nine agencies, how
much of the rating business do you do, does Moody's do?
Ms. Levenstein. I do not think that I know how much we do
relative to the other rating agencies.
Mr. Perlmutter. Alright, so but the real reason we are here
today, and the two mayors really and the chairman are talking
about some structural things as to why people do not get better
rates, the purpose of our hearing today though was here we were
going along merrily, people are doing their--selling their
municipal bonds, everything is honky dory until we hit February
and all of a sudden it goes from 4 percent to 20 percent for
the Port Authority in New York.
Mr. McCarthy. Right.
Mr. Perlmutter. And there has not been any testimony that
the Port Authority of New York became any greater credit risk
in February than it was in January or that the Denver Health
and Hospitals are any greater credit risk--
Mr. McCarthy. That is correct.
Mr. Perlmutter. --than they were. What happened?
Mr. McCarthy. Well, what happened, I tried to cover, and
not well, in my testimony. Essentially, auction rates, if I can
give you just a one minute history of the floating rate market
at the municipal area. Going back 25 years ago, which is when I
had a lot more hair, the first floating rate transactions that
were done were called ``upper floaters.'' Cleveland Electric
did the first transaction, and essentially they were just like
auction rate deals today, meaning that there was a promise for
the investment banker to re-market these bonds on a periodic
basis and find new investors, okay. Then those bonds in the
1980's, right after they got formed, failed to actually clear
the market.
Mr. Perlmutter. There were not any buyers?
Mr. McCarthy. There were not any buyers because they
couldn't because there was again a market stress environment,
if you remember back then, municipal long rates were 15 percent
and the issue that happened there was that the community
decided to attack real bank liquidity to these transactions
such that if there was a put, that it was a bank who really is
in the business of providing their liquidity to these
transactions. That is the way that market operated for 20
years. Three years ago, all of a sudden investment bankers
said, ``You know what, we don't really need the liquidity
provider. What we can do is we can re-market it for you and you
will save 10 basis points instead of paying a liquidity
provider some. We will charge you a little bit more for the re-
marketing fee, but we will promise that we can make that
market.''
Now, I will tell you that part of the problem was that
stress or the downgrade issues that have happened in the
monoline area started people being nervous about owning option
rate bonds that did not have liquidity. And no option rate
bonds have liquidity attached to them, so they started to put
them to the investment banks. Well, that is not really what
they do. So they tried their best to re-market them.
Mr. Perlmutter. Just a basic question, option rate bonds
does not have liquidity behind it but it does have a revenue
stream behind it?
Mr. McCarthy. It does not. They have to clear the market.
The way these structures work is they are floating rate, they
are owned by funds and they are counted as a short-term
financial instrument. Therefore, the difference between a
variable rate demand bond, which has liquidity, and an auction
rate bond that does not, those were counted as short term
products. But the reason why that interest rate spiked up for
all the auction rate products, regardless of whether it is the
Port Authority, a student loan transaction or the State of
California, was because investors, the liquidity market started
to dry up and investors were nervous and not comfortable that
they would own this bond and not be able to get out of it. They
owned the bond thinking it was variable rate and therefore a
short term security, which they had to qualify for. And they
thought it is like musical chairs that say, ``Holy cow, if I
don't put this back to the re-marketing agent right now, I am
going to own this as a long-term bond, and that is not what I
intended.'' So all of those bonds came back.
Now, at FSA, we are spending--kudos to our municipal
finance analytical team, they are spending 23 hours a day
underwriting transactions to try to convert municipalities from
auction rate, regardless of who did them, to either floating
rate or fixed rate to solve this particular problem. And it has
nothing to do with the quality, which in most cases for option
rates is very good, it has nothing to do with the credit
worthiness of the municipality.
Mr. Perlmutter. Thank you.
Mr. Cleaver. A follow-up, please.
Mr. Perlmutter. I would yield to Mr. Cleaver.
Mr. Cleaver. Thank you. One final question, what do you
call the professionals who are paid a fee to unwind the option
rate securities into other instruments?
Mr. McCarthy. Well, investment bankers.
Mr. Cleaver. I'm sorry?
Mr. McCarthy. Investment bankers and then financial
advisers are the two counter-parties. You can speak to that
better.
Mr. Vogtsberger. That is right, yes. Investment bankers who
underwrite bond issues are, as Sean mentioned, working to
restructure option rate bonds into either variable rate bonds
or fixed rate bonds, and they are paid a fee to do that.
Mr. Cleaver. By whom?
Mr. Vogtsberger. By the issuer.
Mr. Cleaver. That is all. Thank you, Mr. Chairman.
Mr. Capuano. [presiding] I want to thank you for putting up
with this abuse today, and I hope you did not take too much of
it personally, but at the same time, honestly, it is the first
time I have had in 18 years to tell you what I think, and I was
not going to pass up the opportunity. I also hope that you get
some of the frustration and some of the disappointment that has
happened over the years, and my hope, my preference is that the
industry takes action without government interference, if you
want the truth. However, I will tell you that if something does
not happen, the likelihood of government involvement increases
dramatically, and I think you have heard some of the
frustrations. Some of the things that have been mentioned here
today, I think many of us agree with relative to some of the
SEC rules and some of the other things. But like many times, I
for one would prefer that the market does its own work but
government regulation to me is not a swear word, it is a
bastion of last resort.
Before we dismiss, before we end this panel, the Chair
notes that some members may have additional questions for the
panel, which they may wish to submit in writing. Without
objection, the hearing record will remain open for 30 days for
members to submit written questions to these witnesses and to
place their responses in the record.
With that, I declare that this hearing is adjourned.
[Whereupon, at 4:15 p.m, the hearing was adjourned.]
A P P E N D I X
March 12, 2008
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