[Senate Hearing 110-931]
[From the U.S. Government Publishing Office]
S. Hrg. 110-931
THE ROLE AND IMPACT OF CREDIT RATING AGENCIES ON THE SUBPRIME CREDIT
MARKETS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE CIRCUMSTANCES, THE INTEGRITY OF THE RATINGS PROCESS, THE
OVERSIGHT OF THE SEC, AND WHETHER STATUTORY, REGULATORY, OR INDUSTRY
CHANGES ARE ADVISABLE IN LIGHT OF SIGNIFICANT DOWNGRADES TO THE CREDIT
RATINGS OF SECURITIES IN THE SUBPRIME MARKETS
__________
WEDNESDAY, SEPTEMBER 26, 2007
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho
SHERROD BROWN, Ohio JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania ELIZABETH DOLE, North Carolina
JON TESTER, Montana MEL MARTINEZ, Florida
Shawn Maher, Staff Director
William D. Duhnke, Republican Staff Director and Counsel
Dean V. Shahinian, Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
Jim Crowell, Editor
C O N T E N T S
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WEDNESDAY, SEPTEMBER 26, 2007
Page
Opening statement of Senator Reed................................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Senator Schumer.............................................. 4
Senator Sununu............................................... 6
Senator Casey................................................ 7
Senator Brown................................................ 8
Senator Bunning.............................................. 9
Senator Menendez............................................. 10
Senator Allard............................................... 11
Senator Martinez............................................. 13
WITNESSES
Christopher D. Cox, Chairman, Securities and Exchange Commission. 14
Prepared statement........................................... 47
John C. Coffee, Adolf A. Berle, Professor of Law, Columbia
University School of Law....................................... 27
Prepared statement........................................... 53
Michael Kanef, Managing Director of the Asset Finance Group,
Moody's Financial Services..................................... 29
Prepared statement........................................... 74
Vickie A. Tillman, Executive Vice President for Credit Market
Services, Standard & Poor's.................................... 30
Prepared statement........................................... 108
Lawrence J. White, Arthur E. Imperatore Professor of Economics,
Leonard N. Stern School of Business, New York University....... 32
Prepared statement........................................... 135
THE ROLE AND IMPACT OF CREDIT RATING AGENCIES ON THE SUBPRIME CREDIT
MARKETS
----------
WEDNESDAY, SEPTEMBER 26, 2007
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 9:34 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed presiding.
OPENING STATEMENT OF SENATOR JACK REED
Senator Reed. Let me call the hearing to order.
I want to thank Chairman Cox for joining us this morning. I
particularly want to thank Chairman Dodd and Senator Shelby for
their leadership on this issue. Both have expressed significant
concerns about problems with the subprime market and have
raised serious questions about the role that credit rating
agencies have played in the current situation.
According to the FDIC, since the beginning of June 2007 the
credit rating agencies have downgraded more than 2,400 tranches
of residential mortgage-backed securities. The recent wave of
downgrades have caused some investors to lose confidence in
both the integrity and reliability of these ratings.
This hearing provides us with an opportunity to examine the
role of the credit agencies in structured finance products and
consider their impact on financial markets.
Back in April I chaired a Subcommittee hearing examining
the role of securitization, where witnesses testified that
problems in the subprime asset market area were confined to a
small part of the market. Of course, since then we have learned
that the fallout from the subprime turmoil was and is deeper
and broader than we were led to believe. As a result, it seems
that securitization not only distributes risk but that it can
hide it as well.
Credit rating agencies play a critical role in capital
markets. The agencies can enhance or reduce investor confidence
depending on the information they provide. The increasing
complexity of structured products like mortgage-backed
securities and CDOs, collateralized debt obligations, and the
perceived lack of transparency in this investor appears to have
made investors more dependent on the rating agencies to perform
quality analysis. In that sense, the agencies have become
gatekeepers for the multibillion-dollar structured finance
industry.
Furthermore, the credit rating agencies are the only market
participants who make it their primary focus to evaluate and
disseminate information and the importance of their central
roles is further affirmed and supported by rules such as those
that are used to determine pension investor guidelines and
capital requirements for financial institutions. All of these
factors indicate that the credit rating agencies have
substantial responsibilities for providing timely and accurate
information to other market participants.
With the complexity and volume of new types of securities
being created, the rating agencies are uniquely situated in the
process of structuring RMBS products through their close
interaction with the issuers. These close relationships have
led many to question the integrity of the process. Former SEC
Chairman Arthur Levitt has said that the credit rating
agencies' decreasing dependence on revenues from structured
finance products creates a conflict of interest that undermines
their ability to provide fully independent ratings assessments.
They are, in his words, ``playing both coach and referee in the
debt game.''
Finally, Lou Ranieri, the pioneer of MBS, suggested in 2006
that the mortgage-backed security sector was ``unfettered in
its enthusiasm'' and ``unchecked by today's regulatory
framework.''
He further stated that ``We have a quasi-gatekeeper in the
rating services and in the end the SEC is the regulatory of the
capital market. It is the one who can touch this stuff and make
a difference.''
So I am eager here about the SEC's activity in this area.
Last year, under the leadership of Senator Shelby, Congress
passed the Credit Rating Agency Reform Act that gave SEC more
regulatory and oversight authority over credit rating agencies.
In June 2007, the Commission adopted implementing rules. These
rules require a Nationally Recognized Statistical Rating
Organization, an NRSRO, to disclose a general description of
its procedures and methodologies for determining credit
ratings. We are interested in learning how the recently adopted
rules will help address investor concerns.
Of course, we want to hear from the credit rating agencies
about why there were so many downgrades of RMBS in such a short
period of time. We want to know what did they fail to
anticipate and what have they learned from recent events? How
are they updating their models to account for changes in the
market and the complexity of structured products.
I hope everyone here today recognizes the seriousness of
this issue. We have been down this road before. After Enron we
addressed the relationships among corporate managers, auditors,
and analysts. I worry whether there may have been lessons
learned with respect to the importance of independent objective
analysis in those cases which were not recalled in this
particular situation.
So steps need to be taken and all options are on the table.
Ultimately our goal is to strike the right balance between
voluntary and regulatory actions and, in doing so, to enhance
and restore investor confidence in the capital markets.
Before I call on Chairman Cox, I would like to recognize
Senator Shelby, the ranking member, and other members of the
Committee for their statements.
Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Until the highly publicized failures to warn investors
about the impending bankruptcies at Enron, WorldCom, and other
large companies, credit rating agencies operated under the
regulatory radar screen for decades in spite of their important
role in capital markets.
In recent months, widespread attention has been devoted to
downgrades of credit ratings on structured financial products,
particularly subprime residential mortgage-backed securities.
Numerous reasons have been offered for why the rating agencies
got it wrong. Some have suggested the rating agencies awarded
high ratings to curry favor with the large investment banks.
Others have criticized the rating agencies for playing an
active role in structuring these complex deals, which presents
a number of conflict of interest concerns.
The purpose of this hearing is to explore these and other
questions.
In the 109th Congress, as Chairman Reed mentioned, the
Banking Committee conducted a comprehensive review of the
market in which the rating agencies operate. This investigation
revealed an extremely concentrated and anti-competitive
industry. Two of the most profitable public countries in the
U.S. operated what has been called a partner monopoly, each
controlling approximately 40 percent of the industry's revenues
and issuing 99 percent of corporate debt ratings. This virtual
absence of competition was repeatedly cited as a major factor
leading to ratings of inferior quality and practices deemed to
be abusive and anti-competitive. The business model of the debt
issuers paying for their own ratings also led some to question
whether the rating agencies could effectively manage the
inherent conflicts of interest.
The Committee's examination, culminated in the passage of
the Credit Rating Agency Reform Act of 2006, as Chairman Reed
alluded to. The Act is not quite a year old so it is premature
to judge its impact. Moreover, SEC regulations implementing the
Act have only been in place for a few months.
The centerpiece of the Act replaced the opaque SEC staff
licensing system with a more transparent and open registration
system that will result, we hope, in a greater number of
Nationally Recognized Statistical Rating Organizations, or
NRSROs.
The Act also provided the SEC with broad authority to
supervise the rating agencies. The Commission may examine
registered rating agencies for compliance with the rules passed
pursuant to the Act, such as the management of conflicts of
interest, adherence to disclosed procedures and methodologies
for determining ratings and recordkeeping requirements. I look
forward to hearing about the examinations currently underway,
the first such exams conducted pursuant to the Act.
In light of recent difficulties, I would also like to know
if the Commission has all the authority, Chairman Cox, it needs
to conduct vigorous oversight of the rating agencies. I
understand this is a very complex analytical discipline. The
process of rating structured financial instruments can be
confusing and very difficult to comprehend.
What is not difficult to comprehend, however, is the fact
that some specific ratings were just plain, plain wrong and the
subsequent downgrading actions by the rating agencies have had
a serious impact on a significant sector of our financial
system.
It is my hope that we will be able to use today's hearings
to explore what a rating is, what it is not, how it is
determined, and what leads an agency to change its rating.
Finally, we will want to hear what went wrong. If there have
been lessons learned, what are they? And what can be done to
make sure it does not happen again?
I would like to thank all of the participants appearing
here today, especially Chairman Cox. Welcome again to this
hearing. You spend a lot of time.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Shelby.
Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman.
I want to thank you and Senator Dodd and Senator Shelby for
holding this timely hearing, and thank Chairman Cox for being
here.
I guess we can look at the subprime crisis in two ways, or
in two parts really. First, how do we deal with the present
problem, the 2 million homeowners who are likely to go into
foreclosure? I believe that involves two things: one, finding
people who can do workouts for the people on the edge of
foreclosure. There is no one around so for so many of these
people. Senators Casey, Brown, and I have put $100 million in
the transportation appropriation to do that but we need more.
Second, money for financing of these new refinancings. And
there we are looking, some of us anyway, FHA reform has passed
this Committee. That will affect a smaller number of homes. But
getting Fannie Mae and Freddie Mac involved one way or the
other will make a great sense.
We also have to look at how to prevent this crisis from
occurring again, how to prevent the poor people who were taken
advantage of from being taken advantage of again. To that end
some of us, I have proposed dealing with the mortgage brokers,
the unlicensed mortgage brokers, who many of them are fine
people and many of them are rapacious people who deserve future
regulation, and punishment in a certain sense, although
probably there is no law to do it for what they have done. That
deals with the individual borrower, where the crisis started.
But there is also the problem of how, with so many of these
mortgages that were done on a bad basis, that were almost
impossible to be repaid, that investors just scooped them up.
And there we have the look, No. 1, at that credit rating
agencies because you cannot expect an individual investor to
know the details of these complex regulations, these complex
packages whether they be mortgages or derivatives or anything
else. We really depend more and more, as society gets more
complicated we depend more and more on credit rating agencies.
And the fundamental question here is what went wrong? What
went wrong? I met with the head of one of the agencies and they
were telling me nothing went wrong. I will tell all of the
representatives of companies that I have worked with and
defended in the past, they are good New York companies, to say
nothing went wrong, that is not going to fly. It defies common
sense.
These were not AAA rated packages, just shown by what has
happened now. But the point is they were not AAA rated because
many of the mortgages in them were not repayable to begin with.
Now maybe the agencies will say it was not our job to do
that. But that, too, defies what we think a credit rating
agency should do.
And so I think we have to explore this. This is one of the
untold chapters so far in the subprime story, how the risks
associated with subprime mortgages were underestimated and then
swept under the rug by eager investors. And that is why this
hearing is so important.
One of our witnesses spoke about the potential distorted
incentives that result from the fact that most--at the Joint
Economic Committee we had a hearing on this. One of our
witnesses spoke about the potential distorted incentives that
result from the fact that most rating agencies are paid by the
companies they rate rather than by investors who use the
ratings. Chairman Reed pointed out, I think very aptly, that
the last crisis we had in terms of accounting problems there
was the same problem. The accountants were paid by the people
who were getting the ratings from them.
And so the question is is this a conflict of interest?
First the rating agencies market their rating services to the
issuers who, of course, want better ratings. Could this be
creating a tendency to inflate ratings in the marketplace?
And second, rating agencies typically get paid after the
issuer decides to accept the rating. Well, on its face, that
one just seems ripe for potential conflicts of interest.
So when the rating agency has done a thorough objective job
of rating a security, the issuer can pull its business if it
does not like the rating. Up until the 1970's, it was pointed
out at our Joint Economic Committee hearing, all of the
original credit rating agencies were funded by investors. It is
the investors that care the most about the independence of the
credit rating analysis, the integrity of the evaluation of
credit quality, and the timely review of ratings.
In the 1970's, a switch in payment structure took place and
today the bulk of the major rating agencies, rating related
income now comes from fees charged by issuers. So the question
looms, should the structure be changed? Or should there be two
types of agencies out there, one that is paid for by investors
and one that is paid for by the issuer?
Are there conflicts of interest in the other model, the
investor related model? And do those conflicts of interest
outweigh the conflicts of interest we potentially have seen
here? We should discuss whether we should promote the entry of
serious viable investor funded rating agencies to compete
against rating agencies that are purely paid by the issuers or
to provide incentives for today's rating agencies to go back to
their roots and have investors pay for the ratings.
I do not know the answer to that question. I have not made
up my mind. But it is certainly worth exploring, both to see if
we should move to a new model, and also to help us shine a
light on what went wrong in the past.
I look forward to the witness's testimony.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Schumer.
Senator Sununu.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. Thank you very much, Mr. Chairman.
I think, insofar as the credit rating agencies are
concerned, their role in rating these securities is signaling
the markets as to what the level of risk inherent in the
securities is. The markets use that to price the risk.
What we have seen really over the past 18 months, changes
in the financial services markets, indicates that in many areas
of financial services the pricing for risk was inaccurate, that
there was not an appropriate premium placed on risk. Not just
in mortgage-backed securities but in other areas of the market
as well. We have seen the financial services industry and
financial instruments respond to that.
What we want to do today is to get a better understanding
of how the rating services priced or estimated risk in these
securities, whether they looked at the securities clearly,
effectively, indifferently in the way that a rating agency
should and to better understand what the impacts of re-rating,
downgrading, or upgrading those securities has been. And to
find out whether the legislation we passed last year will help
address whatever problems may have existed in the rating
agencies themselves.
That was, I think, good legislation. I think it has been
broadly supported as laying the groundwork for better assessing
performance of credit rating agencies and also encouraging
greater competition among credit rating agencies. And those
that misprice risk or misgrade securities should be punished in
the marketplace.
However, I think it is important that we look at this, the
problems here, with an understanding of what the larger
fundamental economic problem is. And that is a collapse of the
housing industry in the real estate market. Housing inventories
are now at a 10 month supply. It is very likely that those
inventories will go even higher as the sales situation in the
housing market further deteriorates. And that, in turn, is at
least in part what is driving foreclosures, reduction in price
sales, loss of equity and creating an untenable financial
situation for hundreds of thousands if not millions of
consumers.
So we want to make sure we do not do anything, even as we
take all of these steps, we do not want to do anything that
ultimately will restrict consumer credit where credit should be
made available and we do not want to discourage the
securitization of mortgages because that is very important to
making credit available to those that are trying to purchase a
home or refinance a home. And we certainly do not want to
discourage the ability of those who hold mortgages to go to the
homeowner and work out a modification and write down part of
that mortage so that someone can stay in their home.
And bad legislation, bad regulation, could possibly do any
one or all three of those things. Again, in an environment
where it is much more likely than not that we are moving from
10 months of inventory to 12 months of inventory to 14 months
of inventory over the next six to 9 months, I think we need to
be very thoughtful and cautious in making any changes to the
regulatory structure so that we do the right thing for all of
those that are in the most difficult of situations with regard
to their homes.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Sununu.
Senator Casey.
STATEMENT OF SENATOR ROBERT P. CASEY
Senator Casey. Mr. Chairman, thank you very much and I
appreciate the opportunity to participate in this hearing.
Chairman Cox, we appreciate your presence here and your
testimony, which we will hear.
I have just a brief statement. First of all, with regard to
what brings us here, which is the crisis that is in the
subprime problem we have across the country. I think the
evidence now is irrefutable that this is a real and substantial
problem for families. But as we know now, it has had an impact
on credit and other financial measures across the world. So
this is a major challenge. Part of this challenge is examining
the role played by and the impact that our credit rating
agencies have.
I have to say in a personal way I have had some experience
dealing with rating agencies as the Auditor General and State
Treasurer of Pennsylvania. But in particular, when I was the
State Treasurer, I remember waiting with great anticipation
about whether or not a rating agency would give an investment
grade rating to our tuition account program which I was in
charge of and I had said I would make reforms to. And I could
not, as a public official, reform or reintroduce that tuition
account program that so many families depend upon without
having the seal of approval, so to speak, of a rating agency.
So I realize that as a public official, and I know I speak
for probably lots of public officials and agencies, the
importance we place upon that rating in terms of determining
whether we can market or certify or at least point on a
positive note to a program. So it is critically important and I
realize the role that those agencies play in our system.
But I think this question raises--or I should say this
crisis raises some real questions about conflict of interest.
It raises questions that we also encountered, I think our
country encountered, in the lead up to the enactment of
Sarbanes-Oxley. Like what happens when an entity is doing
consulting services for entities that are involved with or seek
ratings from that same entity?
There are a lot of questions and we will be asking those
today. But I think even, Senator Shelby mentioned the fact that
the Credit Rating Agency Act is only a 2006 act. So we should
not be precipitous in our judgments.
But I think that when an act is in place, even for a year,
I think it bears scrutiny and examination, especially in light
of this crisis. So we want to make sure, Chairman Cox, that you
have the resources that you need and also the authority that
you need. We may determine that the authority is substantial
and adequate but we want to make sure that that is among the
many questions that we ask of you today and ask the panel that
will follow you.
Thank you very much.
Senator Reed. Thank you very much, Senator Casey.
Senator Hagel.
Senator Hagel. Mr. Chairman, thank you. I do not have a
statement and look forward to Chairman Cox's testimony, as well
as our witnesses on the second panel.
Thank you.
Senator Reed. Thank you very much.
Senator Brown.
STATEMENT OF SENATOR SHERROD BROWN
Senator Brown. Mr. Chairman, thank you. Senator Shelby,
thank you. Chairman Cox and other witnesses, it is good to see
you again, Chris. Thank you for joining us to offer your
insights.
The Federal Reserve Bank of Cleveland this week held a
conference in Pittsburgh on how to reclaim vacant properties.
But the big question on the minds of the hundreds of local
officials and others attending was where to find the money to
tear these properties down. It is not just a house here and
there. Whole neighborhoods in my State and the States many of
you represent have been devastated. In many areas the only
workout left is at the business end of a bulldozer.
Chairman Schumer held a hearing earlier this year that
focused on one neighborhood in Cleveland. One of the witnesses
had a chart showing the loans of Argent Mortgage, a top lender.
The purported value of these properties was two or three times
the real value of these homes. On paper, the loan-to-value
ratio for these loans might have been consistently 90 percent.
But in the real world the ratio was 150 or 180 percent or even
higher. More than a quarter of the loans Argent made over the
last 4 years have already resulted in foreclosure.
The current crisis is not simply the invisible hand at
work. A lot of very visible hands peddled these loans to the
people of Cleveland and elsewhere. I doubt that Adam Smith
anticipated a financial product that was mass marketed and
designed to fail on a slow fuse. Yet at every hearing on this
topic we have heard that nobody was at fault. Not the brokers,
not the lenders, not the issuers, apparently not the rating
agencies. Evidently, we are witnessing the immaculate
deception.
I am sorry but, as Senator Schumer said, I do not buy that.
Everyone is at fault. And everyone includes Congress. Congress
needs to act quickly to enact the type of borrower protections
contained in the legislation that Senators Schumer and Dodd
have introduced. We also need to figure out how to get the
financial markets to provide faster punishment for bad actors
through pricing or plain lack of access to capital. It is not
enough that these companies only go bankrupt because by that
point they have left a trail of destruction in their path.
The benefit of structured finance is the dispersion of
risk. But today responsibility is dispersed, as well. We need
to figure out to maintain responsibility through both legal and
economic means.
I appreciate the ideas that some of today's witnesses have
suggested. It seems to me we can and we should try to refine
the data that goes into rating products so that each actor is
scrutinized on an ongoing basis with those available details.
It may be, as our witnesses will testify, that it takes
some time to decide whether an overall trend is in place. But
it should take much less time to determine the outliers like
Argent Mortgage and price them out of business.
We can talk clinically about credit enhancement steps, such
as the over-collateralization of security, but there is nothing
excess about that collateral to the homeowner who lives in it.
We must be much more careful in what we do.
Thank you, Mr. Chairman.
Senator Reed. Thank you very much, Senator Brown.
Senator Bunning.
OPENING STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman.
First of all, I would like to welcome Chairman Cox, who is
my good friend.
As easy as it would be to blame one bad actor in the
housing markets, that is not the case. Numerous groups
contributed to the mess, though some contributed more than
others.
At the top of the list is the Fed and its former chairman
and now author, Alan Greenspan. This hearing is not about the
Fed or its role in the housing bust, but understanding
Greenspan's Fed monetary policy is key to understanding what
happened next.
In 2000, Mr. Greenspan kept raising interest rates in the
face of a slowdown, driving the market and the economy into a
recession. In order to undo the problem created by tight money,
he then went too far the other direction, taking rates as low
as 1 percent. That easy money encouraged excessive risk-taking.
Even though Mr. Greenspan knew it would lead to problems,
he did nothing about it. With mortgage rates dropping to all-
time lows housing became hot and people rushed in. Things were
going great until about 2005, when rising interest rates and
housing prices appreciation overcame the abilities of borrowers
to afford the house they wanted.
But instead of accepting that the good times were coming to
an end, borrowers and lenders looked for ways to keep the party
going. What they found was a breakdown in responsibility and
common sense by regulators, lenders, investors, brokers, and
borrowers.
By 2005 everyone believed they had figured out the way to
take the risk out of the lending to home buyers, even those
with poor credit. How was this miracle pulled off? By packaging
loans into bonds that were given a gold star by the rating
agencies and sold to investors seeking higher returns. The
banks, rating agencies, and everyone else in the middle got a
nice fee and washed their hands of the loans.
Let me be clear that everyone involved in the process
shares the blame for today's mess, including the borrowers. But
we are here to talk about the rating agencies and their roles.
As I just mentioned, the rating agencies sat right in the
middle of the scheme and enabled the whole thing to happen.
Their ratings created a sense of security and gave investors
the green light to buy mortgage-backed bonds. But oddly enough,
I find myself in agreement with Chairman Greenspan when he said
last week that the rating agencies did not know what they were
doing. The rating agencies simply got it wrong.
In fact, downgrading of mortgage-backed securities have
already surpassed the level from the last housing downturn and
are almost certain to increase further. That kind of mistake
matters when your decisions are relied on by the entire market.
Important questions need to be answered. Why and how were
the rating agencies so wrong? Why did the marketplace rely on
them so heavily? How much risky lending did the generous
ratings enable? Can their ratings be relied on in the future?
Even the rating agencies will admit that their business
models represent a conflict of interest. They get paid a
substantial fee by the person wanting to get rated, who then
uses that rating as a reason to buy their product. That is like
a movie studio paying a critic to review a movie and then using
a quote from his review in the commercials.
Senator Shelby was right when he led this Committee to pass
the Credit Rating Agency Reform Act last year. Under that act,
we are finally going to get a look at how the agencies operate
and how they try to manage their conflict of interest. More
importantly, the public is going to get information that is
accurate.
Chairman Cox, your Commission has just finished the rules
and registered the first seven agencies. The information you
learn from them will help us determine whether further
regulation is needed or whether the market will be able to take
their ratings for what they are worth in the future.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Bunning.
Senator Menendez.
OPENING STATEMENT OF SENATOR ROBERT MENENDEZ
Senator Menendez. Thank you, Mr. Chairman.
Well, here we are, 6 months after our first hearing to
examine the subprime crisis, and we are still seeing the
effects of the fallout. As far as I am concerned,
unfortunately, the storm is not over. In fact, in some respects
it still seems to be picking up wind.
Home sales dropped yet again last month and yesterday one
of the Nation's largest homebuilders reported its worst ever
quarterly earnings. This means much more than a ripple effect
on our markets. It means Americans are still losing their
homes.
We still have to get to the bottom of the crisis and, as
far as I am concerned 6 months into this, time is running out.
Today we have a chance to examine one piece of the subprime
puzzle. It is only one piece, however. I will reiterate a point
I have made before at some other hearings, we have to look
carefully at everyone who has had a hand in this chain from the
point a loan is signed by the borrower until it is sold on the
secondary market.
The cracks in the system cannot be patched up with a few
tweaks here and there, and I am convinced that the market
cannot fix this alone. Until we have uncovered all of the root
causes of what led to the tsunami in this market, it remains
ripe for more turmoil.
As a member of this Committee over the past few months, I
have heard all of the players duck their responsibility and
point the finger at anyone but themselves. This has become a
game of hot potato and it has to stop.
If you ask me, everyone is responsible and should be held
accountable. The fact is these loans had a real impact on real
lives. We are not just talking about lower annual earnings or
stock prices that have dropped. We are talking about people
whose dreams have been shattered. We are talking about homes
being taken away. We are talking about disintegration for some
of what is, in essence, the American dream.
And yet no one, no one, is willing to step up and say what
hand they had in the process. So while I do not believe this is
just about placing fault I think we cannot lose sight of the
larger picture, and that is that we still have not gotten to
all of the root causes of this fallout. I hope the Committee
will not seek to presume that the marketplace is going to take
care of all of this. I hope that that will not be the view of
the committee and that, in fact, we must act.
Finally, while the credit rating agencies may not be at the
center of this chain, they are still a link. The question is,
in my mind, which I hope we will explore today--I certainly
intend to do--is how much did the credit rating agencies affect
the process and the end result? Did they provide less than
accurate information? Did they react too slowly to changes in
the market? And above all, did they become enablers of the now
crisis? Did they do so by compromising ratings by potential
conflicts of interest?
I am not quite sure how you go about doing the rating and
then going ahead and advising how to package it so you get the
best ratings possible. I am not quite sure that that is really
in the interest of other than those who wanted to package these
products and get the best possible ratings. I am surely not
convinced that that was appropriate by any stretch of the
imagination.
So I am looking forward to that testimony to hear how it
was proper to have the very essence of what would be a conflict
be pursued as a normal course of business.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Menendez.
Senator Allard.
OPENING STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Thank you, Mr. Chairman.
First of all, I would like to thank you for holding this
hearing. Earlier this year we held a Securities Subcommittee
hearing to learn more about the role of securitization in the
subprime markets, so we had a very interesting discussion.
Credit rating agencies came up a number of times at that
hearing so this will be a good opportunity, I believe, for the
Committee members to follow up on many of those matters that
were raised during our Securities Subcommittee meeting.
Credit rating agencies or Nationally Recognized Statistical
Rating Organizations play an important role in our financial
markets. Confidence in those ratings has been shaken following
a number of downgrades of residential mortgage-backed
securities. In fact, just in July and August, Standard & Poor's
issued 1,544 downgrades of residential mortgage-backed
securities.
The downgrades and lack of confidence have dramatic
consequences. Besides the direct consequences in the financial
market, the situation has curtailed securitization, which has
made it more difficult for families to buy a home.
Now former Federal Reserve Chairman Alan Greenspan has been
quoted a number of times. I will give a more complete quote to
the Committee. He issued a sharp rebuke in a newspaper article
earlier this week. He said he believes that the volume of
structured finance products will decrease. He said, and I quote
``People believed they--'' meaning the credit agencies ``--knew
what they were doing, and they do not'' said Greenspan. ``And
then, quoted again, ``What kept them in place is a belief on
the part of those who invested in that was that they were
properly priced. Now everyone knows that they were not and they
know they cannot really be properly priced. ``That is one of
the things I want to follow up in my question is that last
statement.
In a foreshadowing of these concerns, Congress enacted the
Credit Rating Agency Reform Act of 2006. Unfortunately, the law
is still being implemented. But I am hopeful that once it is in
place it will foster a stronger more robust system with better
accountability in order to prevent this situation from
recurring.
At today's hearing we will hear about a number of concerns,
some that have already been mentioned by my colleagues here on
the Committee. But I again would like to highlight that what I
see as a potential Achilles' heel of this entire system is that
credit ratings are not paid for the work of researching,
analyzing, and creating a rating. Rather they are paid for the
actual rating. It does not matter how much work they did or did
not do that went into determining the rating. It is if the
client does not like the final rating, they can walk away
without paying a dime.
The analogy that I can think of is if you are an accountant
and you are doing the tax forms for somebody and you do not
come up with the right tax balance, you would not expect them
not to pay the accountant. I think if you want credit ratings
to be accountable, I think you base it on the time and research
and effort that goes into the program, not on the results and
whether you like the results or not. So I think we need to
check into that more closely during this hearing.
I find this startling, especially when you put into other
housing market context. For example, just like credit ratings,
a number of entities rely on appraisals. Lenders use the
appraisal in underwriting homes. Buyers use the appraisal in
making their decisions, and so forth. To give the appraisal
integrity, we value the objectivity of the appraiser. He or she
is paid for the professional service of appraising a home, not
just a specific number at the end of the process.
Similarly, what if home inspectors were not paid for
conducting the inspection but only for delivering the desired
report on the end? So there are numerous examples that we can
use where this is not a desirable business practice.
So I am hopeful that the FCC will be closely examining this
issue as part of its ongoing work. We have a good lineup of
witnesses, I know, that have a great deal to say. And I look
forward to their testimony.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Allard.
Senator Martinez.
OPENING STATEMENT OF SENATOR MEL MARTINEZ
Senator Martinez. Mr. Chairman, thank you very much. I will
be very brief.
I just wanted to say that I agree with my colleague from
New Jersey that there is an awful lot of people or entities
involved in this process. The outcomes are horrible.
We saw a tremendous wave of home ownership, particularly
among minority families, first-time home buyers, that are now
facing the flip side of that coin as they face the potential
for foreclosure.
During the good times it is very difficult to focus on the
problems that exist within the industry and the problems have
existed and have been obvious. It is very difficult to convince
anyone that there is broker abuse when the good times are
rolling. It is equally difficult to convince anyone that RESPA,
the Real Estate Settlements and Procedures Act, is deeply
flawed and must be reformed, earnestly performed. Not during
the good times, no one wants to think about that. We still have
to look at that. It is part of the ongoing review that we
should be doing as to all things that need to look in the whole
industry.
The Government-Sponsored Enterprises have a weak regulator.
We have known that. These are enormous entities with the credit
backing, presumed credit backing, of the U.S. Government. They
can be tremendously at risk. Yet we have a weak regulator
providing the oversight for these GSEs. We have got to have GSE
reform. They may be part of the solution to the problems we
currently face, but GSE reform also must be a part of it.
So along with that I also believe that the rating agencies
are part of the process and part of the circle of all that we
need to examine and look at. I look forward to hearing the
testimony of the witnesses. I will not prejudge whether, in
fact, the current crisis is one that can be solved by us here
in the Congress acting. It may be that, difficult as it is, we
do not have the power to reverse the excesses of the past
years.
But I do look forward to hearing the testimony from the
witnesses today and probing into this important area of what it
is we have to review, which includes the rating agencies as
well.
Thank you for the hearing, Mr. Chairman and Ranking Member
Shelby, we look forward to the testimony from the witnesses.
Senator Reed. Thank you very much, Senator Martinez.
Chairman Cox, thank you for joining us today and we all
await your testimony. Thank you.
STATEMENT OF CHRISTOPHER D. COX, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Chairman Cox. Thank you very much, Chairman Reed, Senator
Shelby, and members of the Committee.
I am pleased to be here today to discuss the important the
Securities and Exchange Commission is doing concerning credit
rating agencies.
When Congress gave the Commission statutory authority in
the Credit Rating Agency Reform Act of 2006 to oversee credit
rating agencies registered with the Commission, you explicitly
found that Commission oversight would serve the interests of
investor protection. And that it would foster competition,
accountability and transparency in the industry.
The rating agency act grants the Commission broad authority
to examine all books and records of an NRSRO. This broad
examination authority permits the Commission to examine every
NRSRO on a periodic basis for compliance with the Commission's
new rules governing rating agencies that we put into effect
since the enactment of the law, including rules addressing
conflicts of interest and rules prohibiting unfair, coercive or
abusive practices.
The law makes it clear that the commission's otherwise
broad authority does not extend to the regulation of the
substance of the credit ratings or the procedures and
methodologies that a ratings agency uses to determine its
credit ratings. In striking this balance, the legislation gives
the Commission responsibility for promoting competition in the
credit ratings industry and for policing ratings agency
activities, including in particular conflicts of interest, as
has been mentioned by virtually every Senator speaking this
morning.
At the same time, the law declares that it is not our role
to second-guess the quality of their ratings.
The rating agency act is still just months old and it set
out an aggressive schedule for implementation. The Commission
is ahead of that schedule. The SEC proposed six new rules on
February 2nd of this year, just 4 months after the law was
signed. We adopted the final rules on May 23rd, months ahead of
the June 26th--pardon me, more than a month ahead of the June
26th statutory deadline. And earlier this week the Commission
issued orders granting registration under the rating agency act
to seven credit rating agencies. Each of these applications was
swiftly reviewed, evaluated, and determined within the 90-day
timeframe specified by the act. As a result these seven new
registered credit rating agencies are now subject to both the
provisions of the act and the Commission's final rules
implementing it.
In recent months, the credit rating agencies have been
heavily criticized for their ratings of structured finance
products, especially subprime residential mortgage-backed
securities. Critics have faulted the rating agencies for
assigning ratings that were too high and for failing to lower
those ratings sooner, as the performance of the underlying
assets deteriorated.
There has also been criticism that the agencies have failed
to maintain appropriate independence from the issuers and
underwriters of those securities.
For their part, the rating agencies generally have stated
that the incidence of mortgage delinquencies in 2006 far
exceeded their original credit loss expectations. That was
particularly so, they said, for subprime mortgages. They have
also point out that in the past their expectations have turned
out to be more conservative than the actual loss experience.
They have noted several factors that seemed to have caused the
unexpected losses this time around, including fraud in the
mortgage origination process, deterioration in loan
underwriting standards, and lending standards that became more
restrictive very quickly, which in turn made it ever more
difficult for over-leveraged borrowers to refinance.
As of today, the SEC has not formed a firm view on any of
these purported reasons that have been advanced by the credit
rating agencies for what has happened. But we are carefully
looking into each of them in the context of an overarching
examination the Commission has begun with respect to these
rating agencies that are active in rating residential mortgage-
backed securities.
This examination, which is being conducted on a nonpublic
basis, was commenced in response to the recent events at the
mortgage markets. In particular, the Commission is examining
whether the ratings agencies were unduly influenced by issuers
and underwriters to publish a higher rating. This examination
is also focusing on the NRSROs followed their stated procedures
for managing conflict of interest that are inherent in the
business of determining credit ratings for residential
mortgage-backed securities. In this regard, the examination
will seek to determine whether the rating agencies' role in the
process of bringing RMBS to market compromised their
impartiality.
In addition to the Commission's examination that I have
just described, the President has requested that the
President's Working Group on Financial Markets examine the role
of credit rating agencies in lending practices, how their
ratings were used, and how the repackaging and selling of
assets--the securitization process--has changed the mortgage
industry. As a member of the President's Working Group, the SEC
is taking a leading role in this study.
The Commission is also a member of the Credit Rating Agency
Task Force created by the International Organization of
Securities Commissions. In that connection, we recently chaired
an IOSCO meeting at which the rating agencies that are most
active in rating residential mortgage-backed securities made
presentations to the SEC and the securities regulators of
several countries, focused on their role in developing
structured finance products.
Mr. Chairman, I appreciate the opportunity to provide this
Committee with this update on the Commission's oversight of
credit rating agencies, and I look forward to answering your
questions.
Senator Reed. Thank you very much, Chairman Cox and let me
begin.
You make the point that you do not feel the statute gives
you the authority to examine the substance of the credit
ratings or the procedures and methodologies. Would you want
that authority, given the situation we have seen in the
marketplace?
Chairman Cox. No, Mr. Chairman, at this juncture it is my
judgment that you and the Congress have struck a sound balance.
We have a great deal of authority that we are on the very front
end of exercising. It may be that more needs to be done in this
area. We may learn that as a result of our examinations now
under way.
But it is very easy to see in the abstract what would
become of competition, what would become of the market, what
would become of the substance of the ratings themselves if they
just disintegrated into following a Government regulation on
how to do it. There would be no innovation. There would be no
potential for improvement. Or at least there would be a real
collar on that because we would have determined a priori here
is right away.
Particularly, as Senator Schumer pointed out, in a market
that is becoming more complex we have got to recognize that the
statistical models that are used, the stress tests that are
applied, are constantly being reevaluated and updated, and so
there has got to be room for that.
Still whether or not ultimately the business practices, the
resources that are being applied, and the outputs are all
within the range that Congress in the law and the SEC in
practice consider reasonable, I think do fall within the
statutory authority that you have given us.
Senator Reed. Mr. Chairman, among your responsibilities,
and you listed how aggressively you have been pursuing them,
which is to try to prevent self-dealing and conflict of
interest which I think is appropriate, but it seems to me, too,
you have to have an interest in--as the statute describes--that
these agencies are consistently producing credit ratings with
integrity.
How do you accomplish that unless you are able to go in and
look at the substance of their procedures and methodologies?
Chairman Cox. As I say, I think that you and the Congress
have struck the proper balance here because----
Senator Reed. We should restrike the balance which I think,
at least in terms of discussion, that is on the table.
Chairman Cox. Yes, of course.
In implementing the law and adopting our rules earlier this
year and fleshing this out we came to the tentative conclusion,
similarly, that we have ample authority to disgorge information
from the credit ratings agencies, to make it public in
appropriate circumstances so that the market can judge and
better understand what the methodologies look like, so that
rather than putting a collar on innovation we have a lot more
hot white light focused on how this is done. That will affect
the pricing of the services offered by the ratings agencies
because we will have, in the marketplace, a better idea of what
they are worth.
It will also affect the way that people use the ratings. I
am sure we will hear soon a full throated defense from the
rating agencies of what they have done, in part because they
think people are trying to use the ratings for purposes for
which they were originally not intended. The more disclosure,
the more transparency there is here, the better the market is
going to be able to deal with that.
Senator Reed. Given the scope of your responsibilities, do
you have a plan for regular examination of these credit rating
agencies? And would that examination involve both the Office of
Compliance and Inspection and the Division of Market
Regulation?
Chairman Cox. The very short answer to that question is
absolutely, yes. The further answer is that we are in the
midst, as I described, of just such an examination right off
the bat with the law fresh on the books.
Senator Reed. What are your instructions to these
examiners? What are they looking for?
Chairman Cox. First, they are focused on the bread-and-
butter of what the statute requires of these agencies. We want
to look at their resources. The threshold questions that we
also consider at the time, which is very recent, 48 hours ago,
when we issued an order to register initially these seven
agencies. Are you a fly-by-night operation or are you serious?
Do you have the resources that are necessary to do a thorough
job of this? What kinds of people do you have? What kinds of
backgrounds and experience do they have? What is your
management structure and so on? What are your financial
resources?
Next we move on to conflicts of interest. Those are
inherent in the business, as has been described here. How do
you manage those? What are your procedures? We have, in our
rules, stated ab initio that several things are just flat
prohibited. We, of course, examine against those and make sure
that those rules are being followed, that associations between
the credit ratings agencies and those whose products they are
rating are either nonexistent or within the rule.
And then last, we take a look at--although not last in
importance--we take a look at unfair and abusive practices.
This stems from the competitive, the pro-competitive charter
that you have given the SEC.
We will find, I think, over time, whether or not each of
our authorities in those three main areas can be embroidered
sufficiently to give us all of the power that I think you want
us to have.
Senator Reed. The possibility exists, given that scheme,
that if they are reasonably capitalized and their operations
are funded at an adequate level, and there are no overt
conflicts of interest, et cetera, but they are consistently
wrong in their ratings, they would still pass your test.
Chairman Cox. I think that is theoretically correct. One
wonders, however, if we are doing a much better job of
providing transparency, how long that would last in the
marketplace. How much can you charge for being wrong every
time?
Senator Reed. Thank you very much, Mr. Chairman.
Senator Shelby.
Senator Shelby. Thank you.
Chairman Cox, it is my understanding that the SEC never
intended or expected that the National Recognized Statistical
Rating Organization concept would become so widely relied upon.
Given all of the problems we have seen over the years in the
rating industry, conflicts of interest, a lack of competition,
questionable ratings quality, abusive practices and so on, is
it appropriate to reconsider the regulatory reliance on NRSRO
ratings?
Or let me ask it this way: if you were to create a new
system today would you design it differently? And if so, how
so? Obviously, the system is flawed.
Chairman Cox. The answer to the first question is yes. And
the answer to the second question is almost certainly somewhat
different because we would have so much benefit of hindsight.
The reason I say yes so readily to the first question is
that we are already doing that within the SEC. We are examining
our own rules to take a look at whether or not the express
mention and reliance upon the NRSRO concept in our own rules is
appropriate and what its consequences are.
This all started out in 1975. It has been an accretion of
small steps. But it has included the Congress making express
mention of it in the 1934 act. And so I think all of us in the
Congress and in the SEC would do well to consider whether or
not post-enactment of this landmark legislation, in a world
where we expect there to be more competition and more
transparency, whether all of that was really taken into account
in the first instance dating back to 1975 when we first
introduced this concept for purposes of our net capital rule.
Senator Shelby. I appreciate that. We all, I believe,
realize that there is something gone wrong here in the rating
agencies.
Chairman Cox, would you support the forfeiture of an NRSRO
status, either for all securities or a class of securities, by
rating agencies that fail to satisfy minimum accuracy
standards? There is some bad stuff out there.
Chairman Cox. That is a difficult question to answer the
way you put it because our authority to revoke registration or
to limit it derives directly from the statutory language as it
is written. So if you are asking me whether we would use our
authority in that way, given the current statute I think it
would be very difficult.
If you are asking me whether I would urge the Congress to
amend the statute to give us more clear authority to do what
you have suggested, I would say that the answer to that
question awaits a little more induction. We need to learn a
little bit more than presently we know on the front end of
these examinations.
Senator Shelby. Professor Lawrence White of New York
University, who will testify on the next panel, says--and I
quote--``Capital markets have no way of knowing or discovering
whether there are better, more efficient, and effective ways of
assessing the creditworthiness of bond issuers.''
Do you agree with Professor White that there is no more
test for the rating agencies? Do they lose market share for bad
performance? Do inaccurate ratings cost the rating agencies
business? Will a more competitive ratings market, which we
envision, create more significant ramifications for inaccurate
ratings?
In other words, if people come out with inaccurate
ratings--and they have, Enron, WorldCom, the subprime debacle--
are they really punished for that? The market punishes most
people when they are wrong. It seems like the rating agencies
are getting by and who is getting punished are the people who
bought these homes, for the most part.
Chairman Cox. Without question one of the major premises of
credit rating agency legislation that Congress has just put in
place is that competition is a remedy to these problems. We are
now at the beginning of opening up that space to more
competition.
As a footnote, we should observe that anybody can rate
bonds but not anyone can be an NRSRO. So using this process we
will see whether or not the space really does open up. And
given that we might move from an oligopoly to a more full
throated competitive market, whether or not the transparency
that comes along with that--because that is another leg that
the legislation stands on--also provides discipline, including
price discipline in the marketplace.
Senator Shelby. There is no substitute for transparency and
competition, is it not?
Chairman Cox. Certainly when we are talking about pricing
and risk allocation and so on, that is absolutely right.
Senator Shelby. Thank you. Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator.
Senator Casey.
Senator Casey. Thank you, Mr. Chairman. Chairman Cox, thank
you for your testimony and your service.
I was struck by the juxtaposition of two parts of your
testimony just for purposes of my first question. The question
really focuses on I guess the threshold determination that the
SEC makes when it seeks to commence an examination of the kind
we are talking about here with regard to the rating agencies.
The juxtaposition I am focused on is on page two of your
testimony, you talk about the criticisms of the rating
agencies. Your testimony says in part critics have faulted the
rating agencies for initially assigning rates to those
securities that were too high. That is one criticism, rates
that are too high. Second criticism, failing to adjust those
ratings sooner as the performance of the underlying assets
deteriorated. That is the second criticism. And the third that
you site, the third criticism, maintaining appropriate
independence--or for not maintaining appropriate independence
from issuers.
Two paragraphs down you tell us what the Commission will
examine. You say, in particular the Commission will examine
whether the rating agencies were unduly influenced by issuers
and underwriters--which seems to connect to that third
criticism. And then second, you say the examination will focus
on whether or not the rating agencies followed their procedures
for managing conflicts of interest. And it goes from here.
I guess I have two questions. One is in this case or in any
case how is that threshold determination made as to what you
will examine based upon a body of criticism or a body of public
information or even other information that the SEC has?
Chairman Cox. The broader canvas of the various criticisms
that have been made provides the backdrop for what we do. But
the statute tells us, and our rules that we have adopted in
furtherance of the statute, tells us precisely in which
direction to head. That is why we have a focus on managerial,
financial resources, on the competition piece, unfair and
abusive practices and on conflicts of interest.
Senator Casey. So it is the SEC's opinion that when you
talk about--in terms of what the critics have said--that either
faulting the rating agencies for assigning too high a rate or
not adjusting midstream, you think both of those lie outside of
the statutory authority that you----
Chairman Cox. No, I think it is clearly within the
statutory authority to the extent that the reasons that we are
examining are the cause. If conflicts of interest, for example,
result in the credit ratings agency being too cozy with the
person paying and with, therefore, the issuer or the
underwriter of the security to be rated, and that is the reason
for the pathology, the particular problem, such as too good a
rating to start with and not a quick enough adjustment, then we
would be right down the center lane of what you have authorized
us to go after.
Senator Casey. I wanted to ask you about the process. Once
you make a determination about what you will examine based upon
your statutory or other regulatory authority, what does the
process entail from that point? How many people are you
deploying on this? And what is the process? What is the
timeline? If you can take us through how this process would
work.
Chairman Cox. Certainly. One reason that we were able to
beat the deadlines that you put in the statute was, watching
the legislative process, we had fair notice that this might
actually be signed into law. You had consulted with us during
the legislative process. So from a budget standpoint, I was
able to prepare budgets and submit them to the Hill and to OMB
and the President that contemplate doing this work.
Certainly for the next fiscal year we are in good shape, no
surprises here. This is a big priority and we are putting
people from the Division of Market Regulation, from the Office
of Economic Analysis and the Office of Compliance, Inspections
and Examinations on the job.
I should also add that we are locating many of those people
not in Washington but in New York, which is the locus of a lot
of this activity.
Senator Casey. My time is running out but maybe I will
submit a question in writing for the record that speaks to this
balance that I know we have got to strike, and it is a
difficult balance. But I am wondering whether or not--we are
out of time but I will just put it in for the record--that
whether or not at the end of your examination, even if you are
concerned about and compliant with striking the right balance,
whether or not the SEC can recommend to these rating agencies
that even on the question of the ratings themselves or changing
or altering those ratings midstream, whether or not that is not
an appropriate role for the SEC to play to make recommendations
based upon expertise that you could retain or may have residing
within the Commission.
I will sketch that question out and send it to you.
Thank you very much.
Chairman Cox. Thank you, Senator.
Senator Reed. Thank you very much, Senator Casey.
Senator Sununu.
Senator Sununu. Thank you, Mr. Chairman.
Senator Reed and Senator Shelby both mentioned the concern
about getting the ratings wrong, the degree to which
inaccuracies in ratings done by the rating agencies should cost
market share, the degree to which if you are getting the
ratings wrong there should be some punishment, some discipline
exercised in the marketplace. But all of that presumes that we
have good information to determine whether or not they got the
ratings right or wrong in the first place.
And I think that is an issue that really has not been
explored to any large degree in all of these discussions. I
have the testimony here and there are some numbers about
default rates and upgrades and downgrades but very little
comparative information. And we are actually in a position
where performance can be measured fairly accurately. Because
these are ratings designed to give an indication of the
likelihood of default. Over time you can determine whether, in
fact, the securities went into default or companies, if it is
an equity, went into default. We can actually measure
performance.
It would seem to me that it is relatively easy to calculate
accuracy and performance over time, to disclose that
information and then to naturally compare it. Compare one
agency to another. It is I think great, as was indicated here,
that we have seen the approval of seven agencies and people
have talked about the need for greater competition in this
area. But we would want competition to be based on performance.
But again, competition based on performance requires that you
have accurate performance statistics out there.
My question is to what extent does either the SEC or market
participants have access to historical default rates, accuracy
for these securities or others rated by the agencies? And is
that made available in a way that we can compare performance
from one organization to another over time?
Chairman Cox. That has not been the case in the past. It is
now and will be the case in the future as a result of
legislation, as a result of our rules. This is a very important
change. Giving the marketplace this better information will, I
think, provide a great more useful information than people have
ever had before, which will in turn affect the way that ratings
are used, the way that rating services themselves are priced,
and certainly the way that the assets that are rated are priced
and the risk is assessed.
Senator Sununu. Will data reflecting accuracy and
performance be made available across different types of
securities, asset-back securities, debt instruments, and
equities, as well?
Chairman Cox. The ratings performance information is, I
believe, going to be provided in a way that will make it
susceptible to a good deal of intermediation by analysts. So
that not only what you describe but perhaps a lot more
granularity might be possible.
Senator Sununu. Who is going to determine the format of
presentation, the statistics and data that will be made
available for all companies? In other words, is the SEC
facilitating this? Or is it happening through the rating
agencies themselves or through a cooperative effort facilitated
by a third party?
Chairman Cox. First, the form NRSRO that is provided under
our new rules by the rating agencies provides a format--it is a
forum--for this information. Second, what becomes of that
information as people manipulate it and add it, subtract it,
divide it, and so one is up to the marketplace.
This is, however, an area that I should add, we are going
to look at and see whether or not we cannot constantly find
ways to cause the information to be reported in the first place
so that is more useful to investors. Not only is this the case
with respect to the way the information is divided up when it
comes to us, but also the technology that is used to report it.
We have an overarching initiative to use computer data tags to
attach to the information so that it can be much more easily
manipulated than presently any SEC report can.
Senator Sununu. Is data regarding the rating agencies'
accuracy for the 2006 class of subprime asset-backed securities
available now for all of the agencies that rated those
securities?
Chairman Cox. I believe as a result of registration that is
the case, but let me inquire and make sure.
[Pause.]
The additional information I can provide, with staff help,
is that the firms are now making information publicly
available. But if there is a failure here we will step in and
make sure that it becomes available.
Senator Sununu. I will interpret that to mean not quite yet
but we all hope it is forthcoming. And I appreciate your
willingness to help. I think that is very important information
to have as part of the record of this hearing and I look
forward to seeing it.
Thank you, Mr. Chairman.
Senator Reed. Thank you very much.
Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Welcome,
Chairman Cox. We appreciate your appearance here today.
On an aside, I had submitted questions from your July
appearance and have not received them yet. And I hope we can
get answers soon.
Chairman Cox. Senator, just to give you some insight into
our Commission process, I finished with those answers some time
ago but they go through a Commission-wide process. I will make
sure that, with your public urging here, that you have those
ASAP.
Senator Menendez. Thank you, I appreciate that.
Mr. Chairman, here we are here 6 years after Enron, long
after we knew the vulnerabilities that existed surrounding
credit rating agencies. But it seems that we are, in some
respects, still at square one. Don't you think that we are
behind the curve here?
I know you just came to the Commission 2 years ago and we
just passed a law last year. But there were other powers the
SEC had before this bill.
Chairman Cox. In fact, Senator, the powers that we have and
had then extend to areas that I think are not the center of the
action here. Obviously, we have got anti-fraud authority. We
had some very minor opportunities to get to the real meat of
this with respect to those, not all, firms who were registered
as investment advisers because we could examine their books and
records qua investment adviser.
But not until this legislation did the SEC have the
authority to inspect and examine credit rating agencies as
credit rating agencies.
Senator Menendez. I look at the report that the Commission
issued in January of 2003 as required by Sarbanes-Oxley, and it
is interesting to note on its final page, amongst the three
major areas: potential conflicts of interest were listed. There
were three different categories within that context.
That is 2003. And here we are in 2007 still talking about
potential conflicts of interest.
Let me ask you this: do you----
Chairman Cox. Senator, as you know, the conflict of
interest piece is a centerpiece of the Credit Rating Agency Act
and our rules now. And so that is very sturdy authority than
presently we have. So the registrations that brought these are
firms within our rules as of 48 hours ago give us authority
that we just did not have before.
Senator Menendez. I am only pointing out that in 2003 the
Commission said that this was a challenge.
Chairman Cox. Yes, we were aware of the problem.
Senator Menendez. Four years later either it did not seek
powers to look at it beyond it, and the Congress did not act
before then. And so we have actually had warning signs for some
time.
Let me ask you this. It seems to me that credit rating
agencies are playing both coach and referee in the debt game.
They not only rate these instruments but they also offer the
issuer help in constructing the product in order to obtain a
certain rating. For some agencies these structured finance
deals have accounted for more than 40 percent of their total
revenues. Isn't that a problem?
Chairman Cox. It is certainly potentially a problem. If is
one of the reason that we are examining and it is one of the
very points that we are examining against.
Senator Menendez. Let me ask you this: don't we need more
oversight? Do you believe that you presently have the authority
to set standards, monitor and evaluate compliance, discipline
rating agencies for violations including, in the most egregious
cases, revocation of the SEC recognition? Do you believe you
have those powers today?
Chairman Cox. Yes, we do.
Senator Menendez. In that respect, isn't one of the things
we should be looking at here is more transparency, the
disclosure of any services a ratings agency has provided to the
company in connection with the issuance or rating of debt,
including any consulting on the structuring of the transaction
and the amount of fees related to those services that were paid
to the rating agency? Wouldn't that be something that would be
desirable?
Chairman Cox. Indeed, providing such services in addition
to ratings would fall within the category of identified
conflicts of interest. Our current rules require the agency to
self-identify those conflicts of interest, and beyond that to
identify the procedures that it has put in place to mitigate
those conflicts.
Senator Menendez. So finally, what is your timeline, Mr.
Chairman? What do you see as the timeframe in which the
Commission will act so that we can all understand what we
expect of these credit rating agencies so we do not find
ourselves in a future debacle of this sort?
Chairman Cox. The examinations are already underway. And so
we are talking almost certainly months, not any longer period
of time. But even during the pendency of the examinations, we
are going to be learning things in real time. And so I would be
very pleased to maintain a dialog with this Committee about
lessons learned on an ongoing basis.
Senator Menendez. I appreciate that. I think it would be
helpful for us to know so that we do not wait an inordinate
period of time if here is something that we can would respond
to.
Thank you.
Senator Reed. Thank you.
Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
I agree that we need to get more information to the
investors and I appreciate your answer in that regard. I just
want to make sure that they have good information.
If we are talking about subprime loans, doesn't that
indicate that there is some risk there?
Chairman Cox. Indeed.
Senator Allard. Is there a way of the investor knowing what
portion of the portfolio that they may be investing in is
subprime?
Chairman Cox. Almost certainly the disclosures that would--
certainly, if these are publicly registered debt instruments.
Senator Allard. How does a company that has subprime loans,
how do they get some of the higher ratings that we saw say 2 or
3 years ago?
Chairman Cox. I think that is very dependant on the facts
and circumstances. As you know, there are a variety of complex
instruments that have been and are being designed repackage
these securities. Diversification of the risk, a combination of
one type of underlying asset with another, tranching, all of
these are ways to segment and allocate risk.
Senator Allard. Does the consumer, when they buy a
security, do they understand--as a general rule, do they
understand those factors that go into----
Chairman Cox. I am sorry, who is the ``they'' in this
example?
Senator Allard. This would be your purchaser of stock or
investor. Let's say the investor.
Chairman Cox. One certainly would hope and expect so. But I
think, looking back, it is also empirically true that everyone
here ended up with something that they did not want or expect.
And that certainly includes the investors.
But the rating agencies themselves underestimated the
default probabilities and they underestimated the loss that
could occur in the event of default and overly relied, I think
they have tacitly admitted, on historical data that was
different from what actually happened in this case.
The investors, perforce, who relied in part on that, on
those ratings, were surprised and surely not all of them knew
beforehand that this is what they were getting into.
Senator Allard. One aspect that I would bring up is the
valuation of the home. One of the problems we have had in these
home failures is that we found that the appraiser--which is
regulated by the State if they are regulated at all, or in some
aspects maybe even their reputation is locally determined. And
sometimes whether a bank uses an appraiser or not depends on
whether they facilitate that loan being made or not.
One of the key links is the actual appraisal of the home.
Is there a way of knowing and identifying whether certain areas
of the country have a greater problem with appraiser values
than other parts of the country? And can that be plugged in to
the evaluation? Do you see that as a problem?
You understand, I mean, when it is overappraised, your risk
is higher.
Chairman Cox. I would imagine, because this is a subject
that is inherently understandable and knowable, that if such
data do not already exist, they could be readily compiled. And
that further, putting together better information on the input
side would almost certainly help is you aggregate the risk
information. Senator Martinez earlier mentioned the possibility
of RESPA reform as a way to improve the inputs.
Senator Allard. I am not sure that can be readily compiled.
I am trying to figure out how you can compile that. It can be a
variable. It can be a pretty extreme variable, I think
depending on maybe how these markets work out locally. I think
it may be----
Chairman Cox. It may not be readily compilable by you or by
me right now with what is available. But it just strikes me
that if this were a priority that things could be arranged so
that it would be subject to ready compilation.
Senator Allard. The reason I ask is I do want to see us get
the information to the investor so they know what kind of risk
that they are taking. One aspect of it is the actual appraisal
of the property, the home itself. It seems to me like that
would be very difficult to assess and put together and I see a
lot a variation happening by region of the country and perhaps
even from one time period to another time period depending on
what the dynamics might be in a market in a certain locale.
Thank you, Mr. Chairman. I see my time has expired.
Senator Reed. Thank you, Senator Allard.
Senator Martinez.
Senator Martinez. Thank you very much, Mr. Chairman.
Chairman Cox, thank you for being here and it is very fine
work that you are doing.
I noticed in your testimony that you mentioned that the
President has requested the President's Working Group on
Financial Markets examine the role of credit rating agencies.
As a member of that Presidential working group, the SEC has
been taking a lead role in that study. Can you tell us a little
more about what you are specifically focusing on in that aspect
of your work?
Chairman Cox. Yes, the role of rating agencies in the
process of bringing these securities to market, the overall
economic impact, and of course, each of the members of the
President's Working Group has a different perspective on this
and we have different information. So when we put our resources
together from the Fed, from the Treasury, from the SEC, and
from the CFTC, we have a much better picture. And our staff are
working on aggregating all of that information.
Senator Martinez. From the SEC perspective, what is your
focus as you participate in this analysis?
Chairman Cox. We will be able, certainly, by order of
magnitude more, post our orders earlier this week, to
contribute real-time information as a result of what we are
learning in our examinations.
Senator Martinez. Thank you, sir. That is all I have.
Senator Reed. Thank you, Senator Martinez.
Chairman Cox, thank you for your testimony and for your
service at the Commission. I am sure we will be involved in
this issue going forward and we seek your advice and your
counsel. Please do that.
Chairman Cox. Thank you very much, Mr. Chairman. The SEC
looks very much forward to working with you on this issue.
Senator Reed. Thank you.
I would now like to call forward the second panel.
Let me thank all of our witnesses on the second panel for
joining us today. I would like to introduce them and then call
upon them individually for their statements.
All of your statements will be made part of the record so
you may summarize. In fact, we encourage summaries. I would ask
you all to try to abide by the 5-minute timeline, so that we
could engage in questioning after your comments.
Mr. John Coffee is the Adolf A. Berle Professor of Law at
Columbia University Law School and Director of its Center on
Corporate Governance. He is a Fellow at the American Academy of
Arts and Sciences, and internationally recognized authority on
securities. He has testified before several Congressional
Committees, including the Senate Banking Committee. It is good
to see you back, Professor Coffee. We always welcome your
presence and your testimony. We greatly appreciate his
contributions, particularly to the drafting of the Sarbanes-
Oxley Act, and particularly Title V. Thank you, Professor
Coffee.
Ms. Vickie A. Tillman is Executive Vice President of
Standard & Poor's Rating Services. Prior to assuming her
current position in 1999, Ms. Tillman was Executive Managing
Director of Standard & Poor's Structured Finance Ratings where
she had worldwide operational and financial responsibility for
directing rating activity for all S&P structured finance
ratings services. Thank you, Ms. Tillman.
Mr. Lawrence J. White, Dr. Lawrence J. White, is the Arthur
E. Imperatore Professor of Economics at New York University's
Stern School of Business and Deputy Chair of the Economics
Department at Stern. From 1986 to 1989 he served as a board
member of the Federal Home Loan Bank Board and from 1982 to
1983 he served as Director of the Economic Policy Office and
the Antitrust Division at the United States Department of
Justice. He is currently the General Editor of the Review of
Industrial Organization and Secretary-Treasurer of the Western
Economic Association International.
Mr. Michael Kanef is a Group Managing Director at Moody's
Investor Services, where he has worked since 1997. He is the
head of the Asset Finance Group, which is responsible for
ratings on residential mortgage-backed securities, term asset-
backed securities, and asset-backed commercial paper issued in
the United States, Canada, and Latin America.
Thank you all for your presence here today. We look forward
to your testimony.
Professor Coffee, please.
STATEMENT OF JOHN C. COFFEE, ADOLF A. BERLE PROFESSOR OF LAW,
COLUMBIA UNIVERSITY SCHOOL OF LAW
Mr. Coffee. Chairman Reed, Ranking Member Shelby, members
of the Committee, thank you for inviting me.
Because you have shown in your questions that this is a
very informed panel, I am going to delete about five pages of
background information and get right to the core of my
testimony.
I want to make three proposals. But it summarizes what I
say in my written testimony to say that the current market for
debt ratings is one in which there is very little penalty for
inaccuracy. It is one in which there are strong incentives for
optimism and grade inflation. There is very little reason to
downgrade a rating that you have already made. You do that only
under pain of great embarrassment.
The result is we have a market in which there is a tendency
toward rating inflation and toward stale ratings. I am not
suggesting that there were demons here. I am going to paint a
picture of the gatekeeper in this market who is under great
pressure and who is vulnerable to that pressure. And I think
the proposals have got to look at how to create countervailing
pressure to make this market more sensitive to the need for
greater accuracy.
What is causing this? I give a given number of reasons. But
one distinctive factor in this market is behaving very
differently in its rating of corporate bonds versus its rating
of structured finance products. I think that is because
structured finance gives new power to the investment banks.
They are assembling large pools of securitized assets. They are
repeat players. And they can remove their business if they do
not get what they like. They have much more power than the
traditional corporation, which was only 0.01 percent of the
agency's business.
Let me document this. The data that the agencies themselves
are producing show a huge disparity. Moody's data--and I
congratulate Moody's on presenting this data--Moody's data
shows that for its minimum investment grade rating, Baa, over a
5-year cumulative default period ending in 2005 corporate bonds
that received the minimum investment grade had only a 2.2
percent default rate. The collateralized debt obligations,
CDOs, had a default rate of 24 percent. They both got the same
rating. That is a ratio of over 10 to one.
Now Moody's tells me, quite properly, that maybe 2005 was
aberrational and they suggested we look at 2006. On that basis
the ratings changed slightly. The corporate debt credit default
rate for Baa was 2.1 percent and the defaults rate for CDOs was
17 percent.
I do not care whether you look at the 24 percent default
rate or the 17 percent default rate, this was a default rate on
securities labeled investment grade. And that means to each
Senator who is here that there were public pension funds in
your jurisdiction, there were also other institutional buyers,
universities, hospitals, charities, who are thinly staffed and
rely on, live or die on--perhaps improperly, perhaps too
casually--whether or not the securities had an investment grade
rating. That is all they are checking before they buy. The
market may efficiently price these, but there are
unsophisticated debt purchasers who are taking more risk than
they intend because they are buying investment grade ratings
that have a default rate that would be extreme for a junk bond.
That is the current problem.
What can we do? I will also give you one other fact. These
gatekeepers are subject to great pressure. Moody's has told the
Wall Street Journal, which quoted this just a month ago, that
when they downgraded debt ratings in July of 2007 this year
they experienced a market reaction. Their market share in
residential real estate-backed CDOs went from 75 percent to 25
percent. That means there is extreme pressure on this kind of
gatekeeper and it is going to keep them from downgrading
properly and it gives you stale ratings.
What should be done? I want to make three quick
suggestions. One, picking up on what has already been
suggested, I think the SEC should compute the default rates
using its own criteria, not letting the agencies do it
themselves because they will all use different criteria. It
should publish this on a computer screen on a real-time basis
so for each asset class and for each investment grade we will
see ratings that the SEC has verified.
What am I trying to do? I am trying to establish a
competition based on quality and accuracy. I am trying to
create a reputational penalty and embarrassment cost because
that is the only sanction we can really use easily.
Second, I would suggest, as Senator Shelby already has
suggested, that NRSRO status should be forfeitable for extreme
inaccuracy. If the debt rating should be 3 percent default rate
and you have a 20 percent default rate, I would suggest that at
some level, whether it is 6 percent, 10 percent, or 12 percent,
being outside that boundary could cost you your NRSRO status.
You forfeit it until you get it back.
The last point in just 5 seconds, the real hope in this
field might be the entry of new competitors who are based on a
subscription-funded system, not an issuer-funded system. They
face an obstacle. They cannot get data from issuers. Corporate
issuers do not want to deal with people they have not hired.
They like their friendly allies. I would protect the new
competitors who can play a useful watchdog role by extending
Regulation FD, Regulation Fair Disclosure, so that if a company
gave any data to an NRSRO rating agency, it would have to give
the same data to all other NRSRO rating agencies. That is the
way to protect the independence of the process and protect the
objective new input. None of these are costly or intrusive.
I will leave you on that note.
Senator Reed. Thank you, very much, Professor Coffee.
Mr. Kanef.
STATEMENT OF MICHAEL KANEF, MANAGING DIRECTOR OF THE ASSET
FINANCE GROUP, MOODY'S FINANCIAL SERVICES
Mr. Kanef. Good morning, Chairman Reed, Ranking Member
Shelby, and members of the Committee.
I am pleased to be here on behalf of my colleagues at
Moody's Investors Service to speak about the role rating
agencies play in the financial markets and to discuss some of
the steps that we believe rating agencies and other market
participants can take to enhance the effectiveness and
usefulness of credit ratings.
Moody's plays an important but narrow role in the
investment information industry. We offer reasoned independent
forward looking opinions about relative credit risk. Our
ratings do not address market price or the many other factors
beyond credit risk that are part of the investment
decisionmaking process and they are not recommendations to buy
or sell securities.
Let me briefly assess the subprime mortgage market which
has been part of the broader residential mortgage market for
many years. While subprime mortgages originated between 2002
and 2005 have generally continued to perform at or above
expectations, the performance of mortgages originated in 2006
has been influenced by what we believe are an unprecedented
confluence of factors.
These include three key factors. First, increasingly
aggressive mortgage underwriting standards in 2006 and numerous
sources also indicate that there have been instances of
misrepresentations made by mortgage brokers, appraisers, and
others.
Second, the weakest home price environment on a national
level since the 1960's.
And third, a rapid reversal in mortgage lending standards
which first accommodated and then quickly stranded
overstretched borrowers needing to refinance.
Moody's response to these increased risks can be
categorized into three broad sets of action. First, beginning
in 2003, Moody's began warning the market about the risks from
the deterioration in origination standards and inflated housing
prices. And we published frequently and pointedly on these
issues from 2003 onward.
Second, we tightened our ratings criteria, steadily
increasing our loss expectations for subprime loans and the
credit protection we looked for in bonds they backed by about
30 percent between 2003 and 2006. While Moody's anticipated the
trend of weakening conditions in the subprime market, neither
we nor most other market participants anticipated the magnitude
and speed of the deterioration in mortgage quality by certain
originators or the rapid transition to a restrictive lending
environment.
Third, we took prompt and deliberate action on specific
securities as soon as the data warranted it. We undertook the
first rating actions in November of 2006 and took further
actions in December 2006 and April and July 2007, and will
continue to take rating action as appropriate.
In addition, we are undertaking substantial initiatives to
further enhance the quality of our analysis and the credibility
of our ratings. These include enhancing our analytical
methodologies, continuing to invest in our analytical
capabilities, supporting market education about what ratings
actually measure in order to discourage improper reliance on
them, and developing new tools to measure potential volatility
in securities prices which could relieve stress on the existing
rating system by potentially curtailing the misuse of credit
ratings for other purposes.
We also continue to maintain strong policies and procedures
to manage any potential conflict of interest in our business.
Among other safeguards: at Moody's ratings are determined by
committees, not individual analysts. Analyst compensation is
related to overall analyst and overall company performance and
is not tied to fees from the issuers an analyst rates. And our
methodologies are publicly available on our website. And
finally, a separate surveillance team reviews the performance
of each mortgage-backed transaction that we rate and that
surveillance is a monthly basis.
Finally, beyond the internal measures that we undertake at
Moody's, we also believe that there are reforms involving the
broader market that would enhance the subprime lending and
securitization process. These include the Federal licensing of
mortgage brokers, tightening due diligence standards to make
sure all loans comply with law, and strengthening and enforcing
representations and warranties.
We are eager to work with Congress and other participants
on these and other measures that could further bolster the
quality and usefulness of our ratings and enhance the
transparency and effectiveness of the global credit markets.
Thank you. I will be happy to answer your questions.
Senator Reed. Thank you very much.
Ms. Tillman, please.
STATEMENT OF VICKIE A. TILLMAN, EXECUTIVE VICE PRESIDENT FOR
CREDIT MARKET SERVICES, STANDARD & POOR'S
Ms. Tillman. Mr. Chairman, members of the Committee, good
morning.
I am Vickie Tillman. I head the rating activities at
Standard & Poor's.
Recently, there has been much public discussion around
credit rating agencies and problems in the subprime market and
I appreciate the opportunity to clarify S&P's role in the
financial markets, to discuss our record of offering opinions
about creditworthiness, and to assure you of our ongoing
efforts to improve.
While ratings are not guarantees, S&P's record of
evaluating the credit quality of RMBS transactions is
excellent. As the chart on page six of my prepared testimony
demonstrates, we have been rating RMBS for over 30 years.
During that period of time, the percentage of defaults of
transactions rated AAA is 0.04 percent. Even our lowest
investment grade rating, BBB, has a historical default rate of
only slightly over 1 percent.
That said, we at S&P have learned some hard lessons from
the recent difficulties in the subprime area. More than ever we
recognize that it is up to us to take steps so that our ratings
are not only analytically sound but that the market and the
public fully understand what credit ratings are and what they
are not. Our reputation is our business and when it comes into
question we listen, we learn, and we improve.
Credit ratings speak to one topic and one topic only, the
likelihood that rated securities will default. When we rate
securities, we are not saying that they are guaranteed to
repay, but the opposite, that some of them will likely default.
Even our highest rating, AAA, is not a promise to performance
but an evaluation of the risk of default.
Recognizing what a rating constitutes is critical, given
the recent market turmoil has not been the result of widespread
defaults on rated securities but rather the tightening of
liquidity and to a significant fall in market prices. These are
issues our ratings are not meant to and do not address.
I want to spend a minute now on how and why ratings change.
While ratings may not be as volatile as market prices, they are
not static either. Our view of a transaction can and does
evolve as facts develop, often in a way that is difficult to
foresee. Changes in ratings reflect these developments. This
has been the case with a number of recent residential mortgage-
backed transactions involving subprime collateral. In these
transactions a number of the behavioral patterns emerging are
unprecedented and directly at odds with historical data.
At S&P we have been expressing in publications our growing
concerns about the performance of these loans and the potential
impact on these rated securities for the last 2 years. I have
quoted a number of them in these publications and in the
written testimony.
We have also taken action including downgrading RMBS
transactions more quickly than ever before and updating our
analysis in terms of increased risk. Moreover, we continue to
work to enhance our analytical processes by tightening our
criteria and increasing the frequency of our reviews, modifying
our analytical models, completing a recent acquisition that
will help further enhance our analytics and our models, and
analyzing areas in which we can do more, such as a way to
enhance the quantity and the quality of the data that is
available to us.
We also take affirmative steps to guard against conflicts
of interest that may arise out of the fact that we, like most
other major rating agencies, use an issuer pay model. As the
Committee knows, this issue was thoroughly debated by Congress
during the consideration of the 2006 act. A number of
independent commentators, including the head of the SEC's
Division of Market Reg, apparently agree that any potential
conflict of interest can be managed.
At S&P our policies and procedures include the fact that
analysts are neither compensated based upon the number of deals
that they rate, nor involved in the negotiation of fees. These
controls and others are set forth in a code of conduct modeled
after the IOSCO code. Every employee receives training on this
code and must attest to its compliance.
Equally important, S&P has not and will not issue higher
ratings so as to garner more business. From 1994 through 2006,
upgrades on U.S. RMBS ratings outpaced downgrades by a multiple
factor. This pattern would not exist if S&P deliberately issued
high ratings to please issuers. Nor would we have our excellent
track record of predicting the likelihood of RMBS defaults if
our ratings were the subject of undue influence.
Finally, Mr. Chairman, I would note that the issuer pay
models helps bring greater transparency to the markets as it
allows all investors to have real-time access to our ratings.
Unlike under a subscription model, the issuer pay models allow
for broader market scrutiny of ratings every day.
Others have questioned S&P structured transactions that we
rate. Again, my written statement responds to this point in
detail but let me make our position clear. S&P does not tell
issuers what they should or should not do. While we may discuss
aspects of proposed transactions and our analysis, we do not
compromise our criteria. Nor could we, as we make our basis
criteria publicly available and deviations from it would be
readily discoverable.
Since my time is running very quick, let me end by
reiterating our commitment to do all that we can to make our
analytics the best in the world. Let me also assure you again
of our desire to continue to work with the Committee as it
explores developments affecting the subprime market.
Thank you, and I would be happy to answer any questions you
may have.
Senator Reed. Thank you very much.
Dr. White.
STATEMENT OF LAWRENCE J. WHITE, ARTHUR E. IMPERATORE PROFESSOR
OF ECONOMICS, LEONARD N. STERN SCHOOL OF BUSINESS, NEW YORK
UNIVERSITY
Mr. White. Thank you.
Mr. Chairman, Ranking Member Shelby, members of the
Committee, my name is Lawrence J. White. I am a Professor of
Economics at the NYU Stern School of Business. I thank you for
the opportunity to testify this morning. I am pleased to be
here. I am going to summarize my statement, which in its full
length is available to you.
As you have already heard this morning, there is a lot of
blame to go around. I will not repeat the parties, we basically
know who they are. The bond rating firms are among them.
What I want to do is summarize how we got to where we are,
provide some context, and make a plea to the Committee, to the
Congress. Let's see what the new legislation can do before we
enact--before you enact new legislation.
How did we get here? Back in 1975 the Securities and
Exchange Commission wanted to establish capital requirements
for broker dealers, and it wanted to base those capital
requirements on bond ratings, just as bank and insurance
regulators had done in earlier decades. But whose ratings
should be used for these purposes? To its credit, the
Securities and Exchange Commission recognized the problem of
the bogus rating agency that might hand out AAA ratings to
everyone, or DDD ratings to everyone. And so it created the
NRSRO category.
Unfortunately, the NRSRO category became a protective ring
around the incumbent bond rating industry. It protected
incumbents and restricted entry. As recently as early 2003
there were only three NRSROs. And the whole process for
administering the NRSRO regime was exceedingly opaque. Until
the Enron hearings in early 2002, NRSRO was one of the best-
kept secrets in Washington. Even today it is certainly not a
household phrase.
The importance of the NRSRO designation can not and should
not be understated. Regulated financial institutions across the
financial sector were and still are required to heed the
ratings of the NRSROs in deciding what bonds they can and
cannot hold in their portfolios. In essence, the financial
regulators have been delegating to third parties, the NRSROs,
safety judgments about what is or is not appropriate for
financial institutions' portfolios.
Because financial institutions are forced to heed the
NRSROs ratings, the bond markets in general must heed those
ratings even if they were to believe that the NRSRO ratings
otherwise have no value.
Senator Shelby earlier mentioned my earlier statements and
I will repeat them again. There has been no clean market test
of whether the NRSROs really are providing value to the
financial markets under the until very recent regime.
However, we do have the new legislation that is just 1 year
old. The implementing registrations are just 3 months old. The
new law was intended, is intended, to bring down the entry
barriers in the bond rating business, open up entry, create
more competition, more alternatives, let different business
models be out there, and let the financial market participants
make their decisions as to whose ratings are to be trusted and
whose are not to be trusted.
I would have preferred to have gone farther and to have
gotten rid of the NRSRO category entirely, but I think the
legislation provides a good start in the right direction.
Accordingly, I urge the Committee to not enact new
legislation. First, it would be extremely difficult, if not
impossible, for legislation to prevent the kinds of mistakes
that I believe the bond rating firms have made in the recent
past. And efforts to do so really run great risks of
stultifying the industry, of distorting the industry, and
creating new barriers to entry.
Second, as I just stated, the new legislation should be
given an opportunity to work. We need to see what new
competition, real competition, among rating companies with the
different opportunities, different models, different ideas,
what that can do. The financial markets, if given the
opportunities, I think can make good choices.
And the financial regulators should be given the
opportunity to rethink this delegation question in light of the
new market opportunities for bond rating firms with more bond
rating firms out there.
So let's see what the recent legislation can do before new
legislation concerning this industry is considered.
Thank you again for the opportunity to testify today, and I
will be happy to answer questions from the Committee.
Senator Reed. Thank you very much, Dr. White.
Thank you all for your excellent testimony.
Let me ask a question to both Mr. Kanef and Ms. Tillman. I
will begin with Ms. Tillman first.
You indicate and you take very seriously there is a code of
conduct in your firm, and the same with your firm. Do you
believe that independent of whatever we do that, that code of
conduct should be strengthened in areas, for example post-
employment? When someone leaves your firm and goes directly to
a client of yours it raises the specter--and frankly, that
should be obvious.
Second, we have been told in regard to these particular
difficult products, structured finance, that the rating
agencies were not only rating them but they were also helping
structure them or advising the client as to what they could do,
which raises I think an inherent conflict. Should those
functions be totally separate or clearly disclosed or something
in terms of what you can do today short of new legislation?
Ms. Tillman. In terms of the first question about
employment, I mean theoretically, I mean I do not necessarily
think that that is either right or wrong in terms of whether
somebody should be restricted.
From a cost-benefit analysis, being that I do manage the
ratings business, it may, in fact, have an unintended
consequence of allowing us to hire the kind of skilled people
that we need if they know that their career paths are going to
be limited by where they could next.
Senator Reed. I think the assumption would be for a
suitable period of time, as is imposed upon----
Ms. Tillman. Right. So in general, it is not something
that, you know, I think could not work. But again, I have not
thought through what the implications would be relative to the
business.
In terms of your second question, relative to structuring
debt, we do not structure debt, structure the transactions.
If I can be given a few minutes to sort of explain what our
role is relative to this. First of all, I would like to make a
point clear, that our criteria is absolutely transparent to all
of those in the marketplace. They understand it. they see it.
The models that we use internally to look at the stress testing
or look at the probability defaults around the loans that are
packaged in these, these are readily available in the
marketplace, as well.
So there is a lot of understanding around what kind of loan
characteristics, what kind of stressing we do in the
marketplace.
So as the originator originates the loan, the investment
banker works with the originator to package the loan. They
already have an idea of what kind of loans they are looking
for, relative to the way Standard & Poor's looks at the almost
70 different characteristics, if you will, on every loan that
is put in a pool.
Once that is packaged, I think there seems to be a point
that needs to be made, that this is actually a very
sophisticated investment community. Most of these bonds, if not
a majority of them, are sold to institutional investors or had
been sold to hedge funds who have their own staffs that not
only look at ratings, which again is only speaking to credit
risk. But the ratings does not speak to suitability of the
investment, the pricing of the investment. They have their own
firms there, their own people that run their models. Or they
use our models as a benchmark and run their own proprietary
models before they will make a decision as to whether that is
an appropriate investment for a particular risk appetite.
So they go through that process and they present to
Standard & Poor's a package of pooled securities----
Senator Reed. Let me just get to the point, because my time
is limited.
Ms. Tillman. I am sorry.
Senator Reed. So there is no collaboration between Standard
& Poor's and the issuer, in terms of how the product is
structured? That you simply take what they present you,
evaluate it, and give a rating?
Ms. Tillman. We have a great dialog. We have an open dialog
with the investment bankers. They need to understand what our
criteria is. We need to understand better what their structure
is. And if we tell them that it does not fit with our criteria,
what we do is tell them why it does not fit with our criteria--
--
Senator Reed. And how to make it fit.
Ms. Tillman. No, sir. We do not tell them how to make it
better. That is up to them to make the determination as to
whether they want to change the structure, change the pool,
change the over-collateralization.
Senator Reed. I appreciate that. I do not want to be abrupt
but I want Mr. Kanef to get a chance and I have another
question.
I think, at least on the surface, there is a suggestion
here that there is something going on more than simply being
presented a group of loans or a product, here is our rating,
take it or leave it. There is this dialog.
Mr. Kanef.
Mr. Kanef. Thank you, Mr. Chairman.
With respect to the first part of your question, I think
the British actually may call it gardening leave, a period of
time before you can go to a client. Certainly, I think Moody's
would be willing to consider such a thing, as well as other
potential changes to our code if the SEC or yourselves were to
feel that there were some aspects of that code that were not
sufficient. Certainly, we would be willing to consider the
things that you might suggest.
With respect to your second question, as with S&P, our
methodologies and models are publicly available and the parties
that are participants with respect to the structuring of the
deals, the investment bankers and their clients, are very
sophisticated.
The process actually plays two important roles, from our
perspective. The first is we gain additional information from
the issuers and the investment bankers about their transactions
that we may not have otherwise known. We also are able to
provide them with feedback as to the way in which our publicly
available methodologies, which are very broad, apply to a
specific set of facts and circumstances.
I guess the last point I would make--I know you are running
short on time--is that this process is really very similar to
the process that occurs on the corporate side, as well. For
example, a corporation might come to Moody's, that Moody's
rates, and say I would like to take out a loan for $4 billion.
Would that have an impact on the rating of my company? And that
sort of dialog happens across the rating spectrum, not just in
structured finance.
Senator Reed. Thank you.
We will have the second round because of the--I do not know
about the quality of the questions, but the quality of the
answers.
Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Professor Coffee, Professor White, I want to just
personally thank you for your incisive and unvarnished
observations regarding this whole ratings business which is
obviously flawed and conflicted in many, many ways.
A recent article by an American Enterprise Institute
Visiting Scholar, Charles W. Calomiris, and a Drexel University
Finance Professor, Joseph Mason--you might know them--says, and
I will quote ``Unlike typical market actors, rating agencies
are more likely to be insulated from the standard market
penalty for being wrong, that is the loss of business. Issuers
must have ratings--'' as you have pointed out ``--even if
investors such as banks, insurance companies, and pension funds
do not find them accurate. That fact reflects unique power that
the Government--'' Dr. White alluded to ``--the Government has
conferred on rating agencies to act, in a sense, as
regulators.''
Do you agree, Professor Coffee?
Mr. Coffee. I think both Professor White and I agree that
what the NRSRO rating agency is doing is two things. It is
providing information and it is providing licensing power. The
issuer needs that rating, even if the market rating is
inaccurate.
Senator Shelby. They are delegating the job, in a way, are
they not? They are delegating their job.
Dr. White.
Mr. White. That is thoroughly the phrase that I think is
correct, delegating to third parties the assessment of the
safety, of the portfolio, of their regulated institutions.
Senator Shelby. Do both of you professors agree that credit
rating agencies have power that no other gatekeeper possesses
and an NRSRO can sell its services to issuers even if the
market distrusts the accuracy of its ratings because it is, in
effect, licensing the issuer to sell its debt to certain
regulated investors?
Mr. Coffee. I have said that and I still agree with that.
Senator Shelby. Do you agree with that?
Mr. White. Accountants may well have--auditing firms may
well have similar powers. You said unique. I am not sure this
is completely unique. But the power to issue that kind of
license. I think Professor Partnoy, Frank Partnoy, has used
that phrase of licensing.
Senator Shelby. Something is wrong in the rating agencies,
you both would agree?
Mr. White. Yes.
Senator Shelby. Mr. Kanef, a former Managing Director at
Moody's, Mr. Mark Adelson--I am sure you know him--recently
told, and this has been mentioned here already, told the Wall
Street Journal that investment banks would take their business
to another rating agency if they could not get the rating they
needed. He said, and I quote ``It was always about shopping
around for higher ratings'' although, he says, euphemisms were
used for this process such as ``best execution'' or
``maximizing value.''
Given the highly lucrative nature of this sector, it has
been reported that 40 percent of Moody's total revenues last
year came from structured finance alone, it seems natural that
the banks would have some leverage over rating agencies eager
to profit from these deals.
Could you comment on that?
Mr. Kanef. Thank you, Senator.
As an initial point, I would reiterate something that we
mentioned just previously, which is that our methodologies for
rating all of these assets are publicly available. They are
available on our website free of charge. And they are widely
distributed. So that most parties who have a desire can read
the way in which we would be rating a transaction.
Senator Shelby. Is that the methodology where you are
talking about structured instruments?
Mr. Kanef. Yes, that is correct, sir.
Senator Shelby. And is that basically, and you correct me
if I am wrong in my questioning, where you put some so-called
better mortgages in a structure with some that are probably
less desirable a rating, and then you tie them all together and
you come up with some methodology and say in our judgment this
is now investment grade ratings?
I know this is a simplification, but isn't that what you
do?
Mr. Kanef. Yes, I guess it is fair to say that what we do
is explain to market participants and to regulators and others
the desire to read the pieces, the way in which we will apply
analysis to derive a rating in structured finance. So that
would be a review of the pool of assets and a review of the
legal structure.
If I could just make one more statement with respect to
rating shopping, which is the issue that I think you raised
second, Moody's ratings are driven primarily by the desire of
the purchasers of securities. We call it a demand/pull model
where the purchasers of the securities are the ones that are
requesting the rating. The investment bankers and the issuers
that we deal with only work with Moody's and the other rating
agencies that they choose to work with because of the pull from
the investors.
If the investors lose faith in the rating agencies
themselves, that demand goes away and the desire for the
ratings goes away.
Moody's has not been shy about stepping away from markets
in structured finance where we have not been comfortable with
the risk that we saw. So for example----
Senator Shelby. Were you comfortable when you issued the
rating, though?
Mr. Kanef. I misspoke, Senator. What I mean to say is there
are whole markets that we have not rated at all, not from
inception. So for example, the ABCP market, which is the Asset-
Backed Commercial Paper market, in Canada, which we felt had a
structural flaw in it----
Senator Shelby. Let's talk about the ones in the U.S. that
you have rated and profited by rating and then you become
uncomfortable later when you see that a lot of those mortgages
are non-performing; is that correct?
Mr. Kanef. Yes, sir. The ratings are not static statements
of opinion. The ratings are made at inception as a forward-
looking opinion of the credit risk inherent in a transaction
and in the securities issued pursuant to that transaction. As
in any forward-looking opinion, as the facts that the opinion
was based upon change, the rating changes as well.
In fact, we view our role as participants in the market to
provide current up-to-date rating opinion to the market. So
when we see changes in the market, either changes in economic
situations or changes in performance, that were not initially
anticipated, we change the ratings to communicate that to the
market.
Senator Shelby. Does it ever bother you in any way that the
people that you rate these for pay you for rating them? I mean
that is an obvious conflict to a lot of people that study
ethics.
Mr. Kanef. We acknowledge at Moody's that there is a
conflict----
Senator Shelby. There should be a better way, should it
not? In other words, there has got to be a better method of not
paying you to rate bonds and you profit from it and then people
now are holding the bag, so to speak, and will so in the
future.
My last question to you, because I hope I will be around
for another round but I am not sure. And I have some questions
for the record.
Did it bother you when you were looking at these structured
mortgages, so to speak, so many subprime, that a lot of these
mortgage rates would be reset in 2 years, more than likely
upward rather than downward, they generally always are? And
that payments consequently to an individual borrower would go
up?
Now having realized that a lot of people pay very little,
if anything, down on these mortgages, having realized or should
have realized that the credit of a lot of these people was kind
of spotty to begin with, does it not defy common sense to think
that a lot of these mortgages would not go into default, if not
before they were reset, but certainly after they were reset?
Because a lot of these people are working folks all over
America that I think people have taken advantage of.
Does that bother you at all? Did it bother you when you
were rating these things?
Mr. Kanef. Mr. Chairman, do I have time to answer that
question? I apologize, Senator. I am just looking at the clock.
I do not know if I am permitted.
Senator Reed. You are permitted.
Mr. Kanef. Thank you, sir.
Senator Shelby. Are you apologizing to the people that have
been victimized or are you apologizing for taking the time?
Mr. Kanef. I am apologizing for taking the time right now.
But I would like to answer both of your questions, sir.
The first question you raised was one with respect to the
conflicts of interest in the issuer pay model, which is the
model whereby the issuer who is seeking the rating pays for the
rating.
Moody's acknowledges that there are conflicts in this model
and we have several procedures and processes in place which we
believe insulate the ratings process from those conflicts. I
know that the SEC has newly provided ability to review that and
comment upon the degree to which we have been successful in
limiting those conflicts of interest.
The basis of that is the committee's decision is not an
individual's decision. So although there will be a lead analyst
that interacts with an issuer, there is a committee of five to
eight people who make the determination with respect to what a
rating is. And the pay for analysts is not tied to the
individual number of deals that an analyst rates. It is tied to
the quality of the work that that analyst performs.
Senator Shelby. But the more deals you handle and the more
issuers, the more money you get paid; is that right?
Mr. Kanef. That is fair, but we are a global institution
and----
Senator Shelby. That does not mean that you do not get paid
for what you do.
Mr. Kanef. That is fair.
Senator Shelby. And you do not benefit from your conflicts
of interest.
Mr. Kanef. The other point that I would make is that the
other models that have been suggested, including the investor
pay model, also have conflicts of interest. So for example, if
you are paid by an investor, the investor may wish for you to
provide a lower rating which would enable them to receive a
higher yield on the security issued.
In addition, if an investor pay model is adopted, the
benefit of the public good of the rating, the fact that the
rating is made publicly available to regulators, to
governments, to other investors, would not necessarily remain
in place.
So there are issues with the other forms of payment for
ratings, as well as the existing one.
Senator Shelby. My time is up but it seems to me that money
is trumping ethics in this area of ratings.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Shelby.
Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman.
I want to ask both Ms. Tillman and Mr. Kanef a question I
asked your companies in April of this past year when we had a
hearing. Do you think you have any responsibility or are in any
way to be held accountable for the mortgage market meltdown? A
simple yes or no would do.
Ms. Tillman. I am not sure it is a simple yes or no, but
certainly we have stated publicly that the assumptions that we
used in the 2006 originated deals did not meet the
expectations. They far exceeded, in terms of early payment
loss, what happened. I think one thing we do recognize is that
while we have used historical information to make predictions
of the future, that we have to find better ways of doing it.
So we certainly understand that some things did not work in
our analysis and we are looking into what the root causes are
and what we can do to improve that.
Senator Menendez. But not meeting expectations is not the
same thing as saying you performed in every way as you should
have.
Ms. Tillman. I think in terms of the process and the
procedures that we followed, we did follow. We gave an
independent assessment of what the probability of default was
and the risk.
Senator Menendez. Mr. Kanef.
Mr. Kanef. I think that with the information that we had at
the time that we made these ratings, we provided our best
opinion to the market of the credit risk inherent in these
securities.
Senator Menendez. So the answer is no.
Let me ask you this then, you have both discussed changes
that you have made either to your methodologies or additional
data that you are collecting to make more informed decisions
about ratings. If you do not think you had any responsibility--
any responsibility--to contributing to the subprime crisis,
then why is there a need for change now? Could some of these
changes have affected a different outcome?
Mr. Kanef. Senator, the rating process is a continually
improving one. As we learn new information about the market and
about the type of information that we have received, we adjust
our rating process and we continually strive to improve our
methodologies. In that way we try to ensure that on a going-
forward basis all of the information that we have is
incorporated in the ratings that we provide.
Ms. Tillman. I would just agree with Mr. Kanef and say that
ratings are not static and ratings can be for 7 years, the term
of maturity over a longer period of time, and things change.
One of the things that is important to understand is that we
rate in terms--the initial rating is for the expectation of how
we think things are going to happen.
On the surveillance side, we actually get live information
of is this performing the way our expectations, in fact,
expected? So it is actual behavior as opposed to what we
assumed might have happened.
As those things change, we look into what are the
challenges associated with it or what are the assumptions that
we made that are causing these things to perform differently.
Senator Menendez. Ratings certainly are not static. That is
for sure. On August 21st Standard & Poor's, in a single day, in
a single day, cut its rating on two sets of AAA bonds to a CCC
rating. And Moody's also drastically downgraded in late August.
That was not a slight shift in a rating. Those were pretty
massive changes, just like scratching the surface off of a bar
of gold to find out it is only lead.
I hope when you talk to us about static that that type of
action is not the action that you subscribed to in the market
not being static and that your reviews are not static.
My main concern, which I still do not get the sense that
the rating agencies see themselves as having any responsibility
here, I still do not get that. I did not get it in April, I do
not get it today.
How many other gold-plated blocks of lead are out there?
Are you expecting any more downgrades of this magnitude in the
coming months?
Ms. Tillman. To comment, I do not know which security that
you are referring to. But if it was one called a SIV-Lite, the
structure of those deals are such that if the value of the
collateral exponentially changes within a month, then it hits a
trigger and therefore causes the deal to unwind very rapidly.
We call it a credit cliff, if you will. So if it does not meet
the value requirements as expected--and we have not seen that
happen ever.
That has got to be one of the first time, and I have been
in the business for 30 years, that we have seen the value of
the collateral within a bond change so quickly within 1 month.
So if that is the one you are thinking about, the way they
are structured actually has embedded in it a trigger that
requires the SIV or the SIV-Lite, which is a structured
investment vehicle, to unwind.
Senator Menendez. But you did not look ahead to look at the
value of that----
Ms. Tillman. Absolutely, we looked at----
Senator Menendez. So you went from AAA to CCC and so your
judgment sometime had to be pretty faulty.
Ms. Tillman. Well, what I am saying is we have never seen
the value really unwind and deplete as much as it did in a 1-
month period. So we do stress it. We do stress it in terms of
what happens in the event of this and what happens in the event
of that.
Senator Menendez. Let me just follow, if I may----
Ms. Tillman. In terms of responsibility----
Senator Menendez. I have only got a minute left. So let me
follow up where Senator Shelby left off, because I think he
made some excellent points, and I agree with them.
If, Mr. Kanef, you have 40 percent of your Moody's total
revenue last year from structured finance deals, and I listened
to your answers to these questions, Ms. Tillman, you said we do
not tell them what to do. We have a dialog. And Mr. Kanef, you
said we have a feedback.
Clearly, someone comes to you and in this dialog, in this
feedback, I assume that there are conversations going on to say
well, if you did this or if the entity comes to you and says
what if we did this, then you would say we would do X, in terms
of rating. Is that a fair assumption?
Mr. Kanef. Yes sir, I believe it is.
Senator Menendez. So then the dialog and the feedback goes
into a process in which the entity is molding how they are
going to present to you in order to achieve a certain rating, a
higher rate hopefully for their purposes. Is that not a fair
statement?
Mr. Kanef. I think, Senator, that that is a fair statement.
I believe that the question is not to what extent that we are
responding to an issuer's request for feedback on a proposed
structure, but what happens to that rating overall over time.
Again, the demand/pull model that we operate in means that if
our ratings are not right over a long period of time we will
not be in business.
I would suggest to you that we have seen very significant
adverse economic situations relating to the subprime market
this year. But for the period from the end of 2001, 2002, 2003,
2004 and into 2005, in fact, the subprime RMBS ratings that
Moody's had produced performed significantly better than the
expectations that we had.
In fact, even in 2006--and we acknowledge that the economic
situation, the liquidity situation, and the information that we
had provided all worked together to cause a very difficult
situation for those bonds----
Senator Menendez. Mr. Kanef, it does not take a rocket
science--and I will stop here, Mr. Chairman.
It does not take a rocket scientist to figure out that if I
have no document loans, if I have no down payments, if I have
ARMs that clearly within the income scheme are not going to
allow me to be able to meet the future, that that security-
backed instrument is weak in its potential.
And so I assume that that is part of what you do in your
analysis. And yes, maybe your analysis changes over time. But
it is the initial analysis that drives the marketplace,
certainly at the beginning where the hedge funds decided to go
and spend a lot of money and then fuel the whole process, even
though the instruments that were being used were clearly weak
in terms of its security and its underpinnings.
I just do not understand why we make it so complicated. It
seems to me it is pretty simple. It just seems to me that some
people missed it along the way. And why they missed it is the
heart of the problem.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Menendez.
I propose several more questions, if my colleagues would
want to stay, that is fine. We will make this brief.
Professor Coffee, I was listing to Chairman Cox and he
seemed to suggest that he would be amenable to posting
information about performance of the rating agencies. You
suggested in your testimony that the SEC could calculate a 5-
year cumulative default rate, put it out there, and do it in a
way to give the market another benchmark for their decisions.
Mr. Coffee. This is not a radical proposal. Essentially, I
am saying that sunlight is the best disinfectant. I would like
to take credit for that line, but I think Justice Brandeis said
it first.
What I want the SEC to do, however, is to compute the
default rate because each rating agency will use different
methodology and each will be more favorable to it.
If you just had one screen where we saw the default rates
on structured finance and a small pension fund out in your own
State could look at that screen and realize that these seven
new agencies were rating this below investment grade and the
old agencies were rating it an investment grade, they would
have some pause for concern.
And the default rate really is the output. All I am saying
is that the proof is in the pudding. And I would like to focus
us on the output data, what the default rates are, and less on
the input data, how many hours did you spend agonizing over
this problem?
Senator Reed. Given your review of the legislation that
Senator Shelby authored, they have the authority to do this
today?
Mr. Coffee. I thought we had a very interesting sentence of
dialog in which that question was asked by Senator Shelby of
Chairman Cox. Chairman Cox said, quite properly in my judgment,
that it is highly ambiguous.
The statute is framed in terms of basically input data.
What were your processes? What were your methodologies? You
might have great processes, but if you consistently get it
wrong, I think you should forfeit your status as a NRSRO.
It is like an umpire who might have great training, but he
cannot tell the difference between a strike and something that
is five feet wide of the plate. That is where I think we should
act.
Senator Reed. I noticed, in my quick review of the statute,
is that the agency, the Commission has the authority to
actually revoke the status if there is not managerial and
financial resources producing consistent ratings over time.
Mr. Coffee. That does focus on the input data. It is very
hard for the agency to prove that you did not have a good staff
or you did not work hard. I would just say if you are
consistently wrong, that is a basis for forfeiting your status.
Senator Reed. So that might be a change, Professor White,
that you would at least consider?
Mr. White. Certainly in the old regime I was consistently
advocating a focus on output rather than inputs. In the new
regime, if Jack is right that it is going to take new
legislation, I worry that who knows where new legislation--with
respect to the bond rating firms and I am only focusing on the
bond rating firms--would go.
I think the markets will, with more NRSROs out there, with
more choices, more alternatives, more opportunity to decide
what business model, investor pay, issuer pay, I do not know
who else might pay, let the markets figure this out.
In the old machine, they could not. They were forced to
heed the NRSROs. That kind of forced participation, restrictive
entry, naturally we would expect to see poor results. We would
expect to see high prices, high profits, sluggish behavior. And
I think we saw that sort of thing.
I want to see what a new more competitive regime can offer.
Senator Reed. Mr. Kanef and Ms. Tillman, again thank you
all for your excellent testimony.
One of the issues that was raised, I think by Professor
Coffee, is the notion that for corporate debentures, corporate
debt, it is a pretty straightforward analysis. You look at the
company's sheet. As you mentioned, a company could come to you
and say if we borrow $5 million what are you going to do? That
is a pretty straightforward transaction.
In these new instruments, highly complicated, in fact
people that I respect suggest that it is very difficult to
understand even if you devote a lot of time and attention.
Should there be red flags, i.e. a AAA on a corporate debt of
Mobil Oil, in the mind of a pension fund, was the same as a AAA
in one of these esoteric mortgage funds?
Were you safe in making that sort of its all the same?
Because frankly, there are hedge funds and private equity
people that are buying this stuff. But there are also a lot of
managers of county pension systems and people like former
Treasurer of Pennsylvania Senator Casey buying this. And they,
I would assume, rely almost exclusively on well, if it is AAA
it is the same stuff. I am buying Mobil debentures at AAA and I
am buying whatever life mortgage company of the world CDOs.
Was that not--looking back was that something that should
have been much more clearly designated in your ratings?
Ms. Tillman. I cannot speak to Moody's statistics on what
Professor Coffee has outlined. But in the same timeframe that
Professor Coffee was talking about Moody's statistics, our
statistics relative to lowest investment grade BBB, in terms of
its default rate was probably around 2 or 2.5 percent. In that
same timeframe our corporate ratings default rate were around
2.5 to 3 percent. So in terms of what we are looking at, we did
not really see these huge distinctions around the default rates
of a corporate bond versus a default rate of a structured bond.
In fact, if you look--and by the way, all the transition
and default studies that we do are publicly available and have
been publicly available for a very long time. They do go by
sector. You can look at a corporate bond default. You can look
at an ABS, you can look at RBS. We will continue to make sure
that those are publicly available.
But if you look at the default rates relative to structured
debt versus corporate debt, actually structured debt has been,
since 1978, actually performed better than corporate debt.
So again I am not--so I will let Mr. Kanef respond to the
rest of it.
Senator Reed. But that structured debt, particularly the
residential structured debt, a lot of that was guaranteed
mortgage-backed securities by Fannie and Freddie and others.
Ms. Tillman. No, we actually do not rate those.
Senator Reed. You do not rate those at all?
Ms. Tillman. No. We rate the non-agency debt.
Senator Reed. I want to make sure we are doing apples and
apples.
Mr. Kanef. Mr. Chairman, could I respond as well, please?
Senator Reed. Yes, you may. Please.
Mr. Kanef. As a preliminary matter, our transition studies,
the studies of what ratings move up or down to, as well as our
rating default studies, are also publicly available, as is the
data that underlies those studies. So we make both of those
things available to the public, as well. So certainly we are
all for sunshine and disclosure.
With respect to the total structured finance universe, the
same item that Ms. Tillman was speaking to, Moody's has a
similar result. That is if you look at all of the investment
grade structured finance issuance and you compare that to all
of the corporate investment grade issuance over I think pretty
much a 15 year time period going back from the present, you
find that the overall default rates for the total investment
grade buckets are very, very similar. So that there are
differences based on specific product in specific time period.
But over a longer term you find that, in fact, the performance
is very similar.
Senator Reed. Professor Coffee, do you have a comment?
Mr. Coffee. I do not have any stake in this debate between
Moody's and Standard & Poor's.
All I would suggest is if the institutional investor out
there who does not have its own staff could see the default
rates disclosed on one SEC screen and could see a 17 percent
default rate, I do not think they would buy that security at
any price
Senator Reed. Let me ask another question about
methodology, because you have said your methodology is fully
available on the Web, you can see it. Did anyone ever come to
you and say your methodology is all screwed up with respect to
these exotic mortgages?
For example, I am told that for a long period of time some
of the NRSROs were not including the debt-to-income of the
borrowers in their models. Which, to me, is an interesting
point which now has been reincorporated. So to what extent does
this public exposure of methodologies actually result in any
changes or feedback?
Mr. Kanef. I guess, Senator, I appreciate you raising that
point because this is something that has been widely reported
in the press and it is just not a true statement of fact. For
the record, I would like to correct that.
Senator Reed. No, that is your role.
Mr. Kanef. For the subprime RMBS transactions that we rated
in 2006, for over 99 percent of those transactions we received
DTI or debt-to-income and we, in fact, considered that in our
valuation. So I very much appreciate the opportunity to change
that.
With respect to your question, though, if I could respond,
we actually do receive a significant amount of feedback on our
methodologies, some positive, some negative. We try to
incorporate that which we feel helps move the process forward.
Senator Reed. Let me ask another question with respect to
methodology. Do you similarly publish the methodology of your
surveillance activities, the frequency of your reviews, the
information, the specifics? And how detailed is this? If this
is general, an equation that says we take these five factors
into consideration, that might be very difficult to match up
with a specific investment that an investment fund has made or
a pension fund has made.
Mr. Kanef. Senator, we do publish, and we have published,
methodologies of our surveillance process. It is always a
balance between exactly what to include in that methodology for
publication to ensure that people actually get to read through
it. I do not know exactly--I guess I can only say that we do
make that available and we are certainly willing to discuss
questions that market participants have about that.
Senator Reed. Let me ask a final question, because you have
been very patient. That is, a lot of the criticism has been
directed against the rating agencies but also against the
issuers because of the incredible complexity of these
instruments, with several different tranches including--was
there any public transparency on the actual instruments you
were rating?
Ms. Tillman. Absolutely. I think that is one of the main
things that we make available is why the different tranches are
rated a specific way. That goes into the transparency in terms
of what we provide.
The other thing I would like to add, and I believe Moody's
does the same thing but I will let Mr. Kanef speak to himself.
We have investor counsels, we have issuer counsels, we have
counsels, we speak to the investment community. And sometimes
when they are--in terms of what our methodologies so there can
be a discussion. Again this is away from any transaction so
that we have a dialog and get input from the community in terms
of what it is that we are doing.
In fact, when we are thinking of a major criteria change
relative to specific types of bonds, we have put out an RFP to
the community to get input from them, to see what their--and it
is not just to the investment bankers, it is to a larger
broader community that extends beyond that in terms of what do
you think about the way we are thinking.
Because we cannot operate really insular around a lot of
the stuff that we are doing. And so that process in itself
takes on and really is an open dialog around they are more than
happy to tell us that we are crazy around what our thoughts
are. They do not hold back. But that dialog, in itself, does
take place as well.
Senator Reed. I want to thank you. I think this could go
longer. The issue is complex and multifaceted. But you have
been extraordinarily patient and we thank you for your
attendance and your testimony.
The record will remain open for an additional week. There
may be following on questions from my colleagues. If you have
additional information that you would like to send us, please
do so.
At this time, I would adjourn the hearing.
[Whereupon, at 12:04 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
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