[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
APPROACHES TO IMPROVING CREDIT
RATING AGENCY REGULATION
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
MAY 19, 2009
__________
Printed for the use of the Committee on Financial Services
Serial No. 111-33
----------
U.S. GOVERNMENT PRINTING OFFICE
51-592 PDF WASHINGTON : 2009
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Washington, DC 20402-0001
HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina RON PAUL, Texas
GARY L. ACKERMAN, New York DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California WALTER B. JONES, Jr., North
GREGORY W. MEEKS, New York Carolina
DENNIS MOORE, Kansas JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts GARY G. MILLER, California
RUBEN HINOJOSA, Texas SHELLEY MOORE CAPITO, West
WM. LACY CLAY, Missouri Virginia
CAROLYN McCARTHY, New York JEB HENSARLING, Texas
JOE BACA, California SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia RANDY NEUGEBAUER, Texas
AL GREEN, Texas TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois JOHN CAMPBELL, California
GWEN MOORE, Wisconsin ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota KENNY MARCHANT, Texas
RON KLEIN, Florida THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio KEVIN McCARTHY, California
ED PERLMUTTER, Colorado BILL POSEY, Florida
JOE DONNELLY, Indiana LYNN JENKINS, Kansas
BILL FOSTER, Illinois CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana ERIK PAULSEN, Minnesota
JACKIE SPEIER, California LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York
Jeanne M. Roslanowick, Staff Director and Chief Counsel
Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises
PAUL E. KANJORSKI, Pennsylvania, Chairman
GARY L. ACKERMAN, New York SCOTT GARRETT, New Jersey
BRAD SHERMAN, California TOM PRICE, Georgia
MICHAEL E. CAPUANO, Massachusetts MICHAEL N. CASTLE, Delaware
RUBEN HINOJOSA, Texas PETER T. KING, New York
CAROLYN McCARTHY, New York FRANK D. LUCAS, Oklahoma
JOE BACA, California DONALD A. MANZULLO, Illinois
STEPHEN F. LYNCH, Massachusetts EDWARD R. ROYCE, California
BRAD MILLER, North Carolina JUDY BIGGERT, Illinois
DAVID SCOTT, Georgia SHELLEY MOORE CAPITO, West
NYDIA M. VELAZQUEZ, New York Virginia
CAROLYN B. MALONEY, New York JEB HENSARLING, Texas
MELISSA L. BEAN, Illinois ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin J. GRESHAM BARRETT, South Carolina
PAUL W. HODES, New Hampshire JIM GERLACH, Pennsylvania
RON KLEIN, Florida JOHN CAMPBELL, California
ED PERLMUTTER, Colorado MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana THADDEUS G. McCOTTER, Michigan
ANDRE CARSON, Indiana RANDY NEUGEBAUER, Texas
JACKIE SPEIER, California KEVIN McCARTHY, California
TRAVIS CHILDERS, Mississippi BILL POSEY, Florida
CHARLES A. WILSON, Ohio LYNN JENKINS, Kansas
BILL FOSTER, Illinois
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
C O N T E N T S
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Page
Hearing held on:
May 19, 2009................................................. 1
Appendix:
May 19, 2009................................................. 49
WITNESSES
Tuesday, May 19, 2009
Auwaerter, Robert F., Principal and Head of The Fixed Income
Group, The Vanguard Group...................................... 11
Dobilas, Robert G., President and Chief Executive Officer,
Realpoint, LLC................................................. 13
Joynt, Stephen W., President and Chief Executive Officer, Fitch
Ratings........................................................ 17
Pollock, Alex J., Resident Fellow, American Enterprise Institute. 19
Smith, Gregory W., General Counsel, Colorado Public Employees'
Retirement Association......................................... 21
Volokh, Eugene, Gary T. Schwartz Professor of Law, UCLA School of
Law............................................................ 15
APPENDIX
Prepared statements:
Kanjorski, Hon. Paul E....................................... 50
Garrett, Hon. Scott.......................................... 52
Auwaerter, Robert F.......................................... 54
Dobilas, Robert G............................................ 58
Joynt, Stephen W............................................. 70
Pollock, Alex J.............................................. 84
Smith, Gregory W............................................. 89
Volokh, Eugene............................................... 123
Additional Material Submitted for the Record
Kanjorski, Hon. Paul E.:
Letter from the Association for Financial Professionals...... 133
APPROACHES TO IMPROVING CREDIT
RATING AGENCY REGULATION
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Tuesday, May 19, 2009
U.S. House of Representatives,
Subcommittee on Capital Markets,
Insurance, and Government
Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 2:08 p.m., in
room 2128, Rayburn House Office Building, Hon. Paul E.
Kanjorski [chairman of the subcommittee] presiding.
Members present: Representatives Kanjorski, Ackerman,
Sherman, Capuano, McCarthy, Baca, Scott, Klein, Perlmutter,
Donnelly, Wilson, Foster, Minnick, Grayson, Himes; Garrett,
Castle, Royce, Biggert, Hensarling, Gerlach, Neugebauer, and
Jenkins.
Ex officio present: Representative Bachus.
Chairman Kanjorski. This hearing of the Subcommittee on
Capital Markets, Insurance, and Government Sponsored
Enterprises will come to order. Pursuant to committee rules,
each side will have 15 minutes for opening statements. Without
objection, all members' opening statements will be made a part
of the record.
Today we meet to examine the operations of credit rating
agencies and approaches for improving the regulation of these
entities. Given the amount of scrutiny that these matters have
garnered in recent months, I expect that we will have a lively
and productive debate.
The role of the major credit rating agencies in
contributing to the current financial crisis is now well
documented. At the very best, their assessments of packages of
toxic securitized mortgages and overly complex structured
finance deals were outrageously optimistic. At the very worst,
these ratings were grossly negligent.
In one widely reported internal e-mail exchange between two
analysts at Standard and Poor's in April of 2007, one of them
concludes that the deals ``could be structured by cows and we
would rate it.'' I therefore fear that in many instances the
truth lies closer to the latter option, rather than the former
possibility.
Moreover, if we were to turn the tables today and rate the
rating agencies, I expect that most members of the Capital
Markets Subcommittee would agree that during the height of the
securitization boom, the rating agencies were AA, if not AAA
failures. Clearly, they flunked the class on how to act as
objective gatekeepers to our capital markets.
Along with the expressions of anger, outrage, and blame
that we will doubtlessly hear today, I hope that we can also
explore serious proposals for reform. Unless we can find a way
to improve the accountability, transparency, and accuracy of
credit ratings, the participants in our capital markets will
discount and downgrade the opinions of these agencies going
forward.
One could hope that the agencies would do a better job in
policing themselves. But if past is prologue, we cannot take
that gamble. This time their failures were not in isolated,
case-by-case instances. Instead, they were systemic problems
across entire classes of financial products and throughout
entire industries. Stronger oversight and smarter rules are
therefore needed to protect investors and the overall
credibility of our markets.
As a start, the rating agencies must face tougher
disclosure and transparency requirements. For example,
investors receive too little information on rating
methodologies. The financial crisis has illustrated the danger
flawed methodologies pose to the system. If methodologies
remain hidden, there exists no check by which to expose their
weaknesses.
In addition to establishing an office dedicated to the
regulation of rating agencies within the Securities and
Exchange Commission, oversight must also focus more intently on
surveillance of outstanding ratings. The industry has done an
inadequate job of downgrading debt before a crisis manifests or
a company implodes. Moreover, we must examine how we can
further mitigate the inherent conflicts of interest that rating
agencies face.
In this regard, among our witnesses is a subscriber pay
agency. This alternative model is worthy of our consideration.
At one time, all rating agencies received their revenues from
subscribers, but they evolved into an issuer pay model in
response to market developments. I look forward to
understanding how a subscriber pay agency succeeds in today's
marketplace.
Additionally, the question of rating agency liability is of
particular interest to me. The First Amendment defense that
agencies rely upon to avoid accountability to investors for
grossly inaccurate ratings is generally a question for the
courts to determine, but Congress can also have its say on
these matters. Much like the other gatekeepers in our markets,
namely lawyers and auditers, we could choose to impose some
degree of public accountability for rating agencies via
statute. The view that agencies are mere publishers issuing
opinions bears little resemblance to reality, and the threat of
civil liability would force the industry to issue more accurate
ratings.
In sum, the foregoing financial crisis requires us to
reevaluate how rating agencies conduct their business, even
though we enacted the Credit Rating Agency Reform Act just 3
years ago. As this Congress considers a revised regulatory
structure in a broader context, this segment of our markets
also needs to be examined and transformed. By considering
proposals aimed at better disclosure, real accountability, and
perhaps even civil liability, we can advance that debate today
and ultimately figure out how to get the regulatory fit just
right.
Now, I will recognize the gentleman from New Jersey for 5
minutes.
Mr. Garrett. And I thank the chairman for holding this
important hearing today.
I believe it is critical, as he says, that this
subcommittee conduct proper oversight of the credit rating
agencies and examine all of the issues surrounding the role
that they played, if any, in the lead-up to the Nation's
current situation.
I would like to thank all the witnesses of the panel
attending. Unfortunately, we don't have a representative from
the SEC. That's the government agency tasked with overseeing
and regulating the NRSROs here with us to testify.
And so I feel it's essential that before this committee
does formally consider any regulatory reforms regarding the
rating agencies, that we should at some point hear directly
from the SEC, as to what, if any, additional powers or changes
they see necessary.
Over the past decade, we have seen a large increase in the
role that credit rating agencies have in determining the
creditworthiness of financial institutions and different type
of securities. Whether it is corporate, municipal, or
structured finance, any entity seeking to assure investors of
the quality of the debt must receive a good grade from one of
these entities.
And so investors have become increasingly, and too often
solely, reliant on the use of these ratings in determining the
safety and soundness of an investment. This situation, like
many of the other problems of this financial crisis, has, in
large part been created by government policy itself.
For literally hundreds of Federal and State government
statutes and regulations, there are specific government
requirements mandating certain grades from approved agencies.
It is this formal requirement that provides an implicit stamp
of approval, if you will, to the investors.
When an investor sees that the government has required a
specific grade to make a ``safe investment,'' it basically
reinforces the belief that any investment attaining such a
grade is a safe investment.
But to its credit, the SEC recognizes this problem, as
well, and they are moving to address it. So in December of last
year, the SEC proposed several new rules, one of which would
reduce the reliance on the NRSROs' ratings in the SEC's
regulations.
I believe it was Commissioner Casey who had it right when
she said, ``These requirements have served to elevate NRSRO
ratings to a status that does not reflect their actual purpose,
much less the limitations of credit ratings.''
So Congress really should try to follow suit and reexamine
all the areas where statutes mandate the ratings of NRSROs.
Credit ratings are only one piece of the puzzle--I think we'll
hear that from the panel--in determining creditworthiness.
Investors must be encouraged to do their own due diligence in
evaluating issuer credit quality.
Now, one of the other areas that needs to be addressed is
increased competition within the industry, and I hear from the
panel that they may be amenable to that, as well.
The 2006 Act made a number of significant improvements to
the process. Unfortunately, the law was just beginning to be
implemented at the time when the financial system started to
hemorrhage; and the very worthwhile goals of the 2006 laws, as
far as fostering more competition, enhancing transparency, and
increasing accountability may still be achieved.
So two things I do not think Congress or the SEC should do
are to eliminate specific types of pay models or prescribe
exact analytics that NRSROs must use. This would go against the
intent of the legislation by providing a further reduction in
competition and increasing investor reliance on the ratings.
In regards to competition, a recent rule issued that also
runs contrary to the goals of 2006 is from the Fed, the
requirement that any securities used as collateral in their
Term Asset-Backed Securities Loan Facility, the TALF, must have
an A-1 rating from a major NRSRO. So this major NRSRO term is
entirely new and refers to the Big Three rating agencies.
While I assume that the Fed added this requirement due to
the perceived better quality of the Big Three firms, I would
remind the Fed that the Big Three rated Lehman, unfortunately,
as A-1 on the day of bankruptcy.
Another area in which I would like to see increased
competition is the manner in which credit quality is
determined.
And I know that some of my friends on the committee would
like to demonize credit default swaps as a horrific gambling
bet made by fat cats smoking cigars and sitting in luxurious
boardrooms, but the fact of the matter is, credit default swaps
are actually additional measures of assessing the
creditworthiness of different corporations or securities, and
during the height of the financial panic and collapse of many
major firms, credit default swaps provided a more accurate
gauge or risk that some of the credit rating agencies.
So in conclusion, Mr. Chairman, I believe that the
government must continue to wean investors off being solely
reliant on credit ratings and encourage them to conduct their
own more due diligence.
I do greatly appreciate the chairman holding this very
important hearing, and I look forward to all the witnesses'
testimony today.
Thank you.
Chairman Kanjorski. Thank you very much, Mr. Garrett.
You have heard the bells. We have about 5 minutes remaining
on the first vote. There are three votes. We estimate it will
take us about 25 minutes.
So we will stand in recess until we complete those votes
and reassemble here immediately thereafter.
[recess]
Chairman Kanjorski. The committee will reconvene.
I now recognize the gentleman from New York, Mr. Ackerman,
for 3 minutes.
Mr. Ackerman. Thank you, Mr. Chairman.
This is not the first time that the committee has explored
the role and the future of credit rating agencies in our
financial system.
Time and again, we have heard from the agencies that their
ratings were really sound, despite the billions of dollars in
losses that investors realized on so-called AAA rated mortgage-
backed securities.
I would disagree with them. For mortgage-backed securities
to collateralized debt obligations and the structured finance
market, the bond markets, the types of products that receive
inaccurate ratings in the markets in which those products were
traded are far too vast to support the argument that the overly
favorable ratings of 2006 and 2007 were just a fluke. Clearly,
a systemic approach to the ratings process is needed.
Mr. Castle and I have introduced legislation that would
institute such an approach. The bill, H.R. 1181, would require
the SEC to promulgate rules that would determine the types of
structured finance investments that are eligible to receive
NRSRO ratings from credit rating agencies that have been
designated as nationally recognized statistical rating
organizations.
The bill also defines the credit rating agency to which
NRSRO-rated finance products must adhere. You cannot accurately
predict performance of newer products that have no long-term
track records. That doesn't mean that you can't sell them.
To be clear, we do not want to stifle creativity, and
nothing in our bill restricts the ability of originators to
continue to securitize less predictable or riskier products.
The legislation permits NRSROs to continue to provide
ratings for securities that do not meet the proposed NRSRO
criteria, as long as they are not designated as NRSRO ratings.
These, you know, are the ratings upon which pension fund
managers, who are collectively tasked with managing the nest
eggs of millions of Americans, rely.
I'm also concerned by the assertion of many of the credit
rating agencies that their ratings are mere opinions, and
therefore, are protected by the First Amendment.
Of course, I might be more inclined to support the
agencies' position if the companies didn't have an implied
government license, and by their financial relationships with
issuers. In my view, the often inappropriately favorable
ratings that the agencies assign to products issued by their
clients amounts to nothing more than paid advertisements and
endorsements, not an expression of opinion.
I hope that the subcommittee will continue to work towards
restoring transparency and objectivity to the credit rating
agencies, as the future of our financial markets depends upon
it.
I look forward to hearing from our expert witnesses, and I
yield back the balance of my time.
Chairman Kanjorski. The Chair recognizes Mr. Bachus for 3
minutes.
Mr. Bachus. I thank the chairman.
It's not normally my tendency to be overly critical, but
I'm going to make an exception in this case.
I think surely everyone now recognizes that the credit
rating agencies have failed, and failed spectacularly and
broadly. Inaccurate rating agency risk assessments are one of
the fundamental factors, in my opinion, in the global financial
crisis, and effective correction action must address these
shortcomings.
As Mr. Ackerman alluded to, the rating agencies say that
these assessments or ratings are opinions, predictive opinions,
and I think from a legal standpoint, that's true. But in the
real world, that's not reality.
The SEC special examination report of the three major
credit rating agencies uncovered significant weaknesses in
their rating practices for mortgage-backed securities, and also
called into question the impartiality of their ratings.
As the SEC report detailed, the rating agencies failed to
accurately rate the creditworthiness of many structured
financial products. Investors and the government both over-
relied on these inaccurate ratings, which undoubtedly
contributed to the dramatic collapse of the United States and
its financial market, or near-collapse.
In order to avoid future meltdowns, we must return to a
time where the rating agencies are not deemed a valid
substitute for thorough investor due diligence. My own view is
that while the SEC report did not address municipal securities,
the rating agency practices were also significant factors in
the problems that plagued municipal issuers.
The Federal Government must also share the blame for
fostering over-reliance on rating agencies. The Federal
Reserve's recent designation of certain rating agencies as
major nationally recognized statistical rating organizations
implies a government stamp of approval that does not exist.
What we have is what I would call, and others have called,
a government-sanctioned duopoly. I think that's a mistake.
As we move forward with regulatory reform proposals, the
committee should consider removing from Federal laws,
regulations, and programs all references that require reliance
on ratings. The SEC also should take action to remove similar
references in its own rules as quickly as possible.
At a minimum, the committee should consider changing NRSROs
from nationally recognized to nationally registered statistical
rating organizations, to further reduce the appearance of
government support or approval.
As Mr. Garrett said, I think credit swap derivatives have
been an accurate predictor of credit risk, and more so than
credit ratings, and the credit ratings have become almost--
well, I won't go into all that, but what I would say, this
should give us caution in discouraging the use of credit
default swaps, and it's critical that this committee doesn't
restrict these CDS contracts in the marketplace as we consider
broader regulatory reform.
Let me close by saying, to say what has occurred in the
marketplace since 2006 has been volatile and frightening is an
understatement. Correcting inadequacies of the credit rating
process is absolutely essential to restoring investor
confidence.
There must be further changes in the current rating system
to respond to very serious concerns expressed by investors,
market participants, and policymakers alike.
I look forward to hearing from the witnesses concerning
these matters.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Bachus.
Next, we will hear from Mr. Castle for 2 minutes.
Mr. Castle. Thank you, Mr. Chairman.
Credit rating agencies occupy a very important place in the
world of finance, as we all know. Therefore, I think this
committee needs to more fully understand things about the
industry and its practices.
Our present circumstance leads us to many questions.
How did the agencies repeatedly miss the mark on structured
finance products only to have to lower ratings or watch a
record number of these products default?
What experience in history did the agencies have with some
of the products they were rating, and even if their ratings
were accurate, were subsequent downgrades made public fast
enough?
What about the relationship the agencies have with company
management, representatives of the same businesses or products
they are engaged to rate?
Investors, governments, broker dealers, investment banks,
and others all rely upon credit rating agencies to more
precisely understand credit risk. They have to do a first-rate
job, Mr. Chairman. However, in some instances, they are the
problem, or at the very least, part of the problem, and need to
become part of the solution.
I recently joined Representative Gary Ackerman, who just
spoke to this, and reintroduced legislation that proposes
reforms for the industry.
Under H.R. 1181, credit rating agencies would only be able
to give an official rating to asset-backed securities that have
been sufficiently tested with a proven track record or where
their performance can be reasonably predicted.
The SEC would have the authority to strip nationally
recognized statistical rating organizations of their NRSRO
designation if the rating agency fails to comply with
provisions set forth in the legislation.
We need to address this problem as part of our efforts to
reform the financial system to ensure financial products are
adequately examined and restore investor confidence.
I thank you, Mr. Chairman, and I yield back.
Chairman Kanjorski. The gentleman from California, Mr.
Royce, is recognized for 2 minutes.
Mr. Royce. Thank you, Mr. Chairman.
You know, the extent to which our entire financial system
was and continues to be dependent upon the grades issued by
NRSROs is really remarkable. Rating agency grades are
incorporated into hundreds of rules, laws, and private
contracts, and that affects banking, insurance, mutual funds,
and it affects pension funds.
By making the agencies' opinions count toward determining
whether banks had an adequate amount of capital in essence gave
their opinions a quasi-official status, basically, from the
government.
And considering how badly the rating agencies misjudged the
risks in recent months, the quasi-official treatment of their
opinions should be reevaluated.
The Federal Government's over-reliance on the rating
agencies compounds the market-wide perception that these
ratings are in some way more than just opinions, and are, in
fact, the best indicators of risk.
This signal to the market lessens the perceived need for
counter-party due diligence that a well-functioning market
requires.
Both our over-reliance on the major rating agencies and the
poor performance of these entities during the recent market
downturn has led me to believe that major reforms to the
industry are needed.
I believe Congress should focus on encouraging alternative
tools to assess potential gains or losses, which would enable
consumers and institutions to better comprehend investment
risk.
Further, Federal regulators should reevaluate their
dependence on these ratings before the Federal Government is
asked, once again, to dedicate another $13 trillion due to the
economic consequences of this lack of foresight.
And Mr. Chairman, again, I thank you for this important
hearing, and I yield back the balance of my time.
Chairman Kanjorski. Thank you very much, Mr. Royce.
Mr. Capuano, for 3 minutes.
Mr. Capuano. Thank you, Mr. Chairman.
Mr. Chairman, first of all, thank you for having this
hearing, and I'm looking forward to both this testimony and
actually moving some legislation further in the year.
I haven't been able to go through all the testimony here
before me, but I know there has been a lot of talk by some that
somehow the freedom of speech amendment allows people to say
and do anything they want, and I would respectfully disagree.
I consider myself a major defender of the First Amendment,
and I would do whatever I can to maintain the freedom of
speech. However, I don't think freedom of speech applies when
you are getting paid. When you are getting paid, you should be
held to a higher standard. And if you want freedom of speech,
stop getting paid, write an op-ed in the paper, not a problem.
Say whatever you want. People can listen to you, or not listen
to you. That's all well and good.
But when your words can and do, number one, ask people to
rely on you and, number two, move markets, I do think you
should be held to--I think it's unequivocal that you should be
held to a certain standard. What that standard is, I think
that's fair.
I don't think it's fair to say that people can't be wrong.
Everybody can and is wrong, on a regular basis, and it is a
hard thing to distinguish between what is simply an appropriate
and fair and reasonable error of judgment versus some other
action that might require some reaction.
So anyway, I'm looking forward to this hearing, Mr.
Chairman. I thank you very much for doing this, and I actually
look forward to being able to improve the market for investors
and to make it so that people can actually rely on the opinions
of the credit rating agencies.
Chairman Kanjorski. Thank you very much, Mr. Capuano.
The gentleman from Texas, Mr. Hensarling, is recognized for
2 minutes.
Mr. Hensarling. Thank you, Mr. Chairman.
We know there are a number of causes of our Nation's
economic turmoil. Most have their genesis in flawed public
policy.
To state the obvious, the three major credit rating
agencies missed the national housing bubble. This doesn't
necessarily make them duplicitous, doesn't necessarily make
them incompetent, but it does make them wrong--very, very
wrong.
Unfortunately, many investors, due to legal imperatives or
practical necessity, relied exclusively on ratings from the
three largest CRAs, without performing their own conservative
due diligence.
We now know that the NRSRO term has been embedded in our
law, approximately 10 Federal statues, approximately 100
Federal regulations, roughly 200 State laws, and around 50
State rules.
I believe the failure of the credit rating agencies would
not have generated the disastrous consequences that it did had
the failure not been compounded by further misguided government
policies which effectively allowed the credit rating agencies
to operate as a cartel.
By adopting the NRSRO system, the SEC has established an
insurmountable barrier to entry into the rating business,
eliminating market competition among the rating agencies.
People assumed, wrongly, that the government stamp of approval
meant accurate ratings.
Now, we took a step in the right direction with the Credit
Rating Agency Reform Act of 2006, but it was too little, too
late.
There's a vitally important lesson we must all learn
regarding implied government backing. We have seen the results
from the government stamp of approval on Fannie Mae and Freddie
Mac. We now see the results, the impact of denying a
competitive market for credit rating agencies.
We must certainly consider this in a development of a
potential systemic risk regulator designating specific
institutions as too-big-to-fail, creating a self-fulfilling
prophecy.
Outcomes in the market cannot and should not be guaranteed
by the government. It causes people to become reliant,
dependent, and engage in riskier behavior than they otherwise
would.
When people believe that the government will perform their
due diligence for them on the front end, or will bail them out
on the tail end, this is very dangerous for the investor, and
disastrous for the Nation.
I yield back the balance of my time.
Chairman Kanjorski. The gentleman from Georgia is
recognized for 2 minutes.
Mr. Scott. Thank you very much, Mr. Chairman.
This is a very important and timely hearing.
As we continue to monitor the current economic climate
we're in, and look towards solutions and improvements that can
be made, I believe that this hearing is very, very timely, as
the credit rating agencies did in fact play a considerable role
in what has transpired, what will also impact, what transpires
in the near future.
Once our financial institutions achieve the desired quality
grade on a product, it pays the agency for the rating. This
process, as some claim, is rife with conflict, as they believe
the agencies are acting as the market regulators, the
investment bankers, and as a sales force, all the while
claiming to be providing independent opinions. That's it, the
problem in a nutshell.
As these organizations are extremely important to the
financial world, we should realize they did have a role to play
in where we are now, but I also want to more intently focus on
finding some consensus on how to move forward.
These organizations determine corporate and government
lending risk, and are an integral part of our financial
services sector, and as such, I want to ensure we take all
issues into account, including conflicts of interest, as well
as the international finance world, in reforming just how we
rate financial products.
More examination of these agencies is indeed in order, to
evaluate the need for improvement, as many have complained that
the rating agencies did not adequately assess the risky nature
of mortgage-backed securities.
The credit rating agencies have grown more powerful over
the years, maybe more powerful than anyone had really intended.
However, I do look forward to the witnesses' testimony and
how their review of and opinions on this subject will shape the
committee's further review of this issue.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you very much, Mr, Scott.
We will now hear from the gentlewoman from Kansas, Ms.
Jenkins.
Ms. Jenkins. Thank you for holding this hearing today, Mr.
Chairman.
I am by no means an expert on the topic of credit rating
agencies, so I'm certainly glad that we have this opportunity
to learn more about this issue.
The credit rating agencies' role in the economy is a
straightforward one. They are to provide independent analysis
of the quality of various financial assets.
These agencies, led by Standard and Poor's and Moody's, for
quite some time have been relied on by the capital markets to
provide independent, meaningful analysis. Investors relied on
the supposedly independent ratings, giving these agencies, for
investment decisions, where a AAA rating had become the stamp
of approval inferring that the investment was a safe one.
Over time, the original business model, where agencies were
paid by the investors, was replaced with a model where the
agencies were paid by the issuers themselves. Some would say
this led to an inherent conflict of interest that led to the
financial collapse that we have been witness to.
Others have said that, over time, the agencies became
little more than a mirror of the market's assessment of risk of
a particular bond, providing minimal additional value.
The question can also be asked whether ratings replaced
investor due diligence.
Thank you, Mr. Chairman. I yield back the remainder of my
time.
Chairman Kanjorski. Thank you very much.
And now we will hear from the gentleman from California,
Mr. Sherman, for 2 minutes.
Mr. Sherman. Thank you.
Most entities will eventually work in their own interest.
Patriotic speeches and appeals to patriotism only go so far.
This is an industry that gave AAA to Alt-A, and is as
responsible for where we are now as anyone else playing on Wall
Street.
Two things create this self-interest. The industry is
picked by the issuer, and believes it cannot be sued by the
investor. One of those two needs to change.
Now, the public accounting forms are picked by the issuer,
but they're subject to lawsuits. The auditing firm that audited
WorldCom doesn't exist anymore. And in the old days, they were
general partnerships, so 100 percent of all the partners'
personal equity would be gone. That provided even more
incentive to provide for a good audit.
If we're not going to force the firms to renounce any First
Amendment arguments as a condition for doing business on Wall
Street, then we need to end the system where they're picked by
the issuer. Otherwise, there will be a race to satisfy the
issuer by providing the highest ratings to the issuer and we'll
get AAA on Alt-A. It won't be mortgages next time, it'll be
some other kind of bond. And we'll be back here in another
economic crisis.
We don't allow the pitchers to pick the umpires. If we did,
the strike zone would go from the ground to well above the
head. We cannot allow the issuers to pick the bond-rating
agencies or the credit rating agencies unless we're going to
then bring in trial lawyers with instant replay cameras. That
would assure that the umpires wouldn't cater to the pitchers,
if they were subject to lawsuits and instant replay. But one of
those two things needs to change, or the fear of God will
prevent us from being in this situation with mortgages for a
few years, but we'll be back here in another semi-depression
with some other kind of credit instrument.
I yield back.
Chairman Kanjorski. Thank you very much, Mr. Sherman.
I will now introduce the panel, and I want to thank you all
for appearing before this subcommittee today.
Without objection, your written statements will be made a
part of the record. You will each be recognized for a 5-minute
summary of your testimony.
First, we have Mr. Robert Auwaerter, principal and head of
the Fixed Income Group, Vanguard.
Mr. Auwaerter.
STATEMENT OF ROBERT F. AUWAERTER, PRINCIPAL AND HEAD OF THE
FIXED INCOME GROUP, THE VANGUARD GROUP
Mr. Auwaerter. Mr. Chairman, and members of the
subcommittee, thank you for the opportunity to testify at this
important hearing.
I am the head of the Fixed Income Group at Vanguard, which
is the world's largest mutual fund company.
Credit ratings provide a useful purpose in the financial
markets for the small investor. They act as a way to provide a
standardized way for investors to do an initial screen of
potential investment choices. For institutional investors, they
provide instructions to their managers on how to limit risk.
They also serve a constructive purpose in government
regulations, the most prominent being SEC Rule 2-A(7) governing
money market funds.
Their NRSRO ratings protect investors by limiting the
funds' ability to chase higher yields through riskier
securities based on the funds' own subjective assessment. While
NRSRO ratings serve as an objective and necessary qualification
for buying a security, on their own, they are not sufficient to
warrant an investment.
Importantly, credit ratings are a starting point. Investors
must do their own analysis when determining the appropriateness
of an investment.
Investors choose Vanguard to invest on their behalf in part
because of our ability to employ significant resources toward
assessing credit risk in our bond portfolios. In total,
Vanguard has 25 senior credit analysts with over 400 years of
cumulative industry experience.
It's important to recognize that in order to avoid the
mistakes of the past, 100 percent perfection and accuracy in
ratings cannot be the goal. However, we believe there's need
for further regulation of credit rating agencies.
The focus of these efforts should be on improving the
transparency and reliability of credit ratings, while at the
same time controlling disclosing the conflicts of interest that
exist in all credit rating agency business models.
For example, the ratings process for corporate borrowers
must address the need to protect material non-public
information from being disseminated.
Currently, issuer-paid credit rating agencies will take
material, non-public information, such as management forecasts,
into account in the ratings assessment process.
We are concerned that proposals which force full disclosure
of all credit rating material from corporate issuers, including
non-public information, to all potential credit rating agencies
will, in the end, end up limiting disclosure to all credit
rating agencies. Under this scenario, we would expect credit
ratings to become less reliable, not more reliable.
However, on the other hand, we're in favor of greater and
more frequent disclosure by issuers of municipal and structured
finance securities. Structured finance, and for that matter,
municipal ratings, are impaired by a lack of transparency of
key credit rating determinants by the issuer of the security.
We would like to see greater transparency and disclosure from
the issuers to the investors as a feature of improved
regulations.
Regardless of the business model, the ratings product must
be subject to very high standards of independence, diligence,
and accountability. For that reason, Vanguard supports an
increase in the authority of the SEC to provide appropriate
oversight of the NRSROs.
Improved regulations and oversight should focus on
transparency and reliability of the ratings process. The NRSROs
should be subject to regular audits that test compliance to
internal procedures, the independence of rating actions, and
the diligence of the ratings process.
The goal of these should not be to regulate the actual
ratings, but rather, the process by which the rating agencies
derive these ratings.
The NRSRO designations should also be limited to CRAs that
are in compliance with strict regulatory requirements. There's
opinion out there that by inducing greater competition to the
CRA marketplace, rating quality will automatically improve.
While competition itself can be constructive, it may come at a
significant cost.
By artificially leveling the playing field, inducing many
new participants, the market will be littered with a wide
dispersion of credit ratings for issuers in structured finance
transactions.
It's very important in designating a credit rating agency
as an NRSRO that the SEC determines there is sufficient
analytical and operational resources to perform an appropriate
level of independent credit analysis. By definition, NRSROs
should have a wide market appeal, and should not be niche
rating agencies focusing on narrowly defined segments of the
market.
Importantly, under these new rules, the ability to pull an
NRSRO designation would provide a powerful incentive for
compliance.
Regulators should finally consider creation of a standing
advisory board comprised of key rating agency constituents. It
could serve an important role in providing feedback on new
product types, ratings performance, and regulatory proposals to
both the credit rating agencies and the appropriate regulators.
In summary, we think the credit rating agencies serve a
useful purpose in the market and in government regulations, and
we support an increase in authority of the SEC to provide
oversight to ensure that credit rating agencies have the
appropriate resources and procedures to deliver a ratings
product that meets very high standards of independence,
diligence, and accountability.
Thank you.
[The prepared statement of Mr. Auwaerter can be found on
page 54 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Auwaerter.
Next, we will hear from Mr. Robert Dobilas, president and
chief executive officer of Realpoint, LLC.
Mr. Dobilas.
STATEMENT OF ROBERT G. DOBILAS, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, REALPOINT, LLC
Mr. Dobilas. Thank you for the opportunity to participate
in this hearing.
The rating agency legislation passed by Congress in 2006
was an important step forward. It greatly improved the
regulatory process by which a rating agency can receive a
national designation from the SEC, and it has in fact increased
the number of competitors.
But given the worldwide collapse of the credit markets, and
the loss of trillions of dollars by individuals, companies, and
governmental entities, it is now clear that Congress needs to
take further action addressing the conflicts of interest which
have arisen in the context of having rating agencies paid by
the corporations whose debt they are evaluating.
As the Congressional Oversight Panel has stated, the major
credit rating agencies played an important and perhaps decisive
role in enabling and validating much of the behavior and
decisionmaking that now appears to have put the broader
financial statements at risk.
Realpoint uses a different business model than S&P,
Moody's, and Fitch. We are an independent, investor-paid
business, which means our revenues come from investors,
portfolio managers, analysts, broker dealers, and other market
participants who typically buy a subscription to our services.
We produce in-depth monthly rating reports on all current
commercial mortgage-backed securities. Moody's, S&P, and Fitch,
on the other hand, are paid by the issuers of the securities.
They are paid substantial upfront fees on a pre-sale basis by
the corporations selling securities or investment banks which
are underwriting the sales. The fees can exceed $1 million in a
single transaction.
In a word, the results of the issuer-paid business model
have been miserable. The SEC recently published data showing
that Moody's has had to downgrade 94.2 percent of all the
subprime residential mortgage-backed securities it rated in
2006. This is the equivalent of a major league baseball player
striking out 19 out of 20 times at bat. We see a similar trend
developing now in the CMBS market.
In contrast, Realpoint's ratings were lower from the
outset, and have proven to be more stable than those of the
issuer-paid agencies. Even during these unprecedented times,
downgrades at Realpoint are less than 30 percent on all current
CMBS transactions, and have generally taken place 6 to 12
months sooner than the corresponding rating actions taken by
other rating agencies.
The core problem with the issuer-paid system, and the most
important message I would like to leave with the subcommittee
today, is that the integrity of the rating process is
undermined by the pervasive practice of rating shopping.
When an issuer decides to bring a new security to market,
it generally begins the process by providing data to the three
rating agencies. The three rating agencies are more than
willing to provide preliminary levels on ratings, knowing that
the issuer will tend to hire the agencies that provide the
highest ratings.
We hear a lot about complexities of modern finance, but the
rating process is hardly complex. The solution is equally
simple, and it only takes one step. Let all the designated
rating companies have the same information and prepare their
own pre-sell ratings, regardless of whether or not they are
ultimately paid by issuers or by investors.
In our view, there is simply no better or more
straightforward way to enhance the integrity of the ratings
process than to share the information with all agencies which
the SEC has deemed as worthy of being a nationally recognized
agency. In fact, the SEC has already proposed precisely such a
rule, through an amendment to its fair disclosure rules.
The public benefits of taking this simple step are
immediate and manifestly obvious.
Last year, the Federal Reserve began implementing the Term
Asset-Backed Securities Loan Facility, or TALF Program.
Initially, the ratings component of TALF was limited to
Moody's, S&P and Fitch.
We are pleased to learn that the Federal Reserve is now
taking steps to increase the number of rating agencies eligible
to participate in this program. As a matter of fact, we just
learned that Realpoint and DBRS are now part of the TALF
program.
We believe that this will increase competition and lead to
more accurate ratings behind the taxpayer guarantees which
stand behind these programs.
TALF and other comparable programs utilize the standard
industry practice of requiring two ratings in order for
securities to be deemed suitable collateral. There is likewise
no valid public policy reason for not insisting that at least
one of these ratings be an independent investor-based rating.
In this manner, the TALF program serves not only as a
catalyst for restarting the securitization market, but as a
vanguard to reform the credit rating industry.
A mandate to have TALF and other government assisted
programs utilize the ratings of at least one independent rating
agency would enhance investor confidence in those programs and
set the stage for ultimately resurrecting reliable ratings in
the private sector.
In short, the American taxpayers should not be subject to
the same failed rating shopping syndrome I described earlier.
In conclusion, the integrity of the ratings process is
deeply flawed, but this is not a complex problem, and, in fact,
it is not that different from when we were all in high school
and everyone sought out the teachers who were known as easy
graders.
We simply need to put an end to the rating shopping process
that encourages issuer-paid rating agencies to inflate their
ratings.
Thank you very much for your time.
[The prepared statement of Mr. Dobilas can be found on page
58 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Dobilas.
We will now next hear from Mr. Eugene Volokh, Gary T.
Schwartz professor of law at UCLA School of Law.
Mr. Volokh.
STATEMENT OF EUGENE VOLOKH, GARY T. SCHWARTZ PROFESSOR OF LAW,
UCLA SCHOOL OF LAW
Mr. Volokh. Mr. Chairman, members of the committee, thanks
very much for having me here.
I was asked to provide an objective First Amendment
analysis of the free speech issues raised by regulation of, and
liability for, the speech of ratings agencies.
I am a scholar of the First Amendment. I am not a scholar
of commercial law. And I will try to stick to what I think the
First Amendment law sets forth, without opining on what I think
is sound financial policy here.
So my first point is that the ratings issued by rating
agencies are, generally speaking, speech of the sort that is
presumptively protected by the First Amendment. They are
predictive opinions based on factual investigation, and based
on some degree of expertise.
In that respect, they are quite similar to the work product
of investment newsletters, or, for that matter, of the
financial pages of well-respected newspapers. Those, too, offer
predictive opinions based on factual investigation with some
degree of expertise on the part of the author.
Now, those, too, are for-profit entities, or at least they
try to be for-profit entities. This does not strip them of
First Amendment protection. The First Amendment protection has
long been understood as covering for-profit entities. In fact,
otherwise, newspapers, magazines, movie studios, all of them
would be constitutionally unprotected.
To be sure, rating agencies are particularly, or at least
were particularly respected, and their speech was found
particularly valuable, but the fact that speech is especially
valuable generally does not diminish the scope of First
Amendment protection that is offered it, and the fact that
people rely on that speech, generally speaking, does not
diminish the scope of First Amendment protection.
So, generally speaking, the First Amendment is
presumptively in play here. That is not just my view. That is
the view of the Federal circuit courts that have considered
this issue in the related context of libel lawsuits by the
ratees against the rating agencies. The Sixth and the Tenth
Circuits have spoken to this very issue, and have said this
speech is generally protected by the First Amendment.
Now, to be sure, not all such speech ends up being
protected by the First Amendment. So, for example, if an agency
is actually paid to issue a favorable report, not just issue a
report, but issue a favorable report, that would probably make
it commercial advertising, which is much less protected under
the First Amendment, much as if a newspaper were paid to write
a favorable article about a company--which I believe is
considered quite unethical in newspapers, though I am told that
it is not uncommon in fluff entertainment magazines and the
like--that would presumably be commercial advertising.
The fact, though, that there is a payment being made not
for the positive review, but a payment being made by a company
to the subject of the review, does not make the review
commercial advertising. Newspapers routinely take advertising
from the very same companies whose products they review, and
there is some degree of possible pressure to bias the reviews
in this respect. If you want to keep getting advertising from
Ford, you may want to write positive reviews of Ford,
counteracted by the desire to maintain the value of the
newspaper's own brand. But generally, while that risk may lead
some papers to be very careful about such practices, those
payments do not strip speech of full protection.
Likewise there are certain situations in which a company
may be hired specifically to give personalized advice to an
investor, much like an accountant or a lawyer or a
psychotherapist or what have you could be hired to give
personalized advice to a client. That would presumably fit the
speech into the category of professional-client speech, which
is much less protected. And that might, in fact, describe what
some rating agencies do in certain circumstances. There are
some cases in which rating agencies have been found to do just
that.
But, generally speaking, the fact that they are
professionals who offer expert commentary does not make them
subject to this kind of restriction. So long as they are
speaking to the world at large, and they are not addressing
their advice to the personalized circumstances of a particular
person whom they are counseling, their speech generally remains
fully constitutionally protected.
So such speech would likely be protected categorically to
the extent it is treated as a matter of opinion, and would
likely be protected under the New York Times v. Sullivan actual
malice standard, to the extent that it implies specific,
verifiable facts. That means that it wouldn't be judged by a
negligence standard, but rather by whether the ratings agencies
knew the statements were false or likely to be false. Again,
there is lower court case law on that very point.
So those, I think, are the constraints in direct regulation
or litigation against rating agencies.
However, say that the government chooses to say, we will
give some special status to certain agencies on condition that,
for example, they don't take money from the companies that they
rate, or that they only take money from subscribers, and if
they don't want to be subject to those conditions, they are
free to express their opinions but they will not get this
special government-provided status.
That kind of restriction on agencies that are given this
specialized status as a condition of getting that status would
probably be constitutionally permissible.
Thank you.
[The prepared statement of Professor Volokh can be found on
page 123 of the appendix.]
Chairman Kanjorski. Thank you very much.
We will now hear from Mr. Stephen W. Joynt, president and
chief executive officer of Fitch, Incorporated.
Mr. Joynt.
STATEMENT OF STEPHEN W. JOYNT, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FITCH RATINGS
Mr. Joynt. Thank you, Chairman Kanjorski, Ranking Member
Garrett, and members of the committee.
I would like to spend just a few minutes summarizing my
prepared statement.
Nearly 2 years has passed since the onset of the credit
crisis. What began as stress focused on the global capital
markets has evolved into a more severe economic slowdown.
An array of factors have contributed to this, and these
have been broadly analyzed by many market participants, the
media, and within the policymaking and regulatory communities.
During this time, the focus of Fitch Ratings has been on
implementing initiatives that enhance the reliability and
transparency of our ratings. More specifically, we are
vigorously reviewing our analytical approaches and changing
ratings to reflect the current risk profile of securities that
we rate.
In parallel, we have been introducing new policies and
procedures, and updating existing ones, to reflect the evolving
regulatory frameworks within which the credit rating agencies
operate globally.
I have provided details in my written statement, so I would
like now to move on to the primary focus of today's hearing:
where do we go from here?
As this committee considers this important topic, we would
like to offer some perspective on a number of the important
issues.
Transparency is a recurring theme in these discussions, and
at Fitch, we are committed to being as transparent as possible
in everything we do. But transparency also touches on issues
beyond the strict control of rating agencies.
All of Fitch's ratings, supporting rationale, and
assumptions, and related methodologies, and a good portion of
our research, are freely available to the market in real time,
by definition, transparent. We do not believe that everyone
should agree with all of our opinions, but we are committed to
ensuring that the market has the opportunity to discuss them.
Some market participants have noted that limits on the
amount of information that is disclosed to the market by
issuers and underwriters has made the market over-reliant on
rating agencies, particularly for analysis and evaluation of
structured securities.
The argument follows that the market would benefit if
additional information on structured securities were more
broadly and readily available to investors, thereby enabling
them to have access to the same information that mandated
rating agencies have, in developing and maintaining our rating
opinions.
Fitch fully supports the concept of greater disclosure of
such information. We also believe that responsibility for
disclosing such information should rest fully with the issuers
and the underwriters, and not just with the rating agencies.
Quite simply, it's their information and their deals, so they
should disclose that information.
A related benefit of additional issuer disclosure is that
it addresses the issue of rating shopping. Greater disclosure
would enable non-mandated NRSROs to issue ratings on structured
securities if they so choose, thus providing the market with
greater variety of opinion, and an important check on perceived
ratings inflation.
The disclosure of additional information, however, is of
questionable value of the accuracy and reliability of the
information is suspect. That goes to the issue of due
diligence.
While rating agencies have taken a number of steps to
increase our assessments of the quality of the information we
are provided in assigning ratings, including adopting policies
that we will not rate issues if we deem the quality of the
information to be insufficient, due diligence is a specific and
defined legal concept. The burden of due diligence belongs with
issuers and underwriters.
Congress ought not to hold rating agencies responsible for
such due diligence, or requiring it from others. Rather,
Congress should mandate that the SEC enact rules to require
issuers and underwriters to perform such due diligence, make
public the findings, and enforce the rules they enact.
In terms of regulation more broadly, Fitch supports fair
and balanced oversight and registration of credit rating
agencies and believes the market will benefit from globally
consistent rules for credit rating agencies that foster
transparency, disclosure of ratings, and methodologies, and
management of conflicts of interest.
We also believe that all oversight requirements should be
applied consistently and equally to all NRSROs.
One theme in the discussion of additional regulation is the
desire to impose some more accountability on rating agencies.
Ultimately, the market imposes accountability for the
reliability and performance of our ratings and research. That
is, if the market no longer has sufficient confidence in the
quality of our work, the value of Fitch's franchise will be
diminished and our ability to continue to compete in the market
will be impeded.
While we understand and agree with the notion that we
should be accountable for what we do, we disagree with the idea
that the imposition of greater liability will achieve that.
Some of the discussion on liability is based on misperceptions,
and while those points are covered in my written statement,
it's worth highlighting that the view that the rating agencies
have no liability today is unfounded.
Rating agencies, just like accountants, officers,
directors, and securities analysts may be held liable for
securities fraud, to the extent a rating agency intentionally
or recklessly made a material misstatement or omission in
connection with the purchase or sale of a security.
Beyond the standard of existing securities law that applies
to all, fundamentally, we struggle with the notion of what it
is that we should be held liable for. Specifically, a credit
rating is an opinion about future events, the likelihood of an
issue or issuer that they will meet their credit obligations as
they come due.
Imposing a specific liability standard for failing to
accurately predict the future, that in every case strikes us as
an unwise approach.
Congress also should consider the practical consequences of
imposing additional liability. Expanded competition may be
inhibited for smaller rating agencies by withdrawing from the
NRO system to avoid specialized liability. All rating agencies
may be motivated to provide low security ratings just to
mitigate liability.
In closing, Fitch has been and will continue to be
constructively engaged with policymakers and regulators, as
they and you consider ideas and questions about the oversight
of credit rating agencies. We remain committed to enhancing the
reliability and transparency of our ratings, and welcome all
worthwhile ideas that aim to help us achieve that.
Thank you.
[The prepared statement of Mr. Joynt can be found on page
70 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Joynt.
We will now hear from Mr. Alex Pollock, resident fellow,
American Enterprise Institute.
Mr Pollock.
STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Pollock. Thank you, Mr. Chairman, Ranking Member
Garrett, and members of the subcommittee.
As many of the members said in their opening statements, in
the housing and mortgage bubble of our 21st Century, the
government-sponsored credit rating agency cartel turned out to
be a notable weakness. The regulatory NRSRO system made the
dominant rating agencies into a concentrated point of possible
failure, which then failed.
Considering this history, Deven Sharma, the president of
S&P, has rightly said that we need to, in his words, ``avoid
inadvertently encouraging investors to depend excessively on
ratings.''
Let me add, we certainly need to avoid intentionally
encouraging investors to depend excessively on ratings, and to
treat them as one of many inputs.
As Congress made clear in the 2006 Credit Rating Agency
Reform Act, greater competition in the credit rating agency
sector was a key objective, and indeed, this is the right
strategy.
At the beginning of 2005, I published an essay entitled,
``End the Government-Sponsored Cartel in Credit Ratings,'' and
that still summarizes my view.
I do think there has been significant progress in the right
direction by the SEC since the 2006 Act, for example,
registering Realpoint as an NRSRO, but we can go further.
In the ideal case, as Congressman Bachus said, we would get
rid of all statutory and regulatory references to ``NRSROs.'' I
don't know if that is doable.
I would also strongly support his suggestion of replacing
the meaning of ``R'' as ``recognized'' with ``registered,'' so
that we had only nationally registered rating agencies. That
would be a step in the right direction.
As I remember, we talked about that in 2005-2006, maybe
even had it in bills at one point, but it didn't make it into
the final Act.
Now, what everybody in financial markets wants to know is
the one thing that nobody can know, namely, the future. So Wall
Street continually invents ways to make people confident enough
to buy securities, in spite of the fact that they can't know
the future. These assurances, as has been said, are, of course,
opinions, and the credit rating agency ratings are an extremely
important form of such opinions.
In the course of financial events, some such opinions will
inevitably prove to be mistaken, some disastrously mistaken, as
has been evident in the 21 months since the beginning of the
financial panic in August 2007.
We would all like to have infallible knowledge of the
future. Can't we somehow ``assure'' credit ratings which are
``accurate,'' to borrow terms from a current bill in the
Senate? Can't we guarantee having models which are right?
And the answer is, no. No rating agency, no regulatory
agency, no modeler with however many computers, can make
universally correct predictions of future events.
The worst case would be to turn the SEC, through the
regulation of ratings process, which could easily turn into
regulating ratings, into a monopoly rater, which would also
suffer from the same lack of ability to predict the future. So
would any--to touch on a separate topic--so-called systemic
risk regulator, should we make what I believe to be the mistake
of creating one.
But having more credit rating competitors, especially those
paid by investors, in my view, increases the chances that new
insights into credit risks and how to conceptualize, analyze,
predict, and measure them, will be discovered.
It will also reduce the economic rents to the present
dominant rating agencies, and should we create this increased
competition, we should expect and welcome greater dispersion of
ratings. That will tell us we're getting different points of
view, and whether ratings are concentrated around a mean or
dispersed would be very important information for investors.
A particularly desirable form of increased competition, as
others have said, is from rating agencies paid by investors,
which do have a superior alignment of incentives. A frequent
objection to competition in credit ratings is that there would
be a so-called race to the bottom, but this does not apply at
all to the logic of investor-paid ratings.
In my view, all regulatory bodies, not just the SEC, all
regulatory bodies whose ratings supported over-reliance on the
government-sponsored ratings cartel should develop and
implement ways to promote the pro-competitive objective of the
2006 Act, and all regulatory rules concerning rating agencies
from all regulators, not just the SEC, should be consistent
with encouraging competition from the investor-paid model.
I have previously proposed that a group of major
institutional investors, maybe Vanguard, should set up their
own rating agency, capitalized and paid for by these investors,
working from their point of view. It continues to seem to me
likely the market would demonstrate a preference for the
ratings of such an agency, and a successful competitor would
find ways to distinguish itself by creating more valuable
ratings, perhaps, as suggested by our colleague, Rob, in his
testimony, by superior ongoing surveillance.
In sum, Mr. Chairman, competition in the rating agency
sector has made some progress since the 2006 Act, and greater
competition remains, in my opinion, not only an essential, but
also an achievable objective.
Thanks again for the opportunity to be here.
[The prepared statement of Mr. Pollock can be found on page
84 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Pollock.
I now recognize the gentleman from Colorado, Mr.
Perlmutter, to introduce our final witness.
Mr. Perlmutter. Thank you, Mr. Chairman.
It gives me great pleasure to introduce my friend, Greg
Smith, who is general counsel of the Colorado Public Employees'
Retirement Association, of which I was a member.
Greg is the co-chairman of the Council of Institutional
Investors. He is also the chair of the subcommittee which deals
with the credit rating agencies. He has a background in
business and commercial matters, having represented pension
plans, as well as a variety of business interests over the
years.
He holds a Bachelor of Science degree from the University
of Colorado, and a law degree from the University of Denver.
And we look forward to his testimony.
Thank you.
STATEMENT OF GREGORY W. SMITH, GENERAL COUNSEL, COLORADO PUBLIC
EMPLOYEES' RETIREMENT ASSOCIATION
Mr. Smith. Thank you very much. Thank you, Chairman
Kanjorski, Ranking Member Garrett, Congressman Perlmutter. I
appreciate the kind words.
I am here to speak on behalf of the Colorado Public
Employees' Retirement Association, a pension fund with more
than $29 billion in assets, which is responsible for the
retirement security of over 430,000 plan members and
beneficiaries.
I greatly appreciate the opportunity to be heard and talk
about what I believe is the right direction for credit rating
agency reform. My brief remarks will include an overview of how
Colorado PERA uses credit ratings, a suggestion on how the
Securities and Exchange Commission can provide better oversight
of the ratings industry, and views on the need to strengthen
NRSROs' accountability for their ratings.
Credit ratings are an important and sometimes mandated tool
for many market participants, including pension funds. Most
institutional investors do not rely exclusively on ratings.
This holds true for Colorado PERA, as well as most of our
peers. Ratings are a part of the mosaic of information that we
consider during the investment process.
Initially, we define our risk tolerance and we determine
what percent of allocation is necessary to stay within that
range. Ratings serve as a first cut to identify securities for
further consideration and analysis. Without such a tool, we and
many other investors would have no initial way to screen the
tens of thousands of new instruments available for investments
each year.
Because of their significance in the capital market, and
their status as financial gatekeepers, we believe NRSROs must
be held to a high standard of quality, transparency, and
independence. Congress and the SEC must work to strengthen and
extend oversight in several areas, ranging from disclosure to
policies to methodologies.
My written testimony provides more detail, but I would like
to highlight a few suggestions for action here.
Like many institutional investors, we encourage the SEC to
expand its proposal regarding the delayed disclosure of credit
rating actions and credit rating histories, to include all
outstanding credit ratings, regardless of whether or from whom
the NRSRO received its compensation.
Similar to the provisions governing auditors, NRSROs should
be required to disclose business relationships and should be
prohibited from providing ancillary services. They should also
publicly disclose fee schedules and the amount of compensation
received for individual ratings and from individual clients.
A mandatory 1-year waiting period should be in place for
any NRSRO employee seeking a position with a client. And the
SEC should strengthen the current responsibilities and
requirements pertaining to NRSRO compliance officers. That's
their internal compliance officers.
At a bare minimum, more detailed information regarding
NRSROs' rating methodologies should be made available publicly
and in a user-friendly model.
Providing the SEC with the additional authority and
resources, however, will not itself create an adequate system
of checks and balances. The market must have a path of
recourse. Where these financial gatekeepers fail to adhere to
the reasonable industry standards, they should be held
accountable for those failures.
Expressions of concern regarding the business viability of
NRSROs in the event a private right of action were recognized
by legislation are premised on the contention that NRSROs would
become guarantors of the performance of the instruments that
they rate, or would somehow become liable in the event a
particular rating has changed and the value of the instrument
is negatively impacted.
While this premise serves the interests of those desiring
to maintain a lack of accountability, the reality is that no
market participant is seeking that form of accountability.
Rather, we are seeking to have these officially sanctioned
gatekeepers held to a reasonable industry standard for the
process and methodology that is employed, including the
adequacy of the diligence and the unbiased nature of the
conclusions.
The threat presented to NRSROs by a private right of action
is in essence no different than that presented to other
participants in the marketplace, including institutional
fiduciaries like my organization.
We, like others, are responsible for the process we adhere
to. Our honesty and our lack of conflicts of appearances of
conflicts of interest in the discharge of our responsibilities
is imperative to our success.
We protect our organization from liability by creating a
robust process and strictly monitoring our adherence thereto.
We see no legitimate barriers to such a risk management
approach by the NRSROs.
Thank you for the opportunity to be here. I look forward to
your questions.
[The prepared statement of Mr. Smith can be found on page
89 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Smith.
Let me start off with my first question to you.
When you buy a security, how deeply do you look into the
security? Do you do due diligence to see how the security was
supported, what the pool was made up of, and who the
participants are in the mortgages?
Mr. Smith. Absolutely. We look--we drill as far as we can
drill. We look at who the issuers are, obviously, what their
creditworthiness is--
Chairman Kanjorski. Issuers being the underwriters, or the
individuals who have mortgages?
Mr. Smith. Well, it depends on what kind of instrument
we're talking about, but if we're talking about mortgage-backed
securities--
Chairman Kanjorski. Mortgage-backed securities.
Mr. Smith. --mortgage-backed securities, we would attempt
to go back to where the mortgages are, but that's a difficult
thing for us to do. There's--
Chairman Kanjorski. Well, if you cannot do that, then where
do you get the information on whether or not you should buy
that type of security, except that it is rated AAA?
Mr. Smith. What we do as a large institution is, we go out
and buy the research from the very people who are issuing the
ratings, so we try and drill into it by buying that research
from the rating agencies themselves.
Chairman Kanjorski. So they not only rate the security,
they get paid to sell you the materials they use to rate the
particular security?
Mr. Smith. There are certainly research relationships where
we purchase research from the very institutions that issue
ratings, yes, sir.
Chairman Kanjorski. Very good.
Mr. Fitch, how many people does your organization employ? I
am sorry. Mr. Joynt. That is a Freudian slip, sir.
Mr. Joynt. I think our present employee count globally is
about 1,900.
Chairman Kanjorski. 1,900. And you are one of the three
largest in the world; is that correct?
Mr. Joynt. Yes.
Chairman Kanjorski. And how many employees would you have
had, say, in 2002?
Mr. Joynt. 2002. I would be guessing. We had--
Chairman Kanjorski. About the same amount?
Mr. Joynt. No. It would have been much less. Fitch grew by
both growing on its own and merging with other, smaller rating
agencies, so we made some acquisitions of Bank Watch Rating
Agency, Duff and Phelps Rating Agency, GIBCA. So it's very hard
to answer the question. But I would say we may have been half
that size in 2002.
Chairman Kanjorski. Half that size. Okay.
How many of those people are involved as analysts in
mortgage-backed securities?
Mr. Joynt. In mortgage-backed securities, I can get you
that answer. I don't have that answer off the top of my head,
globally how many--
Chairman Kanjorski. Would you be much different than one of
the other three major rating agencies that showed a profit, or
an income in 2002 of $3 billion and then in 2006, $6 billion?
Had your revenue changed as much as that over that 3- to 4-year
period?
Mr. Joynt. Well, our revenues have grown both through
combining with these other rating agencies and growth on our
own. The size of our company is much--is smaller than the other
rating agencies. Our revenue base would be less than $1
billion.
Chairman Kanjorski. $1 billion?
Mr. Joynt. Less than that, $600 million or $700 million.
That would be at its peak. So we're smaller than the other two.
Chairman Kanjorski. Now, in your testimony, it seemed to
say that you are really only giving an opinion here, and you
should not be held for doing the due diligence that would
support that opinion. Is that correct, substantially?
Mr. Joynt. In the technical way, or legal way that due
diligence is described, yes, that's correct. We do a lot of
thoughtful research and analysis.
Chairman Kanjorski. Do you do a professional analysis and
present a professional study? I think I saw in your written
testimony that it is non-professional. Is that correct?
Mr. Joynt. I'm not sure I know the--I believe that we're
highly educated and do thoughtful analysis. How you would
describe professional, I think we act very professionally. If
that's a legal sort of characterization, I'm not sure.
Chairman Kanjorski. Okay. Well, do you think it is the
responsibility of a rating agency to practice due diligence?
Mr. Joynt. No.
Chairman Kanjorski. It is not?
Mr. Joynt. No.
Chairman Kanjorski. Categorically not. So what would--
Mr. Joynt. Due diligence, the way I understand it--
Chairman Kanjorski. Under law.
Mr. Joynt. --as a legal term, yes. I'm not a lawyer, so--
Chairman Kanjorski. Right. Well, what would you say, just
off the cuff, not based on studies, that if the first payment
of a mortgage was not made, and if there were no records or
support documents of income level, what likelihood would that
reflect on the likelihood of default or failure of that type of
a mortgage?
Mr. Joynt. I would think that would be pretty poor.
Chairman Kanjorski. That would be a poor operation?
Mr. Joynt. I would think so.
Chairman Kanjorski. Would you be surprised that a 1998
study of major insurance companies showed that mortgage
securities that were AAA rated by the three major agencies, not
all rating, but in various amounts, that only 3 percent had a
failure as a result of defaulting on payments, particularly the
first payment. Moreover, in 2000, only 4 percent failed that
defaulted on the first payment. But in 2007, 15.6 percent of
the mortgage holders failed to make the first payment on the
mortgage. Would you find that remarkable, if those figures came
to your attention?
Mr. Joynt. Yes. Similar to--I'm not an expert, of course,
on mortgage finance, but having said that, I think we all
recognize that the origination of riskier and lower quality
mortgages accelerated during the period of the mid-2005, 2006,
and 2007. I think we all now see that more clearly.
We also have gone back and studied mortgages and securities
that we have rated, and feel like there was a significant
incidence of poor origination and maybe significant fraud in
the origination.
Chairman Kanjorski. My time has run out. I just want to get
this last question in, if I may.
Assuming those facts that I have related to you are
correct, what system would you recommend so that kind of
information could be made available and brought to the
attention of Mr. Smith and his pension fund when he is making a
purchase of securities?
Mr. Joynt. Very clearly, we have stated that we think all
the disclosure that can be made by anybody in the market that
helps educate all investors, and not just rating agencies, but
all investors, should be supported.
So I would be in support--
Chairman Kanjorski. Well, who is the agent or the person
who should be responsible to make that report? Not you, because
you are not responsible for due diligence.
Mr. Joynt. I would think the issuer of the securities and/
or their underwriter should be presenting the information that
supports the--
Chairman Kanjorski. And nobody is to check the authenticity
or what material has been presented to anyone? In other words,
liars get to keep their lies and get to benefit from their
lies; is that correct? We have no checks and balances in our
system?
Mr. Joynt. No, I would not suggest that. So there are
checks and balances--
Chairman Kanjorski. What is a check and balance? If I'm the
guy who is issuing the pool, and 15 percent of the mortgages in
my pool have failed to pay the first payment on their mortgage,
who is supposed to tell Mr. Smith about that problem?
Mr. Joynt. There should be some kind of check in the
system, some kind of expert--
Chairman Kanjorski. Well, knowing the system, is there?
Mr. Joynt. --that can underwrite or re-underwrite those
securities, those individual loans.
It has not been our expertise. We have not developed
expertise to underwrite individual loans in these securities.
Chairman Kanjorski. So it is not my fault, it is Mr.
Garrett's fault, is that what you are saying?
Mr. Garrett, you are recognized for--
Mr. Garrett. I missed that point. What was my fault?
Chairman Kanjorski. I just blamed it on you.
Mr. Garrett. I know. I was blamed in the last election for
a lot.
I thank the panel for your testimony.
Mr. Pollock, in your testimony, you said an astounding
thing. You said we would all like to have infallible knowledge
of the future, so we can somehow assure credit ratings are
accurate. Can't we guarantee having models that are right?
Well, apparently, you haven't been coming to these
hearings, because we already are coming up with a model. It's
called a systemic risk regulator, and that individual or
individuals is going to be able to do what the credit rating
agencies and investors and everybody else have not been able to
do, and that is predict the future for all these.
Any comment?
Mr. Pollock. I think your point is absolutely right,
Congressman.
Mr. Garrett. Mr. Pollock or somebody else mentioned this
earlier. As far as the regulator right now, and we had a
discussion earlier today on this matter with regard to who
regulates the rating agencies, the SEC, and that they're out
there doing the audits and what have you.
Does anyone on the panel have any comments on the SEC? And
my opening comments was, I wish we would have them here, maybe
in a future hearing have them here, as them being the arbiter
or the regulator of the industry?
You can say something nice about the SEC, if you're
worried.
Mr. Auwaerter. I think with the SEC, they are the proper
regulator. I question whether they have the resources to do it
right now, to go out to the agencies and determine that the
processes are working right.
Mr. Garrett. Mr. Smith?
Mr. Smith. I think also that in the 1996 Act, or I'm sorry,
the 2006 Act, there were some restrictions put on the SEC that
I think they're committed to doing a better job of regulating
credit rating agencies if they're given the full range of
powers to do so.
Mr. Garrett. And I'll just throw out the one idea. Is there
anyone else out there--I mean, banks have to deal with credit
issues all the time, so should we switch this over to bank
creditors, the banking regulators, to look at this? Does
anybody suggest that?
Mr. Pollock?
Mr. Pollock. I just have a comment, if I may, on the
banking regulators.
Of course, what has happened historically is, increasingly,
the banking regulators have outsourced the credit judgment to
the credit rating agencies, notably, as I think someone
mentioned in an opening statement, through the so-called Basel
II capital requirements, which not only outsourced the credit
decision but also the capital requirement decision to the
ratings.
I think you have to say on behalf of the rating agencies, a
lot of them commented that was a bad idea, and it was a bad
idea.
Mr. Garrett. Just very quickly, and then I'll go to Mr.
Dobilas on this--if I'm pronouncing it correctly--Mr. Pollock,
since we can't get an all-seeing, all-knowing person out there,
and my question for the panel if we have enough time will be,
what do we really need, what does the--and sir, this is along
your line of questioning--what do the agencies really need to
be looking at in order to make these proper determinations?
First--saying even if we do away with regulations, it
really comes down to whether you have someone out there,
whether they are a regulator or not a regulator, coming up with
a methodology to try to do the best they possibly can to
predict the future, and then my question following that, Mr.
Dobilas, will be, how come, according to your testimony, you
said that--you alluded to the fact that even in the midst of
this, Realpoint has been able to issue accurate credit
downgrades 6 to 12 months sooner than your largest competitors.
How were you able to evaluate it better?
Mr. Pollock. One important point is who is making a
decision to hire the credit rating agency. An investor-paid
rating agency has to convince investors that its ratings are
worthwhile buying.
Mr. Garrett. Okay.
Mr. Pollock. That's a really good check and balance, right
there.
Mr. Garrett. I'm sure the credit rating agency would say
that there's a separate--there's a Chinese wall through on
that.
Mr. Dobilas. I guess Alex is stealing some of my thunder
here, but I think you have to understand the basic difference
between subscriber and issuer paid.
We are paid by investors, and they have cancellation
rights. We actually are very proactive in our methods with
regards to surveillance and transparency.
Issuer-paid agencies today make a lot of their money
upfront when a deal is initially hired.
Subscriber-paid agencies have more of a focus on the
surveillance process, on an ongoing basis, meaning we review
every CMBS transaction, every single month, and have a detailed
review. What we try to do is be fully transparent to investors.
Mr. Garrett. And you would suggest, and you don't work
there, that the Big Three don't have the same modeling; is
that, in essence?
Mr. Dobilas. They do not have the same basic philosophy
when it comes to surveillance. Their major emphasis has always
been on the pre-issue, the new issue marketplace. That's where
they make most of their money.
The surveillance model wouldn't be in existence today if
the rating agencies were doing a good job on the surveillance
side. Monthly surveillance, we listen to investors, investors
are our clients.
I started in the rating agency business about 15 years ago,
and I can tell you, there has been really no major changes with
regards to clarity and transparency to investors until
Realpoint came along on the CMBS side. We are offering a
different business model to investors, which investors are very
supportive of.
We don't want to tell them what the right answer is, but we
want them to understand fully what our analysis is and how we
got to that analysis. By underwriting all of the underlying
commercial properties, showing them our underwriting, you know,
they're seeing something that they have never seen before, and
it proves to be a more reliable rating than the reactive
ratings of our counterparts.
Mr. Garrett. I appreciate that. I need to better get my
arms around the differences, but I appreciate the testimony.
Thanks.
Chairman Kanjorski. Thank you very much, Mr. Garrett.
We will now hear from Mr. Ackerman.
Mr. Ackerman. Thank you, Mr. Chairman.
Mr. Joynt, if I may read from your testimony two lines:
``A Fitch rating is our opinion about the future financial
capacity of a company or other issuer to pay its debt. It is
not a statement of fact or a professional judgment.'' It's your
opinion. You're entitled to your opinion.
There are 300 million Americans. Do you know how many have
opinions? I would say about 300 million.
My cousin, Sheldon, has opinions. He has opinions on
everything. He is not a professional, either, and sometimes his
statements of fact aren't.
You get paid sometimes, I understand, $1 million by clients
for your opinion, and the reason you get paid so much money for
your opinion is because some people think that this is a
professional judgment. And you get paid because you are
something that is called an NRSRO. My cousin Sheldon isn't.
My cousin Sheldon can't put AAA on some company that
they're going to market. Nobody would pay him 2 cents for his
opinion.
You get paid that much money because you have a government
franchise from the SEC. Of the 300 million people, plus I don't
know how many entities in America, I understand there are only
10 so designated by the government, and the reason is, then
people rely on that, because they think this now has the
government's imprimatur to issue very professional statements
based on some expertise that you have.
Now, if these are only your opinions, which you may think
are better than Sheldon's, would you be adverse to putting a
warning on your ratings, much like on cigarette cartons, that
says, ``This rating is not a statement of fact,'' which is what
you say, ``nor is it a professional judgment, and it's just as
good as my cousin Sheldon's,'' and put that in a box?
Mr. Joynt. Not knowing your cousin Sheldon, I wouldn't
reference him, but I suppose I would respond this way. We try
to be very clear about what the ratings are intended to mean
and what they're not intended to mean, so they're not an all-
purpose recommendation of anything, they're--
Mr. Ackerman. But the point I'm making is there's a
difference in Cousin Sheldon's free speech, coming from a guy
called Cousin Sheldon, who has no other credentials and isn't 1
of 10 entities or people in America who have been selected by
the government to represent themselves as nationally
recognized.
Once you're nationally recognized, and you bear this
franchise, given so rarely by the government, you get to charge
$700 billion, last year is what I think you said--$700 million,
I get carried away--$700 million to people who value the fact
that you bear that franchise and Cousin Sheldon doesn't.
So there's a responsibility there for the exercise of your
speech, which is not free, it's $700 million worth of charges.
That's different than Cousin Sheldon's free speech.
Mr. Joynt. I believe one of the reasons why we receive
remuneration for what we do is because, over a period of time,
many participants in the capital markets, including large,
sophisticated institutional investors, have learned to develop
our opinion across a wide range of ratings and research that we
do--
Mr. Ackerman. People make life-changing decisions based on
your rating. It is not something that is casual. If it's
something that people rely on, that they think that we have
empowered the SEC to license you, in effect, to exercise the
world's greatest judgment and tell people what the best
judgment in the world can say, shouldn't you bear a
responsibility?
You can't just say, ``I'm not a doctor, but I play one on
TV,'' or ``I'm not a professional, but I play one in the
marketplace.''
Mr. Joynt. I believe we feel quite accountable and
responsible for the quality of the work that we do, and we work
very hard to make sure that we're educated in what we're doing
and undertaking, you know--
Mr. Ackerman. I'm sure that Cousin Sheldon feels the same
way, but the problem is if that is just your opinion, why don't
we just strip away the fact that you have a government license
to operate, that you have been franchised as 1 of only 10
entities in the country that's qualified to make that non-
professional, non-statement of fact judgment?
Mr. Joynt. I know in my--and I have been--I think it's wise
for you to think in that way. I believe that NRSROs were
designated and ratings were used for constructive purposes,
including in each of these regulations at the time they were
put in place.
All I have suggested is people think about changing the
regulations or the recognition of rating agencies, that it be
thought about over time, carefully, and consistently. There was
a constructive reason why they were used, and so rather than
just creating a sort of a blanket change, I think it would be
more constructive to not throw the baby out with the bathwater,
to carefully consider it over time. I think that's exactly what
the SEC is doing right now, for many of the regulations that
they have.
Mr. Ackerman. Mr. Volokh gave us a brilliant treatise on
the First Amendment, much of which I subscribe to
wholeheartedly.
Newspapers don't have to have a license. They have a First
Amendment right. It's not like if the country decided, and we
decided we're going to license newspapers, and only license 10
of them. There would be a big difference in the world, in our
interpretation of free speech.
And newspapers are self-policing. They make their own
rules, and put advertisement over something that's an
advertisement, not required by any law or rule. It's their own
judgment to do so.
Your industry, the credit rating industry, does not have
the sense of integrity that those other purveyors of free
speech, the real purveyors of free speech have, and they self-
police and say, ``This is an ad.''
Why don't you just say, ``This is an advertisement, it's
AAA. It's my endorsement.''
You endorse products, is what you do, for a price, like a
baseball player endorses sneakers.
Mr. Joynt. So, Mr. Ackerman, I might also add that at the
recent SEC hearings last month, when confronted with the same
question, both Standard and Poor's and Moody's, I believe,
responded that they thought it was wise that the rating
agencies be taken out of regulation.
And so I was asked my opinion at that time, because I had a
different view, which was I thought that should be thought
about carefully. So because I think there are constructive
reasons to be designated NRSROs and using ratings, and also I
believe that without designating anyone, the present incumbents
would be more likely to be used by investors for the good
reasons that they're used right now, in referencing ratings,
and I think it might inhibit competition and diversity of
opinion--
Mr. Ackerman. Let me just say, because my time has expired,
and the chairman has been very generous, that free speech
cannot be charged for. You don't charge anybody for exercising
free speech.
If you want to exercise free speech, you shouldn't have a
government license, and if you have a government license, and
are only one of a few designated to have that, there's nothing
wrong with paying for the license. You pay for a fishing
license. And the price you pay, or the price you should pay, is
the price of being responsible in the marketplace, to be held
accountable by people who feel they might have been misled by
your endorsement of a product that should not have been
endorsed.
I yield back the balance--I guess I have no balance. Thank
you, Mr. Chairman.
Chairman Kanjorski. Do not push it, Mr. Ackerman.
[laughter]
Chairman Kanjorski. The Chair now recognizes Mr. Bachus for
5 minutes.
Mr. Bachus. Thank you. Thank you, Mr. Chairman.
Mr. Ackerman, your Cousin Sheldon, what does he do, what
line of work is he in?
Mr. Ackerman. Last I heard, he was with the Department of
Sanitation.
Mr. Bachus. All right, then.
[laughter]
Mr. Bachus. That pretty much sums it up.
I ask the panel, do any of you plan to rely on Congressman
Ackerman's Cousin Sheldon for risk assessment? Probably not,
right?
Let me ask you this. Mr. Joynt, first of all, let me say
this: I admire you for being here. It's my understanding that
S&P and Moody's were not invited, but you were. That sort of
leaves you out on the point.
I want to ask you, just ask you some questions, just to try
to understand where we go from here, as you said.
If the debt issuers don't pay for these risk assessments--I
mean, individual investors can't pay for them, so who would pay
for them? Is there a practical--and I know people have talked
about conflicts of interest. But who would fill that gap if the
issuers did not?
Mr. Joynt. So, investors now receive--pay for research, but
they receive the benefits--all investors, retail investors,
institutional--receive the benefit of the public and
transparent nature of the rating agencies that come from the
issuer-paid ratings.
I don't believe that there would be enough payment,
sponsorship, organization of investor payment for the ratings
to support the kind of staffs that we now have in place to do
what I think is, you know, quite a deep and educated job in
analyzing securities.
So I believe somehow we would lose the benefit of the
positive of what with have now in the form of, at least, Fitch.
Mr. Bachus. Yes. And I ask the other panel members, and the
law professor--this may be outside your field, but other than
the professor--who--you know, we all say there appears to be a
conflict when an issuer pays for it, but who else would pay for
it? I mean, is there a practical substitute?
Mr. Smith. Well, as I said earlier, from the institutional
investors' perspective, we buy the research and we get some of
the benefit there, but that doesn't solve the issue, and the
issue, I think you're getting to is, who is going to pay for
the determination by whatever gatekeeper it is, whether or not
a particular instrument meets capital requirements, etc., and I
don't have a good answer for you.
I don't think that turning to an investor-pay model instead
of an issuer-pay model really fills all of the need that there
is for making this determination. There's going to have to be
something else that's identified, or else we're going to have
to make credit ratings something we can actually rely on.
I think that can be accomplished. I think it could be
accomplished through transparency and accountability, and when
there's a price to be paid for not just being wrong in that the
instrument didn't perform as it was expected to--I don't expect
them to predict the future; I think that's a red herring--what
we expect them to do is create a robust process, free of
conflicts, free of bias, and carry out that process
consistently throughout all the products, and put the product
out there for us to buy. And it seems pretty straightforward.
Mr. Bachus. Anyone else?
Mr. Dobilas. Yes, I would like to comment.
You know, I would like to make a distinction, too, in
saying that I only speak for CMBS.
You know, when we look at a subscriber-paid model, it works
very well in the surveillance arena. Now, on the new issue side
though, I have to say there is a real problem with the issuer-
paid model. And that really isn't a problem that can't be
solved, but it's going to need a long-term approach. It's going
to need somebody to set the example and show investors what
subscription-paid models can do in that arena, and somebody is
going to have to absorb the cost, because when you do look at
these new issue deals, there's a very large cost structure
involved for a rating agency when they do go in to rate a new
issue security.
On the CMBS side, you have to visit every property, you
have to underwrite those properties, you have to travel. You
know, somebody is going to have to pick up those expenses.
But I do think that if investors can see the light at the
end of the tunnel, they will wean themselves of, you know, the
dependency on those two, you know, new issue ratings, but
somebody is going to have to step in in the interim and make
sure that the playing field is equal, and investors will
eventually buy those analyses.
Realpoint, we were looking at offering a very cost-
effective--
Mr. Bachus. Let me thank--I mean, I appreciate that, and I
think, really, though, we're saying, I'm not sure how we do
that.
Mr. Pollock. Congressman, if I could comment on that, the
rating agency world I picture is one that has both investor-
paid and issuer-paid competitors in it. I don't think there is
any chance that the issuer-paid agencies are going to go away.
They are going to still be there. There is a large set of free
riders in the public who get the ratings, and they'll continue
to get the ratings, but there will be competitive pressure for
quality from the investor-paid models.
We should say, of course, the ratings, as I said in my
testimony, are very valuable to all sellers of fixed-income
securities, because they're a great part of the ability to move
those securities, and they'll have an interest in making sure
such ratings are available.
Mr. Bachus. And I think part of that answer, if you expand,
and you don't--you know, these nationally recognized, I think,
people have relied on that as somewhat of a guarantee, and we
need to expand that number.
But also, I mean, I would have to say that we also--you
know, there have to be some qualifications for registration.
Can I ask one other question? I know you have gone over
with everybody else.
Mr. Joynt, is the problem--you have mentioned fraud.
Obviously, that can be a problem, when they fail to disclose
information. But how about expertise, I mean, or competence? I
mean, that, on occasion, you know, there probably just wasn't
the competence there, because of the complexity. Is that true?
Mr. Joynt. So for mortgage-backed securities, I would say
the accelerated environment and pace of origination and the
change to broker origination, and usage by financial firms,
which happened quite quickly in large volumes in that period of
2005 and 2006, I think, contributed a lot to a change in the
basic competence of the origination of the mortgage process,
and so the need to have checks on that arose quickly. The
checks probably weren't in place. The reliance, therefore, on
the historical data, of what defaults and delinquencies had
occurred in the past compared to what actually was happening or
about to happen, especially with the weakest-quality mortgages,
would indicate to me that all the competence, up and down the
chain, was not there.
Mr. Bachus. Let me ask you this. Not you, S&P, you know,
Moody's, what is the rate of just saying, ``We decline to rate,
we don't have the expertise?''
Mr. Joynt. So I think the philosophy of the three largest
rating agencies has been to say, ``Let us collect the
information. Let's see if we can rate something. We probably
can analyze it best and offer some kind of analysis or opinion
to investors.''
So there have been occasions where Fitch, particularly,
declined to rate some securitizations, because we were
uncomfortable with the structure or the credit enhancement
level that we would think was appropriate for the given rating
wasn't appropriate. In the case of SIVs, the special investment
vehicles, we were uncomfortable rating the junior capital
notes.
And so there have been instances where rating agencies
declined to rate, but if there's something that we're
uncomfortable about the analysis, we probably would be
assigning, in many cases, lower ratings, and less frequently,
unable to assign any rating.
Mr. Bachus. Okay, thank you.
Mr. Joynt. There have been some.
Chairman Kanjorski. Thank you very much, Mr. Bachus.
And now we will hear from Mr. Sherman for 5 minutes.
Mr. Sherman. Thank you, Mr. Chairman.
Responding in part to the gentleman from Alabama, I think
it's important not who pays the credit rating agency, but who
selects the credit rating agency. And I'll give you a baseball
analysis on that.
Imagine a baseball league in which the league pays the
umpires, but the home team gets to select anybody they want to
be the umpire. That's going to be a home team that's going to
win a lot of games.
In contrast, imagine a baseball league where the home team
has to give $100 to the umpire, each umpire, but the league
sends out the umpires. Those are going to be umpires who are
answerable to the league, whose livelihood depends upon the
league thinking they're doing a good job.
As long as issuers are selecting the credit rating agency,
then the way to be successful as a credit rating agency is to
make the issuers happy, and then conceal from the public that
the way to be successful is to make the issuers happy. It's who
selects, not who pays.
Now, one approach we could have to all this is to try to
make the credit rating more reliable. The other, and I think
our first witness kind of took this approach--I'm sure I'm
over-simplifying--we could just tell everybody how unreliable
these credit ratings are, and tell them not to rely upon them,
or only as a first step.
Now, Vanguard has the advantage of hiring, what did you
say, 30, 40 different credit analysts. I won't ask you whether
it's 30 or 40.
Investors ought to be allowed to invest directly in debt
instruments, without hiring a team of 40 people. They should be
able to rely on the credit rating.
And even--and I have all my money at Vanguard. But when I
even--and so I'm relying on your analysts, but not entirely,
because I have to compare your funds to other funds that tell
me they get better yields. But then I look, and I see which
fund invests more safely. Well, how can I determine that?
I could rely upon your name, although there are some big
names on Wall Street that have tanked recently. I don't know
which names are good and which aren't. Or, I can rely upon the
fact that your bond funds are mostly AA and partially AAA, and
somebody else's high-yield fund--as a matter of fact, that's
what distinguishes your high-yield fund from the lower-yield
funds.
Professor, you said if somebody gathers information,
analyzes it, and expresses their opinion, that would be
protected by the First Amendment. I would add, that's what my
doctor does, but boy, if he's wrong, I'm going to sue him.
But more to the point, that's what accountants do and
that's what legal opinions do, in offering materials, private
placement memorandums, SEC regulations. I think I'm the only
CPA up here.
And what does, when you look in the offering materials, or
financial statements, and then there are two paragraphs,
usually, written by the auditors. They say, ``In our opinion,
the attached financial statements accurately reflect, according
to generally accepted accounting principles.''
So I'll ask you to respond for the record, how the credit
rating agency is different from the accounting firm, both in
public offerings and in private placement memoranda, but also,
you have, if there's a tax advantaged investment, you usually
have an opinion letter from a tax counsel, saying, ``Here are
what the tax consequences are.''
I have been the auditor. I have been the tax counsel. And
in every case, I knew I would get sued if I was wrong.
Otherwise, you would be--well, I would have--my professionalism
would have restrained me, but I have colleagues that would have
issued just about any kind of opinion.
What I'll ask you to respond to orally--those other
questions are for the rating--is, is there any constitutional
bar to us saying, certain credit rating agencies will register
with the SEC, and as part of that registration, should they
choose to register, they have to waive the right not to be sued
for their negligence?
Mr. Volokh. Before I answer, could I ask, what is it that
they get out of the registration? Is it that they have to be
registered in order to--
Mr. Sherman. No. Anybody can register, but then the--well,
the SEC then says, ``If you want to issue a debt instrument,
you must get one of our registered SROs to rate you.'' But, of
course, you can go out and hire 12 other people, even--what was
the cousin? Sheldon. And you could even get Sheldon, and you
could, you know, you got free speech. You can talk all you want
about your offering. But you have to pick one from our panel if
you want to sell it.
Mr. Volokh. Sure. Let me speak in order to both of the
matters that you raised.
The first is the status of professional client speech and
to what extent these rating agencies are the equivalent of a
doctor or a lawyer or an accountant--
Mr. Sherman. Well, in this case they would be registered
professional agencies. If you didn't want to be a
professional--I see that Fitch is saying it's not a
professional judgment--but the SEC would say you can't register
unless you want to be a professional.
Mr. Volokh. Got it. So if somebody wants to go out there
and convey their opinion and have other people pay for the
opinion, they are free to do so, but if they want a special
government imprimatur that allows an issuer of bonds to include
that opinion as part of its issue, they have to comply with
certain things.
I tried to speak to that in some measure in my remarks, and
I think that, generally speaking, that would be
constitutionally permissible if, going forward, the government
were to say, as a condition of getting this particular special
government benefit, we demand that you comply with certain
kinds of accounting procedures or that you not take any money
from the organization that you are rating, or even that you
agree to be liable under a negligence standard, then I think as
a condition--
Mr. Sherman. I have to try to squeeze in one more question.
That is, I'm going to propose that the SEC identify which
credit rating agencies are qualified. In fact, they have
already identified 10, but which are qualified for particular
categories of debt instruments.
And then, every issuer, when they want to take an issue
public, of debt, they call the SEC and the SEC assigns one at
random, the same way the league assigns a team of umpires.
Mr. Joynt, this would mean that you would never have to
please an issuer. As a matter of fact, if you regard it as a
really tough rater, that might be fine, because it would
improve your image with the SEC.
That would change your business model. It would allow
perhaps other competitors to emerge, in that having a big name
like your company does wouldn't matter as much as being rated
as qualified by the SEC.
Do you see--what disadvantage do you see to someone like
myself who would like to invest $10,000 or $20,000 in debt
instruments and get a rating that I can rely on?
Mr. Joynt. I guess I would come back to try to understand
the goal of diversifying that widely among market participants.
From our personal interest, of course, we spent a lot of time
building up our professionalism and our global reputation. I
think we serve investors well as a global rating agency, able
to rate a wide variety of things.
If there was--
Mr. Sherman. Well, you would be qualified in all the
different categories, or maybe there should just be one or two
categories.
Mr. Joynt. So then the question turns to what I mentioned
earlier, which is on what basis would the SEC or anyone choose
among the rating agencies, and if it was just a random sort of
rotation, I suppose that would be just adjusting the market
shares of as many participants joining the system, is what it
would be.
So there would be--I think many people would try to join.
There would be 20, 30, 50 different rating agencies. It would
certainly impact the business dynamics of the existing rating
agencies, including--
Mr. Sherman. But then I would get a rating from an agency
that the SEC thought was qualified to do the job. That rating
agency would be absolutely unaffected by the desires of the
issuer. What's not to like?
Mr. Joynt. So, I believe that we're unaffected by the
desires of the issuer today, so that the difference between
your statement and mine is that--
Mr. Sherman. Look, I have never been in your profession,
but my doctor seems to care whether I'm pleased as a patient.
When I was a lawyer, I wanted to please my clients. When I was
a CPA, I wanted to please my clients. I want to please my
constituents.
You're the only--you don't even claim to be a professional,
but you claim a level of professionalism so high that you don't
care about the business effects to your enterprise of what you
do, and in particular, you don't care about whether you please
the people who can decide whether to give you the next $1
million contract.
Mr. Joynt. But our--
Mr. Sherman. So you're claiming a level of professionalism
I never aspired to, while disclaiming being a professional.
Mr. Joynt. Our credibility comes from building our
reputation, not just with issuers, but with investors,
regulators, and everyone, over a long period of time, so
keeping the proper balance and being independent and doing a
thorough job is very important--
Mr. Sherman. I could have bought that last year, but now I
have seen Alt-A get AAA, and I'm not buying it.
I'll yield back.
Chairman Kanjorski. Thank you very much.
I will now recognize Mr. Neugebauer for 5 minutes.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Smith, have you ever used credit default swaps to
insure any of the securities, debt securities that you bought
to provide additional protection for the organization that you
represent?
Mr. Smith. In fact, we have not.
Mr. Neugebauer. You have not?
Mr. Smith. No.
Mr. Neugebauer. And why is that?
Mr. Smith. Because we judge them to not be something we
wanted to invest our beneficiaries' money in. We did not
participate in that field.
Mr. Neugebauer. I think in your testimony, Mr. Joynt, that
you didn't--you criticized proposals to replace ratings with
bond spreads or CDS spreads, because you think the market
prices, by definition, are inherently volatile than a
fundamentally driven credit rating.
When you were looking at your ratings and kind of, you had
your story and you were sticking to it, were you monitoring the
spreads on some of the credit default swaps to say, ``Hmm,
there's some risk premiums there that other people think are
there, that we're not recognizing.'' I mean, did the bell go
off for somebody?
Mr. Joynt. Yes. We would take all market inputs, prices,
CDS spreads, anything into account when trying to think about
the risks that we analyzed. Individual analysts would receive
market price information and spreads. Our central credit policy
group would monitor CDS prices, and in fact go back to analysts
and individual groups and say, ``Have you thought about and
seen what's happening with these prices?''
So I would say we're aware of, it's an important factor,
it's an influence, and just to respond to what you originally
suggested, we see value in market prices for investors to
reflect and think about the risk. I believe those are more
volatile than fundamental analysis. They are influenced by
market events, volatility, liquidity. And so I think they are
complementary.
So yes, we use them to help think about the fundamental
analysis, as well.
Mr. Neugebauer. So when those risk premiums started going
up, at what point did you start changing? In other words, if I
went back and looked at a security that you rated and I started
looking at the risk premium in that CDS, when would you have
said, ``You know, maybe we don't have this rated right?'' As
opposed to--I mean, how much did the premium--well, how much
premium increase would I see before I saw a rating change?
Mr. Joynt. I can't answer that question specifically, but I
should say that there have been times when market spreads have
widened out, and contracted back, and it wasn't reflective at
all of the fundamental credit risk of a company, and there have
been times when market spreads have widened out and
subsequently the company's performance has proved to be weaker,
ratings were changed subsequently, as well.
So I mean, there are good examples with the auto companies
in the past 10 years, where their credit has weakened and
ratings have weakened, and where market spreads have been
dramatically different than what the fundamental analysis might
have said at the time.
So it's a wide range, I would say to you.
Mr. Neugebauer. I wonder what the difference of the
analysis that the people who were taking on those risks for,
you know, a relatively small amount of money. You have to be
right on those, because they're taking a relatively small
premium for a fairly large risk. I mean, so what did they know
that you didn't know?
Mr. Joynt. I'm not sure how to react to that. There's--
whomever was selling or buying protection, there would have
been two people thinking two different things about that risk
at that price. So one might have been thinking, ``That was a
great trade, I'm glad I got this premium,'' and another was
thinking, ``I'm glad I shed that risk.''
So--also, the CDS market is a synthetic and a derivative
market. It's not physical securities. So the people who trade
or act in that market aren't necessarily--they can act with
leverage and volumes that might indicate they have much greater
rewards than holding physical securities or risks.
Mr. Neugebauer. Well, the issuers are taking a real risk. I
mean, it's not synthetic, it's real. If there's a default on
that security, they have to--there's performance.
Mr. Joynt. No, that I understand, but they don't own
physical securities.
Mr. Neugebauer. Some of them do.
Mr. ``Dobilas''--am I saying that right?
Mr. Dobilas. No, but that's okay. It's ``Dobilas.''
Mr. Neugebauer. ``Dobilas.'' You would think somebody with
a name like Neugebauer could pronounce that, wouldn't you?
So, in your particular business, you do not do any issue
ratings on new issues. When do you start coverage?
Mr. Dobilas. Since the NRSRO designation, you know, we are
eligible to do new issue, but we would have to fall under the
same model, being paid by the issuer, you know, and be sort of
a hybrid rating agency.
Most of our subscription-based business is all--well,
actually all of our subscription-based business is paid for by
investors.
We tend to pick up the deal as soon as the information is
available to the public. We're not actually privy to the post-
sale information that the hired NRSROs have access to.
So usually, it is 30, about 30 days or after the first
payment of the bond that we have access to all the information,
enough information to do a detailed analysis on.
One of our recommendations is definitely to open up that
post-sale analysis and allow all NRSROs to have access to that
information, so we can, in a timely manner, prepare an analysis
that can be available to investors for direct purchase, as
opposed to having a reliance, or over-reliance on issuer-paid
ratings.
That way, if, again, an investor felt it necessary to get
more information or additional information, it is available to
them.
Mr. Neugebauer. So one of the--would one of the ideas be
that companies before, that are thinking about issuing, whether
they have selected your firm or not to rate the issuance, that
you be given the same amount--the same information that they're
giving to the rating agency that they have selected to do that;
so if I'm one of your subscribers, and somebody comes out and
says, ``This is a AAA,'' so that's one opinion, and then I call
your firm up, and you say, ``No, Randy, we think that's an A?''
Mr. Dobilas. Yes, we think more opinions at the post-
issuance, you know, level, the better. Let the investors really
know what kinds of risks are out there, don't limit it to just
two rating agencies.
Mr. Neugebauer. But you're not privy to the information
that, say, if Fitch has been selected, you do not get the same
information up front until after issue; is that what you're
saying?
Mr. Dobilas. That is what I'm saying. Now that we are a
registered NRSRO, though, we can actually join Fitch and, you
know, bid on deals in the same pre-sale analysis that they do.
Mr. Neugebauer. You can bid on it, but if you don't get the
bid, or do you get the information?
Mr. Dobilas. No. We're not privy to share that information
with our clients at this time. Both Regulation AB and FD sort
of prohibit that from happening.
Mr. Neugebauer. Prior to issue, if you have not been
selected?
Mr. Dobilas. Correct.
Mr. Neugebauer. So you can't issue your opinion on that
until after issuance?
Mr. Dobilas. About 30 days after issuance, and we can't
even use the data if we did take a look during the bidding
process. It's a separate group. We can't--
Mr. Neugebauer. Is that one of the solutions?
Mr. Dobilas. We think the solution is definitely make that
information available and disclose it to any registered NRSRO.
There's a lot of private information in that data, so you need
to regulate that somehow, and we think having a NRSRO
designation, you know, would be, again, all the regulation you
need to make sure that information stays private, and then
allow the rating agencies to analyze that information and
prepare their analysis.
And we think having--again, there's no getting rid of
issuer-paid models or no getting rid of subscriber-paid models,
and necessarily, I don't think one is better than the other. I
think the fact is, having more opinions at that post-issuance
is in the best interests of investors.
Mr. Neugebauer. Last question, to the panel.
Under Mr. Sherman's proposal, if somebody else chooses, is
there some validity to, if you are all equally competent, that
a third party would choose--in other words, you would be in a
pool and a third party gets to pick who that is?
Mr. Dobilas. I guess if I could just jump in again, you
know, the Federal Reserve, it's interesting, because they're
faced with that now with regards to the TALF Program.
And I should also just commend the Federal Reserve, because
the level of analysis they did on the rating agencies that
participated in TALF was very detailed and analytic and
quantitative in nature, a very, very thorough process. But
they're faced with sort of a similar distinction now.
I do not think it's necessarily a bad thing to take that
out of the issuer's hands and have a trustee, for instance, be
hired to randomly select the rating agencies. The only thing
you would want to avoid at all costs is stifling competition
and quality, more quality than competition.
You know, you wouldn't want to see the industry just result
in, you know, just, ``Hey, I have a deal coming up in a month,
you know, we'll just hang in there and put out a rating.'' You
know, you definitely want an evolution of transparency for
investors.
Chairman Kanjorski. Thank you, Mr. Neugebauer.
We will now have Mr. Capuano for 5 minutes.
Mr. Capuano. Thank you, Mr. Chairman.
Gentlemen, I want to be clear. I have my problems with the
way credit agencies work, credit rating agencies work, but I
absolutely agree that there is a role for them in the free
market world.
Let me ask you, my problem is trying to figure out a way to
get the credit rating agencies to be independent, so that their
judgment can be trusted. I can't believe any of you really
believe that credit rating agencies' judgments, right now, is
trusted by anybody in their right mind. It isn't. And I want to
get to a point where it is.
Let me ask you, what are the consequences when a rating
agency gets it wrong?
Mr. Joynt, I think, I may as well just start with you. And
I apologize. I don't mean to pick on you. But--
Mr. Joynt. That's all right.
What's the question?
Mr. Capuano. What are the consequences if a rating agency
gets it wrong? What are the consequences to your business if
you get it wrong?
Mr. Joynt. So we put out our rating and our research, and
if we get it wrong, it means we would have been changing our
opinion quickly, downgrading the rating substantially, and
having a surprisingly different rating result or credit
result--
Mr. Capuano. But do you lose an investment? Does anybody go
to jail? Does anybody lose a license? Anything?
Mr. Joynt. So investors that would have purchased those
securities--
Mr. Capuano. I know what they get. What are the
consequences to your company if you get it wrong?
Mr. Joynt. So they would not be interested in using our
services, if we consistently got it wrong.
Mr. Capuano. That's fair and reasonable, but that goes to
Mr. Pollock's comment, which I thought was very good, of a
cartel.
Now, Mr. Pollock, you would agree that a cartel doesn't
necessarily have to be just three or just 10, a cartel could be
100, if they operated as such; is that incorrect?
Mr. Pollock. Congressman, it would be really hard to run a
100-member cartel, but I think the key about what happens to
the credit rating agency, which is an excellent question, is
whether the credit rating agency is judged by the content and
value of its ratings, or whether the rating agency is operating
by providing a regulatory value, which is what the old system
had. Professor Frank Partnoy has discussed this at length, that
when you convey a required license, you are conveying the fact
that, ``I'm just passing on this regulatory license I have,''
whether your ratings have content or not.
I'm not saying the ratings don't have content, but that
there is a regulatory value which is different from the content
value, and the more we could move the market toward what
happens to rating agencies being based on the informational,
intellectual value of the rating, the better we would do.
Mr. Capuano. Content, qualitative analysis, analytical
analysis, not opinion, and understanding that, at some point,
there's always opinion. I get that.
If that's the case, I have a proposal, at least when it
comes to municipal bonds, to simply require agencies to base
their opinion on the ability to repay that debt. And yet, the
industry thinks that's some kind of a major problem, and
opposes the bill.
It simply says, ``Base your opinion on the sole factor of
whether that city, town, county, or State can repay the debt.''
Where's the problem if that's all we're asking? Simply base
your credit rating on that. Where's the problem with that?
[no response]
Mr. Capuano. Good. Nobody has one. So you're all in favor
of the bill? Mr. Chairman, I guess we can mark that one up next
week.
Again, let me ask another question. At Enron, there were
consequences for a lot of people. Several people went to jail
from the company. Arthur Andersen, at the time one of the top
two largest accounting firms in the world, went out of
business.
What happened to the credit rating agencies that rated
Enron's financial status?
Mr. Dobilas. I guess I just want to make a point.
They're still in business. You know--
Mr. Capuano. Bingo.
Mr. Dobilas. --but in a subscription-based service like
Realpoint on the secondary side, I mean, we would be out of
business, too. Our clients would just walk away. I mean--
Mr. Capuano. I get it. And that's one of the things I'm
trying to get at. I think that is one of the key factors.
I don't understand why I have to accept the fact that
issuer-paid business will continue to go on forever. I mean,
again, if that's the case, big red stamp on the front of this,
you know, ``Endorsed by us,'' as opposed to, ``Endorsed for
you.''
And I guess the last factor I have is, we talk as if
somehow credit rating agencies are just out there doing God's
work, and that's it. Most, up until recently, most of the large
investors, up until the last 5 years, were institutional
investors. Now we get hedge funds, private equity firms, and
all that, and different problems we're trying to deal with.
But most institutional investors are required to invest
only in certain rated stock, or actually prohibited from
investing in other stock. That's a captive audience. That means
your rating is critical.
As we see here right now, one of the biggest problems I
have, or the biggest disagreements I have, probably maybe the
only one, at the moment, of major import, with account
administration is the proposal on this public-private
investment program. I hate it. I hate it for lots of different
reasons.
One reason I hate it is, in this program, it says you can
only buy AAA-rated bonds. Excuse me? You rated them AAA. They
went bad. They're now junk, toxic, whatever words we're not
using this week. And yet we can only invest in those. I'm
missing something. Your ratings matter.
And as far as the free speech goes, let me be very clear.
You have every right to say anything you want. Go right ahead.
You don't have a right to sell it. You don't.
And I understand, I'm a lawyer, lawyers will disagree, and
you know much more about the First Amendment than I do. I know
one thing. You can't be running down the halls screaming,
``Fire,'' and you can't be running down the halls saying,
``There is no fire. Don't worry about it. Don't worry about
that smoke that you see over there. Calm down.'' Well, you can,
but you're going to be held liable for it.
Now, we will find out whether the courts have completely
gone completely nuts, which on occasion they do, and then
luckily we get Presidents who get to appoint members of that
court. I don't know where they're going to come down. But there
is no rational person who can step back from the actual, maybe
some of the specific cases, to say that you should have a right
to sell and to move a market on the basis of, ``Don't worry
about this fire.''
Or, as a lawyer, one of the things I'm taught, don't ask
questions you don't know the answers to, or don't ask questions
you don't want to hear the answers to.
Now, I don't know that any--have any of you ever been
rated? Have you ever worked for a company that was rated? Any
of you?
Mr. Pollock. Yes, I have, Congressman.
Mr. Capuano. Okay. I have, as well. And let me tell you
something. My job, when you were rating me--actually, Fitch
wouldn't do it--I don't know if--probably still not. I only had
two to pick from, two, because the rest of you weren't in
business. Fitch was the only one.
And by the way, now that we're talking 10, just as a point
of information, how much business is there that is controlled
by S&P and Moody's? What's their share of the market, about?
Mr. Pollock. About 80 percent.
Mr. Capuano. About 80 percent, and Fitch is probably 10,
give or take?
Mr. Joynt. I think 13.
Mr. Capuano. Okay, 15. So that leaves, you know, 5 to 10
percent of the market to the other seven. I would suggest that
we're not at non-cartel type of competitive market yet.
I understand some of the concerns you have, and I want to
be clear. I have been one of the leading critics of the way
credit rating agencies work. I'm not out to put you out of
business. That's not what I want. I actually think I want you
to be there. I want a strong, independent voice to help make--
allow the market to make thoughtful judgments on investments. I
think that's a good thing.
I want independent auditors. I want independent lawyers. I
think some of the lawyers have gotten away with murder, too.
But we need independent, thoughtful, credit rating agencies who
are not beholden to the people that they're working for.
And with that, I'm actually just hoping that you help us
find the way to get there, because otherwise, you're going to
leave it up to us, and believe me, maybe I'm wrong, but I think
this year, we're going to do it.
So you have two choices. Either let us do it and not have
any input, or help us do it the right way.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Capuano.
Mr. Volokh, one question that I had. You mentioned that the
First Amendment privilege was argued and decided in two circuit
courts within the United States. However, I would imagine the
defense of First Amendment privilege was used in cases, say, in
Europe or Asia, and since they do not have the benefit of the
First Amendment over there, do you recall any specific cases?
Was there liability held that was not recognized as a defense?
Mr. Volokh. You know, I have a hard enough time keeping up
with American law. I can't claim any real expertise as to
foreign law. They don't have the First Amendment, and our free
speech regime and our free speech history is notoriously much
more protective of speech across a wide range of contexts than
in Europe or certainly in Asia.
My sense, also, is that, at least from what I have heard,
we also have a much more aggressive tort liability system in
the United States than there, so it may be that there was no
free speech protection for you, but there are also no legal
causes of action.
In fact even in the United States, until recently, the
dominant rule, and perhaps today still is the dominant rule,
that just as a matter of tort law, there is generally only
recklessness or knowledge-based liability, not negligence
liability, in speech that's said to the public at large in
these contexts.
But I don't know much about foreign precedents in this. My
guess is they're not going to be terribly enlightening.
Chairman Kanjorski. I think I hear a lot of lawyer boots
running down the hall right now to buy steamship tickets. I am
being facetious, relating it to ambulance chasing.
Mr. Joynt, are you aware of any cases that are pending in
Europe or suggested to be--
Mr. Joynt. I think also, like you suggested, that the tort
prevalence in Europe is lower than it is here. I believe the
rating agency, credit rating agency industry has just been
thought about and reviewed in Europe by the European
Parliament, and they chose not to move forward with some kind
of expanded or specialized liability, but, you know, so easily,
the SEC could inform you about why they chose not to do that,
and how it might inform your judgment in this matter.
Chairman Kanjorski. Thank you very much.
I did not realize you had come in, in the meantime, Mr.
Royce, and here I am taking some of your time. So we will give
you a little of whatever is left. I will recognize you for 5
minutes.
Mr. Royce. Mr. Chairman, I thank you for this hearing.
I only have one question, but I think we have to get past
the point of the hard-wiring of these rating references that
exist in statutes, because we have set up a regulatory agency,
or a cartel out of this, and I think that a lot of the
problems, you know, Von Meese has had this theory, after he
looked at the cartel arrangements in Europe, and all of them
were drawn from a government franchise or a government-enabled
or created cartel.
And so if you could figure out a way to get this back to a
market-based system where the regulators are not using these
scores to determine whether banks are adequately capitalized,
then you begin to signal that this isn't the score that you key
off of.
Right now, we certainly see, while the credit ratings
issued by the NRSROs are intended to be opinions, as you
discussed, and of course protected as opinions by the First
Amendment, it appears that the treatment of these ratings by
market participants is way beyond opinions. It seems that, you
know, as Schwazerman, Steve Schwazerman of the Blackstone Group
said, the grades issued by rating agencies, he said AAA has
almost a religious connotation in finance, and if you call it a
AAA, you don't have to analyze it. That's why it's a AAA--as he
stated.
So one of the more egregious abuses of these grades
occurred when AIG used their AAA rating to sell abstract
derivatives based on nothing more than junk mortgages.
So to what extent do you believe the reliance upon the
major credit rating agencies by Federal regulators encourages
the belief that these ratings are more than just opinions? That
would be my first question to the panel.
And from a regulatory standpoint, how can we lessen the
dependence upon NRSRO grades?
Mr. Pollock. If I could start, Congressman, I fully agree
with your point that the regulatory treatment raises these
ratings to beyond opinions, whereas what they really are is,
indeed, opinions.
And secondly, it would be very good, as I suggested in my
testimony, to set all regulators, not only the SEC, to try to
lessen the mandating of ratings in their regulations and to
increasing competition in this sector.
Mr. Royce. Thank you, Mr. Pollock.
Mr. Auwaerter. Congressman, I think in the case of that
discussion that you quoted about AAA securities being almost
religious and the investor didn't have to do any analysis, that
was errors on the part of the investor. They abrogated their
fiduciary duties.
I think regulations--excuse me--ratings have a place in
regulation, sort of as a minimum standard, but it's still
incumbent upon the investor to do the work.
For example, in Rule 2-A(7), the regulations regarding
using a credit rating agency set a minimum floor, and that's a
minimum hurdle that, I, as a money fund portfolio manager, have
to get over, but I am still required, under the SEC rules, to
do my own independent analysis.
What we get concerned about at Vanguard, in particular in
the case of money market funds, is that you have a small money
market fund that doesn't put the proper resources in, doesn't
do their own homework, and they just say, ``Okay, we don't have
to rely upon a rating agency, we just make a subjective
assessment, and we end up being the best house in a block
that's burning down.''
Mr. Royce. Thank you.
Any of the other members on the panel?
Mr. Joynt. I'm not sure you were here earlier when I had
mentioned that the recent SEC hearings, that SEC--S&P and
Moody's both had suggested that removing ratings from
regulation in that way would be something they think would be
okay with them.
So I'm not here representing a different, an industry view.
I happen to think that the reason ratings are used in
regulation in many places is because when they were put in
there, it was deemed constructive and helpful, so that was just
one example there.
So I suggest if we're going to go back and think about
their usage now, because of the way we perceive rating agencies
as being over-relied upon, that it just be done carefully and
sort of individually, not in a blanket kind of way, because
there must have been some good reasons.
Mr. Royce. Would you agree with getting them out of
statutes, and would you agree with Alex's point?
Mr. Joynt. I think it depends. I think the use of ratings
as a basic benchmark in 2-A(7) is a constructive use. If there
was an alternative, then I think that could be used.
In other cases, maybe the ratings' usefulness is not as
great as it was originally intended for.
Someone cited the number of regulations that are used,
including State ones, and it's 200 in the States and 50, and I
think they ought to be looked at individually.
I think the SEC is doing that right now, I believe, so
looking at least at the ones that they use for net capital
rules for broker dealer and other things.
Mr. Royce. Any other responses?
Mr. Dobilas. I would just echo that, as well. I think what
ratings really do is, you know, give you a minimum standard. I
think that is really important.
I think it also enables small investors and small upstart
companies to get into the field without adding, you know, a
staff of 40, you know, individuals, who are going to try to
rate the securities.
What we're really there to do is provide, you know, again,
I hate to beat a dead horse, but an opinion on credit, and
identify possible risks within the deal, and I think some of
those statutes were meant to, you know, ensure there is some
sort of analysis done.
I mean, we ran into problems when we relied too heavily on
broker dealer research. Ratings were supposed to be seen as
more independent, and, you know, give you that basic sense of
security in the sense of opinions.
Mr. Royce. Mr. Smith?
Mr. Smith. I think that my answer would be along the lines
of what's going to come in place of them, and I don't mean to
be flippant by that at all.
I mean that there has to be something, some measuring stick
for us to know what the insurance company can hold as reserve
capital for their obligations, or what the money market can
have in its portfolio and continue to represent itself as same
as cash type of an investment. What tool are we going to use to
fill that need?
And really, these regulations, in my view, came about to
allow insurance companies and banks and so forth to not just
have to hold cash. We wanted to look for what's secure enough
that we can rely that it's always going to be there, but it
doesn't have to be cash. You can make just a little bit of a
margin, a little bit of money on it on the edges, and you don't
have to flat-out hold cash.
That's really how this all started. That's where we started
identifying, well, as long as it's AAA, then you can hold it
and meet your capital requirements with your AAA-rated
instruments. And--
Mr. Royce. And we're still left with the reality that AIG
used their AAA rating to sell abstract derivatives based on
nothing more than junk mortgages.
Mr. Smith. Absolutely, and that's because the AAA rating is
unreliable, and that's what we have to get back to, to me, to
say, well, we're not going to call it AAA anymore, fine. That's
fine. What are we going to use as our measuring stick to
identify what those entities can hold, unless we're going to
make them hold cash, which I don't think is going to be
productive for everybody. How are we going to measure it now?
How are we going to define it now? If we're not going to define
it by terms of these credit ratings, how are we going to define
that?
Mr. Royce. Any further commentary?
[no response]
Mr. Royce. Thank you. Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Royce.
The gentleman from Alabama seeks recognition?
Mr. Bachus. Thank you. Yes, please.
Chairman Kanjorski. You are recognized.
Mr. Bachus. You know, one thing, we received word, I guess
just today, or the last day or so, that the regulators are
going to expand the number of companies who can issue opinions
on the CMBS market and TALF, which is--at least, I think
they're moving in the right direction.
And I know, Mr. Pollock, you have pointed out that you felt
like that was--they were going too much to endorse certain
companies or create a duopoly.
Mr. Pollock. Yes, sir.
Mr. Bachus. So I do commend the agencies for doing that.
Mr., and it was ``Dobilas,'' is that--I heard you and Mr.
Neugebauer; is that right?
Mr. Dobilas. That's perfect.
Mr. Bachus. Is that what you came down with?
Mr. Dobilas. Yes.
Mr. Bachus. On Page 4 of your written testimony, you say,
even in the midst of the unprecedented economic conditions,
that Realpoint was able to issue accurate credit downgrades 6
to 9 months sooner than your largest competitors.
Mr. Dobilas. Correct.
Mr. Bachus. How were you able to evaluate the
creditworthiness so far in advance of the other rating
agencies, and can you give us an example of this?
Mr. Dobilas. Sure. Our emphasis is really on, you know,
surveillance of these bonds. You know, our company is a small
company compared to the Big Three, and I would label us as a
niche company into CMBS securities. We have approximately 50
employees. All 50 are dedicated to the review and surveillance
of the underlying collateral.
And I think a big difference is, we have monthly
surveillance, and we try to be fully transparent to our
investors.
So, we gather information on a monthly basis. We analyze
information. We see trends happening. And we're very proactive
with regards to our ratings and those trends.
You know, at one point, before Realpoint became an NRSRO,
every rating agency subscribed to our service as a research
provider for the basic surveillance capabilities we offered.
When we got the NRSRO, you know, that's when things changed
a little bit, and again, we lost some market share, you know,
at that time.
But the most part is, we have monthly surveillance, we do a
very good job with regards to understanding data, understanding
market trends, and we have to service our clients, who are the
investors.
The investors really don't want to know 6 months after the
fact that a security has gone bad, and we try to provide that
service through better quality and better service.
Mr. Bachus. Do you think that some of the other rating
agencies that lag behind, were they seeing the same data, or do
you think it was--
Mr. Dobilas. They were seeing the same data, and I don't
think all rating agencies on the surveillance front are equal,
in the sense I think some rating agencies do a much better job
at surveillance than others, but they--we were all seeing the
same amount of information and data. It's when do you process
that information.
If you're focused on the new issue markets, and getting
into that business, and all your energy and resources are
there, you're really not going to focus too much on
surveillance, especially in a busy market. And again, not all
rating agencies have that same focus.
You know, I would like to stick up for Fitch in this sense,
and say they have a very good surveillance program, and were
seeing a lot of data, and again, their ratings, you know, have
not seen the increases that Moody's and S&P have.
Mr. Bachus. So they did a better job?
Mr. Dobilas. They did a better job.
Mr. Bachus. Okay. That's some good news.
Mr. Joynt, do you have some--
Mr. Joynt. Yes. It's nice to be endorsed by someone.
Mr. Bachus. Thank you. Maybe that will get in a newspaper
article tomorrow. You'll be rewarded for being sent out here
all by yourself.
Thank you.
Chairman Kanjorski. Thank you very much.
I assume Mr. Garrett has no further questions, and I have
100 questions, but you all have been here very long and
tediously. We appreciate it. I think it was very helpful to the
committee. I think we had some interesting questions.
And maybe I should, Mr. Joynt, thank you, because it was a
bit of courage on your part to come forward and put your head
out there, and you must really trust the operators of the
guillotine.
Mr. Joynt. I'll come again if asked.
Chairman Kanjorski. That is very good. And we will welcome
you back.
Thank you all very much. We appreciate it. And the Chair
notes that some members may have additional questions for the
panel, which they may wish to submit in writing. Without
objection, the hearing record will remain open for 30 days for
members to submit written questions to these witnesses and
place their responses in the record.
Mr. Bachus. Mr. Chairman?
Chairman Kanjorski. Yes, sir?
Mr. Bachus. S&P and Moody's at some later time, I guess,
and maybe Sheldon, the cousin, will be called before the
committee?
Chairman Kanjorski. Well, if you would like, we are going
to try. We have a host of hearings. You know how many issues
lie in our subcommittee. But I would be perfectly willing to
find the time, if you will cooperate with us.
Mr. Bachus. I will. I would like to hear from all three.
Chairman Kanjorski. We will work on that.
Before we adjourn, the following will be made part of the
record of this hearing: A letter from the Association for
Financial Professionals. And there being no further business
before the committee, without objection, it is ordered that the
letter be made a part of the record.
The panel is dismissed and the hearing is adjourned.
[Whereupon, at 5:12 p.m., the hearing was adjourned.]
A P P E N D I X
May 19, 2009
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