[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]




                    REFORMING CREDIT RATING AGENCIES

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

                                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

                               __________

                           SEPTEMBER 30, 2009

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 111-82




                  U.S. GOVERNMENT PRINTING OFFICE
54-873 PDF                WASHINGTON : 2010
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing 
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC 
area (202) 512-1800 Fax: (202) 512-2104  Mail: Stop IDCC, 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

                              ----------                              
                                                                   Page
Hearing held on:
    September 30, 2009...........................................     1
Appendix:
    September 30, 2009...........................................    45

                               WITNESSES
                     Wednesday, September 30, 2009

Dobilas, Robert G., President and CEO, Realpoint LLC.............    19
Gallagher, Daniel M., Co-Acting Director, Division of Trading and 
  Markets, U.S. Securities and Exchange Commission...............    12
Gellert, James H., Chairman and CEO, Rapid Ratings International, 
  Inc............................................................    21
Joynt, Stephen W., President and CEO, Fitch, Inc.................    17
McDaniel, Raymond W., Chairman and CEO, Moody's Corporation......    14
Schacht, Kurt N., Managing Director, CFA Institute Centre for 
  Financial Market Integrity.....................................    23
Sharma, Deven, President, Standard & Poor's......................    16

                                APPENDIX

Prepared statements:
    Bachus, Hon. Spencer.........................................    46
    Dobilas, Robert G............................................    48
    Gallagher, Daniel M..........................................    60
    Gellert, James H.............................................    76
    Joynt, Stephen W.............................................    88
    McDaniel, Raymond W..........................................   109
    Schacht, Kurt N..............................................   124
    Sharma, Deven................................................   129

              Additional Material Submitted for the Record

Kanjorski, Hon. Paul E.:
    Written statement of Dominic Frederico, Chief Executive 
      Officer, Assured Guaranty Limited..........................   155
    Letter from Egan-Jones Ratings Company, dated September 29, 
      2009.......................................................   158
    Written statement of John A. Courson, President and CEO, 
      Mortgage Bankers Association...............................   160
Foster, Hon. Bill:
    Responses to questions submitted to Stephen W. Joynt.........   165
    Responses to questions submitted to Kurt Schacht.............   168
    Responses to questions submitted to Deven Sharma.............   169
Garrett, Hon. Scott:
    Written statement of the Commercial Mortgage Securities 
      Association................................................   174

 
                    REFORMING CREDIT RATING AGENCIES

                              ----------                              


                     Wednesday, September 30, 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 2:10 p.m., in 
room 2128, Rayburn House Office Building, Hon. Paul E. 
Kanjorski [chairman of the subcommittee] presiding.
    Members present: Representatives Kanjorski, Sherman, Scott, 
Perlmutter, Donnelly, Carson, Speier, Foster, Kilroy, Kosmas; 
Garrett, Castle, Manzullo, Royce, Hensarling, Posey, and 
Jenkins.
    Ex officio present: Representative Bachus.
    Also present: Representative Green.
    Chairman Kanjorski. This hearing of the Subcommittee on 
Capital Markets, Insurance, and Government Sponsored 
Enterprises will come to order pursuant to agreement with the 
ranking member. Opening statements today will be limited to 15 
minutes on each side. Without objection, all members' opening 
statements will be made a part of the record.
    Today we meet to discuss one of the most important issues 
Congress will address as part of our overhaul of financial 
regulations: The reform of credit rating agencies. This issue 
has already generated much debate.
    Credit rating agencies play an integral part in our 
markets. Even though they operate as independent firms, they 
hold quasi regulatory powers. Investors around the world also 
heed their words, or the letters, as the case may be.
    These entities also greatly contributed to our current 
economic problems by inappropriately issuing triple A ratings 
for mortgage-backed securities and other complex financial 
instruments that later failed spectacularly. These agencies 
further used the same faulty assumptions as so many others that 
real estate prices would never go down. They were wrong.
    Perhaps most troubling, these agencies failed to learn more 
about the quality of the products they rated. Investors have 
come to rely on the judgment of credit rating agencies, and it 
now appears that rating agencies with their, ``Ask me no 
questions, I will tell you no lies'' approach betrayed not only 
that trust, but also the special status under our laws.
    To correct these problems, I have worked to draft 
legislation that achieves a balance between improving the 
regulatory oversight of credit rating agencies, while also 
creating incentives for investors to recognize that ``caveat 
emptor'' is still the ultimate rule for any financial 
transaction. Today's hearing is therefore on a discussion draft 
that aims to reform and regulate these gatekeepers to our 
markets using these two principles as guides.
    This summer, the Administration released a promising 
proposal to reform rating agency regulation. I have 
incorporated many useful provisions from that document into my 
discussion draft, including reforms aimed at enhancing the 
oversight of the rating agencies by the Securities and Exchange 
Commission and requiring new disclosures about how issuers pay 
rating agencies.
    Under the reforms, rating agencies will remain independent. 
The Commission will not opine on the methods used for 
determining ratings, but it will ensure that rating agencies 
follow their internal procedures. The changes additionally 
require new duties for compliance officers at each rating 
agency to monitor and manage the many conflicts of interest 
inherent in this industry.
    We must however go further. My draft therefore includes the 
sensible proposals to promote accountability through liability 
as first suggested by my friend, Senator Jack Reed.
    One of the most repeated complaints I heard in my district 
is that no one has been held accountable for the credit crisis. 
While the Justice Department belatedly works to take legal 
action against wrongdoers who caused this economic meltdown, 
going forward I believe that all responsibility parties, 
including the rating agencies, should be held accountable for 
their actions, good or bad.
    We can promote accountability in credit ratings through the 
threat of liability. While these legal reforms are an important 
change from current law, I want to assure everyone that I am 
committed to working to refine them as we move through the 
legislative process.
    To get at the tremendous conflicts of interest created by 
the issuer pay model, I have also proposed a new idea: making 
the rating agencies responsible for each others' ratings 
through collective liability. This reform will hopefully incent 
participants in this oligopoly to police one another and 
release reliable high-quality ratings. This reform, however, is 
not the only way to fix this problem, and I am open to other 
ways to achieve this objective.
    My discussion draft further includes many other new 
reforms, like a duty for supervisors to manage the work of 
their subordinates, and the establishment of boards with 
independent directors. Many of us also share the policy goal of 
diminishing the reliance on credit ratings. I wish we could 
just snap our fingers and take away the countless references to 
credit ratings in laws and regulations. While I have proposed 
in this discussion draft the elimination in Federal statutes of 
all credit rating agency references, I have serious concerns 
about the unintended consequences of this plan.
    In sum, this is the start of a process. I want to thank my 
cosponsors, Representatives Cleaver, Kilroy, and Kosmas, for 
joining me in producing this bill. Going forward, I optimistic 
that many more Members--from both sides of the aisle--will join 
me as we find the best ways to reform the regulation of these 
gatekeepers to our markets.
    I now recognize the gentleman from New Jersey, Ranking 
Member Garrett, for 5 minutes for his opening statement.
    Mr. Garrett. I thank the chairman and the members of the 
subcommittee for holding this important hearing today. I also 
thank the chairman for all of his hard work and that of his 
staff as well that they put into this discussion draft. I must 
begin by saying I am a little disappointed, as I am sure the 
chairman is, that we couldn't find 100 percent complete 
bipartisan consensus on all portions of this proposed release, 
but I do sit here today and pledge to continue to work with the 
chairman moving forward in hopes that we can eventually reach a 
place where we both are able to support the eventual final 
legislation.
    One of the provisions, as the chairman just indicated, he 
has some concerns with deals with the national recognized 
statistical rating organizations, the NRSROs and removal of 
them from the statute. I approached this debate on the credit 
rating agencies reform with the belief that the two most 
fundamental problems with our rating system are overreliance on 
ratings and a lack of investors' due diligence. Investors have 
become increasingly all too often solely reliant on the use of 
these ratings in determining the safety and soundness of any 
investment. In literally hundreds of Federal and State 
government statutes and regulations, there are specific 
requirements mandating certain grades from the approved 
agencies is this formal requirement that provides an implicit 
stamp of approval to investors. So when an investor sees that 
the government is requiring a specific grade to make a safe 
investment, it reenforces the belief that any investment 
obtaining such a grade is basically safe. I know that the SEC 
has a similar concern as I do. So 2 weeks ago, the SEC 
announced it is removing references to the NRSROs in several of 
the regulations and studying other areas to determine where 
else they can be removed.
    And so I applaud the SEC for their actions and I urge them 
to continue their work. I believe that Congress should follow 
suit and reexamine all the areas where statute mandates the 
ratings of NRSROs. Credit ratings are only one piece of the 
puzzle in determining creditworthiness. Investors must be 
encouraged to do proper due diligence as well in evaluating 
issuer credit quality.
    Another way in which I believe we can help increase 
investor due diligence that this bill does touch on but does 
not go far enough is to increase disclosure through information 
by the issuer. When dealing with equity securities, investors 
have all the public information about the company because of 
the annual and quarterly filing requirements. So I believe that 
we should require the similar situation with debt securities. 
The issuer of debt securities should disclose the information 
contained in the offering more broadly so that investors have 
the ability themselves to delve in deeper into the submitted 
transaction.
    While there may be other things included in the proposal 
that I do support, like increased disclosure and better 
oversight, there are a couple of provisions that I have a 
little concern with. The provisions that I am most troubled by 
center around the question of liability. Unlike many of my 
friends across the aisle, I do not believe that the solution to 
some of these problems is more lawsuits. In the discussion 
draft, there is a provision to institute a collective liability 
among the NRSROs. And I must say, I am concerned about the 
practicality of this provision, not to mention the 
constitutionality as well. I don't see what positive can be 
obtained by holding all the NRSROs accountable for the actions 
of just one.
    The main thrust of the 2006 Reform Act was to increase 
competition between credit rating agencies. Now, I know that 
the chairman voted for final passage of that Act in 2006, not 
withstanding his previously stated belief that there might be a 
natural oligopoly as he indicated within the credit rating 
industry. If we institute a sharing of financial legal 
liability however between all the NRSROs, I cannot think of any 
bigger impediment to new entries into the marketplace. The 
second area of concern regarding legal liability is the 
language in Section 4 to lower the pleading standards for 
lawsuits against the rating agencies. By making the rating 
agencies subject to suits whenever they are ``unreasonable,'' 
you are essentially lowering the bar from fraud to negligence. 
The practical effect of lowering the pleading standard will be 
a dramatic increase in cases being filed and eventually going 
to court.
    So I don't believe that having more lawsuits brought 
against rating agencies is a really constructive way to improve 
the rating process. As Chairman Frank so often noted during the 
Bush Administration, that he did not realize that he was here 
to defend President Bush and his policies whenever there is an 
argument on the Floor of the House with regard to them, 
likewise, I must say I did not realize it would fall upon me to 
defend President Obama's efforts in this context as well, 
because the Obama Administration has submitted an extensive 
credit rating agency reform proposal and increasing legal 
liability and was nowhere to be found in his proposal.
    Also, a recent ruling by a Federal court judge debunks the 
myth that it is impossible to get the credit rating agencies 
into the courtroom. So we should see how that case plays out 
before we overreact in committee. I have another concern as 
well, basically the increased liability. And so while I support 
the SEC providing better oversight of the NRSROs, I am worried 
that too much SEC involvement with ratings further implies a 
government sign-off on the ratings themselves. At what point 
during the SEC examination process to review whether rating 
agencies are following their methodologies does the SEC start 
prescribing specific methodologies for the NRSROs to follow? In 
my opinion, this would only further the belief that government 
is doing the rating themselves.
    Also, the requirement for differentiation of ratings from 
structured products is a concern. All structured products are 
not the same. And giving them the same connotation implies that 
they are. The SEC has already once considered this idea and 
they frankly dismissed it after an overwhelming number of 
investors voiced their concerns. So in conclusion, I think we 
all agree that significant reforms for the credit rating 
agencies are much needed. And I, quite frankly, do 
wholeheartedly applaud the chairman for his hard work and again 
of his staff. And I do look forward to working closely with him 
and the members of his staff and other members from both sides 
of the aisle as we move forward on this extremely important 
issue. With that, I yield back.
    Chairman Kanjorski. Thank you very much, Mr. Garrett. We 
now recognize the gentleman from California, Mr. Sherman, for 3 
minutes.
    Mr. Sherman. Thank you. Nothing is more responsible for the 
fact that we are in this situation than the credit rating 
agencies giving AAA to Alt-A and otherwise giving outrageously 
high ratings to very bad mortgage-backed securities. Smart 
people in these credit rating agencies discovered that if they 
could devise a model based on the idea that home prices would 
never go down, then they could please the issuer, get the big 
fee, and avoid a liability. And so just sticking to your own 
model is insufficient since devising an issuer pleasing model 
is the key to get more business. We either have to remove the 
incentive the credit rating agencies have to please the issuer, 
or we have to counterbalance that incentive with the fear of 
liability.
    The best way to defend the status quo, to defend a system 
of pleasing the issuer, and getting the big fee and avoiding 
liability is to just tell people, don't rely on the credit 
rating agencies, let them do whatever they want, and we will 
put a little cigarette warning on the bottom of the rating 
agency. This is a clever way to defend the status quo. Blame 
the investor for relying on the rating. How is my mother 
supposed to know which corporate bond to invest in if she wants 
a super safe bond? She either has to rely on the agency or hire 
a team of financial analysts to work for her. Which is a better 
system? And then we are told, well, invest in mutual funds. How 
are you supposed to determine which of two funds is safer if 
you want to invest in the corporate bond fund? The one that 
averages a AA rating or the one that averages an AAA rating or 
is my mother going to have to hire a team of financial experts 
to tell her which mutual fund is necessary?
    Rates are necessary. That is why people rely upon them. No 
matter what we say, people will continue to rely on them, so we 
have to make them reliable. One way to do that--as the chairman 
points out--is to counterbalance the risk that they will give 
to liberal--and a rating with the threat of liability. Another 
is to remove the incentive to give too liberal an A rating by 
eliminating the program where the issuer picks the credit 
rating agency. That is like having the home team pick the 
umpire and that is why I will have a legislative proposal.
    I look forward to working with the chairman on it, perhaps 
including it in his bill. I will have the work on it done next 
week to say that we should select the credit rating agency for 
the issuer at random from among the qualified umpires. That is 
how the American League does it. That is how the National 
League does it. Where would Major League Baseball be if the 
home team picked the umpire? The other way to do it is to have 
instant replay and make the umpire liable if he is calling too 
many balls that were really strikes. That might be effective as 
well. But the current system has failed. I yield back.
    Chairman Kanjorski. Thank you very much, Mr. Sherman. We 
will now recognize the gentleman from New Jersey, Mr. Garrett.
    Mr. Garrett. Just for unanimous consent to issue a 
statement from the Commercial Mortgage Security Association on 
this--regarding this hearing on reforming credit rating 
agencies.
    Chairman Kanjorski. Are there any objections? Without 
objection, it is so ordered. Next, we will hear from the 
gentleman from Delaware, Mr. Castle, for 2\1/2\ minutes.
    Mr. Castle. Thank you, Mr. Chairman. Credit rating agencies 
are meant to provide a valued service to investors by giving 
them an informed judgment on the risk of certain bonds. As we 
know, subprime and other mortgages were fragmented into pieces 
and bundled into mortgage-backed securities and then rated. 
Investors relied heavily on the rating agency models to assess 
the risk of these investments before making a purchase 
decision. Yet when AAA mortgage-backed securities began to 
fail, it became evident there was a problem with the system. As 
the housing bubble burst, I grew increasingly concerned with 
this issue, as did my colleague, Mr. Ackerman from New York. In 
July 2008, again, this Congress in the form of H.R. 1181, 
introduced legislation that directs the SEC to establish a 
process by which asset-backed instruments can be deemed 
eligible for nationally recognized statistical rating 
organizations, NRSRO ratings. Under this bill, eligible 
investments must consist of securities whose future 
performances can be recently predicted, such as those with 
established track records or homogenous structures. 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. I am pleased that we are continuing debate on 
credit rating agency reform.
    Although I believe it is clear that action must be taken, I 
believe we must do more to set guidance on the eligibility for 
investment for NRSRO designation to avoid falling into the same 
problems we currently face. I look forward to working with my 
colleagues to ensure adequate reform moving forward. Just one 
further comment beyond my talking points here, and that is the 
question I will have of the methodology of paying for your 
services. That was raised a little bit by Mr. Sherman, I think. 
And I think it is a matter of legitimate concern, that if the 
entities are asking you to rate a product or paying you, does 
that influence all the way this comes out or not and are 
investors shortchanged for some reason or another? I don't have 
a solution to that. I am just interested in your comments on 
that as we go forward. I yield back the balance of my time.
    Mr. Sherman. Will the gentleman yield? My concern is not 
who pays the umpire, but who selects the umpire.
    Mr. Castle. If the wrong team pays the umpire, regardless 
of who selects him, that could be an issue too. So maybe we 
have to combine the two concerns. I understand where you are 
coming from. I would be happy to try to work with you on it. I 
yield back.
    Chairman Kanjorski. Thank you very much, Mr. Castle. We 
will now hear from the gentleman from Indiana, Mr. Carson, for 
2 minutes.
    Mr. Carson. Thank you, Mr. Chairman, for holding this 
important hearing today. We all agree that reform is necessary 
in the credit rating industry. This has become all too evident 
in the ongoing financial crisis. However, I believe that as we 
work to make the industry more independent and objective, we 
cannot ignore the industry's relation to systemic risk. Credit 
rating agencies can increase systemic risk through 
unanticipated and abrupt downgrades. Such rating crises can 
lead to large market losses, fire sales and liquidity 
shortages. In this financial crisis, we have seen many recent 
examples of this. Defaults of subprime loans have led to abrupt 
and unanticipated rating downgrades of a number of rated 
securities, insurers, and bond insurers. These downgrades in 
turn led to larger market losses for investors. Although 
conflicts of interest and informational issues are key to 
understanding why such rating crises occur, it is critical to 
identify the different facets of risks in the ratings market 
and how it can lead to systemic crises and how to measure and 
manage them. We need to better assess the nature and extent of 
the use of credit ratings in financial markets as well as their 
potential impact on our long-term financial stability.
    It is clear that such an assessment will require a global 
approach that includes both micro and macro level analysis and 
includes all market participants. I look forward to this 
opportunity to discuss these issues with the distinguished 
panel, and I yield back my time.
    Chairman Kanjorski. Thank you very much, Mr. Carson. We 
will now hear from the gentleman from California, Mr. Royce, 
for 3 minutes.
    Mr. Royce. Thank you, Mr. Chairman. As we dissect the 
proliferation of the exotic mortgages throughout our financial 
sector, it is hard to overlook the role played by the ratings 
issued by the various rating agencies. Certainly there were 
flaws in the actual ratings. In January of 2008, there were 12 
AAA rated companies in the world. At that time, there were also 
64,000 structured finance instruments like collateralized debt 
obligations holding that AAA rating.
    Further, many of those products were based on nothing more 
than junk mortgages. Of the $3.2 trillion of subprime mortgage 
securities issued, 75 percent were awarded AAA ratings. But the 
rating agencies missing the mark when assessing the potential 
risk associated with these products was not the core problem. I 
believe the major failure over the years was the blind reliance 
on the rating agencies by investors, financial institutions, 
and by the Federal Government. In many respects, the government 
has institutionalized these failed ratings. Looking back, this 
overreliance was as misguided as the ratings being issued by 
the NRSROs.
    Going forward, nothing will replace due diligence by 
investors and institutions and regulators. Alternative risk 
indicators must supplant what was previously an oligopoly by 
the NRSROs. I think a more competitive market with alternatives 
to the NRSROs ratings is the most effective alternative. And, 
for instance, I would raise the issue that many economists for 
some time have advocated for mandating large institutions to 
issue subordinated debt. Credit default swap spreads have also 
been used as an alternative to agency ratings. I look forward 
to discussing the draft legislation issued by the chairman as 
well as other potential reforms with my colleagues here today 
and hearing from these witnesses and I thank you, Mr. Chairman. 
And I think in retrospect, Mr. Chairman, had we never codified 
under law some of the references to rating agencies that 
essentially put government behind the rating agencies there 
might have been more due diligence. Going forward, I hope we 
learn from that. Thank you, Mr. Chairman. I yield back the 
balance of my time.
    Chairman Kanjorski. We will now hear from the gentleman 
from Illinois, Mr. Foster, for 2 minutes.
    Mr. Foster. Thank you. And I would like to thank Chairman 
Kanjorski for convening this hearing today to discuss the 
important topic of how best to reform the credit rating 
agencies. While I applaud the general thrust of this bill, and 
I think it signals advanced improvement over today's regulatory 
environment, there are at least two major areas where I think 
the bill could be improved. The first major problem that we are 
wrestling with is the conflicts of interest inherent in the 
issuer pays business model for the rating agencies. I believe 
that the best model for going forward is to mimic the way that 
we handle similar conflicts and oversight of accounting and 
maybe modeled on the public company accounting oversight board, 
PCAOB.
    An oversight board like the PCAOB would be constituted 
largely or dominantly by users of credit ratings and would have 
teeth. Specifically, it would have powers to set standards and 
mandate disclosures, conduct spot checks and investigations, 
impose civil fines, ban firms and individuals from the credit 
rating industry. I believe that the PCAOB has been a necessary 
and sufficient entity to restore the credibility of the 
accounting industry in the post-Enron area. So the question I 
will be asking is what, if anything, might be the downside of 
instituting a similar oversight board for the credit rating 
industry. The second major problem that I see is the 
nonuniformity and nonquantitative nature of the language in 
which the ratings are reported by the CRAs. While the draft 
bill mandates the CRAs use generally recognized models when 
arriving at their ratings, I believe that greater detail under 
various well-defined market conditions would be very beneficial 
to investors.
    Specifically, I would emphasize the desirability of, first, 
standardization of ratings terminology so that all firms report 
ratings using identical terms. Second, industrywide 
standardization of stress conditions under which the ratings 
are evaluated. Thirdly, unambiguous quantitative correspondence 
between the ratings and the default probabilities under 
standardized conditions of economic stress. And fourth, 
standardization of terminology across asset classes so that, 
for example, a given rating applied to a municipal bond and a 
corporate bond will have the identical default probability 
under identical market stress conditions. One specific proposal 
that I would like to see investigated are what might be called 
ABZ ratings at a glance in which the three digits of a rating, 
instead of just being things that are made up, correspond to 
default probabilities under three different, well-defined 
levels of market stress.
    So the first digit, for example, could represent the 
default probability under normal market stress, the second 
digit under severe market stress and the third digit represents 
the default probability under extreme market stress. A 50 
percent asset price drop, 10 percent increase in unemployment 
and so on. So a rating, if this style of ratings had been 
applied, then the ratings that would be assigned to an 
intermediary tranche of a mortgage pool, for example, might 
hold up well under normal market conditions and then collapse 
at times of stress would be ABZ.
    And had this sort of language been applied to the ratings 
of mortgage-backed securities, then the right questions would 
have been asked and there would have been no way that AAA 
ratings would have been so freely disbursed. I thank the 
chairman for convening this hearing and I look forward to 
working with him to strengthen this critical legislation. I 
yield back.
    Chairman Kanjorski. Thank you very much, Mr. Foster. And 
now we will hear from the gentleman from Texas, Mr. Hensarling, 
for 3 minutes.
    Mr. Hensarling. Thank you, Mr. Chairman. Clearly, there 
were a number of causes of our Nation's economic turmoil, and 
most had their genesis in flawed public policy. Particularly 
with respect to the affordable housing mission of the 
government-sponsored enterprises, Fannie Mae and Freddie Mac, a 
story we know all too well. Now to state the obvious, the three 
major credit rating agencies badly missed the national housing 
bubble. That does not necessarily make them duplicitous, and it 
doesn't necessarily make them incompetent. It just makes them 
wrong--very, very wrong. It is also a painful and expensive 
reminder that there is no substitute for some modicum of 
investor due diligence and personal responsibility.
    Now there is a sincere bipartisan desire for credit rating 
agency reform in this committee. Unfortunately, I believe the 
draft that is before us now falls short. There are a number of 
good provisions in the draft, in Chairman Kanjorski's draft, 
including essentially removing the NRSRO designation from 
current statute in regulation. Unfortunately, the bill also 
includes provisions that will allow new liability exposure, 
including joint liability for the rating agencies. I feel that 
these sections will actually increase barriers to entry into 
the rating market and make it more difficult to have 
competition. An increase in lawsuits will become, I believe, an 
insurmountable barrier to competition. The joint liability 
provision especially troubles me. To make every rating agency 
potentially liable for the ratings of other agencies, I don't 
see the parallel anywhere else in our body of law. I heard 
someone say that is a little like making Ford liable for a 
defective car manufactured by GM and then not giving Ford a 
chance to defend themselves.
    No nation can sue its way into economic recovery and 
financial stability. Increasing the agencies' liability does 
not get at the root of the problem, which is the de facto 
government stamp of approval behind the rating agency's work 
product. That is indeed where we need to go. People assume 
wrongly that the government stamp of approval meant accurate 
ratings. Congress took a good step with the Credit Rating 
Agency Reform Act, but it was too little too late. Again, there 
is a vitally important lesson we have all learned about implied 
government backing. And so I want to compliment the chairman 
and the ranking member for having a bill before us that would 
essentially terminate the NRSRO designation. But unless we 
eliminate all barriers to entry, I am fearful that it is all 
for naught. And with that, Mr. Chairman, I yield back the 
balance of my time.
    Chairman Kanjorski. Thank you very much, Mr. Hensarling. 
Now, we will hear from the gentlelady from Ohio, Ms. Kilroy, 
for 2 minutes.
    Ms. Kilroy. Thank you, Mr. Chairman. Thank you for your 
leadership on this issue and for the opportunity to work with 
you and the task force on this very important issue. Credit 
rating agencies occupy a unique and powerful position within 
the global markets and reforming this industry is a critical 
part of strengthening our financial regulatory system. Like 
many of my House colleagues, I have firsthand experience with 
the role credit rating agencies play as gatekeepers to the 
financial markets. Before coming to this House, I served for 8 
years as a Franklin County commissioner and also for 8 years on 
the Columbus board of education representing constituents of 
central Ohio and as a county commissioner, worked very hard to 
make our county fiscally responsible and to maintain our 
double, AAA rating.
    It is a rating that we worked hard to keep because we 
thought it had meaning and value, that it represented a seal of 
approval and that it would save our taxpayers their hard-earned 
money. Of course, as you know, the rise of credit rating 
agencies as financial gatekeepers began when the Securities and 
Exchange Commission in 1975 in what probably seemed like a 
benign move tied broker/dealer capital requirements to credit 
ratings issued by the nationally recognized statistical rating 
organization, a designation created and determined by the SEC.
    Since then, the credit rating agencies have experienced 
unprecedented growth. Even when the credit rating agencies 
seemed to get it all wrong, they did amazingly well, posting 
record profits at about the same time they were downgrading 
billions of dollars worth of subprime offerings. And it is not 
just that the rating agencies seemed to miss big. But now an 
infamous instant message exchange has been made public, instant 
messaging between two Standard & Poor's officials about a 
mortgage-backed security deal dated April 5, 2007, which seems 
to suggest that credit rating agencies can make billions of 
dollars to provide an opinion on just about anything with 
little fear of penalty or recourse and that exchange one 
analyst stated over a colleague's objections, ``We rate every 
deal. If it is structured by cows then we would rate it.'' And 
as recently as September 23, 2009, The Wall Street Journal 
reported that Moody's is still assigning inflated ratings to 
complicated debt securities that they still do not fully 
understand. I am a sponsor of this very important piece of 
legislation, because it is this cavalier culture made worse by 
a broken system that cost millions of hard-working Americans 
their live savings and set our Nation into the worst economic 
crisis since the Great Depression.
    Addressing the overreliance on NRSRO ratings and Federal 
statutes and regulations is a good place to start. Rating 
agencies should be a part of the equation when making 
investment decisions, not the equation. That is not to say that 
credit rating agencies do not provide value. For thousands of 
small investors, rating each and every security individually 
would be an impossible task. The proposal directs the SEC to 
adopt rating symbols to help the small investor distinguish 
between a municipal bond issue and a collateralized debt 
compromised of subprime mortgages that have been sliced and 
diced and repackaged into looking like a safe investment.
    Finally, the proposal seeks to deal with credit rating 
agencies that act with malfeasance. Credit rating agencies that 
knowingly or recklessly failed to conduct a reasonable 
investigation into the very ratings they were paid to provide 
an assessment on should not be allowed unfetterred 
constitutional protection. Thank you again, Mr. Chairman, for 
the opportunity, and I yield back.
    Chairman Kanjorski. Thank you very much, Ms. Kilroy. We 
will now hear from the gentleman from Georgia for 1 minute, Mr. 
Scott.
    Mr. Scott. Thank you, Mr. Chairman. As we continue to 
monitor the current economic climate we are in and look towards 
some solutions and improvements that can be made, this hearing 
is quite timely as the credit rating agencies played a 
considerable role in what transpired and what will also impact 
in the future. Once a financial institution achieves the 
desired quality grade on a product, it pays the agency for the 
rating. This process is rife with conflict as I believe the 
agencies are acting as the market regulators, investment 
bankers, and as a sales force all the while claiming to be 
providing independent opinions.
    As these organizations are extremely important to the 
financial world, we should realize they did have a significant 
role to play in where we are now. And 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 that we take all issues 
into account, including conflicts of interest, as well as the 
international financial world in reforming how we rate 
financial products.
    I am very interested to hear each of your thoughts and 
opinions on the recently introduced draft legislation by our 
chairman addressing rating agency reforms. And the requirement 
of disclosure revenue serving the Securities and Exchange 
Commission. Thank you very much, Mr. Chairman, for the time. 
And I look forward to this panel's discussion.
    Chairman Kanjorski. Thank you very much, Mr. Scott. And now 
for our last presenter, Mr. Donnelly of Indiana, for 1 minute.
    Mr. Donnelly. Thank you, Mr. Chairman. Some of the things 
we are going to be determining include whether it makes any 
sense for the very people who are trying to sell the product to 
be paying for the rating on it, whether we need a blind pool 
similar to how they do it with judges throughout this country 
in many places or as Mr. James Simon, whom we heard from, 
talked about a quasi-public utility. Whether a few pennies from 
each trade should go in to try to get an independent rating 
agencies. The fact is that this caused extraordinary damage and 
harm to our country and to Main Street America. In my very 
hometown, of South Bend, Indiana, Moody's, in fact, closed 
their office there. And it was done because of economic 
hardship, allegedly, a very, very, very profitable company, and 
that hardship was supposedly caused by the meltdown we had that 
was caused, in part, by the credit rating agencies.
    So Main Street America has been extraordinarily damaged by 
this. And it is our job to make sure it does not happen again. 
Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you very much, Mr. Donnelly. We 
have a little bit of a dilemma. We have four votes, I 
understand. And of course, we have 7 panelists of 5 minutes 
each for a presentation. Rather than break up the presentations 
of the panel, I suggest we will take our recess now, go over 
and vote, come back, and then hear the entire panel strung 
together so we have a better consensus. That means you are 
going to have to stay. We are sorry. Okay. With no other 
comments, the committee stands in recess.
    [recess]
    Chairman Kanjorski. The committee will reconvene. The Chair 
recognizes the gentleman from Alabama.
    Mr. Bachus. Thank you, Mr. Chairman. I have a written 
statement for the record. So I would just like to submit it for 
the record.
    Chairman Kanjorski. Without objection, it is so ordered.
    We are at the point now where we have to welcome the panel. 
Thank you for accepting the delay. That is not uncommon around 
here. Many of you know that because of your prior experience. 
First and foremost, let me say that 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. Daniel M. Gallagher, Co-Acting Director 
of the Division of Trading and Markets at the United States 
Securities and Exchange Commission. Mr. Gallagher.

STATEMENT OF DANIEL M. GALLAGHER, CO-ACTING DIRECTOR, DIVISION 
OF TRADING AND MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Gallagher. Chairman Kanjorski, Ranking Member Garrett, 
and members of the subcommittee, my name is Dan Gallagher, and 
I am a Co-Acting Director at the Division of Trading and 
Markets at the Securities and Exchange Commission. Thank you 
for the opportunity to testify today regarding the oversight of 
credit rating agencies. I note at the outset that my written 
testimony today was approved by the Commission, but any remarks 
I make today, in particular on the draft bill, will be my own 
and may not reflect the views of the Commission.
    The poor performance of highly-rated securities over the 
last few years has resulted in substantial investor losses and 
increased market turmoil. As we work to restore the health of 
the markets, it is vital that we take further steps to improve 
the integrity and the transparency of the ratings process to 
promote competition among rating agencies and give investors 
the appropriate context for evaluating ratings. The proposed 
legislation Chairman Kanjorski recently released for discussion 
contains a number of measures that could enhance the 
Commission's oversight program, including provisions designed 
to address conflicts of interest, a lack of transparency and 
limited accountability in the credit rating industry.
    I would note that over the last few years, the Commission 
has been addressing a number of these issues and we welcome the 
opportunity to discuss these efforts. As you know, Congress 
provided the Commission with authority to register and oversee 
nationally recognized statistical rating organizations, NRSROs, 
in the Credit Rate Agency Reform Act of 2006.
    In the summer of 2007, using our new oversight authority 
and in response to gradually worsening marketing conditions, 
the Commission staff began examination of the three largest 
NRSROs--Fitch, Moody's, and Standard & Poor's--to look into 
their policies and practices relating to ratings of structured 
finance products linked to aggressively underwritten mortgages. 
To put it bluntly, the examinations revealed a number of 
serious problems. In particular, the examinations raised 
serious questions about the NRSROs' management of conflicts of 
interest, internal audit processes, and due diligence 
activities. Findings from these initial examinations informed a 
second round of rule amendments which the Commission proposed 
in June of 2008 and adopted in February of 2009. Earlier this 
month, on September 17th, the Commission embarked on further 
rulemaking designed to promote greater accountability, foster 
competition, decrease the level of undue reliance on NRSROs, 
and empower investors to make more informed decisions.
    The Commission adopted rule amendments designed to create a 
mechanism for NRSROs not hired to rate structured finance 
products to nonetheless determine and monitor credit ratings 
for these instruments. The goal of this rule is to make it 
possible for nonhired NRSROs to provide unsolicited ratings in 
the structured finance market just like they can in the 
corporate debt market. The Commission also adopted a 
requirement that NRSROs must disclose ratings history 
information for all outstanding ratings initially determined on 
or after June 26, 2007. This new disclosure requirement is 
designed to promote greater transparency of ratings, quality 
and increased accountability among NRSROs. The Commission also 
published for comment three sets of new requirements for 
NRSROs. The first proposal would increase accountability by 
requiring NRSROs to furnish the Commission with an annual 
compliance report describing actions taken to ensure compliance 
with the securities laws.
    The goal of this proposal is to increase accountability by 
strengthening the compliance function at the NRSROs and to 
alert the Commission to issues that may need to be examined. 
The second and third proposals would increase the information 
NRSROs must disclose to the public about the conflict of being 
paid for determining credit ratings and other services. These 
disclosures which would include a consolidated annual report 
are designed to provide investors with additional information 
on the source and magnitude of revenue, including revenues from 
non-rating services that an NRSRO receives from its clients. 
Notably, in its recent rulemaking, the Commission also proposed 
rating disclosure requirements for issuers of securities. For 
example, the Commission proposed amendments that would require 
certain detailed disclosures regarding credit ratings and 
registration statements.
    The Commission also proposed requiring the disclosure of 
preliminary ratings, as well as final ratings not used by an 
issuer so that investors would be informed when an issuer may 
have engaged in rating shopping. The Commission also took 
action to eliminate references to NRSRO credit ratings in 
certain of its rules and forms. This is designed to address 
concerns that references to NRSRO ratings and Commission rules 
may have contributed to an undue reliance on those ratings by 
market participants and the Commission found that the removal 
of references either improved the rules or had no effect on 
them.
    Finally, the Commission issued a concept release seeking 
comment on whether it should propose rescinding a rule that 
exempts NRSROs from expert liability under Section 11 of the 
Securities Act. Rescinding Rule 436(g), coupled with the 
proposal to require disclosure of credit ratings in a 
registration statement if a rating is used in connection with a 
registered offering, could cause NRSROs to be included in the 
liability scheme for experts set forth in Section 11. The 
Commission appreciates Congress' interest in this issue, and we 
stand ready to provide any assistance the subcommittee might 
need in its consideration of measures to reform the financial 
markets. I would be happy to answer any questions you may have. 
Thank you.
    [The prepared statement of Mr. Gallagher can be found on 
page 60 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Gallagher. And 
now we will hear from Mr. Raymond McDaniel, chairman and chief 
executive officer of Moody's Corporation. Mr. McDaniel.

  STATEMENT OF RAYMOND W. McDANIEL, CHAIRMAN AND CEO, MOODY'S 
                          CORPORATION

    Mr. McDaniel. Thank you. Good afternoon, Chairman 
Kanjorski, and members of the subcommittee. I am Ray McDaniel, 
chairman and CEO of Moody's Corporation, the parent of Moody's 
Investor Service. I welcome the opportunity to contribute 
Moody's views to the discussion today on legislative proposals 
of the credit rating industry. As this subcommittee knows well, 
the economic downturn has exposed numerous vulnerabilities in 
the infrastructure of the financial system. It has also 
provided important lessons for credit rating agencies and other 
market participants.
    In light of these lessons, during the past 18 months, 
Moody's has adopted a number of measures to enhance the 
quality, independence, and transparency of our credit ratings. 
While these steps are detailed more thoroughly in my written 
statement, they include changes in the following five key 
areas: Strengthening the analytical quality of our ratings; 
enhancing consistency across rating groups; bolstering measures 
to manage conflicts of interest; improving transparency of 
ratings and the ratings process; and increasing resources in 
key areas. We believe we have made important progress but we 
welcome continued efforts that would reenforce high quality 
ratings and improve market transparency without intruding on 
the independence of rating opinion content.
    To that end, I would like to provide Moody's initial views 
on the discussion draft circulated by the committee last week. 
These views are based on a preliminary review of the draft and 
we will be happy to provide the committee with more detailed 
comments in the near future. Moody's supports the proposal to 
increase the transparency of ratings performance and 
methodologies. We believe such transparency will allow 
comparisons that can drive improvements in ratings quality 
across the industry. We also support enhancing regulatory 
oversight of the industry. Creating a dedicated SEC office for 
example, staffed by individuals with the necessary expertise, 
could increase the focus of regulatory oversight and help 
protect the interests of all market participants.
    We also welcome efforts to limit the use of ratings and 
regulation. Moody's has long believed that using ratings as a 
regulatory tool for oversight of regulated entities can 
adversely affect market behavior. It encourages overreliance on 
ratings as well as rating shopping and it can reduce incentives 
for rating agencies to compete based on the quality of ratings. 
While we strongly support the goal of the discussion draft to 
remove references to credit ratings and regulation, we also 
recognize the wisdom of pursuing this goal judiciously so as to 
not create unintended market disruptions. Moody's also supports 
ratings oversight by an independent board of directors. Eight 
of the nine directors on Moody's board are independent and, we 
believe, effective governance is well served by having the 
board provide oversight with respect to procedures and policies 
for the rating agencies. If, however, their role extends beyond 
oversight to the content of methodology, we believe the content 
of methodologies would suffer. This would replace the judgment 
of our current large body of analysts and credit policy 
professionals with a small body of board members who are at 
best part time experts in credit analysis. One provision in the 
discussion draft that Moody's does not support is imposing a 
collective liability regime on all NRSROs. Credit rating 
agencies currently have the same liability as any other market 
participant if, for example, they knowingly make false 
statements or issue opinions that they don't genuinely hold. We 
do not believe the market would be well served by changing the 
standard of liability in a way that would increase the ability 
of market participants to pursue litigation because they are 
unhappy with our ratings.
    We believe the effect on the credit rating industries would 
be to wash diversity of opinion, reduce competition, negatively 
impact market transparency, and make rate opinions more 
volatile.
    Finally, we strongly support efforts to address rating 
shopping, which is a serious concern. We believe, however, that 
to deter rating shopping, issuers must be required to disclose 
more detailed information to the market. Issuers in the 
structured finance market are not currently required to 
disclose publicly sufficient information for investors to 
engage in reliable analysis of the underlying assets of a 
securitization. We urge this subcommittee and the Congress to 
consider requiring that issuers in the structured finance 
market make disclosures similar to those required in the 
corporate market. Moody's strongly supports constructive 
reforms that can enhance confidence in the credit ratings 
industry and the Nation's credit markets. And we are committed 
to working with you to achieve that goal. I am happy to respond 
to any questions.
    [The prepared statement of Mr. McDaniel can be found on 
page 109 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. McDaniel.
    And now we will hear from Mr. Deven Sharma, president of 
Standard & Poor's. Mr. Sharma.

    STATEMENT OF DEVEN SHARMA, PRESIDENT, STANDARD & POOR'S

    Mr. Sharma. Chairman Kanjorski, Ranking Member Garrett, and 
members of the subcommittee, good afternoon. My name is Deven 
Sharma. I am the president of Standard & Poor's, and I am 
pleased to appear before you today.
    Let me start by saying that at S&P, we appreciate your goal 
to reinvigorate the economy and job growth through stability 
and innovation. This is an important point in history as a 
regulatory reform is being considered that will shape the 
future of capital markets and economic growth for many years to 
come. Since our founding more than a century ago, we have tried 
to learn from experience to improve and strengthen our 
analytics and criteria and to review processes when 
appropriate. Thus in 2008, we announced a series of initiatives 
aimed at improving checks and balances in our organization. 
These measures are designed to promote the integrity of the 
rating process and enhance analytical quality, provide greater 
transparency to investors, and more effectively educate 
investors about ratings.
    Let me assure you that these improvements are substantive 
and will go a long way to restoring confidence in our ratings. 
Another way to restore confidence in ratings is to pursue 
effective regulation of credit rating agencies. Although we are 
already subject to a broad and robust regulatory scheme, S&P 
shares the view that further regulation appropriately crafted 
can serve the goal of restoring and maintaining investor 
confidence. Indeed, we support many recent proposals for 
greater regulatory oversight and enhanced internal processes to 
promote integrity in the ratings process. These include 
increased accountability through SEC authority to oversee NRSRO 
and impose steep fines and other sanctions for noncompliance 
with SEC rules or NRSRO rules, internal procedures and to 
require disclosure around issues such as data quality. There 
are other proposed measures that would seriously disrupt the 
capital markets by encouraging less diversity of opinions, 
providing strong disincentives for analytical innovation and 
creating global inconsistency. One such proposal would seek to 
lower the threshold, legal requirements for bringing a 
securities fraud claim against NRSROs.
    Such a measure, if enacted, would cause some NRSROs to rate 
only those entities and securities that are the least likely to 
default or be downgraded. As a result, issuers who are 
relatively new to the debt markets may have a difficult time 
getting rated and therefore greater difficulty accessing 
capital and contributing to economic recovery. Since small and 
medium enterprises as well as new technology companies, for 
example, green companies or broadband providers, represent 
critical and emerging elements in our national production and 
employment basis, this result could have detrimental effects on 
economic growth. Another proposal would subject each NRSRO to 
collective liability for legal judgments against any NRSRO. No 
NRSRO should be required to act as an insurer for its 
competitors. We are also concerned about a proposal providing 
that rating opinions shall not be deemed forward looking 
statements under the Federal securities laws.
    This proposal ignores that the very essence of a rating is 
forward looking; that is, ratings speak to the likelihood that 
an obligor will pay back principal and interest in the future. 
At S&P, we have heard consistently from investors that ratings 
must be forward looking in order to have value. Another 
proposal would dictate that ratings could only measure 
likelihood of default. At S&P, our analysis includes additional 
important factors such as credit stability, which addresses 
whether an issuer or security would have a likelihood of 
experiencing large declines in credit quality in certain 
stressful situations. These are analytical considerations that 
investors have told us repeatedly that they want. Any 
government mandate that would dictate how NRSROs form their 
rating opinions and which factors they may or may not consider 
would deprive investors of the full breadth and diversity of 
NRSROs' opinions. It could also lead to undue investor reliance 
on rating opinions based on the perception that the government 
has endorsed NRSROs' methodologies and their written opinions, 
a result counter to the goal of recent proposals that would 
remove the NRSRO designation from existing laws and rules.
    In sum, we agree completely with the goal of improving the 
integrity, quality, and transparency of credit rating analysis 
to better inform investors in their decisionmaking. However, we 
urge caution in the crafting of proposals that will result in 
less comprehensive and informative ratings to the detriment of 
investors, business enterprises large and small and the capital 
markets as a whole. I thank you for the opportunity to 
participate in this hearing and would be happy to answer any 
questions you may have.
    [The prepared statement of Mr. Sharma can be found on page 
129 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Sharma.
    Next we will hear from Mr. Stephen W. Joynt, president and 
chief operating officer at Fitch, Incorporated. Mr. Joynt.

 STATEMENT OF STEPHEN W. JOYNT, PRESIDENT AND CEO, FITCH, INC.

    Mr. Joynt. Thank you, Chairman Kanjorski, and members of 
the subcommittee. I am pleased to appear before you on behalf 
of Fitch Ratings. Today's hearing marks the third time this 
year I have appeared before congressional panels on the topic 
of regulation of credit rating agencies. I have attached my 
written statement from August to the end of my statement. 
However, I would like to highlight a few brief important points 
in light of selected recent events.
    I believe in the last several years, Fitch generated and we 
continue to produce a significant amount of balanced and 
insightful fundamental credit analysis across many asset 
classes and capital markets. Having said that, I have also 
previously acknowledged that too many of our rating opinions, 
particularly in some of the most impacted structured finance 
asset classes, did not perform as expected with too many 
downgrades of too many notches. I am aware that this negative 
result is the key factor in our discussions here today.
    Improving our performance drives many of the changes that 
we continue to make at Fitch. Having said that, all credit 
rating agencies are not the same. When it comes to the issues 
of credit culture and intent, I would like Fitch to be judged 
on its own merits. Over the last several years, media coverage 
of the credit rating agencies and related regulatory inquiries 
tend to characterize the industry as being dominated by the Big 
3 agencies. Many market participants and commentators then 
extend the point by asserting and implying that there is no 
difference among the Big 3.
    In the SEC's 2008 report on the rating agencies, the source 
document for many negative e-mails often quoted in the media, 
none of the negative e-mails referenced were from Fitch. That 
same report concluded that our internal processes were robust 
and that our staffing levels were appropriate and kept pace 
with the growth in our business. In the early stages of the 
credit crisis in November 2007, Fitch decided we needed to 
conduct a wholesale review of our CDO methodology. As a result, 
we imposed a moratorium on rating any new CDOs while we 
conducted this review. We subsequently adopted a revamped and 
more conservative criteria for corporate CDOs on April 30, 
2008.
    Since that time, we have assigned very few ratings to any 
corporate or other CDOs. Fitch was also early in highlighting 
the increasing credit risk of the financial guarantors, 
lowering AAA ratings, which resulted in direct public attacks 
against us from these monolines, followed by requests to 
withdraw our ratings and termination of all commercial 
relationships.
    Fitch culture and credit practices consistently emphasize 
the importance of the timeliness, transparency, and integrity 
of our ratings and credit opinions over any revenue 
implications. Turning to recent regulatory developments in the 
United States, the SEC has introduced some final rules and 
proposed a series of new ones, while much progress has been 
made, we are disappointed that one key area has yet to be 
addressed: enhanced public disclosure broadly and structured 
for finance securities. Fitch has repeatedly suggested that the 
information made available to the rating agencies as parts of 
the rating process for securitization should be made available 
to all investors and the responsibility for disclosing that 
information should rest with issuers.
    To date, the SEC continues to focus narrowly on the sharing 
of information only among NRSROs. Regarding the committee's 
recent draft of the bill, Fitch shares the general objectives 
of greater reliability, transparency, and accountability 
embodied in many of the provisions for credit rating agencies. 
A number of the provisions are very reasonable and consistent. 
We will provide comments in more detail to the members and 
staff in the coming days. I would like to highlight several 
issues that have also already been mentioned. The goal of 
reducing the market's reliance on ratings through reference in 
Federal regulation, the proposed bill removes all such 
references. Fitch has previously noted that ratings have been 
used effectively in regulations in many places as independent 
benchmarks, a position that has been supported by many market 
participants. We continue to suggest that an in-depth, case-by-
case review of any removals to determine whether such course of 
action is appropriate.
    The question of what would replace ratings also remains 
unanswered, or at least without a thorough understanding of the 
specific pros and cons or unintended consequences of the 
removals. Also, a bill that mandates the removal of all 
references to NRSROs and all Federal statutes while 
significantly enhancing the Federal regulatory requirements and 
burden on NRSROs seems contradictory to us. I believe it would 
affect the increasing competition that the committee was hoping 
for, for the industry. We have previously commented on the 
concept of the mandatory registration for credit rating 
agencies. I noted in my testimony before the Senate Banking 
Committee in August that Fitch, along with the other NRSROs, is 
already registered and subject to explicit SEC regulatory 
oversight. We believe the mandatory registration concept is 
unnecessary. Fitch has previously stated that it supports the 
concept of enhanced accountability for what we do, but we 
continue to disagree with the notion that far greater liability 
or specific liability is the right way to achieve that.
    Ratings are a forward looking opinion of creditworthiness, 
not a backward looking verification of financial statements as 
conducted by accountants. Creating an additional and separate 
liability standard solely for NRSROs as envisioned by the bill 
seems unprecedented and unnecessary. The bill also introduces 
collective liability for rating agencies. This provision would 
require us to share information with all other rating agencies, 
much of it proprietary or from third party vendors. We cannot 
turn that information over to other agencies. That idea also 
that we should be responsible for verifying other NRSROs' 
information and ratings seems to us quite problematic.
    Finally, the bill also contains some provisions that we 
find to be contradictory. For example, the bill requires 
distinct symbology for structured finance ratings, yet also 
mandates that we try to use all the same ratings and approaches 
for all kinds of asset classes; this is confusing. And in 
closing, Fitch has undertaken a wide variety of initiatives to 
enhance the reliability and transparency of our ratings. I 
believe we can continue to produce a significant amount of good 
work with that in mind, and we are open to all improvements to 
the industry and our own performance. Thank you.
    [The prepared statement of Mr. Joynt can be found on page 
88 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Joynt.
    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 CEO, REALPOINT 
                              LLC

    Mr. Dobilas. Thank you for the opportunity to participate 
in today's hearing. RealPoint successfully operates under the 
investor pay business model. While we issue subscriber paid 
ratings on around $1 trillion worth of securities, our market 
specialty is CMBS, or Commercial Mortgage-Backed Securities. We 
are one of 5 NRSROs designated under the TALF program as an 
eligible rating agency for CMBS.
    Last week, with strong investor support, the NAIC, or 
National Association of Insurance Commissioners, unanimously 
approved RealPoint as an acceptable rating organization for 
CMBS securities. We believe the credit crisis is far from over, 
but we believe that the SEC's recent efforts are working, at 
least with respect to structured finance. New issues are 
creeping back into the market and spreads are contracting from 
their all-time highs of a year ago. Investor confidence is 
starting to return. This momentum needs to be sustained. One 
way to sustain it is to give investors choices in regards to 
their selection of rating agencies.
    It would be a mistake to legislate smaller NRSROs out of 
business and force investors to rely only on a few large NRSROs 
for ratings. We support the SEC's most recent announced changes 
and believe any rating agency reform should be consistent with 
those policies. The discussion draft may be intended to reform 
the larger NRSRO but its measures may eliminate the smaller 
ones. Legislation that creates barriers to entry in practical 
levels of liability or increased internal costs for smaller 
NRSROs furthers the interests of the larger ones.
    The proposal to make all NRSROs jointly liable for an 
unsatisfied civil judgment against another is impractical. No 
one company should be forced to guarantee a competitors 
obligation. A company should not have to risk responsibility 
for a liability over which it has no control. The proposal to 
reduce first amendment protections for credit rating agencies 
is anti-competitive and further enhances the existing oligopoly 
structure. A small company cannot guarantee trillions of 
dollars of rated securities, merely because it provided a 
forward looking independent opinion regarding their 
performance. The proposal to require publication of ratings and 
rating actions without a timeline will put subscriber based 
NRSROs out of business.
    The SEC has already announced rules requiring public 
disclosure of ratings and rating actions with the specified 
time lag. That protects the interests of subscriber-based 
NRSROs. The proposal to require every agency to review and 
improve every other NRSRO's work is impractical. Not every 
agency rates every class of security. This requirement would 
increase the cost of ratings and thereby reduce investor 
yields. This requirement appears to include analytics and 
proprietary information developed by an NRSRO and date of 
purchase by that NRSRO, towards the goal of improved ratings 
and competitive advantages. This requirement would therefore 
reduce incentives to improve proprietary rating methodologies. 
The proposed requirements for independent directors and 
compliance officers may work for large, publicly-traded 
companies, but would require small companies to incur 
significant costs who had board members with a skill set and 
depth of knowledge necessary to fully understand and improve 
analytical models and methodologies and may expose those board 
members to a level of liability.
    The one-year prohibition on performing ratings for an 
issuer that hired a former analyst would increase the cost to 
attract and retain talented analysts. Rating agency employees 
who may also wish to seek corporate work will not be willing to 
impair their right to do so without increased compensation. The 
proposal to require credit ratings symbols that distinguish 
classes of securities is not in our experience desired by the 
capital markets. Investors want to know that AAA means AAA, not 
where one class is a real AAA whereas another represents a 
lower version of AAA. As we have attempted to show with various 
examples, the discussion draft and other well-intentioned 
remedial proposals have a common flaw, namely their proposals 
are aimed at two entirely different types of companies with 
entirely different business models.
    If Congress applies a multitude of new rules, regulations, 
and procedure controls to NRSROs which disadvantage smaller 
companies, the result is to punish the innocent and stifle the 
progress we have made to date. In our view, the better remedy 
is to specifically address the two fundamental problems, market 
concentration and rating shopping. Competition can be further 
enhanced across the broader range of public offerings and--by 
having securities, at least in part, rated coequally by 
subscriber-based rating agencies. No meaningful change can take 
place while three agencies control over 95 percent of the 
market. Thank you for the opportunity to appear at this 
hearing. I look forward to responding to any questions you may 
have.
    [The prepared statement of Mr. Dobilas can be found on page 
48 of the appendix.]
    Chairman Kanjorski. Thank you very much.
    Next, we will hear from Mr. James H. Gellert, President and 
chief executive officer of Rapid Ratings International, 
Incorporated. Mr. Gellert.

STATEMENT OF JAMES H. GELLERT, CHAIRMAN AND CEO, RAPID RATINGS 
                      INTERNATIONAL, INC.

    Mr. Gellert. Thank you. On behalf of my colleagues at Rapid 
Ratings, I would like to thank Chairman Kanjorski, Ranking 
Member Garrett, and the members of the subcommittee for 
inviting me to provide testimony today. As the only non-NRSRO 
on this panel, we appreciate your invitation all the more as we 
and companies like us have what we believe is a critical voice 
in these debates. As with the new subscriber-paid NRSROs, we 
represent the potential for meaningful change to the status quo 
if we are not inadvertently hindered by the consequences of 
legislation and regulation along the way. Ours is a subscriber-
paid firm. We utilize a proprietary software based system to 
rate the financial health of thousands of public and private 
companies quarterly. We use only financial statements, no 
market inputs, no analysts and have no contact in the ratings 
process with issuers, bankers or advisors. We have not applied 
for the NRSRO status. As I have testified to the SEC and the 
Senate in recent months, there are still too many deterrents 
for me to recommend to our shareholders that the designation 
enhances value as opposed to puts it at risk.
    That said, we believe that reform in our industry is 
necessary and time is of the essence for restoring credibility. 
However, we caution that some initiatives may have significant 
and counterproductive consequences. In short, we do not believe 
it is advisable to create more legislation for legislation 
sake. Although we did not necessarily agree with all of the 
elements of the Credit Rating Agency Reform Act of 2006. Its 
intent of appropriate to promote competition to transform this 
industry. Some say the Act has not had enough time to mature 
and others that it wasn't sufficient.
    Nevertheless, the Act is still the basis for constructive 
change and the SEC's recent initiatives have made good progress 
in adding reform and oversight to the prior legislation. These 
improvements have set a better stage for competition than we 
have had in years. The Commission has also been receptive to 
input from industry players. When recently faced with criticism 
about reading disclosure rules, adverse effect on subscriber 
paid firms, the SEC created different standards for issuer paid 
and subscriber paid NRSROs.
    This showed admirable flexibility and not applying a one-
size-fits-all model to new rules. We encourage the subcommittee 
to be guided by this flexibility.
    The subcommittee's discussion draft joins a crowded field 
of rating agency reform initiatives currently underway. There 
are positive developments in the collection of initiatives, but 
even these do not yet go far enough, and the negative ones 
forge entirely new and unfortunately disturbing paths.
    Competition is key to transform this industry. But 
competition for competition's sake is not the answer. 
Competition that effects change will enhance the credibility of 
the ratings process. The new subscriber-based rating agencies 
are the best hope for achieving these goals but are the ones 
put most at risk by the discussion draft. For new players to 
want to register NRSRO status must have value and not carry 
massive compliance costs and legal liability. New players will 
want the designation if they see it as a business asset, not as 
a series of contingent liabilities.
    In order to achieve this, legislation must foster the 
following goals: accuracy in ratings; innovation in business 
models and rating methodology; encouraging, not discouraging, 
new players; equivalent disclosure of structured product 
information; and recognition that many initiatives tacitly 
support the status quo oligopoly.
    Sadly, the trend toward greater and more complex 
legislation and regulation will repel and not attract 
competition and, hence, preserve the status quo, the very 
problem you were hopefully trying to solve.
    In particular, the emphasize on liability I believe is 
being overdone. Should negligence and malfeasance be rooted 
out? Yes. Should a one-size-fits-all legal framework be enacted 
to punish all players jointly, irrespective of whether they 
have sinned in the past? No.
    A few specific notes on liability. Joint liability is a 
great disincentive to NRSRO status. In fact, it is simply a 
nonstarter for a potential applicant. Why would one want to be 
an NRSRO, joining a group dominated by three players who have 
an iceberg of lawsuits looming on their horizon? That would be 
like swimming towards the Titanic.
    Equivalent disclosure. The equivalent disclosure of data 
used in formulating a ratings decision among NRSROs is a boon 
to competition. If the perspective NRSRO sees the ability to 
expand into a new asset class of ratings, for instance, CDOs 
and CLOs, there is a material benefit to the designation. 
Moreover, expanding this disclosure to outstanding issues is 
critical. Likely no greater initiative could be taken to kick-
start liquidity revival in structured products.
    Mandatory registration. Under current law, ratings firms 
have the option to apply for NRSRO status. Requiring 
registration while the hard and soft costs of being an NRSRO 
are currently unquantifiable is a major hurdle to new players 
and is likely a complete disincentive to the de novo firm. Add 
this to joint liability and the potential costs to a new player 
are astronomical.
    Removal of ratings, references, and regulations. In 
general, we are very supportive of removing references and 
regulations because they protect the status quo dominance of 
the ratings oligopoly.
    I will conclude with the issue of conflicts of interest.
    Central to the issuer-paid rating agencies argument for 
defending their conflicted business model is that the 
subscriber-paid rating agencies also conflicted, suggesting 
that a modified version of the status quo is the only real 
alternative. This is a red herring. Let's not miss the irony of 
these issuer-paid agencies shifting public attention away from 
their committed sins to the uncommitted sins of very small 
competitors paid by investors who are seeking protection from 
fiduciary irresponsibility.
    To address all of these issues, legislation and regulations 
must be flexible and not require a one-size-fits-all 
straitjacket, recalling that subscriber-based rating agencies 
are the future solution to the current problems, while issuer-
paid rating agencies were the cause.
    Thank you very much.
    [The prepared statement of Mr. Gellert can be found on page 
76 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Gellert.
    Now, we will finally hear from Mr. Kurt Schacht, managing 
director of CFA Institute Centre for Financial Market 
Integrity. Mr. Schacht.

STATEMENT OF KURT N. SCHACHT, MANAGING DIRECTOR, CFA INSTITUTE 
             CENTRE FOR FINANCIAL MARKET INTEGRITY

    Mr. Schacht. Thank you, Chairman Kanjorski, and thank you, 
subcommittee members, for having CFA here to provide you some 
background and perspective that I think is not otherwise 
represented here, which is the perspective of investors and 
users of these products. So we are happy to have our 95,000-
member organization help with some of that perspective.
    We have been commenting on these various aspects of credit 
rating agency reform for the last couple of years. In my 
written testimony, I reference some of those occasions. And as 
we have commented before, I think there is a lot of confusion 
on the investor side about just what is going on, whether we 
are regulating, whether we are removing reference; and there is 
a good deal of confusion on what is the role of CRAs going 
forward, what should it be, and what can be trusted in this 
process. So we are hopeful that this discussion draft moves it 
along closer to some answers.
    I will concentrate my verbal testimony this afternoon on 
the five questions that you asked us in the invitation.
    Regarding the discussion draft, we very much support the 
efforts there to provide additional transparency of the 
process. I think, most importantly, we support the efforts to 
better align that process and activity with the interest of 
investors, very basic, very important concepts.
    There are sections where we have new Commission rules on 
conflicts of interest. Section 5 is excellent. The look-back 
reviews that you have there with respect to employees going to 
work for firms that they have rated are excellent, and the new 
rules on public disclosure of both ratings performance and 
methodologies we think are very strong.
    We are very concerned about a couple of things, the 
proposed detail of the legislation on setting director pay for 
credit rating agencies as well as setting by statute the roles 
and responsibilities of directors. We think that it is rather 
unusual to see that in statute, as does the some 13 different 
subsections that you have in place related to the dos and 
don'ts, shoulds and shouldn'ts for compliance officers. That 
seems to be something that should be left to general principals 
and articulated by the regulators as they implement this.
    Regarding the liability question, you have heard a lot 
about that today. I don't have to recast that.
    Earlier this year, we help set up an Investors Working 
Group, which put together a very comprehensive report on a lot 
of pieces of regulatory reform related to the crisis, and that 
is all part of our written testimony. I hope you have a chance 
to take a look at it. It is comprised of very senior, very 
well-known investors, former regulators, and experts.
    This group was clear that they felt that NRSROs should not 
be essentially exempt from civil liabilities under section 11 
of the 1933 Act for issuer-paid ratings. We could not find one 
instance where a credit rating agency has ever been held liable 
for any sort of money damages at all in this area for their 
doing things in the normal course of their ratings practice. 
And so claims have been brought, but almost all have failed. 
The Investors Working Group felt that this change would make 
credit rating agencies much more diligent about the process and 
much more accountable for negligent practices.
    I won't comment on the freedom of speech issue. The first 
amendment stuff, we are not experts on that, of course, but 
just to say we are happy and glad to leave that to you to 
referee. That will be an interesting discussion.
    In any event, the group felt that they needed to have 
increased liability. I think we feel that section 4, the 
standards for private actions on page 31 of your consult, moves 
us in that direction, moves us closer.
    This morning, I think you heard this discussion about doing 
something that would give reason for these firms to turn down 
business, bad business; and I think that is probably the one 
area where we should focus.
    I won't say anything more about section 3. I don't think 
anybody likes that idea, maybe with the exception of the 
plaintiff's bar.
    On the issue of the issuer-paid model, there will always be 
an actual conflict of interest. In the research and opinions 
where there is an issuer-paid model, the best we can do is to 
mitigate that conflict. I think that is what this discussion 
draft does. It is what the SEC has been focused on, it is what 
other stakeholders in this debate have been focusing on, trying 
to mitigate those conflicts of interest.
    In the Investors Working Group report that you have, there 
are further suggestions related to the fee area, that fees 
earned for rating should vest over time, that the amount of 
fees paid, they should be based on the performance of the 
ratings over the course of the credit performance of the bond. 
And I think you get to that in your section 5(f) on page 13.
    There are many other discussions going on about the 
somebody-else-pays model. We have not--this Investors Working 
Group nor our organization has really focused much on these 
other approaches, preferring instead to focus on, if we are 
going to have an issuer-paid model, how do you mitigate those 
risks?
    Finally, on the issue of removal and unintended 
consequences, we found this issue to be the trickiest of the 
lot. There has much been said and already done, as you know, 
globally on the removal of the references, but it still appears 
everywhere. We are talking about putting back references 
through this discussion draft, and it continues to appear 
throughout private contract.
    We are not sure what happens if you remove it all. We are 
not sure what happens to the pace and the efficiency of 
financial markets. What the Investors Working Group and CFA 
have focused on is looking at this from the standpoint of the 
investor, and what we do is we scold investors for the blind 
reliance and the very bad habits that this credit rating 
process has developed across many institutions and that is 
using credit rating agencies as really a substitute for their 
own analysis and due diligence.
    Now, I think unless you are fully asleep at the switch, 
investors should be on full alert that the ratings are not 
government-sanctioned, that the quality and validity and the 
accuracy are not examined or otherwise approved by the 
government. We seem to be moving in that direction with the 
discussion draft.
    The Investors Working Group reasons that maybe further 
removal and ultimately elimination of those references would 
further drop that reliance. We just did a survey in the last 
couple of days, and our member survey came back that 54 percent 
of the members would like to see us move towards full 
elimination of those references.
    I will stop there. Thank you very much.
    [The prepared statement of Mr. Schacht can be found on page 
124 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Schacht.
    I will start the questions simply because, to a large 
extent, some of the issues that you raised are issues that I 
put into the draft.
    First and foremost, the explanation of the conflict of 
interest--inherent conflict of interest with issuer pays. I 
find it being exceptional. I cannot think of many examples and 
certainly few good examples, but recently in a discussion with 
a United States Senator, I suggested that I discovered the 
methodology by which we could cut a significant cost out of our 
budget in the United States. If we removed any expenses allowed 
in the budget for the payment of judiciary and that we would 
pay the judiciary by having the attorneys for the winning 
litigants stand the expenses of the judges' salaries and 
expenses.
    And, of course, as I say that, I see some of the people in 
the room smile and smirk. Nobody would even remotely suggest 
that would be a reasonably acceptable standard in justice. And 
yet, if you really analyze what I just said to you, it is 
exactly what you are doing in the rating agency business.
    Now you may be holier than nuns or cleaner than popes, but 
I doubt that at all times there have not been compromises in 
the situation--or else there would not be shopping around. Many 
of the witnesses here talked about shopping. Now why would you 
shop for something if you were not trying to buy a little 
preference in a rating from your potential rater? I think we 
have to concede it is there.
    Now the next question is, can you remove it? And I have 
come to the conclusion obviously this did not come about 
because somebody envisioned just let's do it. It is obvious 
that the other methodology, user pay, was not working too well 
or sufficiently to support a rating agency, a business. So my 
attempt was to find some compromise that would allow users to 
pay but increase their liability--or issuers to pay but 
increase their liability if there is knowing wrongful acts on 
their part.
    And then, secondly, encouraging a mechanism to find 
exposure. What better than to have your competitors examine the 
same figures and information and having them do a reasonably 
good job of oversight? Because if they miss it or do not do it, 
if they do not report actions to the regulator, that will raise 
questions on the validity of the rating. They ultimately could 
become sanctioned.
    Now where we pulled that out, quite frankly, is by analogy 
from the insurance industry. We basically do that in the 
insurance industry, right now, in catastrophic disaster areas.
    If an insurance company is insuring against hurricanes in 
Florida, you could make a fortune. Go down and cut any ratings 
in half, and everybody in Florida will flock to your house, pay 
you the premium, and you can have the major proportion of 
business in Florida. Then what you want to do cleverly is get 
out of town before the hurricane arrives, and if you do that, 
you will make a fortune. The problem is that we have had people 
do that and stay in town and not be able to pay those damages 
that resulted from the hurricane.
    So in order to prevent that irresponsible levying of rates, 
insurance rates, they started pooling. Basically, that is what 
pooling is all about. It says, look, if the one that wrote the 
policy underrated the proper premium to pay for the damage, or 
made some fundamental errors, or did not make any errors at all 
but just because of circumstances was unable to pay, the 
insured should not be the responsible party taking all of the 
loss. Instead, that loss will be shifted to a pool created by 
an assessment of all the other underwriters in the area.
    Now, I do not think that is the best thing in the world; 
and, as a result, we have not even structured the language to 
accomplish this idea.
    What I am trying to encourage is outside-of-the-box 
thinking. We obviously have a major problem of conflict of 
interest. We obviously have rating agencies that are being 
shopped. We obviously have had horrible results in the last 
several years with rating agencies missing many of the 
securitized areas by giving them rates of triple A when in no 
way should they have had triple A.
    I do want to point out that an insurance company came to me 
very recently with a study in their industry; and that industry 
in the United States is almost wiped out. And the reason being 
they showed me that their competitors were buying securitized 
mortgages. It got so bad in 2007 that 15 percent of the 
mortgages included in the pools had never made the first 
installment of the mortgage. There was a default by 15 percent 
in the first installment due to the mortgages that were 
included in the pool.
    Now I do not know whether due diligence is being used. I do 
not know whether proper study measures are being used. But when 
you are including mortgages and marketing them, the securities 
based on those mortgages, as triple A when the installments of 
15 percent of the mortgages are missed in the first instance, 
somebody is wrong and somebody is lax.
    And to some of the testimony here, it seemed to me that you 
are saying, well, sorry, we missed it, or the most important 
thing is we have competition.
    Competition is good and cures things, if competition really 
works. Has anybody suggested the competition that is there now 
is working? And if it is not working, what are your suggestions 
of competition and how we get it to work, other than just 
putting more people into the field when there are only 3 doing 
95 percent of the work.
    I see that my time has expired, so I will pass on my 
comments and questions and hopefully get to the next round.
    I will now recognize the gentleman from New Jersey, the 
ranking member, Mr. Garrett.
    Mr. Garrett. I am going to defer first to--
    Chairman Kanjorski. I am sorry. Mr. Bachus.
    Mr. Bachus. That is okay.
    Mr. Chairman, can we have about 8 minutes on each side? I 
know you took about 8 minutes, if that is all right. There is a 
limited number of members.
    Chairman Kanjorski. Just do not act like rating agencies.
    Mr. Bachus. And I would maybe start my time after I ask 
this question.
    Chairman Kanjorski. Well, no, I think we should certainly 
give you 8 minutes. For you, Mr. Ranking Member, we will give 
you 10 minutes, if you want.
    Mr. Bachus. Thank you. I know the timekeeper heard that, 
too.
    My first question is, we have heard a scenario where an 
issuer gets a rating from one of the rating agencies and that 
rating is not disclosed. Then they go to a second rating 
agency, and they share that rating and say, can you do better? 
Obviously, that could lead to some skewed ratings.
    I would ask Mr. McDaniel and Mr. Sharma, does that happen?
    Mr. McDaniel. Congressman, the issue of rating shopping, as 
we said in--at least as I said in our prepared remarks, is 
indeed a serious issue. It is not, however, an issue that I 
think is driven by the business model and payment. It is an 
issue that is driven by lack of information.
    Mr. Bachus. What I am saying, Mr. McDaniel, are there cases 
where someone goes to, say, S&P and then they come to you. They 
haven't disclosed that rating. And they come to you and say, I 
would like to you do another rating. And then you give a 
different rating and say it is higher. Then they choose which 
one to disclose. Does that happen?
    Mr. McDaniel. Yes, I believe that does; and that is why I 
believe it is a serious issue.
    Mr. Bachus. And you would agree--and, Mr. Sharma, do you 
agree that has happened in the past?
    Mr. Sharma. Yes, Congressman, it does happen; and the 
solution around putting more transparency as to where the 
issuers have gone and who they have selected and why they 
selected, such transparency will bring everything up.
    Mr. Bachus. Would either one of you gentleman object to 
saying that if you go to a second agency, you disclose both 
ratings?
    Mr. Sharma. The issuers and we could be asked to disclose.
    Mr. Bachus. Mr. McDaniel.
    Mr. McDaniel. I think the objective is a good objective. I 
think that it would be difficult to make work. Because I think 
that, to the extent the marketplace does not want to have 
ratings disclosed, they would simply work around that. They 
would ask hypothetical scenarios.
    Mr. Bachus. What if you gave a preliminary rating and you 
were under legal obligation to disclose that? Do you think you 
could work around that?
    Mr. McDaniel. To the extent that we give a preliminary 
rating and are required to disclose that, we certainly would. I 
think they would--to the extent that they are trying to avoid 
having that happen, I think they would try to avoid having a 
preliminary--
    Mr. Bachus. Oh, I can bet you they will try to avoid it.
    Mr. Gallagher, is that a problem and are you going to 
address that at the SEC?
    Mr. Gallagher. Congressman, thank you.
    This is actually something that the Commission has taken 
action on. In our September 17th meeting, the Commission 
proposed rules geared specifically to issuers, going right to 
the primary actor in the scenario that you outlined and 
proposing rules that would require, as you say, under penalty 
of law that they disclose whether they are rating shopping, 
whether they are seeking either preliminary or other ratings.
    Mr. Bachus. Mr. McDaniel, I think he has been quite candid; 
and I compliment you for that, Mr. McDaniel.
    There are ways to get around it. And even if, say, Mr. 
McDaniel doesn't or Mr. Sharma, someone may try to; and I would 
ask you to maybe even consult with them on ways not to get 
around it.
    Mr. Joynt and others, if you would maybe share with the 
industry. Because they know better than anybody else how to get 
around it and could tell you how to build a safer system.
    Mr. Gallagher in his testimony said that analysts were 
sometimes involved in the discussions concerning fees. That to 
me appears--and he said in his testimony that is a serious 
conflict of interest. Mr. McDaniel, do you agree that that 
appears to be a conflict of interest, at the very least?
    Mr. McDaniel. The involvement of analysts in fee 
discussions I do think is inappropriate. We do not permit that.
    Mr. Bachus. Mr. Sharma, do you permit that? Going forward, 
will you permit that?
    Mr. Sharma. Mr. Congressman, we have had long-standing 
policies not to allow analysts involved in any commercial 
activities, and we recently even reinforced that.
    Mr. Bachus. And, Mr. Joynt, I assume you all are already 
doing that.
    Mr. Joynt. That is correct.
    Mr. Bachus. I appreciate all of you saying that.
    And even I think when you share e-mails, if they see the e-
mail traffic about those discussions, I think that you need a 
safeguard there. Mr. Gallagher mentioned that, and I thought 
that was very appropriate.
    Mr. Gallagher. Congressman, I will just jump in and say 
that we actually have a rule that is exactly on point with this 
issue prohibiting that conflict.
    Mr. Bachus. Is that a new rule or something you have had in 
the past?
    Mr. Gallagher. Since we have gotten the statutory 
authority.
    Mr. Bachus. Thank you.
    Mr. Joynt, you mentioned there are certain things you do, 
internal controls, that in the past that maybe S&P and Moody's 
didn't have. What are some of those that you would like to 
elaborate on?
    Mr. Joynt. First of all, I don't want to sound holier than 
thou, as the chairman pointed out.
    Mr. Bachus. Oh, we welcome those kind of testimonies.
    Mr. Joynt. But I do think it is important that, over a long 
period of time, we have tried to build a culture of credit 
orientation. And there has always been a conflict--we have 
talked about that--between being paid by issuers and how we 
have to have completely independent credit rating processes 
with analysts who think independently and ratings that are done 
by committee. And so we have to have at the forefront of our 
mind the fact that the ratings are entirely independent.
    There have been many instances--I am sure other agencies 
have examples as well--where the consequence of taking 
difficult ratings decisions, like downgrading companies, or 
structured financings has resulted in financial impact. And I 
was only pointing out that I think that we have--I have 
examples of those, and I could cite more, where we feel the 
impact of that rating decision, notwithstanding the fact this 
rating decision would change our financial results, because of 
the independence of the credit judgments.
    Mr. Bachus. I actually have seen some articles that the 
Senator confirmed that you have suffered from that.
    Mr. Joynt. Thank you.
    Mr. Bachus. Let me ask Mr. McDaniel--well, actually, let me 
shift gears and say to Chairman Kanjorski, if I could, this 
idea of joint and severable liability, as I understand it, even 
rating agencies that didn't participate in the ratings could be 
found liable. Is that any of you gentlemen's understanding?
    Mr. Gellert, would you comment on that?
    Mr. Gellert. Yes, that is my understanding. To my read or 
at least the intention of the clause in the draft is exactly 
that, that any NRSRO--just to clarify, not anyone who is 
providing ratings or credit research services independently but 
an actual NRSRO would have a joint liability if a problem was 
found and a suit was pursued against one, that all would share 
if collection was not available.
    Mr. Bachus. That sounds--the asbestos legislation, I think, 
was one of the worst things that has ever passed this Congress, 
where you had innocent companies who did nothing wrong and yet 
they were--in many cases, they actually had to file bankruptcy, 
not because of anything they did. And I would hope the Congress 
would not--that is something the Congress has tried to 
straighten out for 30 or 40 years and, regrettably, has 
resulted in some of the greatest inequities in our judicial 
system.
    I used to be both a plaintiff and a defense lawyer, and I 
almost consider that practice un-American. It is certainly the 
opposite of justice. I would hope that we can work with 
Chairman Kanjorski on that particular issue, because I don't 
think that is what most Americans would call justice.
    Mr. Gallagher, what do you consider--are there some actions 
you think have been taken that will go a long way to assuring 
us that what has happened in the past won't happen again? I 
think that ought to be our main motivation here.
    There certainly is enough blame to go around for what 
happened last year, and I think the credit rating agencies were 
a significant contributor to that. But I think our motive ought 
to be stopping in the future, and I think they have 
acknowledged that.
    Mr. Gallagher. Thank you, Congressman.
    Since the Commission got statutory authority to oversee the 
rating agencies in 2006, this is an area in which we have been 
very active, there have been several sessions of rulemaking, 
the last of which, as I mentioned earlier, was 2 weeks ago. The 
rules address a whole number of issues: conflicts of interest 
in particular; accountability; transparency. And we are just 
now starting to see the net effect of some of those rules.
    And so I would say it is an area where we have taken a lot 
of steps. We are not resting on our laurels. We are looking 
constantly to see where there are existing regulatory gaps, and 
where we can do something better, more efficiently. I won't 
promise that we are done by any means, but I think we have 
taken a lot of steps, and we would like to see what the net 
effects of those rules are.
    Mr. Bachus. Thank you very much.
    Thank you very much, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Bachus.
    Mr. Donnelly for 5 minutes.
    Mr. Donnelly. Mr. Joynt, let me ask you this: What would be 
the problem if purchasers paid for the credit rating agency's 
work instead of issuers?
    Mr. Joynt. There is no problem with that. The reason why 
the industry developed with an issuer pay model was cited 
earlier. Going back to the mid-1970's, after the Penn Central 
bankruptcy, the Wall Street community had gotten together and 
suggested that a much stronger, independent rating agency 
business was needed, better funded to do better analysis; and 
they wanted all the ratings to be publicly available to all 
investors. And so that was the germination of the issuer pay 
model, it was to get the ratings out freely and broadly and 
disseminated to everyone and to fund a much more vibrant and 
better ratings business.
    I think that has been accomplished. But there is nothing 
wrong. If there could be developed a way to have all the 
investors pay enough to fund a well-structured and good credit 
ratings business, that would be a good solution, also.
    Mr. Donnelly. Is there a concern, for instance, that on an 
issue that the purchasers would not be able to properly fund 
your work?
    Mr. Joynt. I think that is the case, yes. Investors are 
willing to be subscribers to our research and our ratings, but 
the amount of compensation for that is restricted.
    Mr. Donnelly. Let me ask you this, Mr. McDaniel. In the 
legal profession, when you go to court, you don't get to pick 
your judge, for obvious reasons. There is conflict of interest. 
Can we use a blind pool system with credit rating agencies as 
well so you don't get to, in advance when you bring out an 
issue, pick the organization you want to work with?
    Mr. McDaniel. I think to the extent that issuers are going 
to rating agencies, they are doing so, at least in the 
traditional context, in order to meet investor demand. That is 
a model we would call a demand pool model. The issuers would 
certainly like to make choices that would be most favorable to 
themselves, but at the end of the day their securities must 
satisfy the investor demand for independent, high-quality 
opinions.
    It is one of the reasons why we are supportive of a 
reduction or elimination of the use of ratings and regulation. 
Because I think that traditional system is a healthier system, 
frankly, and would return more of the demand for ratings to the 
investor choice, as expressed through who the issuer reaches--
reaches out to with its rating requests.
    Mr. Donnelly. Mr. Dobilas, let me ask you this. What would 
you think of a blind pool system?
    Mr. Dobilas. You know, I am glad you mentioned that. 
Because, just listening to everyone's ideas and brainstorming 
out of the box, I think you have to remove competition from the 
new issue side. I think what you want to do is what is best for 
the investor. That is really what a rating agency was designed 
to do. I think we lost sight of that several years ago when we 
switched to an issuer-paid system. Ninety-five percent market 
share for three companies is a lot, and nothing is going to 
change without a meaningful change.
    So what I was thinking is--I would agree with you. I think 
if you, again, in the investor's best interest, sort of 
promoted the subscription-based model but had a blind pool on 
the new issue side, you would encourage the three companies 
next to me to focus more on investor-paid models, while at the 
same time breaking up the oligopoly at the new issue site.
    It is really quite simple. Their revenue would have to be 
derived from somewhere else besides rating shopping and where 
else would they get that revenue? They would focus on building 
investor-based products and tools and analysis that promote all 
the values you are looking at promoting and selling those 
directly to investors, and investors will pay for that.
    Mr. Donnelly. And I know I don't have to tell you folks, 
but the critical nature of what you do--in my State, the damage 
caused to our economy was breathtaking, with company after 
company unable to obtain credit because of the collapse of 
credit markets. And there is a deep anger in our area toward 
Wall Street, toward the work done there, that what you did 
there caused our families to lose jobs.
    And that is the perspective that we have in middle America, 
is that--was this done by rating agencies alone? No. But the 
work that was done caused so much damage that we had moms and 
dads going home at the end of a day--I represent the 
recreational vehicle area, the auto area--that they went home 
and lost their jobs because the credit markets had been 
destroyed. And so we had a lot of skin in the game.
    I guess the question I will ask you is, short of the 
liability discussions that we have had, what skin in the game 
do you have or should you have or what can we put in there to 
make sure that your work isn't done for one of the investment 
banks but is done for accuracy and the American people so that 
they have some sense of confidence in what you are doing? I 
mean, what consequence is there to you? The consequence to us 
is our companies are destroyed and our jobs are lost.
    Mr. Sharma, would you be willing to help out here?
    Mr. Sharma. Mr. Congressman, first of all, our focus is on 
the investors, as to what we can do for the investors. And the 
investors ultimately make a choice. They, in fact, even if we 
are in the regulations, investors influence who the issuers 
select as a rating agency. If they are not satisfied with it, 
they are not going to invest in the securities that the issuers 
issue. And that is something that the investors always have 
that choice.
    Second, we are accountable. We are accountable through the 
regulatory process to SEC. If you don't comply with the 
policies and procedures, they have provisions to penalize us 
and even shut us down. Second, we are also accountable through 
the private litigation. If we don't follow policies and 
procedures and there is fraud, then there is security fraud 
laws that we are liable against.
    Third, we are scrutinized by the market everyday. We make 
our criteria around which we rate public. We make our basis 
around which we do the rating actions public. And if people 
disagree with us, they speak up; and we hear that very loud and 
clear. We do feel ourselves very accountable in many ways.
    Mr. Donnelly. One last question. We heard from a number of 
folks in regards to the conflict of interest piece.
    One successful investor said, run it like a private 
utility--like a utility, where there is a couple of pennies 
paid on every trade or that there is a pool of funds available 
to then fund--that it remains private, but the funding comes 
from that pool instead of directly from an issuer.
    And would anybody like to take a whack at that as to what 
you think?
    Mr. Gellert, we will throw you in the bucket, too.
    Mr. Gellert. Sure, why not?
    I think it is one model that is worth exploring, like 
investor-owned rating agencies are worth exploring. I think the 
devil is in the details when you talk about a public utility 
model, because you really have to dive deep into what the value 
is, what investors are going to believe is value being created 
by an entirely new entity.
    We face it. I am sure RealPoint faces it. We all face it as 
newer entrants into the market, that we have to establish 
credibility over an extended period of time. The market doesn't 
immediately grant us the benefit of the doubt and say 
everything that you do is fantastic. So it would take quite 
some time, and I don't you could turn this industry on a dime.
    I would then suggest that a public utility model or a 
government-owned model, particularly in the context of the 
joint liability and other liability issues that we are talking, 
would be extremely problematic and probably not welcomed.
    Mr. Donnelly. The reason it is all so important is the 
extraordinary repercussions that come when we miss the mark in 
the rating system. So--
    Mr. Dobilas. I would like to add to that.
    I think part of the reason why we missed the mark was 
because surveillance of the securities was so poor or it just 
didn't exist, and that is part of the reason why a subscriber-
paid model works so well. Because if we get a rating wrong we 
lose a subscriber. That is the penalty. It is almost like we 
are almost 100 percent self-insured. Because we will go out of 
business if we made the mistakes that, again, few firms have 
made in the past.
    And, also, by focusing on surveillance, you really look at 
things on a monthly basis, as opposed to an annual basis. I 
think that is a big reason, too, why we saw so many mass 
downgrades when we did see those downgrades. And why it 
affected your home State so much. Because all at once it was 
too much for the economy to absorbed. If these things would 
have happened more gradual over time, I think the effect would 
have been less traumatic.
    Mr. Donnelly. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Donnelly, and we will 
now hear from the gentleman from Illinois, Mr. Manzullo.
    Mr. Manzullo. Thank you, Mr. Chairman, for calling this 
hearing.
    Let me ask a question. Can the issuer-pays and the 
investor-pays models for rating coexist in the marketplace? Mr. 
Gellert or Mr. Dobilas?
    Mr. Dobilas. I will take a crack at this.
    I don't think they can. I honestly think you have to 
confront the problem. And when the issuer chooses who does the 
initial rating, I think that is a big problem, and you will 
have rating shopping take place.
    I think the mitigating factor which the SEC sort of put a 
rule in place that really helps out is the fact that 
subscription-paid agencies or any agency can focus on producing 
the same report at the same time and trying to sell that. The 
question is, are investors going to be willing to pay for that?
    Historically, they have not. Historically, they are used to 
getting this information for free and may go back to their old 
ways by just relying on those issuer-paid ratings.
    That is why I think the idea of a rotating structure where 
all the agencies would then focus on making their money for the 
benefit of investors by providing--
    Mr. Manzullo. But even if you had that, you have three 
large credit rating agencies, and that is not much of a pool. 
You are going to pull one out of three. And eventually, let's 
say there is some mischief on the part of one of them, then an 
investor out there or issuers say, well, I reject that rating, 
and then go back to the pool again. And then you are down to 
two and then down to one. What have you accomplished at that 
point?
    Mr. Dobilas. But the good news is there are more than three 
now. There are 10 registered NRSROs. And what you want to do is 
encourage more companies to apply for the NRSRO.
    Mr. Manzullo. What about one of the big three, do you want 
to respond to my question?
    Mr. Joynt. I think one point I would like to make is most 
of what we are talking about seems to be surrounding structured 
finance and the transactions rated there.
    Mr. Manzullo. Except for the problem ones.
    Mr. Joynt. In fact, the rating agencies rate corporations 
and municipal entities. So I just ask you to bear in mind that 
the question about whether we select ratings or not, Fitch has 
been added as a third rating to almost all corporations that we 
rated over the last 10 or 15 years. They didn't select to drop 
someone else and add us. We have been added because they 
respected our research. It wasn't a competition in that kind of 
way.
    So in public finance, I don't believe there is any other 
rating agency among the newer entrants that is in position to 
rate any public finance entities.
    Mr. Manzullo. Mr. Joynt, let's say in 1 year your company 
had a sales of, let's say, $100. How much of that $100 would be 
represented by structured products? Just generally.
    Mr. Joynt. Fifty percent.
    Mr. Manzullo. Fifteen?
    Mr. Joynt. Fifty, ``5-0.''
    Mr. Manzullo. So it is about half the product.
    An issuer wants to sell a product, can he effectively sell 
that product if he does not have a rating at the same time that 
he makes the offering to the public--a rating that goes along 
with the product?
    Mr. Joynt. If it is a public offering, typically they would 
ask for at least for two ratings.
    Mr. Manzullo. And investors demand that?
    Mr. Joynt. Many investors, regulated or not regulated, 
would expect to see at least two different rating opinions on 
public securities that are offered, yes.
    Mr. Manzullo. So even though there is obviously a built-in 
conflict of interest with the issuer paying for the ratings, 
there is no effective way around that?
    Mr. Joynt. Over time, investors have been comfortable and 
confident that management of the conflict of interest has been 
done appropriately.
    Mr. Manzullo. Anybody else want to respond to that? Mr. 
Gellert.
    Mr. Gellert. I think this is more about market norms than 
it is about anything else. I think your typical corporate 
issuer knows that, generally speaking, to get the best pricing 
on your bond deal you need to ensure that there will be the 
most liquidity potential in the secondary market for that bond; 
and you will always have the most potential liquidity if you 
have S&P and Moody's ratings on it and then, more recently, 
Fitch's.
    Mr. Manzullo. Okay. Let me ask this question. Perhaps it 
goes to the heart of the collapse.
    Many of us find it incomprehensible that, in the rating of 
these mortgage-backed securities, the people doing the rating 
simply failed to realize that mortgages that were given to 
people who could not make the first payment were somehow 
tainted and could end up poisoning the whole.
    We are just--I don't know it got missed. When Members of 
this Congress were saying that credit was too easy and other 
groups said, no, it is not; and then everything went along--
yes, sir.
    Mr. Dobilas. I think the answer is simple. Just like in the 
commercial real estate market, it was missed because the models 
that were rating these securities were developed for issuers, 
not for investors. You know, over the last 5 years--
    Mr. Manzullo. They were developed for issuers but not for 
investors.
    Mr. Dobilas. Yes, to get the deal. Over the last 5 years, 
we have seen a deterioration of credit standards across-the-
board on an individual loan level. Commercial real estate, 
which was a fairly conservative industry, again, 5 years ago, 
we have seen the deterioration of credit standards. The rating 
agencies rating those deals should have been the mitigating 
factor to that, should have been the advanced warning signal to 
investors that, hey, something is going on; deals are getting 
riskier.
    But that didn't happen, and I blame rating shopping for 
that. They wanted to be on the deals. They didn't want to take 
a stance. And I think you have to confront that. You have to 
put an end to that.
    Mr. Manzullo. Mr. Chairman, my time is up, but it is up to 
you. If you want to--
    Mr. Donnelly. [presiding] If you would like to take an 
extra 2 minutes, that would be fine.
    Mr. Manzullo. I appreciate that.
    Mr. Gellert, then I want to hear from one of the big three, 
a response to fairness. If you would like to respond to it. Mr. 
Gellert and the--
    Mr. Gellert. I think one of the key issues here as well is 
the availability of information to rate the products, 
particularly in the structured product market. The equivalent 
disclosure initiatives that the SEC has undertaken and that are 
picked up in the draft bill I think are key.
    Because one rating agency that would be--one of the 
traditional three may very well have a model that was geared 
for something other than what it was used for or not. I am not 
speculating. But I can say, if there are more opinions out 
there and there are more of us who are interested in rating 
those products as well, we have the ability to do the due 
diligence that they currently are not doing, but only if we 
have access to the information that is underlying those 
securities. And that is the mortgage information underlying 
residential mortgage bond CDOs and a whole slew of others, 
particularly collateralized loan obligations, things that right 
now we do not have access to.
    And one of the absolute keys as we move forward is not just 
being able to get access to that information on the new issue 
basis but it is on the existing securities outstanding that are 
on people's books. Before we can provide value on new issuance, 
we need to be able to benchmark that new issuance against what 
people are already holding. That means we have to have 
ubiquitous access to information for all securities.
    Mr. Manzullo. Did anybody want to--Mr. McDaniel?
    Thank you, Mr. Chairman, for giving us the extra time.
    Yes, sir?
    Mr. McDaniel. I just wanted to again reinforce our support 
for the availability of information. I think that is just 
absolutely crucial, information available to the investing 
public and to rating agencies which are not selected to rate a 
security by an issuer. If that information is available to all 
of us, as well as to investors, we have the ability to act as a 
check and balance on each other and the institutional 
investment community has the ability to act as a check and 
balance on the analysis of rating agencies. I think that if we 
have one solution to the rating shopping and competition 
problems that are being raised, that is the solution.
    Mr. Manzullo. Thank you, Mr. Chairman.
    Mr. Donnelly. The gentlelady from California.
    Ms. Speier. Thank you, Mr. Chairman; and thank you, 
gentlemen, for being here today.
    In my experience back home in the district, what I hear 
more than anything is just outrage about the fact that no one 
has really been held responsible. And so I guess my first 
question--and my questions are going to be all around 
accountability.
    My first question is to each you at the credit rating 
agencies. You had rated AIG and Lehman Brothers as triple A, 
double A minutes before they were collapsing. After they did 
fail, did you take any action against those analysts who had 
rated them? Did you fire them? Did you suspend them? Did you 
take any action against those who had put that kind of 
remarkable grade on products that were junk?
    Mr. McDaniel?
    Mr. McDaniel. No, we did not fire any of the analysts 
involved in either AIG or Lehman. Lehman did not have a double 
A rating or a triple A rating. It had a single A rating. And an 
important part of our analysis was based on a review of 
governmental support that had been applied to Bear Stearns 
earlier in the year. Frankly, an important part of our analysis 
was that a line had been drawn under the number five firm in 
the market and that number four would likely be supported as 
well.
    Additionally, AIG--
    Ms. Speier. But that is not analysis. That is an opinion. 
That is not--I mean, I could have that kind of an opinion, and 
I am not an analyst. How can you possibly make that kind of a 
decision based on an opinion when you have millions of people 
relying on that?
    Mr. McDaniel. Our opinion applies to whether we believe an 
instrument will pay or will not pay.
    Ms. Speier. That was a political determination that you 
made, Mr. McDaniel.
    Mr. McDaniel. A very important component of that analysis 
is whether we believe there would be external support in the 
event of distress; and that analysis is relevant to financial 
institutions, to governmental entities--
    Ms. Speier. Thank you. Mr. Sharma?
    Mr. Sharma. Congresswoman, financial institutions are 
very--
    Ms. Speier. If you could just answer the questions, because 
I have a series, and I have a limited amount of time.
    Mr. Sharma. No, we did not fire anyone.
    Ms. Speier. No one got fired. No one got their hand 
slapped.
    Mr. Sharma. Congresswoman, ratings had been downgraded over 
time for both of those institutions.
    Ms. Speier. AIG was still double A on the 14th or 13th. I 
mean, it was--
    Mr. Sharma. We had been changing the rating over a period 
of time. And financial institutions are very confidence 
sensitive. So, in Lehman's case, not only were they trying to 
raise capital and they were about to raise capital and when 
they weakened they had declared bankruptcy. And once there is a 
run on an institution, then it is very hard--as you have also 
experienced in California, when these institutions have a run 
on them, it is very hard to manage that and process, because it 
is very confidence sensitive.
    Ms. Speier. All right. Mr. Joynt?
    Mr. Joynt. No, no analysts were fired.
    I would say our lead analysts in those cases, as well as 
the analysts who participated in the committees, are 
disappointed, surprised, went back and reflected on, well, how 
do we reach our conclusion? There are committee deliberations. 
It is not just one person who decides. I think we have done a 
lot of thoughtful soul searching about how do we perceive this 
going forward, how do we think about our analysis.
    Ms. Speier. What are your opinions on consulting services? 
Do you do consulting services in addition to doing the issuing 
for a single client? I know you have done it historically. Are 
you continuing to do that?
    Mr. McDaniel. We do not offer any consulting in the rating 
agency. We offer some professional services in the form of 
credit training and risk management, risk measurement tools in 
the Moody's analytic business, which is another company owned 
by Moody's Corporation.
    Ms. Speier. And there is no sharing of information?
    Mr. McDaniel. That is correct.
    Ms. Speier. Mr. Sharma?
    Mr. Sharma. We do not offer any consulting services. We 
have, in fact, reinforced the policies and added more checks 
and balances that there is none of that even activity 
happening--
    Ms. Speier. Mr. Joynt?
    Mr. Joynt. Any kind of advisory services have been housed 
in a separate company from the rating agency, yes.
    Ms. Speier. Mr. Dobilas?
    Mr. Dobilas. No, we don't provide consulting services.
    Ms. Speier. Mr. Gellert?
    Mr. Gellert. No, we do not.
    Ms. Speier. There is a regulation FD that the agencies 
contend that the exemption is needed in order to fully evaluate 
credit risk. Most notoriously, even though Enron made nonpublic 
credit rating agency presentations, information about the risk 
described in those presentations was not reflected in Enron's 
credit ratings. So my question is, if we are talking about 
accountability, if we are talking about greater disclosure, why 
should you be eligible for this exemption from regulation FD?
    Mr. McDaniel. We operated for 90 years before regulation FD 
became effective. I think we were able to do a very fine job 
during that period, and I think we would be able to operate 
without regulation FD exemption now.
    Ms. Speier. Thank you.
    Mr. Sharma?
    Mr. Sharma. Ratings are forward looking, and information 
that allows us--that gives us more insight as to the future 
helps us to make better decisions.
    Ms. Speier. Mr. Joynt?
    Mr. Joynt. I would agree. I think that regulation was 
passed to allow issuers to more freely communicate with rating 
agencies so they can make better decisions.
    Ms. Speier. But we have lots of examples where it wasn't 
used in that way. So the question is, is it going to hurt your 
business if we get rid of that exemption?
    Mr. Joynt. I believe we could continue to offer educated 
opinions.
    Ms. Speier. I see that my time has expired. Could I be 
offered one more--
    Mr. Donnelly. One more minute.
    Ms. Speier. Thank you.
    I just want to get to this liability issue, this private 
right of action. As I understand it, you only want to be sued 
if you knowingly make a false statement. Now that is akin to a 
doctor only being sued when he knowingly leaves sponges in a 
body during a surgery. And we all know that is just not the 
case.
    For most professionals in this country, you can be sued for 
negligence. You can be sued for gross negligence. And most 
professionals don't have this huge benefit that you have, which 
basically allows you to not be sued by anyone unless you 
knowingly make false statements.
    I am going to read to you one little section here, and I 
want you to tell me whether or not you could live with this 
kind of a standard:
    ``Knowingly or recklessly failed either to conduct a 
reasonable investigation of the rated security with respect to 
the factual elements relied upon by its own methodology for 
evaluating credit risk or to obtain reasonable verification of 
such factual elements from other sources that it considered to 
be competent and were independent of the issuer and 
underwriter.''
    Ms. Speier. So it is a different standard.
    Mr. McDaniel. I am interpreting perhaps correctly, perhaps 
incorrectly, the section that you just read to subject NRSROs 
to the same liability under Section 10(b) of the 1934 Act for 
knowing or reckless actions as other market participants would 
be. While no CEO wants to volunteer for more liability for 
their firm, that does not sound like an unreasonable standard 
to me.
    Ms. Speier. Thank you.
    Mr. Sharma. I think my point--
    Mr. Donnelly. [presiding]. I am sorry. Time is up. The 
ranking member from New Jersey.
    Mr. Garrett. Thank you. And I thank the panel for your 
testimony. Before I begin, I guess I would echo the words 
actually during part of your comments, Mr. Donnelly, with 
regard to how middle America views much of what has transpired 
over the last 9 or 12 months, having that real dilemma of 
trying to find responsibility out there in the midsts of all 
the doom and the gloom on the economic crisis morass that we 
are in and unfortunately just not being able to see what 
Congress is apportioning that liability and just who the 
responsible parties are.
    That is the quagmire that we are in at this point in time. 
The forest is this piece of legislation. I just want to go 
through some particular points on this. I guess I will start 
from right to left or maybe in between to throw you all off. 
Mr. Schacht, you I believe stated in your testimony that with 
regard to the legislation, that maybe some of it might just be 
too specific and some should best be left to the regulators to 
imply. I guess some parts with the compensation, but also 
dealings with the duties of the compliance officer. Can you 
just spend a brief period of time--isn't that the 
responsibility of us to get into that detail? Because obviously 
the regulators haven't been doing that task in the past.
    Mr. Schacht. Well, I think somebody needs to do it. That is 
for sure. I think the question is whether it needs to be 
committed to statute or whether we as I said--whether we just 
articulate the general principle behind this and we leave to 
the functional regulator to implement the various standards 
associated with that. Our view was that it is best left at the 
functional regulator level.
    Mr. Garrett. Thanks. And Mr. Gellert, on another point, 
your firm is not registered as an NRSRO?
    Mr. Gellert. That is correct.
    Mr. Garrett. And in a few seconds, since we are all on 
time, why is that? Why was that decision made?
    Mr. Gellert. It has basically been for the last number of 
years, watching the evolution of the regulatory and legislative 
debate around how to control the NRSROs and finding that there 
has been too much uncertainty as the dust hasn't settled and 
new ideas and concepts continue to come up and that now there 
is an increased focus on litigation liability and there is a 
significant amount of risk involved, and we don't see it so far 
that the advantages outweigh the negatives.
    Mr. Garrett. Okay. Now, one of the provisions that is in 
this legislation is a proposal to remove the imprimatur of the 
government approval by statute and regulation by removing that 
designation. Anyone can answer this question. What are the 
downsides if we implement that? Even if we did so over an 
appropriate period of time, recognizing that the SEC is already 
taking some actions and going through the review process and 
picking a few out here and there. But if we just put a date 
certain and said going forward for purposes of this, in a 
reasonable period of time, what would be the downside 
particularly on the--as far as the investors' perspective and 
would there be something you could look to and say oh, my 
goodness, pension funds are all the sudden going to have a 
calamity in there or something like that that I am missing? 
Some are nodding your head, but--
    Mr. Dobilas. I could take a stab at that to start with. I 
think there is a downside. I think the NRSRO being a regulated 
entity serves its purpose as a benchmark for investors. I think 
removing the NRSRO is going to create a lot of problems for 
investors. They do depend on that minimum benchmark. It gives 
them comfort in their decisions. But first and foremost is the 
data issue. A lot of these securities are public-private 
securities. A lot of information like rent rolls, financial 
statements--
    Mr. Garrett. We are not suggesting that you couldn't do 
that, that institutions still could not make that choice to 
actually go out and say we want to have an AAA rated by one of 
the Big 3 and that is the way our town, county or State or 
government is going to do it. It is just that we are no longer 
going to have the stamp on it saying that you have to do that, 
that it is up to the investors or the institutions.
    Mr. Dobilas. Yes. And again my point is having that stamp 
does encourage a certain bare minimum, a certain competency. 
Are you going to go into broker/dealers and see if they have 
the competency to put the securities together and really 
subject yourselves to that kind of regulation or is the rating 
agency--again, could that be a regulated entity where again it 
is a bare minimum competency of risk?
    Mr. Garrett. From the other rating agencies, do you have a 
problem with that?
    Mr. Joynt. A couple of thoughts. I think the money market 
fund industries' response to the idea that the ratings would be 
withdrawn from--I don't know the exact SEC rules, but--
2(a)(7)--sorry--is still being openly dialogued about. But they 
were concerned about having no minimum standards. So new 
entrants into that business were likely to take extraordinary 
risks and sort of besmirch the reputation or the minimum 
standard of the larger or more general population of money 
funds. So whether there is a substitute or not for that, it is 
a good example of the sort of benchmarks in place and it is a 
constructive one, even if it is not a full solution. People 
should be doing their own analysis. But it is perceived as 
constructive.
    Mr. Garrett. That is something--I will let you answer, Mr. 
Sharma.
    Mr. Sharma. Thank you. Ranking Member, we have never asked 
for a designation like the NRSRO. So whatever the 
policymakers--you and SEC and the investors make a conclusion 
was the best interest of the investors, we would work with that 
and we would be very comfortable with that, to go in that 
direction.
    Mr. Garrett. And if you did rank the removal, wouldn't it 
be--I guess your sense on the money market funds, what have 
you. But then the onus would be on them to either select the 
concurrent process that they are doing now, or I guess the SEC 
would take a look to see whether they have established their 
own internal mechanisms for making sure that they are making 
the proper investment decisions in those situations. And I 
thought that would be sort of what we are all ultimately 
striving for because there is this question mark remaining out 
here, despite the best intentions. Comments? The liability side 
and again with regard to this legislation, who sees that as 
many of you mentioned this before, who sees as far as changing 
the liability standards as we have here as a significant 
impediment to entry into the field and whether it would change 
the volatility of the ratings? Those are two separate 
questions.
    Mr. Gellert. Everyone is looking at me. It is clearly an 
impediment, it is clearly a disincentive to enter the space, 
and without question, it further solidifies the market share 
that the three largest players have, without a doubt. I cannot 
speak for the other NRSROs that are smaller and outside of that 
Big 3, but without a question. it does. The more you have 
entrenched--the more you have entrenched oligopoly and less 
competition, the more likely it is that you will have stable 
ratings. But they won't necessarily be accurate ratings because 
they won't necessarily have the competitive and innovation--
    Mr. Garrett. Let me flip it around. Does anybody see that 
it would not be an impediment to--no. What about for you guys, 
as far as insuring yourself, you have two provisions in here, 
the liability as far as the pleading section on one hand and 
you have the joint and several liability section there. Would 
you be able to go out into the insurance market to insure 
yourself? How will you intend to do that if either one or both 
of those get through? Which insurance companies want to insure 
you now I guess?
    Mr. Dobilas. I can tell you being a smaller NRSRO that we 
are down to a very limited choices of insurance companies that 
will even insure us based upon the recent events of what is 
happening with the lawsuits against some of the other NRSROs. 
If that were to pass, we would most likely remove ourselves 
from the NRSRO playing field.
    Mr. Garrett. How about the big 3?
    Mr. McDaniel. I cannot imagine being able to obtain a 
satisfactory level of insurance when, in fact, the insurer is 
being asked to insure an entire industry over which the 
individual firms do not have any control over each other in 
terms of their opinions. And I have to at least ask the 
question whether this might have the unintended consequence of 
reducing quality because to the extent that competitors do not 
have any control over each other and one of them is performing 
to a lower standard level, there is really not much reason to 
form of a higher standard level because one is going to be 
liable for the lowest common denominator.
    Mr. Garrett. So it might be actually a race to the bottom?
    Mr. McDaniel. That would be a question I think should be 
considered more carefully in thinking about this, yes.
    Mr. Garrett. Okay. And does anybody have an answer on the 
volatility aspect as far as the ratings?
    Mr. Sharma. The only thing, Mr. Ranking Member, is that it 
would treat rating agencies at a different standard than all of 
the market participants and as a consequence sort of we will 
have to become more--we will have to look at the ratings at the 
lower end of the rating categories because they are generally 
more volatile. And that will restrict access to capital from 
companies that are coming into the market or new and emerging 
companies and technologies.
    Mr. Garrett. I think there is another aspect, but I see my 
time is up, and I appreciate it.
    Mr. Donnelly. Thank you. I know the ranking member has a 
few more questions. And first Ms. Speier, if you would like a 
couple more minutes. Okay. Ranking member.
    Mr. Bachus. Thank you. One thing Mr. Gallagher says in his 
testimony is that the rating agencies relied on information 
provided to them by the sponsor of the RMVSs for instance. But 
let us just broaden that. Any time you rely on the company you 
are rating for information and you have to do that--I mean, 
there has to be a certain level of--you have to rely on them 
for the accuracy. Many times when you relied on them, it turned 
out that information in hindsight was not correct. Have you--is 
there less of a reliance--and I would ask the Big 3 rating 
agencies? Have you made any changes there? Or what were the 
problems there?
    Mr. Joynt. So it was and is our expectation that issuers 
and their representative investment bankers in putting together 
financings would be doing due diligence on any of the 
information they were presenting in order to put together to 
finance and market it and sell it.
    So we certainly would be relying on that information just 
like we rely on public financial statements audited by 
accounting firms when we rate IBM and General Motors and other 
companies.
    So having said that, of course, we are way more cautious 
now in thinking about that issue. So--and we are not in a 
position to go do that kind of due diligence ourselves on 
individual mortgage loans or auto securities and other things. 
So we have taken the position that if we are uncomfortable with 
the amount of information and the quality of information we are 
getting, then we are unwilling to rate.
    Mr. Bachus. Okay. That is a reasonable answer. Mr. Sharma?
    Mr. Sharma. Mr. Ranking Member, similarly as you said very 
appropriately, that this is a whole market share with different 
participants and we have to rely on different market 
participants sort of fulfilling their accountabilities. So we 
do depend on the issuers and the arrangers to give us good 
quality data. But we also do adjust our criteria to sort of 
reflect the data that we are getting in our decision making. 
And if we are not comfortable, we also do not rate it many 
times.
    Mr. Bachus. Mr. McDaniel?
    Mr. McDaniel. Just add to these comments that, again, I 
think a cure is to make the information that goes to rating 
agencies available through the prospectus offering process to 
the investing public. I think subjecting that information to 
the standard of Federal securities filings would certainly help 
with the voracity and completeness of that information.
    Mr. Bachus. I would agree with you there. Are you all 
doing--is that--Mr. Gallagher, can you update us on--
    Mr. Gallagher. Yes. I think the chairman or some of my 
colleagues have spoken publicly recently about an initiative 
underway at the Commission to pursue further disclosure by 
issuers of all of the relevant underlying information we are 
talking about. On September 17th, the Commission took final 
action on the rule that Mr. Dobilas has mentioned earlier which 
provides that this information be provided to the other NRSROs, 
but taking the next step and moving to the public is under 
consideration.
    Mr. Donnelly. Thank you very much. The Chair notes that 
some members may have additional questions for this panel which 
they may wish to submit in writing. Without objection, the 
hearing record will remain open for 30 days for members to 
submit written questions to these witnesses and to place their 
responses in the record.
    Before we adjourn, the following written statements will be 
made part of the record of this hearing: Egan-Jones Ratings 
Company; Assured Guarantee U.S. Holdings; Mortgage Bankers 
Association; and Commercial Mortgage Securities Association. 
Without objection, it is so ordered. The panel is dismissed and 
this hearing is adjourned.
    [Whereupon, at 5:14 p.m., the hearing was adjourned.]
                            A P P E N D I X



                           September 30, 2009



[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



