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




 
          CREDIT RATING AGENCIES AND THE NEXT FINANCIAL CRISIS

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

                                HEARING

                               before the

                         COMMITTEE ON OVERSIGHT
                         AND GOVERNMENT REFORM

                        HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 30, 2009

                               __________

                           Serial No. 111-45

                               __________

Printed for the use of the Committee on Oversight and Government Reform


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              COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM

                   EDOLPHUS TOWNS, New York, Chairman
PAUL E. KANJORSKI, Pennsylvania      DARRELL E. ISSA, California
CAROLYN B. MALONEY, New York         DAN BURTON, Indiana
ELIJAH E. CUMMINGS, Maryland         JOHN L. MICA, Florida
DENNIS J. KUCINICH, Ohio             MARK E. SOUDER, Indiana
JOHN F. TIERNEY, Massachusetts       JOHN J. DUNCAN, Jr., Tennessee
WM. LACY CLAY, Missouri              MICHAEL R. TURNER, Ohio
DIANE E. WATSON, California          LYNN A. WESTMORELAND, Georgia
STEPHEN F. LYNCH, Massachusetts      PATRICK T. McHENRY, North Carolina
JIM COOPER, Tennessee                BRIAN P. BILBRAY, California
GERALD E. CONNOLLY, Virginia         JIM JORDAN, Ohio
MIKE QUIGLEY, Illinois               JEFF FLAKE, Arizona
MARCY KAPTUR, Ohio                   JEFF FORTENBERRY, Nebraska
ELEANOR HOLMES NORTON, District of   JASON CHAFFETZ, Utah
    Columbia                         AARON SCHOCK, Illinois
PATRICK J. KENNEDY, Rhode Island     BLAINE LUETKEMEYER, Missouri
DANNY K. DAVIS, Illinois             ANH ``JOSEPH'' CAO, Louisiana
CHRIS VAN HOLLEN, Maryland
HENRY CUELLAR, Texas
PAUL W. HODES, New Hampshire
CHRISTOPHER S. MURPHY, Connecticut
PETER WELCH, Vermont
BILL FOSTER, Illinois
JACKIE SPEIER, California
STEVE DRIEHAUS, Ohio
JUDY CHU, California

                      Ron Stroman, Staff Director
                Michael McCarthy, Deputy Staff Director
                      Carla Hultberg, Chief Clerk
                  Larry Brady, Minority Staff Director


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on September 30, 2009...............................     1
Statement of:
    D'Amato, Hon. Alfonse M., former chairman, Senate Committee 
      on Banking; Floyd Abrams, partner, Cahill Gordon & Reindel, 
      LLP; Eric Baggesen, senior investment officer, California 
      Public Employees Retirement System; and Lawrence J. White, 
      professor, Leonard N. Stern School of Business, New York 
      University.................................................    70
        Abrams, Floyd............................................    93
        Baggesen, Eric...........................................   105
        D'Amato, Hon. Alfonse M..................................    70
        White, Lawrence J........................................   115
    Kolchinsky, Ilya Eric, former managing director, Moody's 
      Investors Service; Scott McCleskey, former senior vice 
      president for compliance, Moody's Corp.; and Richard 
      Cantor, chief risk officer, Moody's Corp., and chief credit 
      officer, Moody's Investors Service.........................    13
        Cantor, Richard..........................................    20
        Kolchinsky, Ilya Eric....................................    13
        McCleskey, Scott.........................................    18
Letters, statements, etc., submitted for the record by:
    Abrams, Floyd, partner, Cahill Gordon & Reindel, LLP, 
      prepared statement of......................................    95
    Baggesen, Eric, senior investment officer, California Public 
      Employees Retirement System, prepared statement of.........   107
    Cantor, Richard, chief risk officer, Moody's Corp., and chief 
      credit officer, Moody's Investors Service, prepared 
      statement of...............................................    22
    D'Amato, Hon. Alfonse M., former chairman, Senate Committee 
      on Banking:
        Financial Economics Roundtable statement.................    72
        Prepared statement of....................................    89
    Issa, Hon. Darrell E., a Representative in Congress from the 
      State of California, prepared statement of.................    10
    Kolchinsky, Ilya Eric, former managing director, Moody's 
      Investors Service, prepared statement of...................    15
    Towns, Chairman Edolphus, a Representative in Congress from 
      the State of New York, prepared statement of...............     3
    White, Lawrence J., professor, Leonard N. Stern School of 
      Business, New York University, prepared statement of.......   117


          CREDIT RATING AGENCIES AND THE NEXT FINANCIAL CRISIS

                              ----------                              


                     WEDNESDAY, SEPTEMBER 30, 2009

                          House of Representatives,
              Committee on Oversight and Government Reform,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 10:01 a.m. in 
room 2154, Rayburn House Office Building, Hon. Edolphus Towns 
(chairman of the committee) presiding.
    Present: Representatives Towns, Issa, Chaffetz, Clay, 
Connolly, Cuellar, Cummings, Foster, Jordan, Kanjorski, Kaptur, 
Kucinich, Luetkemeyer, Lynch, McHenry, Mica, Murphy, Norton, 
Quigley, Souder, Speier, Tierney, and Welch.
    Staff present: John Arlington, chief counsel--
investigations; Brian Eiler and Neema Guliani, investigative 
counsels; Linda Good, deputy chief clerk; Jean Gosa, clerk; 
Katherine Graham, investigator; Adam Hodge, deputy press 
secretary; Carla Hultberg, chief clerk; Phyllis Love, Ryshelle 
McCadney, and Alex Wolf, professional staff members; Mike 
McCarthy, deputy staff director; Ophelia Rivas, assistant 
clerk; Jenny Rosenberg, director of communications; Ron 
Stroman, staff director; Lawrence Brady, minority staff 
director; Rob Borden, minority general counsel; Jennifer 
Safavian, minority chief counsel for oversight and 
investigations; Frederick Hill, minority director of 
communications; Adam Fromm, minority chief clerk and Member 
liaison; Kurt Bardella, minority press secretary; Benjamin 
Cole, minority deputy press secretary; Christopher Hixon, 
minority senior counsel; Brien Beattie, minority professional 
staff member.
    Chairman Towns. The committee will come to order.
    Today, the committee continues its investigation of the 
credit rating agencies, companies at the heart of the last 
financial collapse, companies that will be at the heart of the 
next financial collapse.
    The average American has probably never heard of credit 
rating agencies, but these companies play a powerful role in 
our economy and they played a starring role in the collapse of 
the financial system last year.
    The main mission of credit rating agencies is to tell 
investors how risky bonds and other debt securities are. 
Pension plans, banks, insurance companies, and other investors 
depend on these ratings to help them decide where to invest 
their funds.
    Unfortunately, for the past decade, the credit rating 
system has not worked well at all. A year ago, this committee 
learned that ratings did not capture the true risk of many 
deals because the rating agencies were more concerned with 
their own bottom line than anything else.
    As one rating agency official said in an internal e-mail, 
``We rate every deal. It could be structured by a group of cows 
and we would rate it.'' The result was a marketplace flooded 
with toxic debt, so-called structured securities, such as CDOs 
and other complicated securitizations backed by risk mortgages 
and propped up by inflated ratings.
    More and more money was funneled into bonds and other debts 
that were destined to fail. Predatory lending flourished, which 
families got in over their heads buying houses they could not 
afford. Investors were left holding bonds and other securities 
that were dramatically over-valued. When the housing bubble 
finally burst, we wound up in the deepest recession since the 
Great Depression. A year after the collapse of Lehman Brothers 
and the massive government bailout of AIG, Bank of America and 
others, it looks like not much has really changed.
    Today, we will hear testimony from Eric Kolchinsky, until 
recently an insider at Moody's, one of the largest credit 
rating agencies. We have obtained a memo written by Mr. 
Kolchinsky to his superiors at Moody's detailing very serious 
allegations about Moody's rating practices. If true, these 
allegations indicate troubling behavior in the credit rating 
industry. According to Mr. Kolchinsky, they continue to use 
inaccurate and outdated models. They continue to have conflicts 
of interest, and they continue to rate novel securities with 
little historical data that no one really understands.
    He was not alone in having concerns about the new way 
Moody's operates. We will also have testimony from Mr. Scott 
McCleskey who was senior vice president of compliance at 
Moody's, until he rocked the boat too hard. Mr. McCleskey's job 
was to ensure compliance with SEC regulations and other 
requirements. In theory, he was a senior executive with 
important responsibilities. In practice, he got the old 
mushroom treatment: keep him in the dark and bury him in 
fertilizer.
    In short, it looks like not much has changed since the 
crash of 2008. We ignore this situation at our peril. In the 
next financial crisis, will the credit rating agencies be part 
of the problem or part of the solution?
    Both the House and the Senate are drafting legislation to 
rein in these types of abusive practices by credit rating 
agencies. Our second panel of witnesses will provide 
suggestions on how to accomplish this.
    One other note, I would particularly like to thank my good 
friend, Senator Alfonse D'Amato, the former chairman of the 
Senate Banking Committee, for being here today as well; also 
Floyd Adams, another well known and highly regarded New Yorker.
    And let me conclude by saying I look forward to hearing 
from the witnesses.
    At this time, I yield to the gentleman from California, 
Congressman Issa, the ranking member of this committee.
    [The prepared statement of Chairman Edolphus Towns 
follows:]

[GRAPHIC] [TIFF OMITTED] T5751.001

[GRAPHIC] [TIFF OMITTED] T5751.002

[GRAPHIC] [TIFF OMITTED] T5751.003

[GRAPHIC] [TIFF OMITTED] T5751.004

    Mr. Issa. Thank you, Mr. Chairman, and thank you for 
holding this hearing today.
    I strongly suspect that the gentleman from Pennsylvania to 
my left, Mr. Kanjorski, would rightfully so say, aren't we 
coming dreadfully close to overstepping the bounds of this 
committee and going into the territory well held by the 
Financial Services Committee.
    And I would agree with him up to a point. I would differ 
with him in one sense. Although the oversight of this party of 
the financial community clearly belongs to the Financial 
Services Committee, as does the SEC, transparency in government 
and transparency for the people who live under that government 
clearly falls within the jurisdiction of this committee.
    So as we review the failures in the financial crisis, I 
would say to my friend, the gentleman from New York, that in 
fact this committee must look beyond the failures of the 
private sector in this case, look to the public sector which we 
have direct jurisdiction over, and essentially we have the 
power today, which we didn't have back in the 1930's when the 
New Deal came about and in the Depression, post-collapse era, 
the Federal Government began outsourcing the oversight and 
regulation and rating of credit instruments.
    Today, we have technology like XBRL and other standards 
which we, the Federal Government, can insist allow for full 
transparency, not by the select few that we dribble and drabble 
out the ability to rate for pay, but in fact we have the 
ability today to insist that every instrument made available to 
the American people can be transparent to the American people 
directly.
    We have the ability that instead of standing in line at 
your broker, you can go online and look at every element of 
that. That allows, of course, not every private citizen to 
necessarily do his own analysis. They don't do that on every 
stock or mutual fund. But it does allow literally thousands of 
educated people to scrutinize credit products and, on a 
continuous basis, evaluate the underlying risk that happens.
    In my own State of California, it is very clear, if you 
bought a bond 2 years ago, it is not the same bond it was 
today. You shouldn't have to wait for a credit agency to tell 
you California is in a financial meltdown in order to see a 
daily change. And you shouldn't have to do it if it is G.E. 
paper or anyone else's.
    So I would hope to work with the chairman in insisting on a 
real change in reporting, one that eliminates these credit 
agencies as monopolies, duopolies, triopolies or whatever a 
quadopoly is, and in fact opens it up to all the people of 
America.
    Additionally, as I said, this committee has broad 
jurisdiction, and I would hope that as the chairman said this 
morning on CNBC, we would use it. I cannot agree more with the 
chairman for what he said today. He said, ``People are now 
suffering.'' But Mr. Chairman, why are they suffering? When you 
said we are going to look at the whole financial meltdown 
across the board, why is it we left Freddie and Fannie out? Why 
is it Franklin Raines, who apparently committed perjury before 
this committee, has not been brought back before this committee 
or referred for prosecution?
    Why is it that in fact Bank of America still holds vital 
documents showing 28,000 loans, mixed in with them are hundreds 
or thousands of loans to government officials throughout the 
country, from the top to the bottom, from Republican to 
Democrat to Independent, who were clearly given what amounts to 
a bribe of government by a man who was brought before this 
committee because he made too much money while Countrywide 
stock was dropping, but has not been brought before this 
committee once we discovered that the Friends of Angelo Program 
in fact was designed to influence Members of Congress, key 
staff, and people throughout the government.
    That is not a small scandal. That is the crux of this 
scandal. If the trillions of dollars that the American people 
are on the hook for at Freddie and Fannie as GSEs are in fact 
because Countrywide had a cozy relationship bought and paid for 
that allowed them to unload not all, but much of these bad 
debts, and in fact allowed for the promotion of subprime and 
other risky instruments, then in fact, Mr. Chairman, that is 
the heart of the financial meltdown.
    The financial meltdown is not about the failure of the SEC. 
It is not even about Bernie Madoff and the billions that in 
fact he did opaquely without proper supervision. That is 
important and we need to deal with it, along with the Financial 
Services Committee. But the very underpinnings of good 
government require that government officials when they take an 
oath to their city, their State or our country, in fact operate 
without an agenda bought and paid for by public or private 
money. It is clear that is not the case here. It is clear that 
the distortions in the market go back years and they go back to 
government officials, quasi-government officials and private 
sector, including obviously the Friends of Angelo Program.
    So Mr. Chairman, I challenge you today either to issue a 
subpoena to Bank of America to get those records, or allow this 
committee to have an open vote so the people of America can 
understand that in fact this is an important issue. It is not a 
side issue. It is at the crux of this very investigation.
    And I might note that when we began looking at this 
problem, when we had Angelo Mozilo in front of us, there were 
tapes, digital copies of every single conversation between 
Members of Congress, members of the administration, postal 
workers, Freddie and Fannie, even Franklin Raines that were 
held so we could hear them. Today, I am told they may have been 
destroyed. When I hear they may have been destroyed, I realize 
we have been lax in our duties. That chair was held by Mr. 
Waxman and we had a crook in front of us that Mr. Waxman called 
a crook, said in fact that he was hurting the American people. 
Now we know in fact he bought and paid for what hurt the 
American people.
    Mr. Chairman, I call on you today to issue that subpoena. 
It is that important that I bring it up at this hearing, and I 
call for you, if you cannot do it, to step aside and allow the 
committee to have a vote.
    And I yield back.
    Chairman Towns. Let me just respond to the gentleman. I see 
he is sort of worked up over that issue.
    Mr. Issa. Yes, Mr. Chairman, I am worked up because we need 
to protect the American people. We won't do it if we don't 
investigate this corruption.
    Chairman Towns. Let me respond to you by saying, No. 1, the 
Justice Department is looking at it.
    Mr. Issa. Mr. Chairman, that is what the chairman of this 
committee said previously as an excuse. It turns out they 
didn't. It turns out the Senate Ethics Committee has failed to 
act and said in fact there was no ethical violation. We are 
beyond ethics here. We are at a point where the American people 
at least should know who they gave money to or benefit to, how 
they did it, and so on.
    We have ignored that paper. I have never seen this 
committee refuse to at least ask to see documents before 
deciding to ignore them.
    Chairman Towns. Before we go to our witness, let me just 
say to you that I did not say the Senate Ethics Committee was 
looking at it. I said the Justice Department. As you know, 
there is a difference.
    Mr. Issa. Mr. Chairman, if the Justice Department had 
subpoenaed the audiotapes, they would have them. They didn't. 
It appears as though Bank of America allowed them to become 
destroyed or they were destroyed in the last days of 
Countrywide. But more important, those documents, as we have 
been told, have not, in fact, been subpoenaed. The Justice 
Department does not have the boxes of documents that Bank of 
America has gathered, but will not turn over without a subpoena 
for reasons of privacy.
    If you tell me today you are referring it, because you have 
enough information, to the Justice Department for prosecution 
or investigation, fine. But today, we don't know what we don't 
know. What we do know is there is a level of intended 
corruption by Countrywide that clearly had an effect on 
government decisions for years, and we are ignoring it.
    We cannot really understand the failure of government if we 
don't understand the failure of government officials led by, in 
fact, an attempt to bribe them.
    Chairman Towns. The gentleman's time has expired.
    Mr. Issa. Thank you, Mr. Chairman.
    [The prepared statement of Hon. Darrell E. Issa follows:]

    [GRAPHIC] [TIFF OMITTED] T5751.005
    
    [GRAPHIC] [TIFF OMITTED] T5751.006
    
    Chairman Towns. Let's move forward.
    We will now turn to our first panel of witnesses. It is 
committee policy that all witnesses are sworn in, so please 
stand and raise your right hands as I administer the oath.
    [Witnesses sworn.]
    Chairman Towns. You may be seated. Let the record reflect 
that they answered in the affirmative.
    Mr. Eric Kolchinsky is a former managing director at 
Moody's Corp. He has worked in structured finance for over 12 
years, 8 of which were at Moody's. While at the rating agency, 
Mr. Kolchinsky focused on rating collateral debt obligations 
[CDOs]. He has also worked at Lehman Brothers, Merrill Lynch 
and MBIA in the CDO groups.
    We welcome you this morning.
    We would also like to introduce Mr. Scott McCleskey. He was 
a senior vice president for compliance at Moody's Investors 
Service from April 2006 until September 2008. In this role, he 
was responsible for the organization's compliance with rules 
and regulations established by the SEC and other regulators. 
Prior to joining Moody's, Mr. McCleskey spent approximately 15 
years in the financial services industry in both compliance and 
regulatory positions in the United States and in the European 
Union.
    Mr. McCleskey is currently managing editor for a firm 
providing news analysis and compliance solutions for the 
financial industry.
    We welcome you as well.
    Mr. Richard Cantor serves as the chief risk officer for 
Moody's Corp., and as the chief credit officer for Moody's 
Investors Service. In his role as chief credit officer, Mr. 
Cantor heads the Credit Policy Group and chairs the Credit 
Policy Committee, both of which are responsible for the review 
and approval of rating methodologies.
    Mr. Cantor's Policy Group also works with the rating group 
at Moody's to promote consistent rating practices and improved 
rating quality.
    Let me welcome you as well.
    At this time, I ask that each witness deliver their 
testimony within 5 minutes. The yellow light means you have 1 
minute remaining, and the red light means stop. Everywhere in 
America red light means stop.
    And then, of course, we will have time to raise questions 
with you and seek the answers.
    So we would like to start with you, Mr. Kolchinsky, and 
then come right down the line.

 STATEMENTS OF ILYA ERIC KOLCHINSKY, FORMER MANAGING DIRECTOR, 
MOODY'S INVESTORS SERVICE; SCOTT MCCLESKEY, FORMER SENIOR VICE 
 PRESIDENT FOR COMPLIANCE, MOODY'S CORP.; AND RICHARD CANTOR, 
 CHIEF RISK OFFICER, MOODY'S CORP., AND CHIEF CREDIT OFFICER, 
                   MOODY'S INVESTORS SERVICE

               STATEMENT OF ILYA ERIC KOLCHINSKY

    Mr. Kolchinsky. Good morning. I want to thank Chairman 
Towns, Ranking Member Issa and all the members of the committee 
for giving me an opportunity to speak this morning.
    My name is Eric Kolchinsky and during the majority of 2007, 
I was the managing director in charge of the business line 
which rated subprime-backed CDOs for Moody's Investors Service. 
More recently, I was suspended by Moody's as a result of a 
warning I sent to the compliance group regarding what I 
believed to be a violation of securities laws within the rating 
agency.
    I am grateful for the opportunity to speak in front of you 
on the need of rating agency and financial markets reform. 
Despite the circumstances of my separation, I still believe 
that Moody's is a good company and the vast majority of 
analysts there are smart, capable, and want to do a good job of 
rating financial products.
    Unfortunately, these ingredients are not sufficient to 
produce quality ratings or to safeguard the financial system. 
While I do not believe that the rating agencies were the main 
cause of the credit crisis, there are other parties that were 
far more responsible, there are still unresolved problems which 
will lead to poor ratings performance.
    No. 1, conflicts of interest. The conflicts of interest 
which ail the rating industry remain unmanaged. Senior 
management still favors revenue generation over ratings quality 
and is willing to dismiss or silence those employees who 
disagree with these unwritten policies.
    No. 2, Credit Policy Group lacks independence. The Credit 
Policy Group is a team of analysts whose role is to ensure that 
the methodologies and procedures used in the ratings process 
are sound and meet minimum credit standards. Unfortunately, the 
Credit Policy Group at Moody's remains weak and short-staffed. 
The group's analysts get routinely bullied by business line 
managers and their decisions are overridden in the name of 
generating revenue.
    Inadequate methodologies. Methodologies produced by Moody's 
for rating structure finance securities are inadequate and do 
not realistically reflect the underlying credits. Rating models 
are put together in a haphazard fashion and not validated if 
doing so would jeopardize revenues.
    Compliance Group lacks independence. The Compliance Group 
is entrusted with enforcing laws and internal policies. The 
group is understaffed and has little professional compliance 
experience. Instead of ensuring that the ratings process is 
free from conflict, this group sits idly by while these 
transgressions occur.
    In many ways, the incentives for rating agencies have 
become worse since the credit crisis. There are more rating 
agencies and they are all chasing significantly fewer 
transaction dollars. The new controls put in place by 
regulators are too weak to significantly alter this dynamic.
    As an example of how little things have changed, ABS CDOs 
are being rated once again. These are the same products which 
are responsible for hundreds of billions of dollars of losses 
at major financial institutions. They are significant 
contributors to the problems at CitiBank, Merrill Lynch, and 
AIG. I firmly believe that ABS CDOs cannot be rated with any 
certainty and especially not during this volatile period in the 
capital markets.
    The new methodologies used to rate ABS CDOs have not 
improved their poor credit performance. Many of the recent 
deals have been downgraded or have had to resort to 
restructuring to maintain their ratings. This toxic product 
needs to be consigned to the dustbin of bad ideas, but 
unfortunately there are no incentives for rating agencies to 
say no to a product no matter how poorly thought through.
    Investors like pension funds, insurance companies, and the 
Federal Reserve who are required to purchase securities with 
certain ratings deserve better than this. They need ratings 
which reflect an analyst's best judgment and not the profit 
targets of the agency.
    However, I believe there is a very simple and 
straightforward solution for the ills which haunt the ratings 
industry. It begins with the admission that the function which 
their agencies perform is quasi-regulatory. Fortunately, a 
model already exists which combines quasi-regulatory authority 
with private competition. It is the accounting industry.
    While accountants have not been free from scandal, the 
profession has not suffered the free-falling standards which 
have befallen the ratings industry. The key limitation has been 
the existence of a single set of standard methodologies which 
all accountants need to abide by, for example, GAAP.
    While CPAs are free to compete on price and service, they 
cannot change much the definition of revenue or loss. A single 
set of standards makes a lot of sense from a market and a 
regulatory point of view. It is much easier for regulators to 
learn to pass judgment on a single set of policies, rather than 
understanding the minutiae in the particulars of multiple 
approaches. The same benefit applies to investors. A single set 
of criteria which is debated and promulgated in a public manner 
will greatly add to the cause of transparencies.
    I have witnessed too many instances of rating agencies 
talking their way out of a poor decision by confusing the 
listener with esoteric details of their particular methodology.
    If I were a doctor, I would diagnose the rating agency 
patient as very curable. But treatment needs to be urgently 
applied to avoid further damage. Rating agencies can once again 
be productive members of the financial community, but they 
cannot do this by themselves. They need a helping hand to get 
back on the right track.
    Thank you very much.
    [The prepared statement of Mr. Kolchinsky follows:]

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    [GRAPHIC] [TIFF OMITTED] T5751.008
    
    [GRAPHIC] [TIFF OMITTED] T5751.009
    
    Chairman Towns. Thank you very much.
    Mr. McCleskey.

                  STATEMENT OF SCOTT MCCLESKEY

    Mr. McCleskey. Thank you, Mr. Chairman, Ranking Member 
Issa, and members of the committee.
    My name is Scott McCleskey and I served as senior vice 
president for compliance at Moody's Investor Service [MIS], 
from April 2006 to early September 2008. In that capacity, I 
was the executive formally designated as responsible for the 
organization's compliance with relevant regulations and 
internal policies.
    I have been asked to discuss my experiences with respect to 
the independence and authority of the Compliance Department. I 
will start by saying that in my time at Moody's, I had the 
privilege to work with a great many professionals of high 
ability and unquestioned integrity, and that in many cases and 
in many respects, things worked well. However, my honest 
assessment is that the compliance function came to lack 
independence and authority in some important respects.
    Before I go into detail, I think it is important to give a 
caveat that it has been over a year since my departure from 
Moody's, and until I was contacted by the staff of this 
committee a few days ago, I had not put a great deal of thought 
into these past events, so I am at a slight disadvantage with 
respect to some of the specific dates and details. And for 
clarity's sake, I would point out that in keeping with the 
scope of the SEC regulations, my remit did not extend to the 
accuracy of the rating methodologies themselves.
    Until the end of 2007, I reported to an executive vice 
president who in turn reported to the CEO. This executive vice 
president had responsibility for three departments: compliance, 
regulatory affairs, which generally handles relations with 
regulators and legislators on policy matters, and information 
technology. During this period, I would characterize the 
environment as generally supportive of compliance.
    In late 2007, my reporting lines were changed. From that 
point forward, I reported to Michael Kanef who was made 
responsible for both my department and the Regulatory Affairs 
Department. Michael reported to the general counsel who 
reported to the CEO.
    So as you can see, an extra layer of management was 
inserted into my reporting chain, effectively moving the 
department one level further away from the CEO. Nonetheless, I 
remained as the formally designated compliance officer in all 
public SEC filings.
    It soon became clear to me that my authority and 
independence would be greatly diminished. In the interest of 
time, I will summarize my experience and concerns.
    Over the following months, experienced compliance officers 
on my staff were pushed out over my strenuous objections and 
structured finance analysts without a single day of compliance 
experience were foisted upon me. Although I did come to believe 
that one of the new hires had promise, it does not balance the 
loss of 35 years of compliance experience from my staff.
    The hiring of structured finance analysts also creates a 
clear conflict of interest issue since, like Michael Kanef, who 
came from structured finance, they could find themselves 
passing judgment on their own former practices in deciding 
whether to discipline friends or former colleagues and 
potentially their own future managers should they return to 
their previous business units.
    Second, I found myself more and more frequently excluded 
from decisionmaking meetings concerning potential violations. I 
will note that this did not occur on each and every occasion, 
but it did so with increasing frequency and in particularly 
important matters. This includes an examination conducted by 
the Securities and Exchange Commission which was handled by our 
Legal Department and by outside counsel. I was flabbergasted 
that I, the designated compliance officer, would be excluded 
from meetings with the SEC during an examination and I was 
vocal in making this point.
    A common answer whenever I would object to these exclusions 
was that it was necessary in order to preserve attorney-client 
privilege, although it is my understanding that other non-legal 
department staff were included in these meetings. This focus on 
preserving confidentiality, I believe, also led to the 
sometimes explicit and often implicit directive not to put 
anything in writing that could be used against Moody's in 
litigation or regulatory proceedings.
    My time at Moody's came to an abrupt end a little over a 
year ago when I was dismissed without any specific reason, 
other than senior management no longer has confidence in you. 
This came as a bolt out of the blue. At no time had Michael or 
the general counsel given any indication of dissatisfaction 
with my performance.
    Moreover, a few weeks before I was pushed out, I was given 
responsibility for addressing the issues raised by the SEC 
following its examination, the one I had been excluded from, 
following which Michael went on a previously scheduled and I 
think well-deserved vacation. I hardly think that an 
organization which takes its regulatory responsibilities 
seriously would give such a critical project to someone it had 
lost confidence in. I am left to speculate on the real reason 
for my departure.
    One hour after my departure, it was announced that I would 
be replaced by an individual from the Structured Finance 
Department, who had no compliance experience and who, to my 
recollection, had been responsible previously for rating 
mortgage-backed securities.
    I do understand that he has been replaced now by somebody 
with compliance background, and if that is the case, I hope 
that person has the authority that I lacked in the 
organization.
    The matter before you regards how credit rating agencies 
should be regulated in the future, and I will make two brief 
observations before closing.
    First, my experience leads me to recommend strongly that 
the regulations be amended to require that the designated 
compliance officer report directly to the CEO or to the Board 
of Directors, and that this person not have come from one of 
the business lines within that organization within the last 3 
years. Second, with respect to the notion of removing reference 
to NRSRO ratings from Federal regulations, I would recommend 
caution. At present, NRSRO status is the only hook by which 
regulators in the United States are able to exercise oversight 
of credit rating agencies. If NRSRO status is made irrelevant, 
I would urge you to ensure that other measures are taken to 
continue this important oversight of these important agencies.
    Now, Moody's will undoubtedly respond as they habitually 
do, that I am a disgruntled ex-employee who has an axe to 
grind. To this, I will simply respond that it has been a year 
since my departure and I did not actively seek the opportunity 
to testify today. By putting my head above the parapet again, I 
am likely burning a lot of bridges with former colleagues whose 
esteem I value. I am putting my family through stress that 
could be avoided very easily by simply saying I don't know 
anything.
    Thank you for your time.
    Chairman Towns. Thank you very much, Mr. McCleskey.
    Mr. Cantor.

                  STATEMENT OF RICHARD CANTOR

    Mr. Cantor. Good morning, Chairman Towns, Congressman Issa 
and members of the committee. I am Richard Cantor, the chief 
credit officer for Moody's Investors Service. I welcome the 
opportunity to contribute Moody's views to this hearing.
    I would like to begin with a brief overview of Moody's 
rating process. At the start of the ratings process, an analyst 
gathers relevant information from issuers and public sources. 
He or she then conducts a credit analysis applying Moody's 
methodologies which are publicly disclosed and freely available 
on our Web site.
    After forming an opinion an analyst brings his or her 
analysis to a rating committee, which is a critical mechanism 
in promoting the quality, consistency, and integrity of our 
ratings process. The committee discusses and then votes on the 
appropriate rating for the security.
    One of the core principles of this process is that 
different analysts can and will legitimately hold different 
views on the credit risk, based on the same set of facts. And 
the committee process is the vehicle for resolving these 
disagreements.
    Once finalized, credit ratings are communicated to the 
general public free of charge. We monitor these ratings on an 
ongoing basis and we modify them if our view of the 
creditworthiness of the issuer or the obligation changes.
    The unprecedented credit crisis that began 2 years ago has 
provided important lessons for Moody's, other credit rating 
agencies and all market participants. In light of these 
lessons, Moody's has adopted an array of measures to enhance 
the quality and transparency of our credit ratings.
    These steps 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've made important progress, but more can be 
done. Indeed, Moody's supports a number of reform proposals 
currently under discussion that can help restore the 
credibility of credit rating agencies and return confidence to 
structured finance markets.
    We also believe that other steps could be taken to increase 
disclosure in structured finance markets. Specifically, we 
believe that increasing information disclosure by issuers, 
sponsors, and underwriters of structured finance securities 
would yield three principal benefits: one, reduce the risk of 
over-reliance on credit ratings; two, improve the information 
available about structures and assets; and three, broaden the 
range of opinions and analysis available to the market.
    Finally, let me turn to the allegations raised by Mr. 
Kolchinsky in a letter sent to this committee. Mr. Kolchinsky 
has raised a series of evolving claims over the past year. And 
in July, Moody's retained the outside law firm, Kramer Levin, 
to conduct an independent investigation of all of these issues. 
It is important to note that Moody's didn't direct the 
investigation. Rather, the company gave the independent law 
firm unfettered access to our personnel and documents. I 
understand that the outside lawyers have interviewed 22 Moody's 
employees and the only person who has refused to meet with the 
investigators is Mr. Kolchinsky.
    As the committee is aware, Moody's, in anticipation of 
today's hearing, also asked the independent law firm to provide 
the committee staff with a briefing on the preliminary findings 
of that investigation. These findings have also been shared 
with our regulator. I understand that the committee has been 
informed that these preliminary conclusions are consistent with 
Moody's own internal review. Specifically, Mr. Kolchinsky's 
claims of misconduct are unsupported. Instead, Mr. Kolchinsky 
raises issues of longstanding and healthy debate within the 
company and the credit rating industry. When debates have been 
resolved contrary to Mr. Kolchinsky's personal views, he has 
alleged that the process was fraudulent, unreasonable or 
otherwise improper, when they were not.
    All of us at Moody's are committed to meeting the highest 
standards of integrity, quality and transparency in our rating 
practices, methodologies and analysis, and we will take all the 
appropriate steps to uphold these standards.
    I am happy to respond to any questions.
    [The prepared statement of Mr. Cantor follows:]

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    Chairman Towns. Thank you very much, Mr. Cantor.
    Let me begin by raising questions, and each Member will 
have 5 minutes to do so.
    Mr. Kolchinsky, I have here a memo you wrote to Michael 
Kanef, the head of compliance at Moody's. In the very first 
sentence, you said, ``Moody's was engaged in illegal conduct.''
    What kind of illegal activities was Moody's engaged in?
    Mr. Kolchinsky. Sir, I believe that Moody's violated 
securities laws by issuing ratings on Nine Grade funding in 
January. They knew that the ratings were incorrect. They had 
knowledge of it. And yet they still went forward and issued the 
rating.
    It is not, as Mr. Cantor states, a matter of policy. It is 
a matter of law, whether you can or not knowing that the 
ratings are wrong actually opine on a rating, and that is what 
I believe was the violation of the law.
    Chairman Towns. Well, did you warn Moody's of the problem?
    Mr. Kolchinsky. Yes, sir, I did. In the past, Moody's came 
very close to doing something very similar, and that was 
September 2007. And at the time, I was able to prevent the 
occurrence of that from happening. I had warned both the 
Compliance Group and the Credit Policy Group about these 
issues, and about precisely this type of an action leading to 
securities laws violation. And those warnings were ignored.
    Chairman Towns. Is it true that you also warned Moody's 
that the ratings procedure used by derivatives groups were 
inadequate?
    Mr. Kolchinsky. Yes, sir, I did. I believe specifically 
this relates to the new methodology for rating ABS CDOs, which 
was used in the process of rating the deal in question here. I 
had told Mr. Cantor's group and I had told the Compliance Group 
that the methodology was not realistic. It had many problems. 
It was not based on real world scenarios or real world views of 
how the credit would perform.
    Chairman Towns. Is it true that you warned Moody's that the 
ABS CDO methodology used by the Derivatives Group produces 
misleading ratings that will continue to destabilize the 
financial markets, as well as cause losses for investors and 
shareholders?
    Mr. Kolchinsky. Yes, sir. I did that.
    Chairman Towns. Mr. Cantor, I understand that Moody's hired 
an outside counsel, as you indicated, from the law firm of 
Kramer Levin to investigate Mr. Kolchinsky's allegations. I 
want your commitment that Moody's will provide to this 
committee within 1 week copies of all documents that were 
provided to Kramer Levin regarding their investigation, along 
with a copy of the preliminary report which they issued just 
yesterday.
    Will you make that commitment right now?
    Mr. Cantor. Mr. Chairman, I will pass along your request to 
the appropriate people at Moody's and I am confident that they 
will be able to comply.
    Chairman Towns. I don't quite understand you. In other 
words, aren't you appropriate? You are testifying here and you 
are under oath?
    Mr. Cantor. Yes. I am the chief credit officer. I am 
responsible for the methodologies that we produce and use in 
the ratings process. And I will communicate your request to the 
appropriate people at Moody's and I am confident they will 
comply.
    Chairman Towns. Well, who are the appropriate people?
    Mr. Cantor. I would expect the general counsel at Moody's.
    Chairman Towns. I am sorry?
    Mr. Cantor. The general counsel at Moody's.
    Chairman Towns. Right. OK. Thank you.
    Mr. McCleskey, I have a letter you wrote to the SEC in 
March 2009. In it, you warned the SEC about Moody's municipal 
securities ratings. Are these ratings just out of date and 
inaccurate? Is it true that Moody's did not warn investors 
these ratings were out of date? Mr. McCleskey.
    Mr. McCleskey. Yes, sir. And the intention of that letter 
was to alert the SEC so they could look into a situation that I 
was aware of in which there are tens of thousands of municipal 
securities out there that just due to the sheer number they are 
not getting the same level of scrutiny, surveillance on the 
ratings that you would expect from a normal bond or structured 
instrument.
    There were concerns. I had expressed concerns about this 
because my feeling is that there will be municipal bonds out 
there that haven't been looked at that may have out of date 
bond ratings that the public may not be aware that these are 
out of date.
    It is one thing for the bond to be the city of New York or 
California, where everybody knows the economic state, but these 
include very small school districts or very small 
municipalities where it may not be as available to the public.
    Now, I am not an economist, but the SEC has economists. And 
that is the reason why I raised this issue and I urged them to 
include a review of this in their next routine examination. And 
I do believe that is important. It has been, as I said, a year 
since I was at Moody's, maybe things have gotten better. I hope 
they have. But at the time that I wrote this letter, I felt 
that it was something that the SEC needed to be aware of.
    Chairman Towns. Thank you very much. My time has expired.
    I yield 5 minutes to the gentleman from California, 
Congressman Issa.
    Mr. Issa. Thank you, Mr. Chairman.
    And I would like to followup on the chairman's statement, 
Mr. Cantor, a question. To your knowledge since you supplied a 
great deal of the information that went to the independent 
investigation, is most of it information which you would 
consider not to be attorney-client privilege?
    Mr. Cantor. I am not----
    Mr. Issa. In other words, the information you provided was 
of a statistical and numeric nature. It was emails pertinent to 
today's discovery. In other words, it was information that 
should not be withheld based on a claim of attorney-client 
privilege. Would you agree?
    Mr. Cantor. I have no expertise in this area.
    Mr. Issa. Well, then I will break it down a little bit so 
the chairman and I are consistent on this part. Was most of 
this information internal emails and correspondence related to 
today's hearing that would either affirm or deny Mr. 
Kolchinsky's claims?
    Mr. Cantor. I am sorry. I am not sure I understand the 
nature of the question.
    Mr. Issa. It is real simple. Today, you weren't able to 
answer and you are referring to general counsel. My concern is 
you go back to general counsel and they claim a broad attorney-
client privilege, and then we play that 20 questions game in a 
subsequent hearing, where I guess we bring your general counsel 
in.
    I want to understand today what it takes to investigate a 
claim by a whistleblower. We are presuming, but I want an 
affirmation at least to your knowledge, it doesn't appear to be 
specific attorneys, you did not turn over, as far as you know, 
lots of things by your attorneys to this independent group, 
which we would presume, if they are independent, they are not 
going to claim attorney-client privilege just because you paid 
them.
    Mr. Cantor. The firm that conducted the investigation had 
unfettered access to all of our documentation.
    Mr. Issa. I am only asking if they had independence.
    Mr. Cantor. There was not specific materials that were 
turned over.
    Mr. Issa. OK. So if I understand correctly today, the 
chairman and I are going to close the hearing based on the hope 
that Moody's will turn over what the chairman has asked for, 
and if they don't, then we have to go back through the process 
of your claim that they are independent, just as Moody's is 
independent when they issue credit ratings, and yet you paid 
them and therefore have an ability to claim attorney-client 
privilege and may.
    Mr. Cantor. I expect there will be a full compliance with 
the request.
    Mr. Issa. Good. That is what we expect.
    Mr. Cantor. I am only pointing out that I am not an expert 
in this area, and you are speaking to someone who----
    Mr. Issa. OK. The chairman and I will be patient on that 
issue, but I wanted to clarify it because I am deeply concerned 
that the word ``independent'' and ``outside'' generally means 
they were done for our benefit and the people's benefit, not 
just for the person paying them, which gets us back to Moody's.
    Do you believe that this very narrow, I guess three, now 
four groups that are allowed to do what you do is reasonable or 
sustainable? In other words, is there any reason to have an 
ogopoly or oligopoly, to use a now-Russian word it seems, or 
could we have dozens of organizations allowed to try to do what 
you do, and then if you do it better, you would rise. And if 
you didn't, somebody else who was more accurate would rise.
    Is that a better way for this committee to look at the 
future? Or should we continue with this narrow group that we 
trust, even though they failed us?
    Mr. Cantor. Moody's favors a vigorous competition in the 
credit rating industry. There are currently perhaps 100 credit 
rating agencies around the world. I don't know how many there 
are in the United States----
    Mr. Issa. Well, let's just say that the big three have 90 
percent, and in electronics, the last 10 percent isn't enough 
for anyone to matter. So if three of you have 90 percent, you 
have a three-way monopoly.
    Mr. Cantor. Well, there----
    Mr. Issa. Let me followup with another question.
    This committee has promoted, I think vigorously, 
transparent reporting systems. XBRL is one of them. Obviously, 
well along the way in a nonprofit. Would you believe that this 
committee should, in fact, make that a public policy so that 
broadly this information that is not available to the 
individual consumer or individual investors could become 
available?
    Mr. Cantor. Moody's strongly supports enhanced disclosures 
in securities markets, including the type that you have----
    Mr. Issa. OK. For my whistleblowers, and thank you for 
being here today. I know it is tough and I know there are 
always the other side whenever someone comes forward. But let 
me ask you a question. Currently, Congress is considering 
giving more authority to the SEC to do what they didn't do when 
you reported to the SEC. Does that seem like it makes sense to 
you? If they didn't act when you reported, should we rely more 
heavily on government? Or should we have, as I am suggesting, 
XBRL and other ways for people to second-guess reporting? 
Either one of you.
    Mr. McCleskey. Sir, if I could go first. I think that 
transparency is generally a good idea, but I think a 
distinction needs to be made between transparency and 
disclosure. In my mind, disclosure is providing information. 
Transparency is providing it in a meaningful way. I would also 
draw a distinction in your example with respect to stocks and 
bonds. I agree with you that many people do not research the 
stocks and bonds before they buy them. But I would assert that 
is because they don't wish to.
    If you are putting our information about a structured 
finance product, there may be people who wish to conduct an 
analysis, but lack the expertise, the models, the methodologies 
to do so. So I would make that distinction.
    Should the SEC have more authority? To my knowledge, they 
have not done their first routine cyclical examination of the 
firms yet. I think that the reason for that is, frankly, this 
is an unregulated industry for the past century. They have 
needed time to get up to speed. I would frankly have expected 
something to happen by now, but I think that with respect to 
the aggressiveness of the SEC with respect to the credit rating 
agencies, I would suspect that part of that is simply because 
they are getting staff up to speed. They are hiring staff. I 
wouldn't write them off just yet.
    Chairman Towns. The gentleman's time has expired.
    Go ahead, Mr. Kolchinsky.
    Mr. Kolchinsky. I would agree with Mr. McCleskey. I think 
the SEC has had a difficult role, especially since each agency 
has its own methodology. I am very familiar with the 
methodology that I was responsible for. It is very difficult to 
understand. It has a lot of minutiae, lots of twists and turns.
    I think what I propose as a public body along the lines of 
FASB, where these decisions would be made in a public matter, 
which would be overseen by the SEC as FASB is, but where these 
decisions are overseen in a public matter, the types of data 
that goes out goes out to everybody, and decisions are made 
publicly with public consent. And I think that would be the 
best way of opening up this industry to transparency.
    Mr. Issa. Thank you, Mr. Chairman.
    Chairman Towns. Thank you very much.
    I now yield 5 minutes to the gentleman from Pennsylvania, 
Mr. Kanjorski.
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    Mr. Cantor, in your testimony, you sort of asserted with 
great pride that the information is made available to the 
general public free of charge. And there is nothing incorrect 
about that statement, but do you mean to indicate that nobody 
pays for this information?
    Mr. Cantor. The information about our rating?
    Mr. Kanjorski. Yes.
    Mr. Cantor. That is correct that the distribution of 
ratings to investors is free of charge.
    Mr. Kanjorski. Yes, but are you going to tell us who pays 
for it, or are you going to just indicate that it is free of 
charge?
    Mr. Cantor. Oh, who pays for the effort that----
    Mr. Kanjorski. You are an eleemosynary corporation, I 
assume? You don't charge? You do this for free?
    Mr. Cantor. No. We are paid by issuers of securities in the 
capital markets for the ratings we assign.
    Mr. Kanjorski. Ah, that is surprising.
    Now, I am just going to pose a question to you and I hope 
you can give me a reasonable response. If we went to our 
colleagues in the House and the Senate and told them that we 
have discerned a new way to reduce the budget of the United 
States by significant proportions, and that is we could remove 
all the expenses for the judiciary branch of government because 
we have come up with a new formula that all lawyers who 
represent winning litigants have agreed to pay the judges' 
salaries.
    Would you sort of conclude that is a good, fair, and proper 
way to carry on the judicial system of the United States?
    Mr. Cantor. I must admit the hypothetical is a little 
confusing to me, but I imagine you are proposing something that 
you feel is a very bad idea. I must admit I got a bit lost.
    Mr. Kanjorski. I am proposing what occurs in the rating 
agencies. You get paid by the issuers, don't you?
    Mr. Cantor. We do.
    Mr. Kanjorski. Well, you didn't want to indicate that. You 
were bragging about that the public gets it free of charge. 
That can or cannot be true. If it is an incorrect or 
prejudicial rating, it is not free of charge. The price we 
would pay for that was exactly what happened a year ago. The 
markets would have bad securities. Some people call them toxic 
securities, and it could in fact cause a crash to occur, which 
in fact happened.
    And I am not saying that we can trace it directly to the 
rating agency, but that is a possibility. That wouldn't make it 
free of charge. That would make it extremely expensive.
    Do you agree?
    Mr. Cantor. Moody's has been operating under the issuer-pay 
model that we were just talking about for 40 years. And we have 
a long track record under this business model that we stand 
behind and it is the basis of our performing.
    Mr. Kanjorski. One of your colleagues in testifying said 
they wanted to operate like the accounting businesses, that 
they don't have any problem. Maybe you are of a short memory. 
Do you recall Enron?
    Mr. Kolchinsky. Yes, sir.
    Mr. Kanjorski. What was the problem that we found in Enron?
    Mr. Kolchinsky. Sir, I believe it was fraud.
    Mr. Kanjorski. No. We found that Enron was being paid 
exorbitant fees for consulting services and those fees had a 
tendency to affect their professional opinions as accountants, 
this exact conflict of interest that exists in this rating 
agency problem today.
    Now, I appreciate if you are whistleblowers that you came 
through, but I listened to both of your testimony, and I didn't 
hear anything terribly shocking. If this is the best testimony 
that we have, I am surprised that Moody's went out and hired 
the lawyer that they did to attack you.
    You haven't given a course of conduct in my opinion of 
fraud. You haven't given a course of conduct of real gross 
neglect or negligence. You have said there are some instances 
like the supervisor was not allowed in the room to meet when 
the SEC came by. Eh? Maybe good, maybe bad. We should rap their 
knuckles, but there is nothing criminal about that, or really 
extreme about that.
    And in your instance, what do you find after all these 
years of issuing these opinions, you said they did things that 
violated the law. What did they do?
    Mr. Kolchinsky. Sir, I believe they violated rule 10b(5) of 
the----
    Chairman Towns. Speak into the mic.
    Mr. Kolchinsky. My apologies. I believe they violated rule 
10b(5).
    Mr. Kanjorski. And what is rule 10b(5)?
    Mr. Kolchinsky. The rule 10b(5) is fraud, securities fraud 
in securities markets.
    Mr. Kanjorski. And how did they do that?
    Mr. Kolchinsky. Sir, if I might, I can quote from a memo 
that was produced on behalf of Moody's by another prominent New 
York law firm, written to the SEC, and they state, ``A rating 
agency would be liable,'' this is with respect to 10b(5), ``if 
it knowingly published a report that falsely misrepresented its 
own evaluation of securities.'' And that is exactly what they 
did.
    Mr. Kanjorski. And how did they do that?
    Mr. Kolchinsky. Sir, they knew that the underlying ratings, 
this was essentially CLO squared. In December, they had just 
decided to change the methodology on the underlying CLOs. And 
they knew, in fact, that all those ratings were now wrong. In 
fact, they ran internal tests that showed that rated securities 
that were rated below AAA would be moved three to six notches.
    That knowledge should have been, must have been 
incorporated in any new rating. Once that was decided, once the 
step was taken, it should have been decided, if you are going 
to base your other ratings on those ratings.
    Mr. Kanjorski. OK. Now, was that directly reported to the 
appropriate officials at the SEC? Or how was that handled on 
your part?
    Mr. Kolchinsky. How was my complaint handled?
    Mr. Kanjorski. What did you do? You found out that they 
were using false information that they knew was false, so 
knowingly they did this.
    Mr. Kolchinsky. Yes, sir. I was not a part of this. I 
reported it to the Compliance Group as I was supposed to. Once 
I was----
    Mr. Kanjorski. What do you mean, you were not part of this?
    Mr. Kolchinsky. I was not in the rating agency.
    Mr. Kanjorski. Well, how did you find this information?
    Mr. Kolchinsky. From speaking to colleagues and off of----
    Mr. Kanjorski. So this is hearsay?
    Mr. Kolchinsky. Yes, sir, but it is backed by documented 
evidence which is available.
    Mr. Kanjorski. Did those colleagues that told you this then 
report that to appropriate officials, either in the Justice 
Department or the SEC?
    Mr. Kolchinsky. I don't know, sir.
    Mr. Kanjorski. Didn't you figure out it may be important to 
determine that?
    Mr. Kolchinsky. Sir, I am just a single person. I was 
trying to do the right thing. As soon as I knew anything, I 
reported to my Compliance Group. After my suspension, I 
reported it, tried to report to SEC, and I also spoke to the 
committee here. But I believe I tried to make sure that these 
matters were brought up to the attention of the appropriate 
parties.
    Mr. Kanjorski. If I could just ask one question of all 
three panelists?
    Chairman Towns. I ask unanimous consent to give the 
gentleman another additional minute.
    Mr. Kanjorski. You have heard the example of how rating 
agencies are paid by the issuer, which poses potentially great 
conflicts of interest. Do the three of you have opinions 
whether we should examine this and change this practice? Or do 
you think it is working perfectly well and has no effect on 
what the rating agencies are doing in the marketplace?
    Mr. Kolchinsky. Sir, I think the conflict of interest at 
the rating agencies is much more pedestrian. It is more a 
short-term profits versus long-term credit quality. There is 
nothing special issue pays or investor pays. It is a short-term 
profit-focused conflict of interest.
    In many cases, in my world, in ABS CDOs, one of the reasons 
you are seeing all the banks like Merrill Lynch, UBS, and 
Citigroup have problems is because they retained the vast bulk 
of the debt that they issued, so it was effectively an 
investor-paid model. They couldn't get outside investors to buy 
the stuff so they retained the deals on the balance sheet.
    So it is very difficult to actually implement a good 
investor-pay model that would not have the same conflict of 
interest if the investor has the same incentives as the banker 
does.
    In the case of ABS CDOs, in many cases, the investor and 
the banker were the same party and they just brought it on the 
balance sheet because they wanted to show revenue.
    So theoretically, I agree with you.
    Mr. Kanjorski. Do I understand your testimony to say it 
doesn't make a difference who pays? It has no effect on the end 
result?
    Mr. Kolchinsky. No, of course it does. Of course it does. 
My testimony is that in practical terms, it is very difficult 
to find the ideal investor. Not every investor is a Warren 
Buffett.
    Mr. Kanjorski. Whoa, whoa, whoa. I didn't ask you the 
question about whether investors should pay. That is our big 
problem, who should pay or who can pay, and why we got to this 
peculiar system that we have. That is what we are examining 
into.
    Mr. Kolchinsky. Yes, sir.
    Mr. Kanjorski. I don't want you to conclude we think that 
is the better system.
    I want to ask you, do you see the gross potential conflict 
of interest when the person issuing the security pays the 
person who rates that security?
    Mr. Kolchinsky. Yes, sir.
    Mr. Kanjorski. OK.
    Mr. McCleskey. Sir, I think I would agree with Mr. 
Kolchinsky. I do see the gross conflict. The problem then 
becomes what do you replace it with? And I don't have an 
opinion. I am not smart enough to know the answer to that 
question.
    Mr. Kanjorski. Neither are we. That is why we are working 
on it.
    Mr. McCleskey. If I could, I think I should also respond to 
your other point about whether it is important that I was or 
was not in a particular meeting. The compliance officer 
position is embedded into law with respect to credit rating 
agencies, as it is in many other sectors of the financial 
industry, and for good reason. These are the people that are 
supposed to be independent and supposed to keep their eyes open 
for any potential violations. If that position is not properly 
resourced, does not have enough authority, then that puts the 
firm, that puts the industry at risk.
    And so this is not just what you would have in normal 
office politics. This was something that, in my view, weakened 
the oversight of the credit rating agencies.
    Mr. Kanjorski. All right.
    Mr. Cantor.
    Mr. Cantor. We believe that any rating agency system in 
which a party that obtains the rating and is interested in the 
outcome of the ratings process is also paying for the rating. 
Whether it be an investor-pays model, a government-pays model, 
or an issue-pay model, it presents a potential conflict of 
interest which must be carefully managed.
    There are a variety of rating agencies using different 
models today and we carefully manage our potential conflicts of 
interest to the highest possible standards. We have been 
engaged in this particular business model for 40 years and 
produced a strong track record.
    We actually have historical experience of operating under 
an investor-pay model for the previous 60 years, which we can 
reflect back upon and compare our performance and we have to 
how we performed under that business model compared to the 
model we adopted around 1970. And the historical data indicates 
that our performance has been stronger since that time, both in 
terms of the way we have been able to rank order the 
probability of loss across different credits, and in terms of 
the losses that would have been experienced by investors who 
bought all the securities that we rated investment-grade in the 
two different periods.
    Chairman Towns. The gentleman's time has expired.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Chairman Towns. I now yield to the gentleman from North 
Carolina, Mr. McHenry.
    Mr. McHenry. Thank you, Mr. Chairman.
    Thank you all for testifying today. This is certainly 
important in light of the financial crisis we have faced over 
the last year. I am on the Financial Services Committee with my 
colleague, Mr. Kanjorski. We have gone into the, you know, 
causes of this crisis and I think there is a wide agreement 
that the credit rating agencies were complicit in this crisis 
for a number of reasons, some of which were errors and 
omissions; others outright fraud by those that are disclosing 
information to the NRSROs.
    So Mr. Kolchinsky, you believe that corruption played a 
major role in this crisis. Is that true?
    Mr. Kolchinsky. Sir, I wouldn't call it corruption. I would 
just say very poor incentives were the major part of----
    Mr. McHenry. OK. Do you believe that a weak analysis of 
these new complex financial products was a part of it as well?
    Mr. Kolchinsky. I think so, as well. More could have been 
done and should have been done in 20/20 hindsight that could 
have analyzed these products. The main part of it is a lot of 
people just should have said no to some of these products. And 
that is 20/20 hindsight, but I think that is the major part, to 
have just said, we can't analyze this with any degree of 
confidence and we should just walk away from it. But that was 
just not possible.
    Mr. McHenry. I think there is probably agreement on the 
panel that reforms need to be instituted. I mean, I think that 
is fair. Even Mr. Cantor gives a small nod.
    But of particular interest to me as a policymaker on the 
Financial Services Committee is whether or not giving the SEC 
the authority to outline the minimum information that issuers 
should provide the NRSROs. Is that a worthy policy that we 
should put forward, empowering the SEC to specify what 
information needs to be given to credit rating agencies? Mr. 
Kolchinsky.
    Mr. Kolchinsky. Yes, sir. I think it is important for 
anybody to set, it could be a private-public, self-regulating 
organization, to set minimum standards that are applicable 
across the board for data that can be provided. And there 
should be some government body that passes judgment on that, 
whether that is sufficient.
    Mr. McHenry. OK.
    Mr. McCleskey.
    We will finish with you, Mr. Cantor. I am asking Mr. 
McCleskey first, then we can finish with you, Mr. Cantor.
    Mr. McCleskey. Yes, sir. I would first have to say that 
this is more within the remit of my colleagues. But I would say 
this from my own experience with regulations here and in Europe 
that I am generally in favor of this, but you have to be 
careful that if you set minimum standards, there is sometimes a 
tendency that people will only do the minimum.
    And I am also familiar enough with the complexity of the 
market that there will be different types of information that 
will be appropriate for different types of securities. And as 
the universe of rated securities expands, that will be 
difficult.
    So there will challenges. But having said that, I am in 
favor of it.
    Mr. McHenry. Mr. Cantor.
    Mr. Cantor. I would be opposed of the idea to create 
minimum standards for disclosure to rating agencies. I think 
minimum standards for disclosure should be to the general 
public. I don't think we want to privilege rating agencies with 
special access to information based on government 
decisionmaking; that there is a wealth of analysis that is done 
on fixed-income securities by rating agencies, by investors at 
large, asset management companies, and in the financial press 
and by academics, and I think it would be a very bad idea to 
have specific rules for what should be shared with credit 
rating agencies.
    Mr. McHenry. I think what I am saying is, what is the, you 
know, what is ratable, what information should the issuer 
provide to rating agencies in order to provide a rate. I think 
you are answering a different question because----
    Mr. Cantor. Well, I am sorry. Maybe I was just particularly 
struck by the notion of what should be shared with rating 
agencies. I do believe there should be minimum standards for 
information disclosure generally, including to rating agencies, 
and it should be expanded for structured finance securities 
from where it is today.
    Mr. McHenry. OK. It seems like you are answering a 
different question originally. Yes, I am saying basically what 
is holding you accountable, what is holding your client 
accountable to provide accurate, full, and complete disclosure? 
Because otherwise, then the credit rating agencies are simply 
incompetent and didn't see a financial crisis coming, if you 
are saying, you know, you got complete information. Is that 
fair?
    Mr. Cantor. You are correct. The standards for what is 
required for an issuer to disclose publicly is very different 
in structured finance than it is in corporate securities.
    Mr. McHenry. Obviously.
    Mr. Cantor. And the potential liability of the issuer of 
such securities for false disclosures is different, and the 
completeness of those disclosures. The requirements regarding 
completeness is very different.
    Mr. McHenry. So then you are in favor of the SEC providing 
those minimums by which the issuer should provide the NRSROs?
    Mr. Cantor. The NRSROs and the general investing public.
    Mr. McHenry. Thank you.
    Chairman Towns. Thank you very much.
    I now yield 5 minutes to the gentleman from Ohio, 
Congressman Kucinich.
    Mr. Kucinich. Thank you, Mr. Chairman. I want to thank you 
for holding the hearing.
    Through the housing crisis and larger financial crisis, the 
credit rating agencies seemed to have otherwise escaped any 
real scrutiny. I have been troubled by the increasing 
popularity of instruments called ``re-remics.'' What this 
stands for is resecuritization of real estate mortgage 
investment conduits, and the shorthand is called ``re-remics.'' 
And it basically amounts to repackaging original investment 
instruments that no investor will touch into more complex 
investment vehicles.
    Mr. Kolchinsky, are you familiar with these re-remics?
    Mr. Kolchinsky. Yes, sir, I am.
    Mr. Kucinich. Mr. Cantor.
    Mr. Cantor. Yes.
    Mr. Kucinich. I wrote a letter, Mr. Chairman, to the 
chairman of the SEC, Mary Schapiro, and I have spoken to her 
about this issue. And here is what I have learned. The total 
resecuritization market right now is approximately $664 
billion. Of that total, only $60 million is considered 
registered transactions. That means that the SEC has looked at 
only $60 million. The vast majority of the transactions are 
exempt from registration with the SEC.
    But, Mr. Chairman, do you know who does look at these 
resecuritized ties to real estate mortgage investment conduits, 
the re-remics? Credit rating agencies.
    So here we have a group of companies who played a 
substantial role in bringing our economy to the brink of 
collapse and we have to ask if they are doing it again. 
Financial institution takes some toxic assets that no one 
wants, crams them together into a more complex instrument, and 
presto, according to rating agencies, you can have an 
investment-grade product. The practice of securitization gained 
popularity as a way to provide liquidity to the mortgage market 
and hedge against risk.
    Apparently, the financial services industry has learned 
nothing from our housing crisis because the rationale behind 
resecuritization is to provide liquidity to the mortgage market 
and hedge against risk, and the credit rating agencies, paid by 
the issuers, are all too happy to oblige.
    Now, Mr. Kolchinsky, seeing as that the re-remics are more 
complex, more opaque than the collateralized debt obligations, 
the CDOs that came before them, what is to stop these 
resecuritization of real estate mortgage investment conduits 
from bringing the entire system to the brink once again? What 
does the SEC have to do to protect against a new disaster in 
the securities market? Do you agree?
    Mr. Kolchinsky. I agree that these re-remics or ``repacks'' 
as they are called are potentially dangerous. Some have a 
purpose. That purpose may be a gaming of capital requirements, 
accounting requirements or what have you.
    Mr. Kucinich. Gaming?
    Mr. Kolchinsky. Yes, sir. Recently, I actually saw a repack 
that was proposed that had absolutely, to my view, no 
discernible economic value. Substantial costs would be 
incurred, but to my knowledge there would be no value added. So 
to me, that is a sign that somebody is playing a game with some 
regulation somewhere.
    Mr. Kucinich. So you would agree, there is a danger here?
    Mr. Kolchinsky. Yes, sir. Yes, sir.
    Mr. Kucinich. And then what about the role of credit rating 
agencies? If someone tries to get assessed what the value of a 
resecuritized real estate mortgage investment conduit is, they 
go to a rating agency. Right?
    Mr. Kolchinsky. That is correct.
    Mr. Kucinich. And is it in the interest of the rating 
agency to try to find a way to give a rating so that they can 
get these things out in the market?
    Mr. Kolchinsky. That is correct.
    Mr. Kucinich. And Mr. Kolchinsky, that is even if you have 
just a bundle of toxic assets where the value of it might be 
washed away, essentially.
    Mr. Kolchinsky. Yes, yes. These can be very problematic. 
Some re-remics that were done last year went from AAA to C or 
CA.
    Mr. Kucinich. And Mr. Kolchinsky and Mr. Chairman, in light 
of that, and we may want to do another hearing on this point, 
Standard & Poor's has already downgraded these re-remics that 
they rated less than 5 months ago, due ``to the significant 
deterioration in the performance of the loans backing the 
underlying certificate.''
    So the bottom line, Mr. Chairman, these are homes, and 
these are families, and communities, our constituents. You have 
to watch these credit ratings agencies. They could be setting 
us up for the same thing all over again, and I am glad you are 
holding this hearing, Mr. Chairman. I hope we can get into this 
deeper.
    I yield back.
    Chairman Towns. Thank you very much. I thank the gentleman 
from Ohio for his words.
    From the State of Missouri, Mr. Luetkemeyer.
    Mr. Luetkemeyer. Thank you, Mr. Chairman. I appreciate the 
opportunity to discuss this issue today.
    Before I get started, I would like to echo the comments and 
sentiments of the ranking member with regards to the subpoenaed 
documents, to be able to further investigate and hold 
accountable those entities that he was discussing a while ago, 
and I would hope that you would certainly respond to his 
request.
    With regards to the gentlemen before us, as a former bank 
regulator, I can assure you that when we looked at the 
investment portfolio of the financial institutions, your 
ratings are extremely important in our analysis of their 
financial structure and the liabilities that they have on the 
books, and assets they have on the books.
    And so for us to have this hearing today with regards to 
the viability of your ratings is extremely disconcerting to me 
from the standpoint of what has happened and how important they 
are not only to the banks, but other investment firms and the 
general public as a whole.
    I guess my question to Mr. Kolchinsky is initially, and Mr. 
McCleskey as well, is why do you believe that this happened? 
What is the incentive for the ratings agencies to not do their 
job correctly or to stray from the practice of doing the job 
they should be doing?
    Mr. Kolchinsky. Sir, in my view, it is slightly the 
opposite. There is no incentive for them not to. There is no 
incentive, and to me, that is the benchmark for the whole 
industry. There is no incentive to say no to a transaction.
    Mr. Leutkemeyer. Then why did they do it?
    Mr. Kolchinsky. For revenue. Rating agencies are large 
institutions with large fixed costs. And people getting a 
transaction in the door. It is very difficult to say no to that 
transaction, especially if that means you can take the revenue. 
You say no to it, you can take it to another rating agency. 
There are no 11 rating agencies. You can take it to another 
one, somebody who will say yes, and that is a problem.
    Mr. Leutkemeyer. So what you are saying is Congressman 
Kanjorski's comment to the question of the agency's being paid 
by the very people who they are rating these securities for is 
an inherent problem, and that is probably the reason for some 
of the problems we have here. That is what you are saying?
    Mr. Kolchinsky. That is right, sir. But the problem is that 
the person can also select which rating agency they go to.
    Mr. Leutkemeyer. OK.
    Mr. Kolchinsky. And they are free to go to one or another 
until they find one that will help them out. And again, these 
are----
    Mr. Leutkemeyer. So there is really, I guess the question, 
it begs the question, how rampant do you believe the 
inadequacies are, or their willingness to look the other way, 
or their willingness to do an inadequate job in lieu of or for 
further profitable gain is there? I mean, is that the general 
method of operating, or are there some inherent, or they are 
normally trying to do a good job, or they just see a big 
client, we have to skew it so we can make a few bucks here.
    Mr. Kolchinsky. Sir, I don't believe it is direct. I 
believe what happens is that you have a client, you have a 
business, and people talk themselves into being able to think 
that they can understand a deal, can understand the structure 
and are comfortable with it.
    I do not believe in most cases that any of this is a direct 
willingness to do something wrong. In most cases, it is getting 
comfortable with something that may be outside of the envelope 
and there are usually small little steps all the way down. It 
is a slippery slope.
    Mr. Leutkemeyer. OK.
    Mr. McCleskey.
    Mr. McCleskey. Sir, it would be speculation on my part to 
guess why organizations are following particular paths, but I 
will make three points. First, I would just observe that, 
especially earlier on in my time at Moody's, I will simply say 
that the senior management of the Structured Finance Group was 
very proud of the amount of revenues they brought in, quite 
vocally. And that is all I will say on that matter.
    Also, I would say with respect to incentives, organizations 
don't make decisions. People do. And I think we need to take a 
look at the incentives that fall on the individuals. And Mr. 
Cantor will point out, and rightly so, that ratings are arrived 
at by committees, but committees are led. Committees are made 
up of individuals. And I think that you would actually have to 
look not just at, for instance, the compensation practices, but 
you should also take a look at things like the performance 
evaluations. What are the criteria on which key people are 
being evaluated? Yes, sir.
    Mr. Leutkemeyer. OK.
    Very quickly, my time is running out and I have one more 
quick question for you.
    Because it seems to be a prevalent problem with all the 
rating agencies, is there collusion between the agencies? Have 
you seen that? Or are you aware of that? Or would you speculate 
on that?
    Mr. McCleskey. I am not aware of any, and I would actually 
say that there were a lot of efforts to make sure that there 
wasn't even the appearance of collusion.
    Mr. Leutkemeyer. OK.
    Mr. Issa. Would the gentleman yield?
    Mr. Leutkemeyer. Yes.
    Mr. Kolchinsky. I agree with that.
    Mr. Leutkemeyer. Yes. Thank you.
    Thank you, Mr. Chairman.
    Mr. Issa. Yes, the model you have is the same model that 
basically PriceWaterhouseCoopers, Ernst & Young uses. You pay 
to get an audit. Why is it yours appears to have failed where 
audits by comparison, particularly after Sarbanes-Oxley, have 
been considered to do better?
    Mr. Kolchinsky. Sir, I believe it is the existence of a 
minimum standard. The problem is rating agencies today are 
judges and juries and executioners of their own methodologies. 
And it is very easy for them to go down a slippery slope and to 
change methodologies and adjust it in order to get a client.
    If you can imagine, for example, if an accountant could go 
to a potential client and say, you know, your current auditor 
thinks that this is a loss, but we think it is a gain. 
According to our methodology, it is a gain. If you hire us, 
bring us in, pass money, we will do your books and we will make 
sure that is a gain. You would see standards fall precipitously 
across the industry.
    Accountants can't really do that. And moreover, because 
there is a minimum standard, if they do deviate from that, it 
is a clear case of fraud or liability. That is one of the 
reasons I think you do see some fraud cases, but it is very 
clear when fraud has occurred, and you can take action in those 
cases.
    Chairman Towns. The gentleman's time has expired.
    I now yield 5 minutes to the gentleman from Illinois, Mr. 
Quigley.
    Mr. Quigley. Thank you, Mr. Chairman.
    Mr. Cantor, you began by talking about some of the 
improvements you thought your firm had made in the last year. I 
guess you would specifically talk about changes in methodology, 
your expertise would be methodology. Can you specify from where 
we were at a year ago how your firm has changed or 
methodologies that they no longer use that someone might have 
questioned at that time?
    Mr. Cantor. Well, I will point out two examples.
    Mr. Quigley. I am sorry. Could everybody move their 
microphone closer because, especially over here, it is just 
very hard to hear.
    Mr. Cantor. I will point to two examples of changes in 
methodology that reflect some of the lessons learned from the 
crisis. One of the big surprises in the crisis was that real 
estate markets, mortgage credit quality declined extremely 
rapidly across the entire Nation within a very short period of 
time, and the ability to refinance a loan, which had been 
generally widely available, would suddenly disappear in nearly 
a blink of an eye.
    This was a change in the environment for mortgage credit 
that was beyond the range of our expectations. We consider a 
lot of scenarios, some of them positive for the outlook for 
mortgage credit quality; many of them negative. And we have a 
whole distribution of scenarios that we are contemplating when 
we evaluate the risk of a mortgage-backed security.
    But the particular experience of the last few years was 
outside that range. We were not alone in being mistaken about 
this. Most observers of the market, I would say nearly all 
observers of the market, were completely surprised by what 
happened.
    But having said been so surprised in this particular 
instance, we recognize now that in all our methodologies, we 
must allow for a greater possibility that outcomes well beyond 
our normal range of expectations could be realized in a short 
period of time. So that is one area of change.
    The other area of change would be in our expectations of 
what issuers of mortgage-backed securities would be providing 
to us when we rate a mortgage-backed security. While it has 
been standard always for issuers of mortgage-backed securities 
or their underwriters to provide representations and warranties 
that the loans underlying the mortgage-backed security met 
certain minimum criteria or were described accurately in their 
offering documents, the ability to enforce those 
representations and warranties was not as strong as it turned 
out was needed to make them effective.
    We are now requiring much stronger representations and 
warranties, so if a loan defaults underlying a mortgage-backed 
security, and it is then discovered that loan was 
misrepresented in terms of its initial credit characteristics, 
such as whether income verification had been undertaken by the 
originator, that loan would have to be bought back by the 
underwriter and the issuer and investors would not lose any 
money as a result.
    Mr. Quigley. There were new plans. There were new creative 
ways of pooling mortgages together that were presented to the 
rating agencies. And it was described as financial alchemy that 
somehow a bunch of lower-rated mortgages bundled together and 
then some sort of wand match waved over them and the package as 
a whole was given a higher rating.
    You know, are products like that given much greater 
scrutiny? Or is that process not allowed at all in your firm?
    Mr. Cantor. Products that have a subprime collateral or 
low-rated collateral are given greater scrutiny than they had 
in the past because it has been revealed that the performance 
of those loans, while we always recognized the performance of 
those loans were going to be worse than higher quality loans, 
we hadn't anticipated the suddenness with which we could have a 
radical change from the historical experience associated with 
those loans and a simultaneous defaulting across all of them at 
once.
    Mr. Quigley. All right. I am running out of time.
    Mr. McCleskey, if there is time, as it relates to municipal 
bonds. Your concern is primarily the fact that the process 
isn't reviewed often enough? Or are there processes similar to 
the ones that have been described last year and the succeeding 
year, are there still, are there questionable practices as well 
as to how municipal bonds are reviewed at the same time?
    Mr. McCleskey. My concern was with respect to the frequency 
of the review.
    Mr. Quigley. You didn't review and find anything that was 
similar to the alchemy that has been talked about previously?
    Mr. McCleskey. No, sir. The municipal bonds tend to be a 
bit more straightforward than these complex products.
    Mr. Quigley. Very good. Thank you.
    Chairman Towns. The gentleman's time has expired.
    Congressman Chaffetz from Utah.
    Mr. Chaffetz. Thank you, Mr. Chairman.
    And thank you all for being here.
    Mr. Chairman, let me just note at the beginning that I too 
would echo the sentiments of our ranking member and the need to 
dive deep into the Friends of Angelo and Countrywide program. I 
would hope and encourage at the very least, Mr. Chairman, is 
that something that we could potentially vote on in this 
committee in terms of being with the offer, or go after those 
subpoenas?
    Chairman Towns. As indicated early on, the Justice 
Department, I understand, is seriously looking at it and we do 
not want to interfere with what the Justice Department is 
doing. But I understand your concern, and I respect the fact 
that you----
    Mr. Chaffetz. Thank you, Mr. Chairman. This committee has 
done an admirable job in a bipartisan way to dive into issues 
of great importance. It is just my way of saying, as one Member 
on the minority side of the aisle here, that this would be 
important and certainly encourage that.
    Let me get right to Mr. Cantor. Over the last 24 months, as 
you look at this, did Moody's succeed or fail over the last 24 
months?
    Mr. Cantor. In the years leading up to the crisis----
    Mr. Chaffetz. No, I am just looking at the last 2 years 
here. Do you think you have succeeded or failed?
    Mr. Cantor. Well, the ratings that were put in place in 
2006 and 2007 on mortgage-backed securities did not perform as 
we expected.
    Mr. Chaffetz. Is that a----
    Mr. Cantor. They performed worse than we expected, much 
worse.
    Mr. Chaffetz. You are a rating agency. How would you rate 
yourself?
    Mr. Cantor. We were deeply disappointed in the performance 
of those----
    Mr. Chaffetz. But how would you rate yourself? I mean, what 
kind of----
    Mr. Cantor. We would not give a high grade to this 
performance in this sector. We were deeply disappointed.
    Mr. Chaffetz. You said earlier in your testimony, I was 
listening here, in response to one of the questions. It was 
about competition, saying that you would encourage and want 
competition. What are you suggesting, then, that we do with the 
nationally recognized statistical rating organization, the kind 
of oligopoly that you have? Are you suggesting we break that 
up? Or are you suggesting that we allow more people to compete 
and more institutions to compete? When you say you are in favor 
of competition, what does that really mean?
    Mr. Cantor. We welcome additional competition. If the SEC 
wishes to approve additional NRSROs, we would favor that.
    Mr. Chaffetz. Do you think you have too much of a grip and 
a stranglehold on that process, in being able to--and this 
oligopoly that exists between the different agencies?
    Mr. Cantor. I don't think we have any influence on that 
process. We don't have any influence on the SEC's process.
    Mr. Chaffetz. But, I mean, you say on the one hand you want 
more competition. On the other hand, and you say that you give 
yourself a, you know, not a very high grade. Is that compatible 
with the current model that we have with the NRSROs?
    Mr. Cantor. Right. Well, I think we had a lot of company in 
failing to anticipate the depth of the mortgage crisis. So I 
expect when investors look at our ratings and think about their 
utility, they are reflecting on the long historical track 
record that we have, the performance of our ratings in the 
corporate sector, in the municipal sector, and other sectors 
during this crisis. And it is not limited to the performance of 
mortgage-backed and mortgage-related securities.
    Mr. Chaffetz. You said that you are increasing the scrutiny 
that is going on within the marketplace. I think I heard you 
say that correctly. How many employees do you have now versus, 
say, 2 or 3 years ago? Do you have more employees or less 
employees?
    Mr. Cantor. We have a few more employees.
    Mr. Chaffetz. Like a few more--help me with the numbers 
here.
    Mr. Cantor. I am really not that familiar with the head 
count numbers. I know we have had some expansion in our overall 
staffing during a period in time when the volume of activity 
has gone significantly down. So during a period of actually 
reduction in the business, we have actually added employees.
    Mr. Chaffetz. For the people that you are responsible for, 
give me a sense of how many people that is. Do you have more?
    Mr. Cantor. In my area, the size of the Credit Policy Group 
has doubled from roughly 25 to over 50. We are a key part of 
our initiatives to improve the ratings quality, so it has been 
a particular focus. And I am regularly asked by my boss, do I 
have the resources I need, and if I need more, I have been able 
to get it in all cases.
    Mr. Chaffetz. Thank you. Let me keep going. My time is so 
short.
    Did you see CNBC's House of Cards?
    Mr. Cantor. No, I did not.
    Mr. Chaffetz. You have not watched that program?
    Mr. Cantor. I did not.
    Mr. Chaffetz. I would be interested to hear your reaction 
if you have seen that.
    Let me go specifically to the two gentlemen that are to 
your right.
    Did Moody's retaliate against Mr. Kolchinsky in September 
2007 after he raised his concerns that the company implement 
its planned downgrade policy for the subprime CDOs, the 
collateralized debt obligations? Did you or did you not 
retaliate against him?
    Mr. Cantor. [inaudible] me?
    Mr. Chaffetz. Yes.
    Mr. Cantor. Mr. Kolchinsky's allegations have been 
investigated and have been found to have no merit.
    Mr. Chaffetz. So why was he transferred and his salary cut 
after he raised these concerns?
    Mr. Cantor. I am not familiar with the personnel decisions 
that were made, and I am certainly not familiar with Mr. 
Kolchinsky's salary.
    Mr. Chaffetz. You don't have any first-hand knowledge of 
why he was transferred?
    Mr. Cantor. I know there was a reduction in staff in his 
area within Moody's. It was an area that----
    Mr. Chaffetz. And he just happened to be the guy that----
    Mr. Cantor. This was--he was the manager in charge of 
rating the mortgage-backed, mortgage-related securities from 
2005 to 2007, I believe, and that area was the area of the 
poorest performance of our ratings, and it was an area that 
wasn't going to see hardly any activity going forward.
    Mr. Chaffetz. So is that the extent of your first-hand 
knowledge? And may I ask you please if there is additional 
first-hand knowledge that you have as to why he was transferred 
and why this happened, that you provide it to this committee.
    Mr. Cantor. That is the extent of my knowledge, totally.
    Mr. Chaffetz. Did Moody's eventually adopt Mr. Kolchinsky's 
recommended policy after his transfer?
    Mr. Cantor. I know there was a policy recommendation made 
before, I am not sure when it was. Before or after his 
transfer, he made one policy recommendation that was 
communicated I think to Compliance, maybe to others. It was 
carefully considered and it was adopted, yes.
    Mr. Chaffetz. So it was.
    Mr. Cantor. Yes.
    Mr. Chaffetz. So he did give some good advice. Interesting. 
OK.
    Mr. Kolchinsky, did the SEC ever respond to you when you 
contacted them about our allegations of misconduct at Moody's?
    Mr. Kolchinsky. They did. They contacted me last week.
    Mr. Chaffetz. Just last week? So after this hearing was 
announced, you got contacted.
    Mr. Kolchinsky. Yes.
    Mr. Chaffetz. That is amazing. I am just absolutely amazed.
    In your opinion, does the SEC's failure to respond to your 
allegation shed any light on the agency's ability to police the 
credit rating agencies, as some in the administration has 
advocated?
    One of the concerns, Mr. Chairman, that we have, and now my 
time is up, is that here we have an agency that is failing to 
police and dive into instances of alleged abuse, when you have 
whistleblowers like these gentlemen here who have stepped up 
and done what is essentially the right thing, and trying to 
shed light, and yet they only respond the week before this 
committee actually calls them to testify.
    So I know my time is expired, but I thank the chairman.
    Chairman Towns. Thank you very much. The gentleman's time 
has expired.
    I now call on Mr. Foster of Illinois.
    Mr. Foster. Thank you, Mr. Chairman, for holding this 
important hearing.
    One of the major problems that we are wrestling with here 
are the conflicts of interest inherent in the issuer-pays 
business model for the rating agencies. And I agree with Mr. 
Kolchinsky that the best analog of this is how we handle 
conflicts in the oversight of the accounting industry. And I 
believe that the best model for going forward may be 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 the powers to set standards, 
to mandate disclosures. It could conduct spot checks and 
investigations. It could impose civil fines. It could ban firms 
and individuals from the credit rating industry.
    I believe that the PCAOB has been necessary and sufficient 
to restore credibility to the accounting industry in the post-
Enron era. And so my question is: What, if any, might be the 
downside of instituting a similar oversight board for the 
credit rating industry?
    I guess I will start with Mr. Kolchinsky.
    Mr. Kolchinsky. Sir, the only downside I can see from that 
would be the argument of homogeneity of the ratings. In 
practical terms, that is not much of a downside because with 
ratings shopping and the bankers in charge of selecting which 
ratings agency to go to, they were effectively, there were very 
few differences between ratings.
    So theoretically, that would be a downside, but in 
practical purposes, that was already the practice.
    Mr. Foster. So your reservations are that it might not be a 
complete solution, but that there would be no----
    Mr. Kolchinsky. It would not be a complete solution.
    Mr. Foster. Right.
    Mr. Kolchinsky. There is no perfect solution to this 
problem, but I think this is something that allows competition 
between ratings firms. It allows some minimum standards for the 
protection of taxpayers and investors. And it allows things to 
be done in a public transparent matter, instead of being done 
in backrooms or committee rooms at the rating agencies.
    Mr. Foster. All right. So in general, you would endorse 
that way forward?
    Mr. Kolchinsky. Very strongly. Yes, sir.
    Mr. Foster. Mr. McCleskey.
    Mr. McCleskey. Sir, the model that you describe also sounds 
analogous to FINRA, which was NASD when I worked there. I 
worked there for 5 years as an investigator, and I have to say 
that I am supportive of that model for the reasons that you 
have already mentioned.
    I think that you are able to draw on more experience. You 
are able to pay people more than on government scale when you 
have essentially a self-regulatory organization.
    Now, I would point out that in essence the SEC backstops 
FINRA, that there are some shared jurisdiction. And I think 
that is a good model as well. The SEC also provides oversight 
of the self-regulatory organizations, and I think that should 
be a legitimate role of such an organization. So I would agree 
it is not a complete solution, but I would say that it would be 
helpful.
    What is the downside? I would say, you know, it has to be 
funded, but you know, some things, you know, my view, having 
been in this business for quite some time, is sometimes 
regulation does cost money. It is a cost of doing business.
    Mr. Foster. Pure industry self-regulation did not stop the 
Enron scandals and so on. And that would be the advantage of 
making it somewhat less than pure industry self-regulation.
    Mr. Cantor.
    Mr. Cantor. In the list of powers that you would ascribe to 
this new entity, it seemed to me that most of those powers 
already reside with the SEC, and I would leave it for others to 
decide where those, you know, what type of organization is best 
able to implement those powers. But I would support and 
continue to support the type of powers that you describe, with 
the exception of a proposal I thought I heard you say to 
establish essentially standards for methodologies, which would 
basically introduce a government agency or a government-type 
agency into the opinion-setting process and effectively stifle 
diversity of opinion and would lead to essentially, eventually 
lead to government-based ratings, not privately determined 
opinions.
    Mr. Foster. I understand. That is an issue that I am 
personally conflicted on. You know, there is the usual debate 
about discouraging innovation versus setting standards. And I 
think there is certainly merit that at least part of what gets 
reported is based on standards that can be compared side by 
side for all rating agencies.
    Anyway, thank you and I yield back.
    Chairman Towns. Thank you very much.
    I now yield 5 minutes to the gentleman from Indiana, Mr. 
Souder.
    Mr. Souder. I thank the chairman, and I want to join with 
the other Republicans. I know you are fair. You try to work 
these things out, to have a Friends of Angelo hearing. I 
understand the Justice Department is looking at it. They look 
at a lot of things that we do, but it appears if we don't do a 
hearing on that very public subject that we are afraid to touch 
it because it might have involved Members of Congress. And I 
would encourage the chairman to continue to look at and I would 
appreciate if he would do so.
    Chairman Towns. I appreciate the gentleman's concern.
    Mr. Souder. I have a couple of general comments I want to 
make, and then a couple of very direct questions that I fear I 
am not going to be able to get an answer to.
    One is that I don't view this as a failure of capitalism. 
Part of the problem here is, as Mr. Issa said, is when you have 
three companies that have 90 percent of the market, how does an 
oligopoly work versus a true competition? And that is really 
what we are kind of probing in these hearings, because the 
function of this committee is to look at the past. We are an 
oversight committee. Other legislative committees look at the 
future.
    So Mr. Cantor, when you say we have made changes, that 
isn't really enough right now. We have to dig in and find out 
what happened to see whether those changes are adequate. We had 
this discussion with Mark McGwire who didn't want to be here to 
walk about the past, but we had to understand steroids before 
we could talk about what we were going to do in the future.
    And that the whole fundamental premise of capitalism 
requires accurate information. We believe capitalism can 
regulate itself if in fact ratings are accurate, information is 
there, and can do that. But in the failure to do that, which 
clearly there were whoppers of errors here, we had five 
billionaires on the panel here.
    When I asked Mr. Paulson, who made the most that year, $3.7 
billion, how did you make the money, how did you make that 
much, because it seemed to me a lot of the evidence of the 
housing bubble was there, he said, ``I bet against all the 
people who were going the other direction.''
    That is how they made $1 billion that year because they 
could figure out that the market was about to collapse, and why 
couldn't the rating agencies figure that out, which are more 
for the average person is likely to buy based on the rating 
agencies. And that suggests that very sophisticated analysts 
could get different information or had either access to 
information or understood information differently than the 
basic bond rating agencies.
    Now, Mr. Issa raised another fundamental question, and Mr. 
Cantor, you gave two things that have been frustrating to this 
committee. One is we never seem to have the right person there 
to answer the questions. And the second part is that in the 
legal question, it was said by Mr. McCleskey, I think, in his 
testimony, says there may be civil lawsuits here. And part of 
the problem in getting all the information is that if you have 
pending lawsuits, just like in the case of Friends of Angelo, 
the No. 1 thing that people in my District want to know, is if 
there was corruption or if there was collusion or withholding 
information, did people go to jail? That is the No. 1 thing. 
They don't want our committee to trample on that.
    But the chairman may have to call some people in to let the 
American people see that there is a refusal to answer the 
questions because, in fact, there is an investigation, because 
my fundamental question is, in Mr. McCleskey's charge, for 
example, that it was 15 to 20 years that some of these agencies 
hadn't been reviewed for public securities of cities and towns 
and so on. Is that true? And have you submitted emails to 
suggest that you had a debate about that?
    Mr. Cantor. You want to know what are, describe our 
surveillance practices for U.S., local and regional 
governments?
    Mr. Souder. In other words, have you submitted evidence to 
this committee that suggests that he was factually incorrect?
    Mr. Cantor. I haven't seen the particulars of what Mr. 
McCleskey has been asserting, so I don't know whether it is 
correct or not correct.
    Mr. Souder. Mr. McCleskey, you made the allegation here 
today in your testimony. Have you ever seen any evidence that 
suggests you were incorrect in your allegation that they hadn't 
reviewed these securities in many years?
    Mr. McCleskey. No, sir. I think that by the time I left, 
there were some discussions about how to improve it, but that 
as I recall there were still a lot of problems out there. And 
the simple fact of the matter is that you have tens of 
thousands of these things out there.
    In my view, the only way that these can be reviewed at all 
is through algorithms that will pop up alerts, the same way 
that we do in a lot of other compliance and regulatory matters.
    Mr. Souder. Let me ask you a broader question here, because 
both of you have made allegations. You were whistleblowers. You 
have a track record of that. The company is responding that you 
were inaccurate; that for one reason or another your department 
wasn't performing well. That is why you were terminated. It 
wasn't anything to do with being whistleblowers.
    Well, the only way to check that is because they claim that 
there was internal debate, and you claim there wasn't internal 
debate. One of the only ways this committee can verify whether 
there was an internal debate is to get documents from the 
company that prove that there was an internal debate. And to my 
knowledge, we don't have those documents.
    And the question is, is the reason we don't have those 
documents is because this is about a lawsuit that if, in fact, 
we found that there were no such documents, that the company 
would be vulnerable to lawsuits because it would show that 
there wasn't any internal debate.
    Do you believe such documents exist anywhere in the system? 
Or have any knowledge that once it matches up, that they had a 
debate and your argument was rejected, as opposed to the fact 
there wasn't a debate, and that is why you were filing your 
complaints?
    Mr. McCleskey. Well, I think, as I said before, the problem 
is: Was anything documented? So there may be, whether there is 
a debate or not, the question of whether people could provide 
you documents may be a different issue, whether documents were 
actually created.
    Mr. Souder. Mr. Chairman, this is a very critical point 
because if they can, because the basic establishment question 
here is that the whistleblowers' charges were just their 
opinion, and that in fact there was a robust debate and their 
opinion was rejected, and they just made a bad decision about 
what was happening in the market.
    Whereas the counter-argument that would say the government 
does it is basically saying that there was corruption involved. 
And if there is a civil lawsuit threat here, we may not get 
those documents. But if there is proof that they actually had 
an internal debate and they just made a bad decision, that 
would affect what we would propose legislatively.
    I yield back.
    Chairman Towns. Good point, and that is why we would ask 
Mr. Cantor to make certain that we get the documents. I mean, I 
think this is so important. There was a meltdown and we are 
really trying to get to the bottom of it, and we need your help 
in the process.
    When we look at the fact that Lehman Brothers was rated 
AAA. AIG was AAA. And then all of a sudden, look what happened? 
So it is important that, you know, we know. And I am hoping 
that you will cooperate, you know, or maybe you feel there is 
no problem.
    Do you feel there is a problem?
    Mr. Cantor. Problem with what?
    Chairman Towns. You don't think there is a meltdown? I 
mean, you have heard of that, haven't you?
    Mr. Cantor. The financial crisis has been severe.
    Chairman Towns. Yes. And you don't see that you had a role 
in it in terms of the rating agencies?
    Mr. Cantor. During the buildup to this financial crisis, 
there was a whole chain of events and participants in the 
market of which we were one that made poor decisions and did 
not perform as expected. I think we were not alone, and I don't 
think we were the biggest and most important player in this, 
but we did misjudge the extent of the coming meltdown in 
mortgage-related securities.
    Chairman Towns. So that is the reason why we need the 
documents.
    Congresswoman Speier from California.
    Ms. Speier. Thank you, Mr. Chairman.
    Mr. Cantor, I have probably sat in on 200 or 300 hours of 
hearings in the last year on the financial services industry, 
and I come to one simple conclusion. The financial service 
industry has basically created this structure so that heads 
they win, and tails the American people lose.
    And it all comes down to something so very basic. Let's 
start with Lehman's. You rated them as AAA. $2 billion was lost 
in Lehman's AAA securities by cities and counties throughout 
this country, money that they were setting aside because they 
were about to do constructions on schools and firehouses and 
the like. And it was just up in air. Poof.
    The American people really want to have some level of 
accountability. And I want to ask you if you took action or 
Moody's took action against anyone who had rated Lehman's as 
AAA. Was there any disciplinary action taken against anyone?
    Mr. Cantor. Lehman was rated A and was rated through a 
rating committee process. There were no actions taken against 
anyone involved in that process, that everything that was done 
was according to our codes of conduct, and there was no basis 
for doing----
    Ms. Speier. If nothing was done to anyone who rated 
Lehman's as an A when it was bankrupt, then something is wrong 
with your methodology.
    Now, isn't it true that a couple of years ago your 
industry, and Moody's was part of it, came to Congress and 
said, we want to be regulated, but we want you also to pass a 
law that provides that no private right of action can be 
brought against us as rating agencies.
    Mr. Cantor. I don't recall any such thing. We currently are 
subject to securities law, and we are subject and can be sued, 
and have been sued.
    Ms. Speier. But no individual private rights of action?
    Mr. Cantor. Again, I am not an expert in legal matters. My 
understanding is there are private rights of action.
    Ms. Speier. All right. Let me ask you about this. In Mr. 
Kolchinsky's internal memo to Moody's executives, he said that 
the assigned ratings in the Sahara Finance EUR, Limited were 
clearly wrong. In fact, Mr. Kolchinsky then urged Moody's to 
stop a related transaction from adding billions of more toxic 
assets to investment balance sheets.
    I guess the first question should be to Mr. Kolchinsky. Did 
Moody's take any action?
    Mr. Kolchinsky. Ma'am, I do not believe the second 
transaction was rated, as far as I know.
    Ms. Speier. Was not rated?
    Mr. Kolchinsky. Was not rated. So the second transaction 
that I warned about----
    Ms. Speier. And the first was rated, and it was rated at 
what?
    Mr. Kolchinsky. I do not recall at this point. It was an 
investment-grade rating, but I don't recall off the top of my 
head.
    Ms. Speier. Mr. Cantor, do you recall?
    Mr. Cantor. I believe this transaction was rated and was 
rated AA three.
    Ms. Speier. AA three. And then what happened to this 
particular transaction?
    Mr. Cantor. It is currently rated AA three.
    Ms. Speier. It still is rated as----
    Mr. Cantor. Its rating hasn't changed.
    Ms. Speier. I am sorry?
    Mr. Cantor. Its rating has not changed.
    Ms. Speier. Its rating has not changed. And the subsequent 
transaction was not rated. And why was it not rated?
    Mr. Cantor. I am not familiar with the specifics of that, 
so I can't address it.
    Ms. Speier. All right. Let me ask you this. One of the big 
problems that some of us see is that there is a huge conflict 
of interest, that issuers come to you and ask you to give them 
consulting services so that when they package their particular 
issuance, it will be rated highly. So much like the accounting 
industry where we put firewalls up, many of us suggest that you 
should have firewalls between your consulting services and your 
rating services.
    It also appears that your compliance staff reports to your 
general counsel, and the general counsel's responsibility is to 
prevent liability for Moody's. But the compliance officers are 
there to make sure that Moody's is complying with all the SEC 
regulation. So it would suggest that you have on the one hand 
compliance officers who are supposedly making sure that you are 
following SEC guidelines, reporting to an individual as general 
counsel who wants to make sure that you have no liability, so 
there will be a conflict, just very significant. Has that 
particular structure----
    Mr. Cantor. I believe on the contrary. The general 
counsel's role is to avoid liability exposure for the company 
and there is no better way to avoid liability than to have your 
employees comply with your regulations and code of conduct.
    Ms. Speier. Well, Mr. Chairman, my time has expired, but I 
can't understand how you could take qualified people in your 
compliance section, dump them, and bring people who don't have 
any expertise in compliance and place them in that role under 
the general counsel unless you were really trying to avoid 
having people who were going to ask questions about how you 
were doing business.
    I yield back.
    Chairman Towns. Thank you very much.
    I now yield to the gentleman from Virginia, Congressman 
Connolly.
    Mr. Connolly. I thank the chairman, and I thank him for 
this thoughtful hearing.
    Well, let me pick up on the last exchange between the 
gentlelady from California and yourself, Mr. Cantor. You said 
the best way to avoid liability is to make sure you comply. Is 
there some reason, our staff were briefed this morning about 
the Kramer Levin review, which I guess you were referring to 
when you said that the allegations put forward by Mr. 
Kolchinsky were investigated and found to be baseless. Although 
it is my understanding that, a), that review is not complete; 
and that b), the entirety of this review will be oral. It will 
not be put in writing. Is there a reason for that?
    Mr. Cantor. We discussed earlier the communications around 
and documentation around that investigation. I will communicate 
the wishes of this committee to our legal counsel and I expect 
they will be able to comply with any request that comes from 
the committee.
    Mr. Connolly. Well, that is really not my question. Is 
there a reason why, I mean, this strikes me as quite unusual 
that a review of charges of fraud by your outside counsel 
would, in fact, not be in writing. And apparently, Kramer Levin 
indicated it is not going to be put in writing.
    Mr. Cantor. I am not familiar with whether there will be a 
written report or not.
    Mr. Connolly. Are you familiar with the fact that it is or 
is not the practice of Moody's to give such instructions to 
outside counsel?
    Mr. Cantor. I am not familiar with the instructions that we 
have given in these cases. My role as the chief credit officer 
is to review the methodologies and the quality of the ratings.
    Mr. Connolly. Do you remember any outside counsel ever 
investigating anything at Moody's in the past? Anything strike 
you in terms of a review and whether it was put in writing or 
not?
    Mr. Cantor. I have not been part of a process of a previous 
external review.
    Mr. Connolly. Well, all right. Sticking to the same sort of 
seeming penchant for secrecy, Mr. McCleskey, in your letter to 
the SEC, you said that John Goggins, the general counsel at 
Moody's, told employees not to put any compliance or rating 
problem in emails or any other written form. Why would he give 
such instructions, do you think?
    Mr. McCleskey. Well, sir, the first thing I would say is I 
didn't have that directly from John Goggins because I had very 
few conversations with John Goggins at all. Everything came 
through Michael Kanef. And although Mr. Goggins, the general 
counsel, was my second-level supervisor, and although he spent 
considerable time with the other person at my level, in the 
almost year that I was underneath him, he did not set foot in 
my office a single time.
    Mr. Connolly. Well, irrespective of whether it was Mr. 
Goggins or not, was it in fact your understanding generally, 
company-wide, don't put anything in writing?
    Mr. McCleskey. That was definitely communicated.
    Mr. Connolly. And why do you think that was generally 
communicated?
    Mr. McCleskey. Well, my speculation, sir, would be really 
going back to the point that was raised earlier. You have two 
different comparatives, if you will, between compliance and 
legal departments that are concerned about liability. In 
compliance, you need to document when you see a problem. You 
need to document what you did about it, because if it is not 
documented, it didn't happen in the eyes of the regulators.
    Mr. Connolly. Yes.
    Mr. McCleskey. So if we would see something, we would want 
to document it. From a liability point of view, at least 
theoretically, you don't want to have documents lying around.
    Mr. Connolly. Let me ask you, Mr. McCleskey, at any points 
did superiors at Moody's tell you not to talk to SEC 
investigators during the SEC sweep investigation?
    Mr. McCleskey. Nobody ever directed me not to talk to the 
SEC.
    Mr. Connolly. So we do have secrecy, well, or at least a 
desire to avoid putting things in writing, whether it be 
outside reports about fraud allegations or whether it be 
anything that could be traceable by the SEC, apparently built 
into the culture. Would that be a fair characterization, in 
your opinion?
    Mr. McCleskey. Yes, sir.
    Mr. Connolly. Mr. Cantor.
    Mr. Cantor. I am sorry. What was the question? That we have 
a secrecy culture?
    Mr. Connolly. I guess I am asking you to comment as to 
whether there is this culture of the avoidance of having 
anything traceable in writing, even to the extent, as I asked 
you earlier, about an outside counsel report on an allegation 
of fraud, from Mr. Kolchinsky which, by the way, earlier you 
assured us was baseless based on a report that is not completed 
and not in writing, and then you told us, well, I am not 
familiar with past history or why it might not be in writing. 
You were confident enough to cite it as exonerating, but not 
confident to talk about the details of whether it is in writing 
or not.
    Mr. Cantor. Moody's conducted its own internal review and 
reached that conclusion. The preliminary findings of the 
outside law firm confirms those findings.
    Mr. Connolly. Was the Moody's internal review in writing? 
Is that something you can share with the committee?
    Mr. Cantor. I have not reviewed anything. There may be a 
document. I don't know.
    Mr. Connolly. Well, if you haven't reviewed it, sir, how 
can you speak with such confidence before this committee under 
oath that internal review can be trusted?
    Mr. Cantor. Because I spoke with our head of compliance and 
regulatory affairs, and he discussed it with me.
    Mr. Connolly. I see.
    My time is up, Mr. Chairman.
    Ms. Norton [presiding]. Next, the gentleman from Florida, 
Mr. Mica.
    Mr. Mica. Thank you.
    Just a couple of quick questions, I guess to Mr. 
Kolchinsky. You made a series of allegations about Moody's 
misconduct. I believe you are the one who made those 
allegations in a letter to the SEC. What was the basis of your 
allegations? I mean, you saw things that were going on and then 
you thought it was your responsibility to report to SEC what 
you saw going wrong. So what did you see wrong at what point, 
and when did you notify the SEC?
    Mr. Kolchinsky. Sir, my first report was to the Compliance 
Group about----
    Mr. Mica. I am sorry?
    Mr. Kolchinsky. My first report was to the Compliance 
Group. I put it into----
    Mr. Mica. In writing?
    Mr. Kolchinsky. In writing. It was a 14-page memorandum.
    Mr. Mica. And did they respond to you?
    Mr. Kolchinsky. As far as I know, they hired Kramer Levin 
and also suspended me.
    Mr. Mica. They what?
    Mr. Kolchinsky. They suspended me.
    Mr. Mica. The company suspended you.
    Mr. Kolchinsky. Yes, sir.
    Mr. Mica. For whistleblowing?
    Mr. Kolchinsky. That is my belief, yes.
    Mr. Mica. OK. But you never got a written response from SEC 
to this date?
    Mr. Kolchinsky. Sir, after I was suspended, I reached out 
to the SEC to make them aware of these violations. I spoke to 
them last week, and we are planning on meeting so I can discuss 
further with them.
    Mr. Mica. OK. But again, first you found that you thought 
it was incumbent on you to report what you saw as improper 
activities. And you talked to Compliance and you also wrote to 
Compliance both?
    Mr. Kolchinsky. I wrote to Compliance.
    Mr. Mica. I am sorry?
    Mr. Kolchinsky. I wrote to Compliance.
    Mr. Mica. You wrote. OK. And you never had gotten a 
response?
    Mr. Kolchinsky. I, as we discussed previous, everything was 
mostly done by phone call. So I received a phone call.
    Mr. Mica. They called you in response to your letter?
    Mr. Kolchinsky. They called me and they said they are 
bringing in Kramer Levin and somebody from Kramer Levin will be 
in contact with me. All communications from them were verbal.
    Mr. Mica. So how did Moody's find out about what took 
place?
    Mr. Kolchinsky. I handed Michael Kanef the memo that I 
wrote.
    Mr. Mica. OK.
    Mr. McCleskey, you also reported wrongdoing. Did you report 
that to the SEC?
    Mr. McCleskey. Sir, I sent a letter after my departure to 
the SEC. It is probably going too far.
    Mr. Mica. I am sorry. For some reason, I couldn't hear you. 
You sent a letter?
    Mr. McCleskey. I am sorry. I sent a letter to the SEC after 
my departure.
    Mr. Mica. After your departure?
    Mr. McCleskey. Yes, sir. And I don't think I would 
characterize it as necessarily whistleblowing with respect to 
wrongdoing. I wanted to flag an issue to them to make sure that 
they were aware of it when they were preparing to conduct their 
examinations.
    Mr. Mica. Was your departure voluntary?
    Mr. McCleskey. No, sir.
    Mr. Mica. So they terminated you. Did they cite the cause 
for which you were terminated?
    Mr. McCleskey. No, sir. All they did was they said that 
senior management had lost confidence in me.
    Mr. Mica. Had you had any contact with SEC or any other 
individuals in reporting activities before the letter that you 
sent after you departed and were dismissed?
    Mr. McCleskey. I did not have any contact with the SEC 
prior to my departure.
    Mr. Mica. Or anyone else who you reported whatever 
activities you thought should have attention of a regulatory 
body?
    Mr. McCleskey. No, sir. I don't think my departure was 
directly related to any whistleblowing.
    Mr. Mica. OK. And did you get a response to your comments 
that you made for attention to SEC after you were terminated 
and departed?
    Mr. McCleskey. They sent me an email confirming receipt and 
said they were considering what to do about it.
    Mr. Mica. OK.
    Mr. Cantor, why should the Federal Government continue to 
grant Moody's and other big credit rating agencies a protected 
oligopoly by requiring financial institutions to rely only on 
your ratings?
    Mr. Cantor. Moody's favors the reduction and elimination of 
the use of ratings in regulation, so we do not favor it.
    Mr. Mica. So you feel that others could be involved in the 
process?
    Mr. Cantor. Yes.
    Mr. Mica. Do you think Congress should regulate that 
process?
    Mr. Cantor. There is currently a draft bill that has been 
prepared in Congress to remove the use of ratings in many 
government legislation and regulations.
    Mr. Mica. How do you think that should be structured? You 
don't have to comment on the bill that is before us, but what 
would be a fair way to have, say, some competitiveness in 
credit rating, but also keep a high standard of rating?
    Mr. Cantor. Right. Well, I think in addition to reducing 
the regulatory reliance on ratings, the field of competition in 
the market could be improved by enhancing the financial 
disclosures required by issuers of structured finance 
securities.
    At present, given the limited disclosure requirements in 
that market, only rating agencies that have been asked to rate 
those securities have the full access to all the information 
that might be needed to evaluate the risks of those securities. 
And we recommend that the SEC require more extensive financial 
disclosure, much as is required of corporations in America when 
they issue debt into the capital markets.
    And that way, multiple rating agencies, not just the 
ratings agencies asked to rate the debt, and multiple analysts 
from different types of firms, can do their own analysis and 
choose to publish that analysis if they wish to monetize their 
conclusions or just provide for some other reason that 
information to the broader marketplace.
    Ms. Norton. The gentleman's time has expired.
    I will take 5 minutes.
    I am curious before I ask a question about the Compliance 
Group that fascinates me, this internal watchdog. Given the 
blanket dependence, I would say of the Nation. It is hard to 
think of an institution, or for that matter, individuals that 
weren't dependent upon these credit agencies. Given the source 
of their revenue, has the fall, the collapse of the economy, 
had an effect on the revenue of Moody's, or for that matter, if 
you know of any of the other rating agencies?
    Mr. Cantor.
    Mr. Cantor. Moody's has had significant decline in revenue 
over the last 2 years, yes.
    Ms. Norton. Why is that? Is it because people aren't, those 
who fund them, which of course those whom they regulate, as it 
were, or who we depend upon them, is it because they go less 
often to the rating agencies? Why has the revenue fallen?
    Mr. Cantor. We have had fewer requests for ratings.
    Ms. Norton. Sorry?
    Mr. Cantor. We have had fewer requests for ratings.
    Ms. Norton. So people are out there on their own? There is 
nobody watching. If you can say they were watching, there is 
nobody watching now. People, does that, any of the three of you 
think that shows a lack of confidence in the agencies now, that 
revenue has fallen and folks don't regard a rating as 
particularly, or at least absolutely indispensable any longer?
    Mr. Kolchinsky.
    Mr. Kolchinsky. I think certainly the confidence in the 
rating agencies has fallen. The drop in revenue is primarily 
due to drop in revenue from structured products, and I think--
--
    Ms. Norton. Due to what? I am sorry.
    Mr. Kolchinsky. The drop in revenue in structured products. 
Those are the products, like mortgage-backed securities.
    Ms. Norton. Yes. Fewer of those products, derivatives, 
etc., to talk about or to grade.
    Ms. Kolchinsky. Yes, ma'am. And I think a lot of that has 
to do with the fact that at the time of the boom, one 
structured product would buy another structured product. So ABS 
CDO would buy subprime, and SIV would buy a part of the ABS 
CDO.
    When that chain broke, that whole market disappeared. So 
there weren't a lot of what is called in the industry ``real 
money investors'' that were actually buying these products. 
These were all moved on bank balance sheets or somewhere else 
into another structured product.
    Ms. Norton. I am fascinated by this internal watchdog. 
Internal watchdogs normally do not yield a lot of confidence, 
and one reason it is hard to set one that can yield confidence. 
We have tried here in this Congress. You know, how do you get 
enough without too much if you are, in essence, trying to do 
internal regulation of your own conduct.
    Mr. Kolchinsky, you have indicated or cast doubt upon the 
independence of Moody's' compliance Group.
    Mr. Kolchinsky. Yes, ma'am.
    Ms. Norton. Why do you believe the Compliance Group is not 
independent, in whatever the word independent can mean within 
those internal watchdog circumstances?
    Mr. Kolchinsky. Ma'am, there are several reasons. First of 
all, I believe----
    Ms. Norton. Speak a little louder into the microphone.
    Mr. Kolchinsky. Sorry. I believe there are several reasons 
for that. I believe, first, a truly independent Compliance 
Group would report up to the independent members of the Board 
of Directors. They would not have a reporting line from the 
general counsel to the CEO on the business generation.
    Second of all, I----
    Ms. Norton. So are they reporting in the same way they were 
reporting?
    Mr. Kolchinsky. I believe so. They are still reporting 
through the general counsel up to the CEO. And there is no 
scrutiny of that from the Board of Directors, or the 
independent members----
    Ms. Norton. So the same people who were reviewing their 
work are still reviewing their work, with whatever lessons the 
collapse may have taught them?
    Mr. Kolchinsky. Yes.
    Ms. Norton. Do you believe that with the same, is it the 
same chain of command, essentially?
    Mr. Kolchinsky. It is the same chain of command as I 
believe when Scott, Mr. McCleskey, was at the rating agency. 
Yes.
    Ms. Norton. So no change in the chain. And I understand the 
conundrum here. How do you change, there are only so many 
people you can report to. What would be the resistance, since 
this is a watchdog? Because it doesn't involve matters of 
ethical matters, matters of the law. You could always ask the 
general counsel to advise you.
    Mr. McCleskey, Mr. Cantor, what would be the resistance to 
reporting to the Board of Trustees who have a fiduciary 
obligation and therefore, it seems to me, are the only really 
appropriate overseers within the organization?
    Mr. Cantor. The individual that is responsible for both 
compliance and regulatory affairs, so the person in charge of 
compliance, has an additional duty as well to also liaise with 
our regulators. That person has met regularly with our Board of 
Directors, I believe quarterly, and meets with our independent 
Board of Directors.
    Ms. Norton. My time, too, is limited. I want to know why, 
as I say, I would expect him to meet. I expect the Board to 
consult with him. What reason could a rating agency offer for 
not having the report unfiltered of a violation go first to the 
Board of Directors? Then they could ask general counsel. They 
could ask outside counsel. They could ask the government.
    Why, in light of what it seems to me was the unkindest cut 
of all, the cut that came from the agencies on whom everybody 
depended, why isn't the way to restore confidence at least to 
place responsibility for notification of violations of ethical 
standards and the law, first to the Board of Trustees or to the 
Board, whatever it is called, so that it can decide whom to 
consult?
    What is the resistance and how would anybody justify 
reporting in the very same way that the chain of command 
occurred before, and that everyone agrees was an ingredient to 
the collapse of the economy?
    Mr. McCleskey. If I could respond to that question, because 
I was the person who was involved in this chain of command. The 
first distinction I would make is that the person who Mr. 
Cantor described is not the head of Compliance. The head of 
Compliance, as designated on public filings to the SEC, reports 
to Mr. Kanef. Mr. Kanef reports to the general counsel.
    Now, when I first got to Moody's, we had a different 
reporting chain and the idea was that once a year I would 
report to the Board, and in the first year, I did. After the 
chain of command changed, I did not have access to the board.
    Ms. Norton. Should you have?
    Mr. McCleskey. Yes. And to answer your question, what is 
the motivation for it, I can only speculate, but in my view, 
having been there and in that situation, it is a matter of 
controlling risk, that you have somebody there who doesn't come 
from the litigation background or has this different agenda, 
the compliance officer. I simply don't believe that it was 
viewed prudent to have the actual head of Compliance have that 
kind of access.
    Ms. Norton. Prudent? I am just looking for a reason, you 
know.
    Mr. McCleskey. It is my speculation, but it is speculation 
based on my experience.
    Ms. Norton. Yes. Finally, if one is looking at how to 
regulate this matter and one is trying to keep the government 
from getting into the weeds, would you suggest that a report 
directly to the Board might be one place to begin?
    Mr. McCleskey. I would, yes.
    Ms. Norton. The requirement of a report to the Board might 
be one place to begin?
    Mr. McCleskey. I would.
    Ms. Norton. Yes.
    Mr. Kolchinsky. Yes, ma'am.
    Ms. Norton. What about you, Mr. Cantor?
    Mr. Cantor. A report from Compliance directly to the Board 
of Directors would be something we would consider. I don't see 
a difficulty with it.
    Ms. Norton. So what was good enough before is good enough 
now. Thank you, Mr. Cantor.
    Mr. Lynch of Massachusetts.
    Mr. Lynch. Thank you, Madam Chair.
    I want to thank the witnesses for helping us with our work.
    It appears that, at least as this reform proposal moves 
forward, we are still going to have over the counter 
derivatives traded. These structured products are going to be 
traded outside of exchanges. And it appears, at least the way 
this is developing, we are still going to have an issuer-pays 
model after all this reform is done. So we are still going to 
have the conflict of interest that we have been dealing with in 
the past.
    It seems to me that if we are not going to eliminate the 
conflict of interest in the issuer-pays model, then we have to 
somehow balance that. And at least the only way I can imagine 
doing that is to introduce some type of liability on the part 
of rating agencies that stamp AAA on these structured products. 
Because the vast majority of the market, they don't understand 
deeply the mechanisms of these structured products, but they do 
understand AAA. They do. And that is what allowed a lot of 
these projects to go viral and cause problems in the first 
place.
    It seems to me that there has to be some type of underlying 
liability for the rating agency if they slap AAA on something 
that doesn't deserve it. And right now, the way we have this 
system, it is tantamount to immunity for the rating agencies, 
even though they recklessly put AAA on a product that turned 
into junk 30 days later or 60 days later or 90 days later.
    Mr. Kolchinsky and Mr. McCleskey and Mr. Cantor, is this a 
viable option of introducing some liability that might act as a 
constraint on these rating agencies from giving ratings to 
these products in return for cash? Because the rating agencies 
are also going to get extra money, they are going to get a 
bigger payday for rating these complex structured products, 
then they do the standard products.
    So how would you suggest that we eliminate this conflict of 
interest and there is liability, one of those options?
    Mr. Kolchinsky.
    Mr. Kolchinsky. Sir, I believe that extra liability should 
come hand in hand with specific defined standards. And that 
does two things. On the one hand, it helps investigators and 
regulators to see when a fraud or misconduct has occurred, 
because they can compare it to a defined set of standards. 
Today, most of these standards come from the rating agency 
itself, so the rating agency becomes the judge, jury and 
executioner of its own standards.
    Second of all, having a defined set of standards would cut 
down on frivolous lawsuits by an investor, for example, who 
just made a bad decision. So if you have a set of standards for 
some minimum sets of things that a rating agency must do, that 
is a good benchmark to see when liability or fraud has actually 
occurred or other types of negligence. At the same time, it 
prevents frivolous lawsuits from investors who just made a bad 
decision.
    Mr. Lynch. Yes. I do agree that it shouldn't be a hair-
trigger test for liability, otherwise you would have everybody 
who didn't think the instrument performed the way they wanted 
it to would have a cause of action. We don't want that.
    Mr. McCleskey.
    Mr. McCleskey. Well, sir, I would be against any kind of 
blanket immunity of the type that you are describing. I think 
that, you know, with respect to the first amendment protection 
for rating agencies, I am not a lawyer, but come on, that is 
not what the first amendment was for.
    Having said that, I would agree that if you are going to 
introduce more liability, you do need to do it in a measured 
way with some sort of controls, because we did have 
difficulties about a decade ago with a lot of frivolous 
securities lawsuits where, as you say, every time the stock 
ticked up or down and somebody lost money, off to court we 
were. So I do see that as a potential danger.
    But having said that, I am not a lawyer, but my personal 
view is that there ought to be some measure of liability.
    Mr. Lynch. Thank you.
    Mr. Cantor.
    Mr. Cantor. As we discussed today, Moody's is already 
subject to liability. We can be sued for fraud and for 
violation of securities laws. We have a number of lawsuits 
publicly announced and outstanding. So we already are subject 
to significant liability.
    What I think is most important is that there be 
accountability, and I think there is a fair measure of 
accountability, certainly in the private market, in the private 
use of ratings we are accountable. Our reputation is being 
constantly reevaluated, and our reputation is being evaluated 
now.
    It has always been the focus of Moody's management and its 
analysts on producing the highest quality ratings and 
strengthening our reputation to the maximum degree. And the 
current and recent experience, if anything, has reinforced that 
concern and the primacy of that concern in our rating 
practices.
    Mr. Lynch. Thank you. My time has expired.
    Madam Chair, I yield back.
    Ms. Norton. The gentlewoman from Ohio, Ms. Kaptur.
    Ms. Kaptur. Thank you very, very much for appearing this 
morning.
    May I ask each of you gentlemen to state for the record 
your professional qualifications? In other words, what your 
background is? Are you attorneys? Are you mathematicians?
    We can begin with the first gentleman here.
    Mr. Kolchinsky. I have an undergraduate degree in aerospace 
engineering. I have a law degree and a master's of science in 
statistics. I have worked in structured finance my entire 
career.
    Ms. Kaptur. Thank you very much.
    Mr. Cantor. I have a Ph.D. in economics. I taught economics 
for a number of years at universities, and I worked for 10 
years in the Federal Reserve system, and have been at Moody's 
for 12 years.
    Ms. Kaptur. Mr. Cantor, thank you.
    And what about Mr. McCleskey?
    Mr. McCleskey. I have a master's degree in financial 
regulation and compliance management. I also have a master's 
degree in international relations from Cambridge, where my 
dissertation concerned financial regulation. I have been in the 
markets in the United States and Europe for approximately 15 
years. I participated in the drafting of regulations and I have 
several published articles and books on the subject.
    Ms. Kaptur. All right. Are any of you gentlemen familiar 
with the term in the law control fraud?
    [Pause.]
    Ms. Kaptur. You are not? Well, if you are not familiar with 
it, then if you have been a part of it, you wouldn't know it, I 
guess, if you don't even know the term.
    Mr. McCleskey. Can you repeat the term again?
    Ms. Kaptur. Control fraud.
    Mr. McCleskey. I am not familiar with it, no.
    Ms. Kaptur. Control fraud is systemic fraud in which many, 
it goes beyond a single person, but the person participates in 
a system that is essentially fraudulent, and as a participant 
in that system causes a great deal of harm and participates in 
illegal activity.
    Let me ask you, as the housing bubble burst and 
foreclosures increased, mortgage-backed securities issued by 
mortgage brokers began to crumble, despite the AAA ratings that 
Moody's and others had placed on these issuances.
    As you look back on this, with all of your education and 
experience, how could you participate in rating particularly 
the senior tranches that had AAA ratings that collapsed? How is 
this possible? Would you please explain that? We can start, 
each one of you.
    What happened, Mr. Kolchinsky?
    Mr. Kolchinsky. I think the main part of the problem were 
was poor incentives everywhere across the board.
    Ms. Kaptur. Poor incentives?
    Mr. Kolchinsky. Poor incentives.
    Ms. Kaptur. Define that.
    Mr. Kolchinsky. You had mortgage brokers who were 
incentivized to get as many mortgages as possible, without any 
concern for the credit quality. They would be paid upon closing 
of the mortgage.
    Ms. Kaptur. Yes, but the rating you gave them, you gave 
them very favorable ratings, AAA ratings. So the paper was 
brought to you. I am asking you, though, in terms of how could 
you have been a participant and your company a participant in a 
system that collapsed? Don't blame those that brought it to 
you. Once you got it, what did you do?
    Mr. Kolchinsky. I think we over-relied on quantitative 
models.
    Ms. Kaptur. On quantitative models. I wanted to ask you for 
Moody's, how many people actually worked for Moody's prior to 
the collapse of the market?
    Mr. Kolchinsky. I don't have that information off-hand.
    Ms. Kaptur. What would you guess? Anybody?
    Mr. Kolchinsky. My guess is about 3,000; 3,000 to 4,000.
    Mr. Cantor. Yes, 2,000, maybe in the rating----
    Ms. Kaptur. 2,000, did you say?
    Mr. Cantor. In the rating agency itself, 2,000.
    Ms. Kaptur. Could you speak into the mic?
    Mr. Cantor. 2,000, I believe, maybe more.
    Ms. Kaptur. About 2,000 people. OK. How many of those 
people, then, would you, of the 2,000, Mr. Kolchinsky, your job 
was Managing Director. You were the head of it all?
    Mr. Kolchinsky. No, ma'am. I was one of four managing 
directors, one of the four managing directors within the CDO 
group. And we had about 100 people total within that group.
    Ms. Kaptur. About 100 people. Were these the people that 
were the mathematical brains that ascertained risk?
    Mr. Kolchinsky. Some were mathematicians. We had a lot of 
Ph.D.s. We had a lot of lawyers. People came from across the 
board. But that was part of the group which decided 
methodologies, built the models, and ran the models.
    Ms. Kaptur. All right. So in other words, the made big 
mistakes.
    Mr. Kolchinsky. Yes, ma'am.
    Ms. Kaptur. All right. And so it wasn't just that the 
mortgage brokers brought this paper to you, but there was a 
system set up. And explain to me internally, inside your 
company, what happened in that risk division that was so 
faulty? What happened and why did it happen?
    Mr. Kolchinsky. I think the system that existed in place 
allowed bankers and other participants to game the models that 
were set up. The models are actually very public, and what 
participants could do, could look at the models and change----
    Ms. Kaptur. When you say model, are you talking 
mathematical model?
    Mr. Kolchinsky. Yes, mathematical models, as put into an 
actual spread sheet or a piece of software or even a 
methodology. In my group in the ABS CDO Group and CDOs in 
general, those models were actually publicly available. Some 
were free to download from the Web site. But that allowed 
bankers and other participants to game those models.
    Ms. Kaptur. But who approved those models?
    Chairman Towns [presiding]. The gentlewoman's time has 
expired. I ask unanimous consent to give her an additional 1 
minute.
    Ms. Kaptur. I thank the gentleman.
    Who approved those models? Who invented the models and who 
approved them?
    Mr. Kolchinsky. It was different groups and people who were 
tasked with that. Most of them internally, based on data that 
was provided to Moody's.
    Ms. Kaptur. Did you approve them?
    Mr. Kolchinsky. I did not approve any specific one model.
    Ms. Kaptur. Who approved them? Somebody above your pay 
grade?
    Mr. Kolchinsky. In some cases it was above my pay rate 
because I wasn't in the position yet.
    Ms. Kaptur. Can you get me a list of who approved them?
    Mr. Kolchinsky. Ma'am, I wouldn't know. It was done by the 
committee, and usually----
    Ms. Kaptur. Which committee?
    Mr. Kolchinsky. By a committee set up for a particular 
methodology. So there is a----
    Ms. Kaptur. Under your watch?
    Mr. Kolchinsky. No, not under, not under my specific----
    Ms. Kaptur. Above you?
    Mr. Kolchinsky. It would be in some cases above me, some 
cases below me, but it all, there was no standard process of 
model review and approval during the credit crisis.
    Ms. Kaptur. Let me just, in closing, Mr. Chairman, I wanted 
to ask Mr. McCleskey. You were the chief compliance officer?
    Mr. McCleskey. Yes, I was.
    Ms. Kaptur. OK. The SEC did an examination of Moody's in 
what was it, 2006, 2007, something back then?
    Mr. McCleskey. I believe 2007.
    Ms. Kaptur. How long did you meet with them as chief 
compliance officer?
    Mr. McCleskey. How long did I meet with them?
    Ms. Kaptur. Yes.
    Mr. McCleskey. I did not meet with them.
    Ms. Kaptur. They did not----
    Mr. McCleskey. They did not meet with me.
    Ms. Kaptur. You were the chief compliance officer and the 
SEC did not meet with you?
    Mr. McCleskey. That is correct. They met with our Legal 
Department and outside counsel, and I did object.
    Ms. Kaptur. That is a shocking statement.
    Mr. McCleskey. I did object to that.
    Ms. Kaptur. Thank you, Mr. Chairman.
    Chairman Towns. Thank you very much.
    I now yield 5 minutes to the gentleman from Maryland, Mr. 
Cummings.
    Mr. Cummings. Thank you very much, Mr. Chairman.
    Mr. Chairman, I wasn't going to ask any questions, but 
listening to Ms. Kaptur's questions, I was just curious, and 
could not help what I heard when she was asking about this 
fraud, and she went on to ask questions concerning why all of 
this happened. And I think you said something about 
insufficient incentives. Did somebody say that? Mr. Kolchinsky.
    Mr. Kolchinsky. Yes, sir, I believe.
    Mr. Cummings. And can you help me with that, explain that 
to me? With all my constituents losing their houses, losing 
their savings, losing everything they have, we hear about 
people on Wall Street getting these phenomenal bonuses. And I 
mean, when I heard those words, I almost fell out of my chair. 
I was trying to eat my lunch, and I had to come and ask you a 
question about that. Can you help me with that? Were they 
making, do we have some making a little bit of money on Wall 
Street? Is that it?
    Mr. Kolchinsky. No. Obviously, people on Wall Street----
    Mr. Cummings. Make a lot of money.
    Mr. Kolchinsky. Yes, sir.
    Mr. Cummings. While messing over the American people, big 
time.
    Now, tell me, just explain to me because my constituents 
want to know, when you say a lot of this happened because of 
insufficient incentives----
    Mr. Kolchinsky. Poor incentives, yes.
    Mr. Cummings. What does that mean?
    Mr. Kolchinsky. Because for the most part, most people in 
the securitization chain were not paid based on the long-term 
performance of the product they originated. So a mortgage 
broker was paid at the closing of the mortgage, not depending 
on how the mortgage did. The mortgage originator, like a 
Countrywide or a New Century, was paid when they sold the 
mortgages to an aggregator bank, like a Lehman Brothers or a 
Merrill Lynch. They were paid right there and then, not 
depending on how the mortgage performed. The bank then 
structured those mortgages. The bankers were paid on the 
closing of the deal, not on depending on how the security 
performed. That security went through an ABS CDO.
    Mr. Cummings. So in other words, it was like selling a 
piece of zero, I started to use another word, and calling it 
something more valuable than what it is, pass it on like a hot 
potato. At some point, somebody is going to have to pay, and 
the American people paid by being thrown out of their houses 
and losing their savings and what have you. Is that right?
    And so, is that right?
    Mr. Kolchinsky. Yes.
    Mr. Cummings. Yes. And then they were also put in a 
position where, what you are saying is that they were being 
paid for quantity and not quality. Is that right?
    Mr. Kolchinsky. That is correct.
    Mr. Cummings. And, I mean, if you were, say, Secretary 
Geithner, what advice would you give to the President of the 
United States? Because I can tell you there are a lot of people 
in my District who are mad, and they are wondering whether or 
not we are doing the things that we need to do to straighten 
out this mess, but not only to straighten it out, but to make 
sure it does not happen again.
    And I want you to look into, just look straight ahead, 
there is probably a camera facing you right now, as if you are 
talking to the President of the United States, and say, Mr. 
President, this is what I would do; this is how you correct 
this mess; this is how you make is so that we don't have to go 
through this again; this is so that Mr. Cummings will not be 
coming before you telling him about all of the things that his 
constituents have suffered through, and continue to suffer 
through, and how they have been robbed of their savings, robbed 
of their futures, robbed of their houses.
    Tell him. Tell the President. He's watching.
    Mr. Kolchinsky. Well, sir, I would recommend that alignment 
of incentives across the board would probably be by far the 
best solution. And that is actually return to the old roots of 
Wall Street where there used to be a term called ``eat what you 
kill,'' and that meant somebody only takes home whatever they 
actually produce, and whatever money that they bring in.
    And my recommendation would be that people who work in 
complex products and structured products retain a vertical 
slice of whatever they produce. And hopefully that would align 
their incentives that their eventual pay and whatever they take 
home is based on whatever they produce.
    So the mortgage broker will get paid based on the mortgage. 
If that mortgage didn't pay on the first payment, then they 
wouldn't originate. They would know that is a bad investment, 
and the same down the line. Countrywide, New Century, Lehman, 
Merrill Lynch and all those bankers, they would not put the 
taxpayers at risk, because they were putting their own 
livelihood at risk.
    Mr. Cummings. Did you have something, Mr. McCleskey?
    Mr. McCleskey. No, sir.
    Mr. Cummings. OK.
    Thank you very much, Mr. Chairman.
    Chairman Towns. Thank you. Thank you.
    I yield a minute to the gentleman from Indiana.
    Mr. Souder. Reinforcing the gentlelady from Ohio and the 
gentleman from Maryland's point, sales people to some degree 
sell, and yes, it would be nice if they had long term. The 
check was supposed to be you. You are the rating agency. You 
knew, obviously, that they had a motive to sell, that there was 
no back check. The back check is supposed to be the rating 
agencies. You are supposed to say what they sold wasn't real.
    And instead, we had the hedge fund people figuring out and 
telling us that they figured out it wasn't real. They made 
money betting against your ratings. And that is what we are 
trying to figure out how to address here because in the market, 
yes, some people are sellers. Other people are supposed to long 
term, but if the rating agencies are cahoots with the sellers, 
there is no public backstop.
    And now everybody is turning to government because the 
private sector didn't perform the function. And her questioning 
was along the lines of where were you all. Now, we are going to 
have some testimony from an attorney, Mr. Abrams, who says that 
you didn't perform an investigative function. You took 
basically the word of the management and you basically said a 
similar thing that they were reporting to you. And the American 
people think you are an investigative agency. They think you 
are doing an independent investigation, not just taking a pass-
on from the companies.
    And so you weren't the check to the sales part. And that is 
part of our frustration.
    I yield back.
    Chairman Towns. They were saying that if you pay us, then 
we will rate it. I mean, all you have to do is just pay us. I 
mean, that is basically what happened here.
    So let me thank all of you for your testimony, and say to 
you, Mr. Cantor, we would appreciate if you would help us get 
the documents. You know, we would like that very, very much, 
because, as we look at the overall meltdown, that our interest 
and concern is to try to make certain that it does not happen 
again. And in order to do that, you could be very, very helpful 
in that process. Thank you very, very much for coming.
    Thank you, Mr. Kolchinsky.
    Thank you, Mr. McCleskey.
    Thank you, Mr. Cantor.
    Thank you very, very much.
    Now, we move to the second panel.
    I would like to welcome our second panel. As with the first 
panel, it is committee policy that all witnesses are sworn in. 
So if you would please stand and raise your right hands while I 
administer the oath.
    [Witnesses sworn.]
    Chairman Towns. You may be seated. Let the record reflect 
that all witnesses answered in the affirmative.
    Let me begin by introducing our witnesses.
    Senator Alfonse D'Amato served as a New York Senator for 18 
years. During his Senate career, Alfonse D'Amato served as the 
chairman of the Senate Banking Committee and was also a member 
of the Senate Appropriations Committee and the Senate Finance 
Committee. Since leaving Congress, Senator D'Amato has founded 
a public policy firm called Park Strategies.
    Good to see you, and I am happy to know there is life after 
you leave this place.
    Mr. Floyd Abrams is a nationally recognized first amendment 
lawyer. Over his long career, Mr. Abrams has represented a wide 
variety of clients, including the Brooklyn Museum of Art, the 
New York Times, Time Magazine, Senator Mitch McConnell, AIG, 
and most recently, Standard & Poor's. Welcome.
    Mr. Eric Baggesen is a senior investment officer of Global 
Equity for the California Public Employees Retirement System. 
He is responsible for implementation and management of 
investment strategy and policy for the pension fund, $132 
billion portfolio in publicly traded equity investments 
worldwide under his current leadership. The Global Equity Unit 
also oversees CalPERS corporate governance, hedge fund, 
domestic long and short cash management, and manager 
development programs, and the ongoing restructuring of the 
asset class that began last year.
    Welcome.
    Dr. Lawrence White is a professor of economics and the 
deputy chair of the Economics Department at New York 
University, Stern School of Business. Dr. White has also served 
as a board member for the Federal Home Loan Board and as the 
director of the Economic Policy Office in the Antitrust 
Division at the Department of Justice. Before joining the Stern 
School, Dr. White was a member of the President's Council of 
Economic Advisers during the Carter administration.
    Welcome.
    At this time, I ask that each witness deliver their 
statement within 5 minutes, and of course, you know the 
procedure. The yellow light comes on, which means you have a 
minute remaining. And after that, then it becomes the red 
light, and that means stop. I have been having some problems 
with the members of the committee recognizing red today because 
it is such an interesting topic and, of course, they are trying 
to get to the bottom of it because so many people have been 
hurt as a result of what has gone on with this meltdown.
    So we will start with you, Senator D'Amato. Good to see 
you.

STATEMENTS OF HON. ALFONSE M. D'AMATO, FORMER CHAIRMAN, SENATE 
 COMMITTEE ON BANKING; FLOYD ABRAMS, PARTNER, CAHILL GORDON & 
    REINDEL, LLP; ERIC BAGGESEN, SENIOR INVESTMENT OFFICER, 
CALIFORNIA PUBLIC EMPLOYEES RETIREMENT SYSTEM; AND LAWRENCE J. 
WHITE, PROFESSOR, LEONARD N. STERN SCHOOL OF BUSINESS, NEW YORK 
                           UNIVERSITY

              STATEMENT OF HON. ALFONSE M. D'AMATO

    Mr. D'Amato. Thank you, Mr. Chairman.
    First of all, Mr. Chairman, let me congratulate you for 
holding this hearing. It is important, because I feel very 
strongly that the failure of the system, and the credit rating 
agencies in particular, contributed substantially to the 
economic chaos that hit this country, small homeowners, 
business owners, and right across.
    Mr. Chairman, credit rating agencies began their lives 
providing an important and very legitimate investment tool that 
allowed investors to evaluate securities. Once the system 
change to one where issuers paid for the agencies to rate their 
securities, the stage was really set for trouble.
    There have been a number of Members today who have raised 
that issue. And if you want to cut through it all, that is the 
problem with the system. Issuers are paying the rating agency, 
and the rating agencies are looking the other way.
    Why? You had two young men testify today, and I dare say 
they lost their jobs and were fired unfairly because they dared 
to sound an alarm. And the higher-ups didn't like it. And the 
fellow who testified for Moody's today, that was a debacle. He 
didn't know anything. He just knew that they try to do good 
ratings.
    You have one person who was the chief compliance officer. 
They finally adopted things that he had recommended. In the 
interim, they said, well, you didn't get along and they dumped 
him out.
    By the way, he wasn't the traditional whistleblower. He 
came in here only after the committee invited him. And I dare 
say Mr. Kolchinsky, his colleague, somewhat naively thought 
that if he brought certain matters to the attention of the 
people that he should have that they would have responded, and 
they did. They threw him out. And the SEC did not investigate 
until 1 week ago after you held these hearings. Shame on the 
SEC. Shame on them. It is like putting a lamb guarding the 
tiger's den. That is what has been going on. And at long last, 
they finally came out with a list of recommendations, at long 
last. I think that this committee and the Financial Services 
Committee should examine them, because they are meritorious. 
But one that is most important and should be acted upon, and 
they have the ability, and Congress has the ability to do so, 
is the SEC's proposed prohibition against letting a rating 
agency act as both a rater and a paid adviser for securities 
issuers. This dual capacity is one that unavoidably creates 
conflicts of interest. And don't buy this firewall nonsense. It 
doesn't work. And the American people have a right to be 
protected.
    Mr. Chairman, I have spent some time discussing this matter 
with the prestigious Financial Economics Roundtable, and they 
have a number of methodologies that they suggest. I am going to 
ask that their testimony that we have submitted, that their 
statement be placed in the record as if read in its entirety.
    Chairman Towns. Without objection, so ordered.
    [The information referred to follows:]

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    Mr. D'Amato. Mr. Chairman, let me go on to say that 
reference was made to the debacle that took place at Enron and 
that took place in corporate America, and things were done to 
deal with that. That doesn't mean we have a perfect system 
today, but you did have an analogy that was striking in terms 
of conflicts, and it undermines the credibility of 
organizations that people are dependent upon.
    Our accounting industry was subverted for a while when you 
had accountants, the big three, the big four, who were not only 
auditing, but being paid as advisers. We stopped that. You 
can't be an adviser today to a public company and be an 
auditor. And that is as it should be because inherently there 
is a conflict to both being an adviser and an auditor.
    And Mr. Chairman and members of the committee, that 
inherent conflict of interest exists today. And all this 
business about, let me tell you. Every one of the big three 
rating agencies tell you they want competition. First of all, 
there is no competition really. They enjoy 90 percent of it. 
They have the stamp of approval from the SEC. The way to really 
provide competition and get the most modern methodologies 
involved today, and there is a way to do that, is to see to it 
that there is a ban on issuers being paid, or paying rating 
agencies.
    It is rather simplistic, but that is where we should start, 
and that is the nub of the problem.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Alfonse M. D'Amato 
follows:]

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    Chairman Towns. Thank you very much for your testimony, 
Senator D'Amato.
    Mr. Abrams.

                   STATEMENT OF FLOYD ABRAMS

    Mr. Abrams. Good morning. Thank you very much for inviting 
me, Mr. Chairman and Mr. Ranking Member.
    I would like to say, first, it is good to have Senator 
D'Amato back in town. We all miss him. I come from New York, so 
I can say that freely.
    I am appearing on my own behalf today because I was asked 
by the committee to come, which is to say I was not designated 
by my client to come. But I do want you to know that I 
represent Standard & Poor's and have, and represented them for 
over 20 years, and I have represented the McGraw-Hill Co., 
their parent, for over 20 years.
    Chairman Towns. But I am impressed that you represent the 
Brooklyn Library.
    Mr. Abrams. So I am here to talk, at least in the first 
instance, about the issue of liability and the questions and 
issues raised in part by the new discussion draft released by 
Representative Kanjorski, because I thought that I could add 
something from the fact that I represent Standard & Poor's in 
now over 30 litigations commenced around the country after and 
as a result of the economic collapse that has occurred.
    Those litigations are of lots of different sorts, under 
lots of different statutes, Federal, State and common law 
theories. The proposal before Congress now, at least in the 
discussion draft, is to amend the 1934 Securities Act, which is 
a fraud statute. And I come here to urge you to try to see that 
three principles are adhered to, if you should amendment that 
act.
    The first is that we should adhere to the core principle of 
the act that currently exists, the 1934 Act, which is liability 
for knowing or reckless misconduct, as distinct from allegedly 
negligent misconduct, not what is argued by someone to be 
unreasonable, but by doing something in bad faith, 
intentionally, on purpose.
    Mr. Kolchinsky, who sat in Senator D'Amato's seat a few 
minutes ago, had the legal test right when he articulated to 
you what he thought the test was. If a rating agency or anyone 
else issues a rating or does something in the securities field 
where they are saying something they don't believe in, that 
they either know or think is false, if they do that, they can 
be held liable. And my view is that you ought to continue to 
adhere to that standard, whatever else you do.
    The second thing I think you should do is to treat every 
defendant equally. Rating agencies should be singled out so 
that they wind up in a situation where if a rating agency, an 
accounting firm, and a securities analyst are in the same case, 
you have different legal standards apply to the three of them. 
They should be the same legal standards, whatever they are.
    And the third is that whatever you do, you ought to do 
something which is as pro-competitive as possible. And what I 
mean by that is that there are proposals now in the discussion 
draft, for example, which I consider extraordinarily anti-
competitive. There is a proposal, for example, which would say 
in so many words that rating agencies have to share all the 
information they gather with all the other NRSROs that exist, 
to investigate everything that comes in from all those other 
rating agencies, to review them, and to be liable if another 
rating agency does something which is against the law. This is 
what the draft statute calls joint liability.
    I think that is not a good idea. I don't think it is fair. 
I don't think it is deserved. I also know it is uninsurable. 
And I ask, who is going to go into this business? Who are the 
new NRSROs going to be if you enact legislation of that sort?
    So I conclude, then, with the notion that with those 
principles outstanding, you can change the statute if you think 
it is necessary to do so. I can assure you on personal 
knowledge there is lots of litigation against rating agencies 
in the multi-billions of dollars going on right now.
    Thank you.
    [The prepared statement of Mr. Abrams follows:]

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    Chairman Towns. Thank you very, very much for your 
testimony, Mr. Abrams.
    Mr. Baggesen.

                   STATEMENT OF ERIC BAGGESEN

    Mr. Baggesen. Yes, good afternoon, Mr. Chairman. Thank you 
very much for inviting me here, and all the rest of the 
committee members, for hearing CalPERS' voice and perspective 
on this issue.
    My name is Eric Baggesen. I am the Senior Investment 
Officer for Global Equity, which also incorporates our 
corporate governance activities at CalPERS. We see the rating 
agency issue as one of governance. That is the reason that I am 
here. This is not simply about fixed income instruments.
    CalPERS is the largest State pension fund in the United 
States. We manage approximately $200 billion currently for 1.6 
billion members--excuse me, million members, not billion, not 
yet. [Laughter.]
    We definitely rely on the quality and the integrity of 
market information, and credit ratings are an important portion 
of that information set. There is a public interest in ensuring 
that the information disseminated to investors is reliable, 
that the providers of the information are free from conflicts, 
and that there is accountability, transparency and proper 
oversight of the delivery and the development of that 
information set.
    There are three components of information that we find 
critical to making investment decisions and positioning our 
investment portfolio. The first of those is financial 
information, constituting financial statements. Those financial 
statements are attested to by auditors.
    The next is governance-type information, where companies 
give us information about the activities of the organization in 
their prospectuses and the activities they have planned for the 
organization.
    And a third component of information is credit-worthiness.
    The first two of these, financial statements and governance 
information, are held to high standards of accountability and 
are highly regulated. The third, credit ratings, fall into a 
never-never land. They are not in the same category of 
integrity as the first two.
    If any of these components of information are weak and 
unreliable, that weakened the entire financial system. There 
are a number of entities that have attempted to quantify the 
impact of credit losses in the recent market dislocations that 
have happened over the last 2 years, and these figures 
currently run into the trillions of dollars.
    The credit rating agencies certainly had a role in that 
activity. Part of the market dislocation that we experienced 
potentially can be laid at the feet of rapidly shifting 
perspectives as to the credit-worthiness of various entities 
that existed in the marketplace. When you go from a highly 
rated entity to an entity that is virtually bankrupt overnight, 
that creates a huge amount of risk in the system, and that 
rolled through every aspect of the financial marketplace.
    CalPERS uses credit ratings in a number of different ways. 
The most prevalent area where we have credit ratings are in our 
policy documents that guide how we structure our investment 
portfolios. Credit ratings are an integral part of that 
activity. They reflect the degree of risk-taking and return 
expectations that we have relative to a number of segments of 
our investment portfolio.
    Another area where these things impact CalPERS is the 
aspect that credit ratings are embedded in many of the market 
indices. As we engage in asset allocation activities, we look 
at market indices to tell us what is the risk and return 
profile of different investment categories. Credit ratings are 
an integral part of that, particularly in the fixed-income 
arena.
    In the third area, credit ratings are used to control the 
risk-taking of outside investment managers, so we will 
oftentimes specify certain types of securities indicated by 
credit ratings as being applicable to outside managers.
    Certainly, our fixed income portfolios make use of credit 
ratings, as well as their own research and activities. The 
credit rating agencies have a position where they have access 
to sets of information that we do not have in our own research 
activities at CalPERS.
    And to the extent in our global equity portfolio, we have 
approximately 10,000 different securities contained within that 
portfolio globally. Many of those issuers are dependent on the 
attachment of a credit rating to allow them to access the 
capital markets as they execute their capital-raising 
activities.
    And the very last area that I see us using credit ratings 
is in the area of performance attribution. It helps us 
understand and disentangle whether investment managers are 
making money for CalPERS based on taking credit risk, whether 
they are taking duration risk, all of the different attributes 
that can be used in that.
    So there are a number of places that these things intersect 
with CalPERS' activities.
    The organization has a number of proposals or concepts that 
they think will help you as you move forward with attempting to 
address these issues. We do believe that the compensation model 
is a problem. We certainly support the SEC's actions. We 
support a stronger SEC. We think that organization is charged 
with investor protection. We see no other comparable 
organization.
    The agency should have high level compliance staff. They 
also need to have accountability and responsibility for the 
actions and the results that stem from their activities in the 
marketplace.
    And at that, I will stop and invite your questions.
    [The prepared statement of Mr. Baggesen follows:]

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    Chairman Towns. Thank you very much for your testimony.
    Professor White.

                 STATEMENT OF LAWRENCE J. WHITE

    Mr. White. Chairman Towns, Ranking Member Issa, and members 
of the committee, my name is Lawrence J. White. I am a 
professor of economics at the NYU Stern School of Business, and 
a member of the Financial Markets Working Group at the Mercatus 
Center at George Mason University.
    During 1986 to 1989, I served as a board member on the 
Federal Home Loan Bank Board. I represent solely myself at this 
hearing. Thank you for the opportunity to testify today on this 
important topic.
    The three large U.S.-based credit rating agencies, Moody's, 
Standard & Poor's, and Fitch, and their excessively optimistic 
ratings of subprime residential mortgage-backed securities in 
the middle years of this decade played a central role in the 
financial debacle of the past 2 years.
    Given this context and history, it is understandable that 
there would be strong political sentiment as expressed in the 
recent proposals by the Obama administration, as well as other 
proposed legislation, and recent rulemaking by the SEC for more 
extensive regulation of the credit ratings agencies in hope of 
forestalling future such debacles.
    The advocates of such regulation want figuratively to grab 
the rating agencies by the lapels, to shake them, and shout: Do 
a better job. This urge for greater regulation is 
understandable and well intentioned, but it is misguided and 
potentially quite harmful. The heightened regulation of the 
rating agencies is likely to discourage entry, rigidify a 
specified set of structures and procedures, and discourage 
innovation in new ways of gathering and assessing information, 
new technologies, new methodologies, new models, including new 
business models, and may well not achieve the goal of inducing 
better ratings from the agencies.
    Ironically, it will also likely create a protective barrier 
around the incumbent rating agencies and is thus likely to make 
them even more central to and important for the bond markets.
    There is a better route. That route starts with the 
recognition that the centrality of the three major rating 
agencies for the bond information process has been mandated by 
more than 70 years of prudential financial regulation of banks 
and other financial institutions.
    In essence, regulatory reliance on ratings, for example, 
the prohibition on banks being able to hold speculative bonds 
as determined by the rating agencies ratings, has imbued these 
third party judgments about the credit-worthiness of bonds with 
the force of law. This problem was compounded when the SEC 
created the category of nationally recognized statistical 
rating organizations, NRSROs, in 1975 and subsequently became a 
barrier to entry into the rating business. As of year end 2000, 
there were only three NRSROs: Moody's, Standard & Poor's, and 
Fitch.
    It should therefore come as no surprise that when this 
literal handful of rating firms stumbled badly in their 
excessively optimistic ratings of the subprime RMBS, the 
consequences were quite serious. This recognition of the 
longstanding role of financial regulation enforcing the 
centrality of major rating agencies then leads to an 
alternative prescription: eliminate regulatory reliance on 
ratings; eliminate it; eliminate the ratings force of law and 
bring market forces to bear.
    Since the bond markets are primarily institutional markets, 
and not the retail security markets where retail customers are 
likely to need more help, market forces can be expected to 
work. And the detailed regulation that has been proposed would 
be unnecessary. Indeed, if regulatory reliance on ratings were 
eliminated, the entire NRSRO structure could be dismantled and 
the NRSRO category could be eliminated. This could well make 
the incumbent rating agencies less important for the future.
    The regulatory requirements that prudentially regulated 
financial institutions must maintain safe bond portfolios 
should remain in force. But the burden should be placed 
directly on the regulated institutions to demonstrate and 
justify to their regulators that their bond portfolios are safe 
and appropriate, either by doing the research themselves or by 
relying on third party advisers.
    Since financial institutions could then call upon a wider 
array of sources of advice on the safety of their bond 
portfolios, the bond information market would be opened to 
innovation and entry in ways that have not been possible since 
the 1930's.
    Thank you again for the opportunity to testify today. I 
would be happy to answer questions from the committee.
    [The prepared statement of Mr. White follows:]

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    Chairman Towns. Thank you very much.
    Let me thank all of you for your testimony. You know, we 
talked earlier with Mr. Cantor. He didn't feel that they have 
played a role in this meltdown, but I want you to know that our 
role here today is to try to find ways and methods to fix what 
is going on.
    I want to start with you, Senator D'Amato, and of course, 
Mr. Baggesen, and probably all of you, as to what can we do to 
prevent credit rating agencies from contributing to the next 
financial collapse. What can we do?
    Mr. D'Amato. Mr. Chairman, Professor White did touch on a 
number of things, and they can get a little bit esoteric. But 
the fact is that once we stamped NRSRO on those three agencies, 
and I think there is one other now, Moody's, Fitch, Standard & 
Poor's and one other. We gave them a headlock. We kept out 
competition, innovation that the market forces are very capable 
of providing.
    So I think there is a lot to what we can do. And I will 
come back, to beat the dead horse, how do you keep honest 
people honest? You have the fence or the wall or the 
prohibition. You do it one way or the other. I think the fence 
and the wall are half-hearted attempts, and you are always 
going to find, I mean, here you saw this fellow McCleskey, who 
was in charge of compliance, and they moved him right out. You 
know, you are still going to have those kinds of things.
    If you want to keep honest people honest, an issuer should 
not be paying or, put it the other way around, the rating 
agencies should not be paid by an issuer for a particular 
issue. The two are incompatible. You saw that situation in the 
accounting problems. It is the same here.
    And I think that is one of the important elements, and I 
think the SEC finally has it right in their proposed 
recommendation. That should be adopted, and we should open the 
system up to competition. Professor White touched on some 
methodologies that can and should be employed.
    Chairman Towns. Right. You know, I get your point because 
even in research with doctors and with the patients, they 
finally had to come up with patients that were involved in the 
research to have their own doctors, because the person that was 
involved in research, the only thing he was doing or she was 
doing was looking at their research, and not at the patient, 
how the patient was doing. So I get your point very well there, 
Senator.
    Any other comments here?
    Mr Abrams, yes?
    Mr. Abrams. My reaction is two-fold. First, one of the 
problems here is that there has been too much reliance on 
rating agencies, as if they were the only source of 
information, which they have never been, as if that was the 
place to go. CalPERS, by way of example, is suing my client, so 
I am very interested in CalPERS and I am glad to sit next to 
the gentleman here who I may depose someday.
    Chairman Towns. Well, we arranged this. [Laughter.]
    Mr. Abrams. And for over $1 billion, by the way. And let me 
read you one line from CalPERS complaint in that case. It says: 
``Other than the rating agencies' evaluation and subsequent 
credit rating of an SIV, a special investment vehicle, an 
investor had no access to any information on which to base a 
judgment of an SIV's credit-worthiness.'' My reaction is that 
if that is the case, and I don't want to argue our case, if 
that were the case, they shouldn't be investing in the sort of 
entities where they know nothing other than its rating. And I 
think in general there has been an over-reliance on ratings 
only.
    One of the things I know that my client has been trying to 
do since the bad events of the last few years is to try to get 
out the story a little bit better about what ratings are and 
what they are not; that they are essentially an assessment of 
credit-worthiness in the future, the likelihood of repayment 
down the road, not of market value, not of volatility, not of 
liquidity, not of a lot of things which will ultimately and 
even short term affect pricing.
    But it is not easy to get that story out, and I think one 
of the things that has to be done is for a much better public 
understanding of just what ratings are and what they are not.
    Chairman Towns. So are you saying that the SEC should play 
a greater role in this process? I mean, I am not sure I 
understand.
    Mr. Abrams. I think there are things the SEC can do. 
Indeed, I think the SEC can play a role in helping to restore 
credibility, if you will, of this whole process, particularly 
if we are moving in the direction of more competition. We have 
10 NRSROs now. As Senator D'Amato said, not so long ago we had 
three, four, give. Now we have 10 since and because of the act 
passed by Congress in 1966, the Credit Rating Reform Act, which 
took effect in 2000, rather, 2006 which took effect in 2007.
    If we are going to open this up and have more and more and 
more NRSROs or perhaps, as Professor White says, not have 
NRSROs anymore, we will still need a significant level of 
oversight by the SEC, and some of their proposals in that 
respect are in the direction, I think, of helping the industry 
to be better viewed because, again with all these entities in 
now and more and more to come, you are taking entities which 
may not always be of the highest level in terms of experience 
and making them NRSROs.
    The SEC used to say, you can't be an NRSRO because you 
haven't had experience. And the argument against that was, how 
can we get experience? And we need the designation, etc.
    All right, we went in the direction, then, of saying we 
will give the stamp, so to speak, of NRSRO to, I don't want to 
say almost any, but any financially secure entity, even if they 
don't have a lot of past experience. There is a societal risk 
in that. I think it was a good decision, but there is a risk-
reward in it. And one of the consequences of doing that is that 
I think you need a higher level of SEC involvement so long, at 
least, as you have the NRSRO designation in the first place.
    Chairman Towns. I yield to the gentleman from California. 
My time is expired.
    Mr. Issa. Thank you, Mr. Chairman.
    Mr. Abrams, under Sarbanes-Oxley, we looked at the auditing 
world and the big 10, 9, 8, 7, 6, 5, 4 accounting firms. And we 
found that in fact they were playing two sides of the game. 
They were doing the annual audited financial, and then they 
were selling a bunch of products. And the two basically could 
not have firewalls. They simply couldn't get past the fact that 
partners all benefited effectively from that. And if there 
wasn't money in one side, and there was money in the other 
side, the partners wanted to share, or they didn't want to be 
on the other side. So Congress made a decision that we could no 
longer have that.
    In the case of rating agencies, do you believe that we 
should consider narrowing what 1 or 3, 5, 10, whatever amount 
of rating agencies can do, versus other services so as to make 
it as close to the equivalent of your annual audit, rather than 
a more broad set of opinions and products being sold? Do you 
think that would help?
    Mr. Abrams. Two thoughts. One is I think the notion of 
saying that rating agencies shouldn't do consulting, say------
    Mr. Issa. That is exactly what I am saying.
    Mr. Abrams. I understand--it is an appropriate one. My 
understanding is my client doesn't do consulting. But without, 
you know, getting into definitional issues, the notion of 
separating consulting as such from ratings I think is a wise 
one.
    But that said, I think you really do have to take care 
about how far you go in terms of limiting------
    Mr. Issa. Let's take it for a moment in the direction that 
Professor White would take it. If I look at stocks, rather than 
bonds or other debt instruments, if I look at stocks, if 
Goldman Sachs wants to take me public, they take me public and 
everybody understands that they are making a market. They are 
making a lot of money. They have a lot of fees. They are making 
their portfolio for me look as good as possible. Basically, 
they are finding ways in a legal way to kite the stock's value 
to the highest possible level for the public offering, and then 
they set it at a little less than that so it pops on day one. 
We all understand that.
    However, if five other institutions begin tracking my 
stock, they are tracking it much more independently, and that 
is the difference between who takes me public and who, in fact, 
is giving their clients' advice.
    Is that model, and I will go to Professor White I think, 
part of where the direction we need to go? We need to recognize 
that those who look at the papers and present an opinion are 
very different than those who provide an opinion on an ongoing 
basis for the value of something.
    And I would like to go to Professor White, perhaps, to see 
when you look at the obsolescence of the existing model, should 
we end it in favor of something with more transparency and a 
number of rating organizations for the protection of CalPERS 
and others? Or should we try to mend the existing system?
    Mr. White. Congressman, the existing model that I would 
abandon is the regulatory reliance on ratings. That is the 
crucial thing. That is where everything else follows. Once we 
get rid of that, and you know, the SEC has taken some initial 
steps. We need bank regulators to do the same, pensions fund 
regulators, insurance regulators. The Congress can legislate in 
this direction.
    Once that is done, remember this is an institutional market 
and bond managers at pension funds, at banks, at insurance 
companies, at money market mutual funds should be and can be 
expected to exercise judgment about who is a trusted source of 
information, look at the business model of an adviser and say, 
you know, I am not so good with that.
    Mr. Issa. I have one person with $200 billion at stake 
here. Mr. Baggesen, in your case, if we moved to a model where 
obviously somebody is going to put the wrapper together 
initially, but instead of relying either on that rating 
organization or, Lord help us, on AIG to wrap it in the AAA 
rating, which often was the problem, wouldn't you be better 
served if, in fact, that model were in place, because you are a 
sophisticated buyer, but you don't have enough to do a full 
analysis, perhaps, in the old model without relying too heavily 
on the rating agency?
    Mr. Baggesen. Yes. There are a number of areas where the 
current model breaks down. These things have been addressed, 
for example, in the auditing profession. You are well aware of 
that. That is one possible alternative, is to move down that 
kind of a structure.
    Certainly, another structure is to remove the regulatory 
reliance. That is another alternative. There is no, in the 
equity world that I am most familiar with, there is no 
requirement, for example, that I look at Goldman Sachs stock 
rating before I purchase a security. That is, you know, or to 
put it into a particular type of a portfolio. That does not 
exist in the equity world in that area.
    Mr. Issa. And you invest in the equity world on an informed 
basis?
    Mr. Baggesen. Absolutely, absolutely. The credit rating 
agencies, currently we are almost required, again by my naive 
judgment, in respect to Mr. Abrams wanting to oppose me 
potentially later.
    Mr. Issa. We will try it later, not here.
    Mr. Baggesen. We are almost required to look a those 
ratings simply because the credit rating agencies are allowed 
access to inside information that we do not have access to. So 
if we did not consider that information, we would certainly 
potentially be ignoring another pool of information, and that 
in itself could cause problems.
    So there are a number of different structures to this. If 
you take away the accessibility of inside information to credit 
rating agencies and make them the equivalent of any other 
security analyst or whatever you care to out there, that 
certainly changes the degree of reliance that we would be able 
to place or would be willing to place on that pool of activity. 
That is definitely a way to mitigate against the power and the 
leverage that these organizations have.
    Mr. Issa. My time is expired. I just want to sort of bring 
to a focus your statement.
    So if you had all the same information that the credit 
agencies had as a sophisticated investor, a large sophisticated 
investor, you wouldn't even be having this potential day in 
court if you had all the same information. At the heart of it, 
you had to rely on something you didn't know that he did know.
    Mr. Baggesen. Conceptually, sir, but recognize there are 
hundreds of thousands of credit instruments out there. So the 
scale of this industry makes it almost impossible for any 
enterprise, even one the size of CalPERS, to go in and dissect 
every possible issue, issuer and so on and so forth. So there 
are some resource limitations to that even in the presence of 
place like CalPERS.
    Mr. Issa. Sure. We understand that, you know, we rely on 
Google when we put in a word, and we don't necessarily get it 
all. But in this case, you believe you were denied access to 
the same information and therefore you relied on it, both 
regulatory-wise and because they were given information you 
were not.
    Mr. Baggesen. Yes, sir.
    Mr. Issa. Thank you.
    Chairman Towns. Right. Thank you very much. The gentleman's 
time is expired.
    I now call on the gentleman from Maryland, Mr. Elijah 
Cummings.
    Mr. Cummings. Thank you very much.
    I want to put all this into some kind of context, Mr. 
Baggesen. I think the point for all of us to remember is that 
CalPERS and other public pension systems is that they manage 
the retirement security for a lot of our constituents. I mean, 
you are from California, I assume, but for teachers, bus 
drivers, policemen, other public servants, and those pensions 
are funded with public tax dollars and losses, however they may 
occur, cost taxpayers money. Is that right?
    Mr. Baggesen. Yes. That would ultimately be correct, sir, 
but recognize that our pension beneficiaries, we do not see as 
being in any risk in this issue. But certainly, if we lose 
money or make less in return on our portfolios, the 
contribution rates that roll back to taxpayers could have to 
increase, certainly.
    Mr. Cummings. Yes, that is the point I was trying to make.
    And I know for a fact, having been a former, in the red 
book and a bond counsel before I came to Congress, that I 
remember when I first started doing bond work and they talked 
about Moody's and Fitch, and what they said, you know, the 
rating of a bond agency you can rely on because it is like God 
talking. That is exactly what they told me. And now I realize 
that, you know, maybe they were over-rating the bond agencies.
    And that brings me to the point of, you know, you didn't 
have much of a choice as to whether or not to use the credit 
rating agencies. Is that right, Mr. Baggesen? What else were 
you going to do?
    Mr. Baggesen. Well, that is exactly right. Their activities 
are enshrined in market practice and regulation throughout the 
marketplace. Throughout the marketplace, sir, their activities 
are rife throughout it.
    Mr. Cummings. Right.
    Mr. Baggesen. Whether it is regulatory requirement, 
historic practice, whatever you care to------
    Mr. Cummings. And so your own investment policies determine 
the portfolio's risk and the bond ratings. Is that correct?
    Mr. Baggesen. Yes, sir. Enshrined again in our policies, 
there are references to the amount of risk that we are willing 
to take within certain segments of our investment portfolio. 
That risk is often expressed in the terms of a rating. Those 
ratings have been held out historically as the yardstick by 
which to judge credit-worthiness.
    Mr. Cummings. And you didn't say this, but the fact is that 
in talking to a member of my staff who used to be involved in 
looking at how Baltimore invests its pension money, he told me 
that they would often look at CalPERS to see what kind of 
things that you all were doing.
    I know you didn't say this, but because you all were seen 
to be so good at it, and of course you are dealing with, what 
did you say, 200 million people? And they figured that if you 
all were doing something, they might want to at least take a 
look at it, because you all, whether you admit it or not, 
became sort of a gold standard. And your gold standard, I 
guess, was based largely on information that you were getting 
from these rating agencies. Is that a fair statement?
    Mr. Baggesen. The information from the rating agencies is 
absolutely incorporated in everything CalPERS does. The degree 
of reliance is something, I guess, that we will explore 
probably in a courtroom.
    Mr. Cummings. Had you decided at some point that you could 
no longer trust the bond ratings being issued? What were your 
options, if any?
    Mr. Baggesen. The option is to try to do the research 
yourself, and that becomes extremely, obviously, labor-
intensive, resource-intensive and very expensive.
    Mr. Cummings. And almost impossible, is that right?
    Mr. Baggesen. Well, the scale of the marketplace is so 
large that we certainly don't have a staff. We have 40 people 
in our fixed income area.
    Mr. Cummings. Now, could you have disregarded those ratings 
without risking suits for breach of fiduciary duties? In other 
words, you are looking at a rating and you don't rely on it. I 
mean, what happens then?
    Mr. Baggesen. Well, for example, I will go back to the 
example of the benchmarks that we use in order to execute our 
asset allocation work to determine where we deploy capital in 
the portfolio. Credit ratings are enshrined in a portion of 
that benchmark exercise. The fixed income indices all are rated 
by are these investment-grade debts, are these junk bonds, all 
different kinds of implied ratings attached to that.
    Those benchmarks have an effect on how you deploy your 
capital as you match your capital deployment to the liability 
stream that we are trying to meet the needs of with the pension 
fund. So certainly the activity in the presence of those 
ratings and their use in the marketplace have impacts on how we 
allocate capital. That is inescapable.
    Mr. Cummings. If I might just ask one quick followup, and 
that is that as a result of all of this, all of this 
information, how has that affected, if at all, your business? I 
mean, from what you have learned about what the rating agencies 
may have failed to do?
    Mr. Baggesen. Well, again, from the perspective of what I 
do on behalf of CalPERS, this looks like a very familiar 
governance problem. This is the same problem that was dealt 
with back in the days of Sarbanes-Oxley with auditors and all 
the rest of that. I mean, so this is a very similar governance 
issue, and it is providing, obviously, a huge array of work for 
us in trying to figure out how to accommodate and how to 
compensate for that.
    So even now, our fixed income portfolios, for example, if 
we are not able to farm capital out to external managers where 
those external managers are being controlled by being 
constrained to investing in certain rated securities or certain 
tiers of securities, if we cannot rely on those managers to be 
able to really understand the risks attached to those 
securities, that causes us to have to bring capital back 
internally to manage, which we may or may not have the 
resources to do.
    So there is a whole raft of effects on our business model 
that are stemming from this activity.
    Mr. Cummings. Thank you, Mr. Chairman.
    Chairman Towns. Thank you very much.
    You know, we promised to have the Senator out by 1:30, so 
Senator, we recognize------
    Mr. D'Amato. Mr. Chairman, the clock is ticking and I have 
a plane to catch.
    Chairman Towns. Yes.
    Mr. D'Amato. I commend you again for the hearing.
    Chairman Towns. Thank you, thank you very, very much.
    Mr. D'Amato. Thank you, Mr. Chairman.
    Chairman Towns. Pleasure. All right.
    We now yield 5 minutes to the gentlewoman from Ohio.
    Oh, I am sorry. I didn't realize you were here.
    The gentleman from Indiana. They change up on me here. Mr. 
Souder? I am sorry.
    Mr. Souder. No. I understood. I switched seats.
    There is a big temptation to go off on a higher level 
challenge about how bubbles work, because in fact, like we 
talked about Enron, the dot.com bubble, back to tulips in 
Holland, like mark to market. You know, you go too much and 
then you contract too much, and it is the challenge of how to 
keep an even flow.
    But one of the fundamental questions that comes every time 
we go through one of these in world history is: Who is actually 
doing the investigating?
    And one of the bankers from my area who is on the Federal 
Reserve sat down with me early on as we were going through TARP 
and TALF and so on, and said one of the challenges here was 
that basically the housing market went up by 400 percent. The 
growth was going up 25 percent. So how did people miss the 
bubble? And that one of the challenges any of you--in other 
words, how did Moody's, how did the investment firms, how did 
the banks? Because once you sit back and go, well, there is 
going to be a housing bubble whenever you have, just like in 
the dot.coms or a run-up in energy, historical, looking back on 
it, you can see it, but sometimes you want to say on this one, 
it was pretty evident.
    Now, I want to probe a little bit with Mr. Abrams' 
testimony, because we had lots of good testimony here. But most 
people thought that bond ratings were investigating, but the 
implications of your talking about what is a reasonable 
verification, reasonable investigation in your written 
testimony, and what in fact bond entities, the rating agencies 
do, that underneath this, if you are mandated, if the firms 
are, and I realize you are not officially representing them 
today, but these firms are to look at the underlying capital. 
In other words, does this firm have enough capital?
    Wouldn't that require investigation into whether some basic 
assumptions like did the housing market grow 400 percent, where 
the economy was only going 25 percent; in securitization, that 
the different tranches, the more far out you went in the 
tranches, the more risk you were taking. And doesn't that 
require investigation to do a capital requirement?
    Mr. Abrams. Well, my understanding is this, that Standard & 
Poor's, at least, has conducted a loan-by-loan investigation 
through its computerized analytic efforts, which I don't begin 
to understand personally, but it is loan by loan. But it does 
presuppose that when they receive information from the entities 
that supply it to them, the information itself is accurate. 
Then they deal with the information.
    Mr. Souder. May I interrupt for a second?
    Mr. Abrams. Yes, please.
    Mr. Souder. In your written testimony, you said that, for 
example, if required assuming in forecasting, because Standard 
& Poor's isn't a forecasting organization, that the management 
forecasts were reasonable. But isn't that assuming that the 
entity that you are about to rate is, in fact, giving you a 
forecast that is accurate, rather than going and looking back 
at the housing market to determine whether the forecast was 
accurate, because otherwise, the capital assumption is wrong?
    Mr. Abrams. Now look, Standard & Poor's has economists. 
Their job is to do the best job they can in forecasting 
internally in a way that helps them how the housing market and 
other markets are going to do. They gather information, lots 
and lots of information, which bears on it. They come to 
assumptions based on history which goes back to the Great 
Depression. And they did that, and they did it with respect to 
the housing market, and the presupposed that the housing market 
was going to go down. I mean, it isn't so, that they thought 
that it was going to keep going up. They thought it would go 
down, and they worked with models based on historic experience 
to try to tell them how much it could rationally, predictably 
be said to go down, and that wasn't enough. It went down much 
more and much more quickly.
    I am sorry.
    Mr. Souder. AIG, I mean, it was a house of cards that it 
appears that nobody really investigated.
    And if I could go to Mr Baggesen for a second. When you say 
that you can't afford enough investigators, I mean, I think 
your investors assume you are doing it. What you are really 
saying is that it would cost you more money and reduce the 
return to your investors if you hired a bunch more 
investigators. Isn't that correct? If you hired 80 
investigators, it would lower your rate of return.
    And part of the problem here is everybody wants a high rate 
of return, so everybody starts chasing, hoping that they can 
get this high rate of return. Nobody really wants to check 
because if you only offer 4 percent and somebody else is 
offering 12 percent, then your holders will complain. And that 
is how it spread to the whole economy because everybody started 
going into speculative stocks because if you didn't buy housing 
tranches and securitization, if you didn't buy pharmaceuticals 
and you didn't buy energy, you couldn't get higher than a 4-
percent to 6 percent because 4 percent to 6 percent was what 
the economy was growing.
    So anything you were getting up here was pretty 
speculative, yet nobody really wanted to dig in, and everybody 
goes, well, we didn't do the kind of core investigation. We 
were just relying on the statistics. And based on past models, 
we thought it might go down a little, but not this much. Yes, 
but nobody got in and looked at the core. And that is what is 
hard to understand. The consumer didn't, the agencies that were 
placing the consumers' dollars, the different companies. 
Insurance companies started speculating more than they would 
have in order to be able to compete to get money into insurance 
policies.
    And it is like somewhere in here, we have to have somebody 
looking at the core, not just circulating information, or we 
will repeat it.
    Chairman Towns. The gentleman's time has expired.
    I now yield 5 minutes for the gentlewoman from Ohio, Ms. 
Kaptur.
    Ms. Kaptur. I thank the chairman for the time and inviting 
this excellent group of panelists this morning, and this 
afternoon. [Laughter.]
    Mr. Abrams, I wanted to ask for the record, in what 
community is your law firm located?
    Mr. Abram. I am sorry. In what?
    Ms. Kaptur. In what community is your law firm?
    Mr. Abram. Oh, I am sorry. New York City.
    Ms. Kaptur. You are in New York City.
    Mr. Abram. Yes.
    Ms. Kaptur. I noticed as a Midwesterner the coastal nature 
of most of our witnesses. And therefore, from the heartland, I 
have to send this message. The first is that going back to the 
1980's, the abuse that occurred in the savings and loan system 
was followed by an even greater set of abuses we are 
experiencing today, because what Congress did back then, and I 
served back then, sent the wrong message. It sent the message 
that if you abuse the financial system, the taxpayers would 
bail you out, and it has been done again to a much greater 
degree.
    If I look at the current situation today and how it affects 
my region, just so the folks from the coast know this, Ohio has 
now lost an additional money center bank. PNC, whose Vice 
President, Mr. Demchak, invented the derivative when he worked 
for J.P. Morgan up there in New York moves to Pittsburgh. And 
one of the results of this debacle has been we have made the 
big banks bigger and places like Ohio, now, we only have three 
money center banks left. National City was bought by PNC.
    We look at which banks are failing, 126 of them, I guess, 
have been resolved at this point at the FDIC. And we see the 
big banks getting bigger. I think three rating services isn't 
enough. That is an oligopoly, the way I look at it. All right? 
Out from the heartland. Maybe folks from the coasts look at it 
a different way.
    I am just putting this on the record. The result of this 
system of housing rescue has been that now the Federal 
Government is the dump basket for all the mistakes of the 
private sector. The large banks have essentially taken profits 
and socialized losses. Just look at FHA. If we look at our 
Federal mortgage instrumentalities, we used to hold one of 50 
mortgages. Guess what? We now hold one of four, because all the 
toxic assets have been dumped on the public.
    And what worries me most is that what is going to happen 
again, because of the power of these institutions, is that we 
are going to open the floodgates more. I don't know how much 
more damage they can do than they have done already.
    But here is what I want, and this is going to be my 
question to you, as you see the financial reform proceeding, 
whatever that reform is over in some of these committees, here 
is what I want. Tell me how close we are going to get from what 
you have seen is occurring over in the Financial Services 
Committee to it?
    I want a safe and sound banking system again. I want more 
than financial services. I want a banking system again. I want 
a healthy housing market. I want the re-empowerment of 
communities capital accumulation versus the movement of that 
capital to just a few money center institutions.
    How close am I going to get to the re-empowerment of 
community capital accumulation? And how close am I going to 
come to the restoration of prudent lending and responsible 
savings, based on what you have heard is occurring here, you 
heard the President's speech, you talk to your colleagues up 
there in New York?
    I asked Mr. Bernanke, and I will end with this statement: 
``Mr Bernanke, you know, we are under the Cleveland Fed, and 
the Cleveland Fed sort of has something to say about what the 
New York Fed does, but not really. Would you be for the 
democratization of the Fed, where every single region has an 
equal vote?''
    You know what his answer was? Absolutely not.
    So my question to you is, based on what you have heard, how 
close are we coming under these reform proposals to a safe and 
sound banking system, a healthier housing market, the 
empowerment of community capital accumulation versus money 
center bank capital accumulation, and prudent lending and 
savings in this country again? Who is brave enough to take that 
on?
    Mr. Abrams. I will go first because I can be very brief on 
this because it is so far from my area of expertise. But 
speaking for myself, I think a number of the proposals will 
move us significantly in the direction that you want, including 
a number that the President has proposed. But to get where you 
want to wind up is going to take a lot of doing.
    Ms. Kaptur. Yes, it is.
    Mr. Baggesen. That is a very difficult question. From the 
capital market perspective, we think that many of the reforms 
that have been proposed are certainly encouraging, things like 
proxy access. There is a whole raft of governance things that 
have been proposed under the, I would say, the new SEC, which 
seems to be reinvigorated at its job as a protector of investor 
interests.
    So we are very encouraged by those actions. It has yet to 
translate into real differences in the behavior of the 
marketplace. You have laid out a number of attributes here that 
it is not clear to me how much of this can be commanded by a 
regulatory system. In many cases, what you are asking for------
    Ms. Kaptur. Excuse me. May I just interject there, it isn't 
just the regulatory system which is the track we are on. It is 
the architecture of the entire system.
    Mr. Baggesen. Excellent point. But you cannot, I don't 
think that you can turn the clock back. For example, if capital 
formation and people are moving, for example, from Ohio to 
California, you are not going to turn back the influence that 
migrates, let's say, to California, in other words, from Ohio. 
So that, you know, people in the dynamics of how they live and 
where they choose to live and what they choose to do are going 
to have a large impact on the relative influence of the 
different regions of the United States.
    Ms. Kaptur. I hear what you are saying, but, I mean, we 
want to have strong community lending. We want rigor and 
prudent lending to be possible again, and it won't be unless 
everyone has a piece of the action. And you just can't sell 
risk up the chain that then ends up being dumped on the Federal 
Government.
    And my concern is we are going to be off into consumer 
agencies, a little tinkering here with regulatory, and we are 
missing the big picture. I can remember the day, and my time 
has expired, and Professor, I would love for you to answer my 
questions to the record, by the way, when they came down to the 
Banking Committee and they took the name off the door. It used 
to be Banking, Housing and Urban Affairs. That is when we had a 
real, that is what was left of a real banking system, what was 
left of a sound housing market, and what was left of a real 
commitment to our urban areas across this country.
    What we have ended up with is financial services. The name 
says it all. We have to go back on top. We are down here in the 
middle. We have to go back to the architecture. And my greatest 
fear is we are not going to get there and we will end up with 
even bigger crisis because the architecture will be wrong, and 
just dealing with regulation won't be enough.
    Thank you very much, Mr. Chairman.
    Chairman Towns. Right. Thank you very much.
    In closing, you know, I am still having problems with this 
conflict of interest. A few rating agencies are paid to help 
structure securities. They then get paid to rate the same 
securities. I am telling you, that to me sounds like a conflict 
of interest. So I am still having that problem.
    You know, Winston Churchill--did the ranking member have 
anything else that he would like to add?
    Mr. Issa. Mr. Chairman, I just want to thank you for this 
hearing. I think, in closing, it certainly has shed light on 
the fact that we are not going to mend this system without 
significant change. And I commend you for doing comprehensive 
and I hope more comprehensive review of all the causes of the 
financial meltdown.
    I yield back.
    Chairman Towns. Right. Thank you very much.
    And let me close by saying Winston Churchill once described 
Soviet Russia as a riddle wrapped in a mystery inside an 
enigma. After listening to today's testimony, I think he could 
just as easily have said that about the way credit rating 
agencies operate.
    Today, we had testimony from two former senior employees at 
Moody's who described a culture of secrecy, a place where 
putting things in writing was frowned upon. Can you imagine 
working at a place where the very act of writing a memo or 
sending an email is suspect?
    This culture of secrecy extended to companies outside 
Moody's as well. Moody's tells us they retained an outside law 
firm, Kramer Levin, to investigate Mr. Kolchinsky's allegations 
of illegal conduct at Moody's. But this morning, we learned 
that this outside firm was given oral instructions, only oral 
instructions.
    Moody's says there is no written statement or work and no 
contract specifying the work to be done. In addition, this 
outside firm is not expected to produce any written report of 
its findings and has no schedule of completion.
    On top of that, Kramer Levin says this is their normal 
behavior. They never produce written reports. Instead, they 
give their clients oral briefings. In other words, the Moody's 
business model could be summed up as: leave no fingerprints; 
don't ask, don't tell.
    This might be all right if the credit rating agencies 
hadn't played a starring role in the collapse of the financial 
system. For that reason, this cannot continue. It is very clear 
to me at this point that effective legislation is needed, along 
with effective oversight, to bring about the confidence that is 
needed to be able to turn things around.
    The testimony we have heard today is just the opening 
chapter of what promises to be a sordid story. We intend to 
pursue this further.
    Finally, I want to thank all of our witnesses, and I want 
to thank the two witnesses, Mr. Kolchinsky and Mr. McCleskey, 
who had the courage to come forward to testify about what they 
saw at Moody's.
    I am aware that testifying before Congress is never, never 
easy, and we want you to know that we appreciate their 
participation and also we appreciate the participation of all 
the witnesses.
    On that note, without anything further to do, the committee 
stands adjourned.
    [Whereupon, at 1:43 p.m. the committee was adjourned.]
    [Additional information submitted for the hearing record 
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