[Senate Hearing 111-341]
[From the U.S. Government Publishing Office]
S. Hrg. 111-341
EXAMINING PROPOSALS TO ENHANCE THE REGULATION OF CREDIT RATING AGENCIES
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
THE EXAMINATION OF THE PROPOSALS TO ENHANCE THE REGULATION OF CREDIT
RATING AGENCIES
__________
AUGUST 5, 2009
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Dean V. Shahinian, Senior Counsel
Julie Chon, Senior Policy Adviser
Drew Colbert, Legislative Assistant
Brian Filipowich, Legislative Assistant
Mark Oesterle, Republican Chief Counsel
Hester M. Peirce, Republican Counsel
Chad Davis, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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WEDNESDAY, AUGUST 5, 2009
Page
Opening statement of Chairman Dodd............................... 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Prepared statement....................................... 51
Senator Reed................................................. 4
Prepared statement....................................... 51
WITNESSES
Michael S. Barr, Assistant Secretary for Financial Institutions,
Department of the Treasury..................................... 5
Prepared statement........................................... 52
Responses to written questions of:
Senator Bennett.......................................... 104
Stephen W. Joynt, President and Chief Executive Officer, Fitch
Ratings........................................................ 25
Prepared statement........................................... 60
Responses to written questions of:
Senator Bennett.......................................... 116
James H. Gellert, President and Chief Executive Officer, Rapid
Ratings
International, Inc............................................. 27
Prepared statement........................................... 64
Responses to written questions of:
Senator Bennett.......................................... 118
John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
University Law School.......................................... 29
Prepared statement........................................... 85
Responses to written questions of:
Senator Bennett.......................................... 119
Lawrence J. White, Leonard E. Imperatore Professor of Economics,
New York University............................................ 31
Prepared statement........................................... 90
Responses to written questions of:
Senator Bennett.......................................... 120
Mark Froeba, J.D., Principal, PF2 Securities Evaluations, Inc.... 33
Prepared statement........................................... 100
Responses to written questions of:
Senator Bennett.......................................... 120
Additional Material Supplied for the Record
Hearings Before the Committeee on Banking, Housing, and Urban
Affairs (January-August 2009).................................. 124
Statement submitted by the Securities and Exchange Commission.... 125
(iii)
EXAMINING PROPOSALS TO ENHANCE THE REGULATION OF CREDIT RATING AGENCIES
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WEDNESDAY, AUGUST 5, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 9:34 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order, and thank
you, Secretary Barr, for being with us, and I thank my
colleagues for being here this morning. The title of our
hearing this morning is ``Examining Proposals to Enhance the
Regulation of Credit Rating Agencies,'' and let me just say
briefly--I want to make a few brief opening comments, then turn
to Senator Shelby and, with the approval of my colleague from
Alabama, ask Jack Reed if he wants to make a quick opening--he
has done a tremendous amount of work on this, as has Senator
Shelby, by the way--some opening comments on this as well. We
had planned to do this at the subcommittee level, but there was
such interest in the subject matter that we made it a full
Committee hearing.
I should just point out to my colleagues, beginning in
March of 2006, under the leadership of Senator Shelby, we had a
hearing in March on this subject matter, in September 2007,
when I became Chairman, on the rating agencies. We had a
hearing on the rating agencies April 22, 2008. We had hearings
on March 10th and March 26th; they were broader hearings, but
we spent a lot of time on the rating agency subject matter. So
over the last 3 years--one, two, three, four, five--this will
be the sixth hearing that focused a lot on rating agencies.
This will be our last hearing before coming back in
September, and I just want to thank not only my colleagues, I
want to thank our staffs. We have worked it pretty hard on this
thing here. This is, I think, our 29th or 30th hearing since
January 20th, and just this week alone, we had two. We have had
15 hearings on this subject matter alone in the last 4 weeks.
And I know that is exhausting for staff, who have worked very
hard for these things, and Members, I know with all the other
work we have and all the other discussions going on, but it has
been tremendously worthwhile, and virtually all of these have
been to try and determine what is the best course for us to
follow as we try and craft what will be maybe the most
important piece of legislation this Committee will deal with or
has dealt with in decades, and that is the modernization of
financial regulations.
So it has been tremendously worthwhile, and I want to thank
our witnesses as well, from the Administration as well as the
private sector and academia and others who have come before the
Committee. There are literally dozens who have who have shared
their thoughts and ideas, and we are all very, very grateful
for that input as we will now begin the process of trying to
take those ideas and incorporate them into some sound
legislative proposals.
Senator Shelby and I are determined to have this be a very
inclusive process. For all of our colleagues who are
interested, you are invited to be at that table as we try and
bring these ideas together and come out with a proposal that we
all can embrace. And there will be points when we will have
some disagreements, I am sure, but at least as I have listened
to all of this, I think we are going to be in agreement far
more than disagreement on matters, and I find that very
encouraging as we go forward.
So I wanted to share those thoughts, and I will ask the
consent that the list of our hearings over 2009 be included in
the record for those who may want to see it [Ed. Note: The list
of hearings is provided on p. 124 in the Additional Material
section of this hearing].
On the subject matter before us today, let me just say that
this hearing on rating agencies--and, again, others may have
different views on all of this, but there are two areas, we all
know, that share in culpability for all the problems that we
have seen unfold in our economy. But two areas alone I think
deserve special recognition for the problems. One was, of
course, the failure to regulate these brokers who were out
marketing and promoting products that they knew were going to
create a problems, that there was no way the borrowers were
going to be able to meet the fully indexed price of these
mortgages, and yet were luring people into it, getting paid,
and selling off, and, of course, covering themselves
financially, but literally knowing full well that this was
going to create a bubble that was going to come back to haunt
us. And the second is the rating agencies. This is to me
stunning in a way that agencies that hold themselves out--in
fact, I was looking this morning, just sharing with Senator
Shelby here, and I will not--this is not the witnesses before
us today that it fits, but a major rating agency--and let me
just read--this is the Web site this morning. This is not the
Web site of 4 years ago. The top of the Web site, the name of
the agency: ``Independent credit ratings, indices, risk
evaluation, authoritative, objective, and credible.'' I mean,
in a sense, first of all, risk evaluation, all they were doing
is being paid by the very people they were rating. Never
bothered to do due diligence at all to determine whether or not
these products were as creditworthy as they were claiming to
be. And yet still to this day it is suggesting somehow that
they are independent, conducting risk evaluation at all. Quite
the opposite.
And so this is an area where I think there is a lot of
shared views on what we need to be doing. You will hear about
that. But I was just this morning asked to pull up this Web
site, and once again find that, despite all that has been said,
despite six hearings on the subject matter--and none of us have
yet the simple, quick answer on how we move in a different
direction. But, clearly, the present situation cannot last.
So this is an area which will clearly be a part of our
legislation and one that is deserving of some real attention in
the coming days. But, again, I thank my colleagues for their
work on this subject matter, and they ought to be--these
companies need to be providing independent research and in-
depth credit analysis on their Web sites, which is not the case
today.
So let me turn to Senator Shelby for some opening comments
and then Jack Reed for any thoughts he has, and then we will
get to our witnesses.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
The nature of today's credit rating industry reflects
decades of regulatory missteps rather than market preferences.
Over the years, the Government granted special regulatory
status to a small number of rating agencies and protected those
firms from potential competitors.
Beginning in 1975, the Securities and Exchange Commission
began embedding NRSRO ratings into certain key regulations.
Once credit ratings acquired regulatory status, they crept into
State regulations and private investment guidelines. The staff
of the SEC controlled access to the prized National Recognized
Statistical Rating Organization, or NRSRO, designation by
subjecting potential entrants to a vague set of criteria and an
incredibly slow timeline. The SEC did little to oversee the
NRSROs once so designated. Nevertheless, because of the doors
they open, ratings from an NRSRO became an excuse for some
investors to stop doing their own due diligence that Senator
Dodd alluded to.
Widespread overreliance on ratings meant that the effects
of poor quality or inadequately updated ratings could ripple
through the markets. By encouraging reliance on a small number
of big credit rating agencies, bureaucrats at the SEC exposed
the economic system to tremendous risk.
Our current financial crisis, which was caused in part by
the credit rating agencies' failure to appreciate the risk
associated with complex structured products, demonstrates just
how big that systemic risk was. The troubles caused by the
SEC's flawed regime, however, did not come as a surprise.
Several years ago, when I was Chairman of this Committee, we
acted to address the problem after the SEC failed to take
action on its own. I felt then that the industry's heavy
concentration and high profits were symptoms of an industry in
serious need of reform.
We then passed the Credit Rating Agency Reform Act of 2006,
as Senator Dodd mentioned. The act set forth clear standards
for the NRSRO application process. It also gave the SEC
authority to regulate disclosures and conflicts of interest, as
well as unfair and abusive practices. Unfortunately, the law we
passed in 2006 did not have time to take root before the
problems that they were intended to remedy took their toll.
The SEC adopted rules pursuant to that legislation in June
of 2007. Over the following months, the number of NRSROs
doubled, just as the performance of many highly rated subprime
securities revealed that such securities were not as safe as
the rating agencies said they were. Today, we will consider a
legislative proposal by the Administration and others to
revisit the regulation of credit rating agencies.
In determining whether new legislative steps are required,
I believe we should keep in mind that the 2006 reforms are
still working their way through the system. That does not mean,
however, that we should not consider further changes. Every
option should be on the table. One option is to remove rating
mandates from regulations. Another is materially improving
disclosure. As with any regulatory reform, however, we must
also be mindful of unintended consequences.
I strongly believe that the credit rating agencies played a
pivotal role in the collapse of our financial markets. Any
regulatory reform effort must take that into consideration, and
I believe we will.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator Shelby. And as
I mentioned, I want to commend our colleague and the former
Chairman of the Committee. Senator Shelby really was early on
involved in the subject matter. He and Paul Sarbanes I think
worked together on that matter and did great work. He has been
followed in that effort by Jack Reed, and I want to thank Jack
publicly here for, as the Subcommittee Chair, dealing with
these matters, and he has worked very, very hard in developing
some legislative proposals which we invite all of our
colleagues to take a look at and to consider as part of our
overall financial modernization bill. But he has been
tremendously helpful, and I want to again publicly thank Jack
Reed for his work.
Jack, any thoughts on this?
STATEMENT OF SENATOR JACK REED
Senator Reed. Thank you, Mr. Chairman. I want to thank you
for not only holding this hearing, but also your efforts to
reform financial institution regulation.
I particularly want to commend Senator Shelby because it
was his leadership really in 2006 that first gave the SEC the
clear authority to begin to regulate the credit rating
agencies. In effect, the credit rating agencies are so central
to investor decisions that it is comparable to the Good
Housekeeping Seal of Approval. To expect a municipal finance
director in a small town to be able to do due diligence, to
make sure he has the AAA rating, is asking a lot. So we depend
significantly on the rating agencies, and as evidence suggests,
part of our current economic problems were a result of ratings
that were not substantiated over the long run.
What I believe we have to do is to give legislative support
to the SEC's efforts to focus on transparency through enhanced
disclosure, and also to counteract the appearance or substance
of conflict of interest. And the legislation that I propose and
in many respects that is reflected in the Administration's
proposal would do that.
There is one other issue that I have included in my
legislation; that is, to change the pleading standard in
securities cases so that a plaintiff could at least reach the
discovery stage with respect to a credit rating agency to see
if, in fact, their behavior was reckless. And we do not change
the overall 10(b)-5 standard, which is a very, very high bar
for liability. But effectively today, under the securities
laws, it is very difficult for a plaintiff to even get to
discovery to see what, in fact, went on with the rating. And I
think this was something that we should pursue.
Mr. Chairman, thank you and I look forward to the
witnesses.
Chairman Dodd. Thank you very much, Senator Reed, and we
thank you again for your work in this matter. We look forward
to your questions, again. And as I said at the outset, instead
of helping people understand risk, it was hiding risk, in
effect, too often and relying on the people who paid their
salaries. And it has much to do with the market failure as
anything else I can think of, the rating agencies, and the
dependency that people had on them. So, clearly, there is a
need for our attention.
So, with that, Mr. Barr, Mr. Secretary, we look forward to
your testimony.
STATEMENT OF MICHAEL S. BARR, ASSISTANT SECRETARY FOR FINANCIAL
INSTITUTIONS, DEPARTMENT OF THE TREASURY
Mr. Barr. Thank you very much, Chairman Dodd, Ranking
Member Shelby. It is a pleasure to be back here today with you
and the other Members of the Committee to talk about the
Administration's plan for financial regulatory reform.
As you know, on June 17th, President Obama unveiled a
sweeping set of regulatory reforms to lay a foundation for a
safer, more stable financial system. We have sent up draft
legislation for your consideration in most of the areas covered
by that proposal, and in the weeks since the release of those
proposals, we have worked with you and your staffs on testimony
and briefings on a bipartisan basis to explain and refine the
legislation.
Today, I would like to focus on credit ratings and credit
rating agencies and the role that they played in creating a
system where risks built up without being accounted for or
properly understood, and how these ratings contributed to a
system that proved far too fragile in the face of changes in
the economic outlook and uncertainty in our financial markets.
This Committee has provided strong leadership to enact the
first registration and regulation of rating agencies in 2006
under Senator Shelby's leadership, and Chairman Dodd, Ranking
Member Shelby, Senators Reed and Bunning have continued that
tradition going forward. The proposals that I will discuss
today build on that already strong foundation of this
Committee's work.
It is worthwhile to begin our discussion of credit ratings
with a basic explanation of the role they play. Rating agencies
solve a basic market failure. In a market with borrowers and
lenders, borrowers know more about their own financial
prospects than lenders do. And especially in the capital
markets, where a lender is likely purchasing a small portion of
the borrower's debt in the form of a bond or asset-backed
security, it can be inefficient for all lenders to get the
information they need to evaluate the creditworthiness of the
borrower. Lenders will not lend as much as they otherwise
might, especially to lesser known borrowers such as smaller
municipalities, or they will offer significantly higher rates.
Credit rating agencies provide a rating based on scale
economies, access to information, and accumulated experience.
At the same time, credit ratings played a key role, a key
enabling role in the buildup of risk in our system and
contributed to the deep fragility that was exposed in the past
2 years. The current crisis had many causes, but a major theme
was that risk--complex and often misunderstood--built up in
ways that supervisors, regulators, market participants did not,
could not monitor, prevent, or respond to effectively. Rapid
earnings from growth driven by innovation overwhelmed the will
or the ability to maintain robust internal controls and risk
management systems.
Rating agencies have a long track record evaluating the
risks bonds, but evaluating structured financial products is a
fundamentally different type of analysis. Asset-backed
securities represent a right to the cash-flows from a large
bundle of smaller assets.
Certain asset-backed securities also rely ``tranching''--
the slicing up of potential losses--and this process relies on
quantitative models that can produce and did produce any
desired probability of default. Credit ratings lacked
transparency with regard to the true risks that a rating
measured and the core assumptions that informed the rating and
the potential conflicts of interest in generating that rating.
This was particularly acute for ratings on asset-backed
securities, where the concentrated systemic risk are quite
different from the more idiosyncratic risks of corporate bonds
and are much more sensitive to the underlying assumptions.
Investors relied on the rating agencies' assessment of risk
across instruments, and they saw those risks as remarkably
similar, despite the complex and different securities
underlying the assets.
Ultimately, this led to serious overreliance on a system
for rating credit that was neither transparent nor free from
conflict. And when it turned out that many of the ratings were
overly optimistic, to say the least, it helped bring down our
financial system during the financial crisis.
We do need fundamental reform. The Administration's plan
focuses on a series of additional measures in three key areas:
transparency, reduction of rating shopping, and addressing
conflicts of interest. It recognizes the problem of
overreliance and calls for reducing the ratings usage wherever
possible.
With respect to transparency, we would call first for
better transparency in the rating agency process itself as well
as stronger disclosure requirements in securitization markets
more broadly. We would require transparency with respect to
qualitative and quantitative information underlying the ratings
so that investors can carry out their own due diligence more
effectively.
Mr. Chairman, I see that my time is up. Would you mind if I
take a couple more moments to outline the key proposals?
Chairman Dodd. No. Go ahead.
Mr. Barr. Second, the use of an identical rating system
between traditional corporate bonds and structured financial
products allowed investors to use their existing standards with
respect to ratings and allowed regulators to use existing
guidelines without the need to consider the different risks
posed by structured and unstructured products. Our proposals
address this directly by requiring that rating agencies use
rating symbols that distinguish between structured and
unstructured financial products. The first point, transparency.
Second, on rating shopping, an issuer may attempt to shop
among rating agencies by soliciting preliminary ratings from
multiple agencies and enlisting the agency that provides the
highest one. Our proposal would require instead that an issuer
disclose all of the preliminary ratings it had received from
different credit rating agencies, so investors could see how
much the issuer had shopped and whether his final rating
exceeded one of those preliminary rating. That should help
deter rating shopping in the first place.
In addition, the SEC has proposed a beneficial rule that
would require agencies to disclose the rating history so that
markets can assess the long-term quality of ratings.
In addition, we strongly support a proposed SEC rule that
would require issuers to provide the same data they provide to
one credit rating agency to all other credit rating agencies to
allow those agencies to provide additional independent analysis
to the market and to improve the ability of competition in the
marketplace in a beneficial, positive way.
Third, with respect to conflicts of interest, strong new
transparency requirements with respect to payments, we would in
addition ban rating agencies from providing consultant services
to issuers that they also rate, and each rating agency would be
required to disclose the fees that they were paid for a
particular rating, as well as the total fees paid to the rating
agency by the issuer over the previous 2 years.
Last, we need to strengthen and build on SEC supervision
with a dedicated office focused on compliance and a requirement
that the SEC evaluate the rating agencies' compliance with
their own rules and their own methodologies.
In conclusion, we all know that markets rely on faith and
trust. We need to restore honesty and integrity to our
financial system, and the plan that we have set forth before
you for consideration would lay a new foundation for financial
regulation that, in our judgment, will once again help make our
markets both vital and strong.
Thank you.
Chairman Dodd. Well, thank you very much, Secretary Barr.
We appreciate that very much. And let me just say we appreciate
very much as well the Administration's continuing conversation
with us in this Committee about your ideas. We welcome them. I
know I speak for all of us here, Senator Shelby and I
particularly. We look forward each week to the ideas that come
up and the thoughts that are coming from the Administration, as
well as from others. As I said earlier, this is a Committee
that is open, and it is a dynamic process that we want to hear
ideas as to how we ought to move forward.
But let me begin by raising the issue of, given the
problems caused by faulty ratings and the need for strong
Federal oversight--I think we have all come to that conclusion.
The question is how do you do this. We all recognize the
problem. Now what is the answer? And there are a lot of
different views on what the answer ought to be.
In fact, I was just saying to Senator Shelby, I have talked
to some people in the private sector who begin to raise the
question of whether or not you even need ratings agencies.
Today, given more transparency, the market in many ways could
help you determine whether or not a given product is actually
worthy of a AAA rating or something less than that. So there is
an argument of saying maybe this is an archaic structure,
although I do not believe that is a widely held view. There are
those who embrace that view.
But I wanted to share with you a view that has been held by
some in direct conflict with the proposal that the
Administration has given us, and that is to create a new office
within the SEC to conduct the oversight of rating agencies.
The Council of Institutional Investors' white paper that
was prepared by Professor Frank Partnoy recommends creating,
and I quote, ``a single independent credit rating agency
oversight board'' to oversee registration, inspection
standards, and enforcement actions related to the NRSROs,
similar to the Public Company Accounting Oversight Board for
accountants. Such an independent board could offer higher
salaries to attract staff with greater expertise. Others have
observed that the regulation could be moved to a systemic risk
regulator, authority.
Please describe, if you would, how the Treasury determined
which regulator among these options would be best to oversee
the credit rating agencies. How is it you came to the SEC
choice?
Mr. Barr. Mr. Chairman, I think that historically the SEC
has had important functions in this area. This Committee's
action under the leadership of Senator Shelby enhanced that
authority to the SEC. We were attempting to build on that basic
foundation in our legislative proposal.
Under our proposal, the SEC could delegate some of those
functions to the Public Accounting Board as a way of
recognizing their expertise. In our judgment, the SEC is able
to attract quite highly talented individuals in this area, and
having a dedicated office focused on this would advance the
mission.
Chairman Dodd. I want to raise a question here with you,
which I was stunned by the question because I just assumed that
this went on, but apparently it does not.
Credit rating agencies, I am told and they state, they do
not undertake to verify the information that issuers provide
them in making rating. This has led, obviously, to a perception
among some that the rating agencies take the issuer's
statements at face value and can choose to ignore other
information they receive or are aware of about the issuers when
producing a rating.
Do you feel it would be appropriate to require rating
agencies in formulating their ratings to consider information
that they receive about an issuer and find credible from
outside sources? What I find stunning is I just assumed that
went on. I am told it does not. So this is sort of a--I am
answering my own question. But tell me why you think there
should be a different answer than the one that I am suggesting
in my questioning.
Mr. Barr. I would never be so foolish.
[Laughter.]
Mr. Barr. I hope.
Chairman Dodd. You should not feel shy. Others do all the
time.
Mr. Barr. So let me just say, we tried to draw a line in
our proposal. We have tried to be quite clear that the
Government should not be in the business of designing the
methodologies for the rating agencies or validating them in any
way, because we think that will just increase reliance on them.
We have been quite clear that they need to disclose
whatever due diligence they do so that there is transparency so
that investors know when they get a rating--the rating company
would say, ``We didn't do any due diligence on this rating,''
or the rating company would have to say, ``The due diligence we
did consisted of calling our buddy.'' Or hopefully when the
transparency kicks in, the rating agency would have to say,
``We did real due diligence. We had a third party, and they can
certify they actually checked loan files.''
And I think that with that level of transparency, it will
be very hard for--harder for rating agencies to continue a
practice of--at least a mixed practice with respect to the kind
of due diligence they have done.
Chairman Dodd. You said something in the first sentence or
two in your answer to my question that we do not want to
dictate or require rating agencies to conduct their due
diligence. Forgive me, but I do not understand what you are
saying at that point. If we do not require them to do due
diligence, if we do not require them to at least consider
information, credible information that may contradict the
information they are receiving from the issuers paying them,
how can we have any confidence if we do not require that as a
matter of public policy?
Mr. Barr. I think there is room for lots of reasonable
people to disagree about exactly where to draw the line on
methodologies, Mr. Chairman, but I think the key principle is
we want to be sure that there is transparency about whatever
methods they used. We want to make sure that the SEC can
examine whether the agencies have actually used the procedures
they say they are using.
Chairman Dodd. They say they are using, they say they are
relying on the issuer, the one who is paying them. They can
have all the transparency in the world. You telling me that you
are relying on that information and that constitutes due
diligence does not give me a great deal of confidence.
Mr. Barr. It does not give me any confidence, sir. I am not
suggesting that. But I think that we should not inflate the
confidence level that the rating agencies would have on the
basis of that level of due diligence, and if the investor
community can see, is required to be shown that the kind of due
diligence that is being conducted is not really the diligence
that ought to be due, I think it will have a significant
salient effect on the process.
Chairman Dodd. Senator Shelby.
Senator Shelby. Secretary Barr, it would take a long
stretch, wouldn't it, to bring a lot of confidence back into
what we feel has been lost with the rating agencies, would it
not?
Mr. Barr. I would agree with that, sir.
Senator Shelby. Secretary Barr, S&P, Moody's, and Fitch
have not, in most people's eyes, performed well in recent
years. I think that is probably an understatement.
Nevertheless, the SEC has ebbed a persistent confidence in
these three firms--three firms--a sentiment that manifests
itself in regulatory requirements that blessed the
organizational structure, approach to ratings, and payment
scheme of those firms. There seems to be similar bias in your
draft legislation. I hope not.
What steps, if any, did you take, you and your team, to
ensure that no particular organizational structure, approached
to ratings, or payment model was favored over another and that
the regulatory structure will accommodate innovative entrance
into the rating? I have always advocated, gosh, three firms
nominate--they do not have it all, thank God, have all the
business, but there has not been enough competition there. You
know, why should you just bless three firms?
Mr. Barr. Senator Shelby, we would agree with you there
should be competition in this space, more entrants into the
market. They should be done on a level playing field. We should
have a diversity of approaches to a business structure so you
have investor-pay and issuer-pay models that need to be
accommodated in the system. And I think all that is absolutely
critical.
Senator Shelby. Something has gone wrong. We both agree
with that. And so what we are trying to do is have a basic new
approach to it to try to bring more transparency, a lot of
transparency, eliminate conflicts of interest and all these
things that were so rampant in this business. Do we agree on
that?
Mr. Barr. Yes, I think those fundamental principles are
embedded in our legislation. We would be in agreement about
that.
Senator Shelby. How is the decision to leave the NRSRO
ratings embedded in the regulatory framework consistent with
the goal of not affording regulatory privilege to a large
entity?
Mr. Barr. Senator, I think that we share the goal of
reducing reliance, both by private investors and by public
regulators, on the rating system. And in our judgment, that
requires methodically and carefully going through each way in
which rating agencies' ratings are used by different regulators
in different contexts.
There may be some areas where you can reduce reliance.
There may be other areas where you can eliminate reliance.
There may be some areas where you can use the rating but you
have to require--you should require judgment, independent
judgment, on top of that. And each of those contexts is quite,
in our judgment, specific. We want to work our way through it.
We are committed to doing that. The President's Working Group
of Financial Markets has a team that is looking at this issue,
again, regulation by regulation.
Senator Shelby. Do you believe that one of the priorities
at the SEC--one of the priorities, they have a lot--should be
to straighten out the problems that we all deem necessary with
the rating agencies?
Mr. Barr. I think it is one of the top priorities in
reform, along with making sure we have resolution authority----
Senator Shelby. Absolutely.
Mr. Barr. ----making sure we have a way of reducing
systemic risk in the system and protecting consumers. So I
think it is a critical part of the overall package.
Senator Shelby. Heretofore, one of the factors that led
this Committee to act in 2006 legislatively was the fact that
the NRSRO policy decisions were being made at the SEC at the
staff level rather than the Commission level, as you well know.
Freestanding offices at the Commission, such as the Office of
Compliance, Inspections, and Examinations, have not always been
subject to the same level of scrutiny as the main divisions.
You propose an office to be created, as I understand it, at the
SEC dedicated to the NRSRO supervision. How would you ensure
here sufficient accountability to the Commission, to the
Securities and Exchange Commission?
Mr. Barr. Senator Shelby, that is an issue I would be happy
to continue to work further with you and the SEC on. In our
judgment, having a dedicated office would increase
accountability to the Commission and to the Congress because
you would know exactly who is responsible for that job.
Senator Shelby. My last question, and my time is about up,
you also propose--your proposal would authorize the Securities
and Exchange Commission to delegate reviews of NRSROs to the
Public Accounting Oversight Board. What is the PCAOB's
expertise that makes it uniquely qualified for this task, and
would you recommend that the PCAOB Board be structured to
reflect the new responsibilities?
Mr. Barr. Senator, the----
Senator Shelby. They are getting into a new field here,
would they not?
Mr. Barr. There may be elements of supervision that could
be delegated with respect to accounting methodologies and other
matters, where they do have expertise. We have not considered
restructuring the Board to accommodate that. I would view that
as an available option to the SEC, but not integral to the
proposal.
Senator Shelby. Thank you. Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much.
Senator Reed.
Senator Reed. Well, thank you very much, Mr. Chairman.
Thank you, Mr. Secretary. The issue that Chairman Dodd
raised with respect to due diligence is embroached by the
second panel, Professor Coffee and Mr. Joynt on behalf of
Fitch. One suggests that we instruct--Professor Coffee--neutral
clients and other institutional investors that they cannot rely
on ratings to meet their fiduciary obligations unless there
was, in fact, third-party due diligence. Mr. Fitch's approach
is to ensure that the issuers and underwriters perform such due
diligence. Do you have a position with respect to these two
views or another view?
Mr. Barr. The Administration hasn't weighed in on the
question whether there should be additional requirements
outside of the rating agencies with respect to the purchasers
of rated securitizations. I think that we would want to be
careful, again, not to take steps that would suggest excessive
confidence in the ratings themselves, and anything that we can
do that improves due diligence by investors is likely to be in
the right direction. But whether that needs to be a requirement
on the purchaser or not, I frankly have not formed a developed
view.
Senator Reed. One of the aspects of the legislation I
proposed is to at least adjust the pleading standards and
effectively, a private right of action would be, I think, a
stimulus for a lot of due diligence. Is that your position?
Mr. Barr. In our judgment, this presented a complicated
question. On the one hand, the changing the pleading standard
might increase the incentives for due diligence in the system.
On the other hand, we were concerned that such a standard might
increase reliance by the investor or public on the rating
agencies and may provide further avenues for issuers to sue
over corporate downgrades, which we thought would potentially
pose a problem in the system. So in our judgment, this was a
very close question and we did not include it in our
legislative proposal.
Senator Reed. Thank you. Mr. Joynt, on behalf of Fitch, in
his testimony says a mandatory registration concept--your
concept--is unnecessary and unwarranted, is not consistent with
basic free speech principles. And then Rapid Ratings' testimony
predicts that the proposal will force compliance costs, raise
barriers to entry of new rating agencies, and essentially
impede technology and innovation. How would you respond to
these, first, that mandatory registration is unnecessary, and
second, to----
Mr. Barr. In our judgment, the credit rating agencies
shouldn't be able to opt out of having high standards and a
level playing field. Consistent with our overall approach to
financial regulatory reform, we don't think that financial
institutions, credit rating agencies, or other participants in
the system should get to choose their regulator or not. And so
in our judgment, having high standards, a level playing field
for competition was really important. I think, on the basis of
the 2006 legislation, there is in place a system for
encouraging new entrants into the credit rating agency process.
Registration is not going to be a significant barrier to entry.
We think competition is a good idea in this space if it is on a
level playing field with high standards so there is no race to
the bottom, the competition is based on everybody playing by
the same rules.
Senator Reed. Finally, Mr. Secretary, in the testimony of
the succeeding panel, there is a question by Rapid Ratings
about the rating symbol, distinguished between structured and
nonstructured products. They suggest the problem is not that
investors did not know they were buying structured products.
They either knew and were happy to get the higher yield or they
didn't understand the risks that they were buying. Essentially,
the problem, they suggest, is not symbology, but accuracy.
Again, how would you respond to that proposal?
Mr. Barr. I think the rating of a structured product is a
fundamentally different exercise from the rating of a corporate
bond. The distinguishing features need to be noted. It is not
just the symbol that is used, but the underlying availability
of qualitative and quantitative information that we would
require disclosure on. The package of those reforms, I think,
will enhance transparency in the market and make it less likely
that garbage ratings can be invented.
Senator Reed. Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much.
Senator Corker.
Senator Corker. Mr. Chairman, thank you, and Senator Reed,
thank you for all of your effort in this regard.
Mr. Barr, thank you for being here. You are a very pleasant
guy and I am hoping that over time, we will get this all in
balance. I want to say, though, just in listening to testimony,
it just seems a little schizophrenic in that this was the
biggest regulatory failure in 30 years, and in essence,
regulators outsourced their regulation to three for-profit
entities. I mean, that is really what has happened here. We
obviously realized they were doing no due diligence and
basically taking what the issuers were saying.
In testimony in answering just a minute ago, you said that
the Federal Government should not be in the business of
designing what these guys do. But on the other hand, as it
relates to consumer protection, you guys want to design the
products that private companies are offering. I just find this
almost an out-of-body thing. When we are looking at trying to
fix the inconsistencies that led to this, on one hand, we are
doing almost nothing but transparency, OK. On the other hand,
we are getting into actually telling companies what products
they are going to offer. This is just sort of an imbalanced
approach, and I don't want to spend long on that, but I wonder
if you want to rebut that at all.
Mr. Barr. Yes, Senator. You and I have had this exchange on
previous occasions. In our judgment, we are not suggesting that
the Government is going to be in the business of designing
products. The legislation provides the authority to say there
is a product in the marketplace that is a standard product, a
30-year fixed-rate mortgage or a 5-1 ARM, and when a customer
is being offered a pay option ARM, the mortgage broker should
show them----
Senator Corker. And I understand all that----
Mr. Barr. ----what a 30-year fixed-rate mortgage looks
like. And so we are not in the business of designing that
product, either. We are saying there is a product in the
marketplace and it is the standard product. How do we judge
those?
We have, in that context, a large group of individuals who
are not sophisticated investors, market participants. It is a
fundamentally different context from the context of credit
rating agencies, where the basic backdrop is the institutional
investor market and sophisticated retail investors'
participation. And so you would want to come up with standards
that are appropriate to each of those marketplaces.
Senator Corker. Well, I appreciate that. I do see, though,
that you are basically keeping the same regulatory scheme and
process and making people rely or pay for these.
Let me go down a little different path. Eric Dinallo, who
is the Insurance Commissioner in New York, or has been up until
recently, suggested that instead of the kind of scheme that we
have now, since insurance companies in particular rely heavily
on ratings, that the insurance entities in these States should
actually pay for the ratings and they should be made available
to all. That way, if credit rating agencies don't perform
properly, they would be discarded. But in essence, it would be
a whole different way of looking at it. Now, that may not be
perfect, but I am just wondering if that kind of thinking makes
any sense from your standpoint.
Mr. Barr. I do think it makes sense to have a diversity of
payment models and investor-pay models and issuer-pay models. I
think investor-pay models have some downsides once the rating
occurs. There are concerns that the investor would have
incentives to avoid downgrades on their own holdings. But I do
think having a diversity of views, a diversity of approaches
within the same basic legal structure makes a lot of sense.
I think we need to reduce reliance by regulated entities on
ratings, but I think it is going to take the process a good bit
of time to figure out how to replace that function in the
regulatory structure with alternative judgments that can
perform a similar function.
Senator Corker. You know, I have issued bonds in the past
and have had rating agencies rate them. I do want you to know
all of them were paid in full.
[Laughter.]
Senator Corker. But it is kind of an interesting process
that you go through. I mean, you really do sort of look for the
entity that is going to give you the rating, and then you pay
them an up-front fee. And then, as the borrower, you sweat
bullets ensuring you could pay everything back over time. I do
wonder----
Mr. Barr. That is very old fashioned of you, Senator.
Senator Corker. Yes. Thank you for that, actually.
[Laughter.]
Senator Corker. I do wonder whether we should consider a
different payment mechanism, where in essence the credit rating
agencies have skin in the game over time. And then instead of
being paid up front, they are paid based on how it performs. We
have talked about that a little bit with mortgage brokers and
others who have had no skin in the game. And I wonder if you
might comment on that.
And I think some folks, some colleagues in the other body,
on the other side of the aisle, have actually been promoting
something called covered bonds, where in essence, instead of
getting all of this risk off banks' balance sheets, they in
essence are in the game all the way through. I wonder if you
might comment on those two, and thank you for your testimony.
In spite of some of the differences we have, and there is not
time to enumerate all those right now, I do look forward to
working with you and others to come up with something that is
in the middle of the road.
Mr. Barr. Thank you, Senator. I think both suggestions hold
out very good promise. One of the features of our legislative
proposal would be to give the SEC authority to require trailer
payments of the kinds that you have described for credit rating
agencies. I think it is a terrific suggestion. And I think
there is also enormous work that can be done with covered
bonds. It is not going to be a replacement for securitization,
but I think it is an additional promising avenue we would be
happy to work with you on.
Senator Corker. Thank you.
Chairman Dodd. Thank you, Senator.
Senator Warner.
Senator Warner. Thank you, Mr. Chairman.
I know a lot of my colleagues have brought up a number of
the failings of the rating agencies, and clearly, in some of
the products lines recently, that has been the case. This is
perhaps non-PC, this point, but there has been value from the
rating agencies. I think back in my tenure as Governor, and I
think Senator Johanns would agree, there was sometimes validity
in the rating agencies when you were looking at State bonds and
others, that they did provide that independent arbiter service
to kind of cut through the political clutter of both sides back
and forth so somebody could come in and to some level of
diligence, at least, assess what your State was doing or your
locality was doing over a short-term or a long-term basis.
We did find usage of the rating agencies, that they did do
due diligence, something that clearly I find what the Chairman
and Senator Reed and Senator Shelby said is pretty amazing, as
well, that they did not in so many of these corporate
circumstances--although again, the idea of legislating that
requirement, I think, Mr. Barr, you have raised some
appropriate concerns about, because would that enhance, put
that Government moral hazard thing that we all don't want to
extend to a whole new set of organizations in terms of the
rating agencies.
I want to ask two questions. One is, we have had mostly the
issuer-paid funding model. The Administration's proposal is
that an investor-paid funding model. I know certain investor-
paid models are starting. Do you really think that marketplace
approach, with the investor-funded rating agencies--I am asking
you to make a prediction here now--do you think it will be
successful? Do you think the market will respond to that?
Mr. Barr. I think there is an opportunity, Senator, to have
a structure that has both models, investor-pay and issuer
model, exist and thrive if there is the appropriate regulatory
backstop of a level playing field. I think that the initiative
to require an issuer to provide the basic information to all
credit rating agencies when it provides it to one, so there can
be true dissemination of information, true competition, will
help significantly in this regard if moved forward. And having
a level playing field for that kind of competition on the basis
of high standards and meaningful disclosure, I think there is
an opportunity for that model to work.
I think, frankly, we have so many challenges right now in
restarting our financial markets, our securitization markets,
and in laying a new foundation that it is not clear yet----
Senator Warner. I didn't make a prediction, and I do
understand this question of whether we should be blessing the
methodologies. It is a real hard issue.
Let me, with only a minute-and-a-half left, go to my other
question. You know, one of the things that we use these terms,
Triple-A, Double-B, what have you, but one of the things that I
have felt that investors have not had, and I am not sure I have
had as somebody who has been on the issuer side and on the
investor side, that we have ever kind of translated that into,
all right, what does that mean in terms of the actual
percentage chance of default, number one, or the second
category, even if there is a default, what percentage of my
investment could be truly in jeopardy, and should we, as we
think about these terms, think about at least putting some
commonly accepted standards around for investors.
You have got a Triple-A. What is your percentage of default
risk? What percentage of your investment are you potentially
going to lose--ten percent, 50 percent, 100 percent? We have
started to talk a little bit about here between structured
products and unstructured products, but should we actually try
to translate these letter-grade ratings into actual percentage
of risk of default or risk of amount of loss?
Mr. Barr. Yes, Senator. I think that is absolutely critical
to demystifying the process, making it more transparent. In our
proposal, we fully agree with you. There should be, in addition
to the rating, a report that describes the probability of
default, the loss given default, the variance, the reliability
of the data, the underlying quality of the asset, all the
information underlying the symbol so that investors in the
market can make better judgments about how to evaluate the
rating itself.
Senator Warner. We would know what a Triple-A rating
equates to, what a Double-B rating equates to in terms of both
percentage chance of default and, you have got $100 invested,
what percentage of that $100 you could lose if that default
takes place----
Mr. Barr. That is right, and on an individual
securitization basis, so you would be making a judgment----
Senator Warner. All the way down to an individual
securitized----
Mr. Barr. Correct.
Senator Warner. Thank you, Mr. Chairman.
Chairman Dodd. Very good question, Senator. Thank you very
much for your thoughts on that.
Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
Secretary Barr, good to see you again.
Mr. Barr. Good to see you.
Senator Johanns. I will say something that I think you will
find very unusual. My colleague from Virginia was talking about
working with the rating agencies as Governor. In our State, the
State of Nebraska, we have no debt. I never worked with a
rating agency in all the 6 years I was Governor because it
wasn't relevant. We paid for everything, even highways. So that
is one way of approaching this. Then you don't need rating
agencies. Kind of an unusual phenomena that to pay for things,
you would actually have two choices, cut spending or raise
taxes, and we could use more of that out here in Washington.
But I did work with rating agencies as Mayor of Lincoln as
we would issue bonds.
Let me ask you a little bit maybe of a mundane question,
but maybe an important question. As you know, there has been,
especially recently, some articles written about First
Amendment protection for rating agencies. Historically, it was
viewed that they were issuing an opinion and therefore they had
the protection of the First Amendment if they were sued.
As you move down this pathway of additional regulation or,
as Senator Corker points out, maybe rating agencies need to
have some skin in the game, if you will, do you have any
thoughts whatsoever about whether that moves a rating agency
out from underneath the First Amendment protection? What would
be your thoughts on that?
Mr. Barr. Senator, let me start by saying I am not an
expert in the First Amendment, so my judgment, the judgment of
the team when we were working on this was that there is lots of
scope for appropriate regulatory requirements on the rating
agencies, including all the ones that we have in our
legislation and a number of the other proposals this Committee
has considered that do not raise significant First Amendment
concerns.
Senator Johanns. So you think they would--and I appreciate
you are not a First Amendment lawyer. I am not, either, even
though I am a lawyer. But you are thinking that they still will
be able to defend their lawsuits by saying, we are protected by
the First Amendment because this is an opinion?
Mr. Barr. Senator, I don't want to get too deep into this
here, again, because I am not an expert in the First Amendment,
but in our judgment, the range of proposals that we have put
forth or that are in the Committee drafts of versions of this
do not raise significant First Amendment concerns, in our
judgment.
Senator Johanns. OK.
Mr. Barr. And so I would not have put that on the top of
the list of issues and the tradeoffs that we have been
discussing. I do not think that that is a significant issue in
the tradeoffs.
Senator Johanns. OK. In your judgment, how have the rating
agencies worked historically? We all know nothing was working
very well over this past period of time, but historically, if
you were to look at how they have done, what kind of mark would
you give them?
Mr. Barr. I think in many areas, the rating agencies have
performed quite important functions with respect to corporate
issuance of municipal bonds. In many areas, they have
significantly fallen down on the job in those same basic
areas--corporates and municipals, sort of really quite
straight-forward assessments that they have been significantly
wrong on. And in the structured product area, I would say the
evidence is really quite negative.
Senator Johanns. Here is my concern, and maybe it is a
question based upon what Senator Corker was asking you again.
But it seems to me that one of the risks that we run here is
that we so gum up this system with additional regulations that,
number one, no one could ever enter into competition. If you
don't have a head start dealing with regulations, you are just
not going to get in. So we exclude competition.
And then the second thing is, I just worry that what we end
up with is literally a system where the consumer pays a heavier
price for this. Somebody has to pay for the regulation. There
just isn't any doubt about it.
Have you done any cost-benefit, any analysis of the impact
on just the average guy out there who may be investing a bit of
their retirement or whatever and the impact this will have?
Mr. Barr. Senator, I think, unfortunately, the whole
country is paying the price. Every consumer is paying the price
today of a significant failure of our financial regulatory
system. So we are all paying for it now in spades. I think we
need to have a system in the future in which the level playing
field and high standards are established in a way that makes it
much less likely we are going to blow up our financial system
and cause this amount of harm to the average American
homeowner, consumer, small business person. So in our judgment,
the tradeoff isn't even close. The kind of approach that we are
suggesting here is not a heavy regulatory burden, but it is an
essential one.
Senator Johanns. Mr. Chairman, thank you very much.
Chairman Dodd. Thank you, Senator Johanns.
I think it has been valuable, by the way, to have two
former Governors, two former mayors on the Committee. And while
I think there is a difference, obviously, in terms of rating
agencies when it comes to municipal or public bonds as opposed
to private securitizations, nonetheless, it is a valuable piece
of information as we look at this, because obviously, when we
talk about rating agencies, there is a tendency for all of us
to focus in on the private side of this. But we ought to keep
in mind the public entity side of this question, as well, and I
hadn't really given that much thought. I am glad you raised it,
as did Senator Warner and Senator Corker.
Senator Merkley, you are up next.
Senator Merkley. Thank you very much, Mr. Chair, and thank
you for your testimony.
I believe that the proposal bans consulting fees by rating
agencies and requires disclosure of payments. Certainly banning
consulting fees addresses part of the conflict of interest. We
still have kind of the fundamental notion that folks are
getting paid for what they provide and the possibility of
shopping between agencies and kind of getting a heads up on if
we did purchase it, what your rating might be. So anything that
we need to do that is kind of more fundamental in terms of
having a different system for structuring payments for rating,
doing it through a central fund that the folks pay into or some
other--is there any ideas you have seriously considered that
would more directly take on the conflict of interest?
Mr. Barr. Well, I think, Senator, we think conflicts of
interest did play a role in this problem. We have a series of
measures with respect to the banning of consulting payments,
strengthening disclosure and management of conflicts,
disclosing the fees paid by issuers, a look-back requirement
with respect to the revolving door to make sure that revolving
doors haven't influenced these structures, designation of a
compliance officer, disclosure of the preliminary rating
received to get at the rating shopping question that you
described. And I think, fundamentally--and we share Senator
Corker's judgment that having trailer payments could play a
positive role in the basic structure.
Having a diversity of different business structures, both
investor-pay and issuer-pay models, together with a requirement
that the information provided to one agency is provided to all
the others, will have a significant impact on the conflicts
problem. It won't eliminate it, but it will have a significant
impact.
Senator Merkley. All those are very good and well, but you
didn't answer the question I asked, which was did you
consider----
Mr. Barr. I tried.
Senator Merkley. ----changes in more--that went more to the
heart of the structural conflict of interest of having the
payments go directly from the bond issuer to the--and if you
rejected such ideas, what did you consider and why did you
reject them?
Mr. Barr. We looked at a range of models that had been
proposed, from switching back to a full investor-pay model. We
looked at the utility model that had been suggested. We looked
at the roulette wheel model of using rating agencies that had
been suggested. In our judgment, each of those suffered from
some significant infirmities. If you used the utility model,
for example, you are really just enshrining the rating agencies
even more in the process and putting a Government seal of
approval on them. If you use the roulette wheel model, you are
reducing the incentives for meaningful competition and for
better ratings. If you go fully to an investor-pay model, it is
not obvious that the resulting conflicts are going to be, on
balance, better.
And so our judgment was, better to have a diversity of
payment schemes out there. Let us have a level playing field
with competition, but on the basis of serious high standards.
And let us provide information that is given to one agency to
all the agencies so that there is a chance for them to show
that their competitor isn't good at doing a rating.
Senator Merkley. Thank you. That is helpful, and I will
have my team follow up to try to get a better understanding of
the weaknesses of those other possibilities.
We have in the structured products world very complex CDOs
and CDO-squared that made it virtually impossible for anyone to
determine the underlying foundation for what went into a CDO-
squared, and by that I mean situations where you had BBB bonds
that you dedicated 60 percent of the revenue and suddenly you
had AAA bonds coming out of the BBB portfolio, et cetera. And
yet you are so far removed from whether they were liar loans,
whether the loans had been thoroughly vetted in terms of the
income of the individual, et cetera--underwritten, if you will.
So is there a level of complexity that should simply be
banned in the interest of reducing systemic risk? Is there a
level of slicing and dicing that gets to where you really
cannot create--it is too messy, the path is too messy from the
buyer back to the foundation that essentially they do not make
sense to allow in the marketplace?
Mr. Barr. I think there are ways of getting at the basic
problem of complexity in alternative strategies than a flat
ban. So, for example, the securitization ``skin in the game''
requirement improved transparency in the securitization
structure that we have proposed requirements with respect to
transparency at the loan level for all investors in the
underlying asset with respect to, say, a borrower FICO score,
what broker originated the loan, what the compensation scheme
was, all of which are designed to get at that set of concerns,
and better qualitative and quantitative information underlying
the rating on such a structured product would permit investors
to go underneath and say, well, the reason that they have
assigned this rating is because their view of the cash-flow
distribution in the waterfall was this, their loss probability
measurement, their loss severity measurement is that. And it is
a way of unpacking the complexity into its component parts.
Senator Merkley. I appreciate your response. I am picturing
what that sort of report might have looked like on some of
those CDO-squared. It may have in itself----
Mr. Barr. I would not want to write it.
Senator Merkley. I am over my time, and so thank you very
much.
Senator Reed [presiding]. Thank you, Senator Merkley.
Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Secretary Barr, before getting into the subject of today's
hearing, I have a question on a different matter. Yesterday,
the Wall Street Journal had a front-page article about a
meeting last Friday where Secretary Geithner attacked
independent bank regulators for expressing their concern about
Treasury's regulatory reform proposal. Were you at that
meeting?
Mr. Barr. Yes.
Senator Bunning. If you were, was the article accurate
about what happened at the meeting?
Mr. Barr. I do not have the article in front of me,
Senator. I would say we have an ongoing series of conversations
with the financial regulators on a regular basis. We have frank
and direct conversations with them on a regular basis.
Senator Bunning. If I give you the article, would you
refresh your memory?
Mr. Barr. I am happy to look at the article. I am trying to
describe for you the discussion, if I could.
Senator Bunning. All right. Go ahead.
Mr. Barr. The conversation that we had with them, the
Secretary made clear the regulators are free to defend their
own agency prerogatives. They are independent agencies. He
expected that they would. He asked that they keep in mind, as
they did that, the fundamental goals that we all share to
protect consumers, to address systemic risk in our system, to
make sure the Government had the tools they need to resolve
financial firms in a crisis, and as they expressed their
differences that we work together in the areas where we do have
agreement.
We had a long conversation about the important roles of the
council versus the independent regulators. We had a long
discussion about micro prudential versus macro prudential
regulation. It was the kind of conversation that we have had
with them on many occasions.
Senator Bunning. The same type of discussion from Secretary
Geithner and you with the regulators that you have had in the
past.
Mr. Barr. I will not characterize the exact verbiage that
was used, but I would say that the frankness of the exchange--
--
Senator Bunning. We are on television. I do not think you
want to do that.
Mr. Barr. Senator, you know, you will not be surprised to
learn that in Treasury, as occasionally up on the Hill, there
is some colorful language that is sometimes used.
Senator Bunning. I have been accused of that. I understand
that completely. OK. Let us get to the current thing. Everybody
agrees that the current rating agency model has failed--I think
everybody up here does--especially for complex structure
products. There also seems to be agreement that better
competition will improve ratings. How we get better competition
is a little more difficult question, but we must break the hold
of the top two or three agencies if we are going to fix the
ratings.
It seems to me that there are two changes that will go a
long way to fixing the competition problem. First, we should
eliminate any regulatory requirements to use rating agencies so
that they will only be used if they add value. Second, we
should require issuers to provide the same information about
the securities to all investors and rating agencies, much like
we do for publicly traded companies with regulatory FD. That
way each agency will be able to compete based on the quality of
their ratings, and we will break the monopoly of the issuer-pay
model.
Let me start first with the first point, that we should
eliminate all requirements to use rating agencies. Do you agree
with that or not?
Mr. Barr. In our judgment, we need to go regulation by
regulation. We agree with the basic goal of reducing reliance
wherever possible. I think we need to go into the specific
circumstances of how the SEC and the bank agencies and other
agencies use the ratings. In some contexts, we can go to
elimination. In other contexts----
Senator Bunning. You do agree that there is a definite
conflict of interest presently?
Mr. Barr. I am sorry. In the rating agency structure?
Senator Bunning. When I would go to a rating agency--I am a
private corporation. I come to a rating agency. I need $200
million in bonds. They say, ``Yes, we will do this.'' They give
me a BBB rating, and then they send me a bill for $250,000 for
that rating. Don't you think that is a conflict?
Mr. Barr. I do think there are serious conflicts of
interest present in the existing model. That is why we require
a series of steps to reduce the conflicts, disclose the
conflicts, manage the conflicts. We strongly agree with your
suggestion that an issuer be required to provide information
when it gives it to one agency to give it to all the credit
rating agencies. I think that is a terrific proposal. It is
part of our plan.
Senator Bunning. Now, about the second point--and I am a
little past my time--that all investors and rating agencies
should have access to the same information about a security so
they can perform their own analysis of it, do you agree with
that?
Mr. Barr. I think when----
Senator Bunning. You just said that.
Mr. Barr. I am sorry. Yes, when you give one rating agency
the information, you should give it to all the other rating
agencies as a way of enhancing competition. I do think that
that is an important part of the plan.
Senator Bunning. Do you think that it is absolutely
necessary for an agency to rate every security or bond that is
sold to the public entities? In other words, I am the city of
Louisville, I am building an arena, and I apply to the IRS for
a portion on it to be tax free, and I go to this agency and
they say, ``Well, we cannot do this.'' And all of a sudden
someone intervenes, and all of a sudden they found their
ability to do this. And I think that is absolutely the wrong
way to do business. For, you know, a half-a-million dollars we
get $4 million worth of bonds that are 80 percent tax free and
15 percent taxable. Do you think that is the right way to run
the business?
Mr. Barr. I think there are enormous inefficiencies in our
revenue bond system in the United States of which the rating
process is one, but there are many, many others.
Senator Bunning. Thank you.
Senator Reed. Thank you very much, Senator Bunning.
Senator Schumer is next. He stepped out. Senator Shelby, do
you have a question?
Senator Shelby. I will just--do you believe, Mr. Secretary,
that eliminating the conflict of interest--it is obvious to me
and a lot of other people--by the rating agencies where they
get paid for rating things, so to speak, and the cozy
relationship there is very important in our regulatory
overhaul?
Mr. Barr. I think we have to tackle the conflict of
interest head-on. I am not sure we can fully eliminate it, but
I think we have to address it.
Senator Shelby. How do we bring back what I thought we all
benefited for a long time, and that is, securitization of
mortgages? For years and years--I would not say every mortgage,
you know, but there was as lot of confidence in the
securitization process, and the securitization process
basically worked. It basically worked. Now it is, for all
intents and purposes, very small, if not dead.
How do we do that? Do we do it with covered mortgages? Do
we do it with stringent ratings and trailing profits like
Senator Corker alluded to earlier, or what? How do we do this?
Because I do not know if the money is ever going to flow until
we bring some confidence back into securitization. Maybe I am
wrong.
Mr. Barr. Senator Shelby, I think it is a central question.
I think that, in our judgment, one of the reasons it is so
critical to move on financial regulatory reform this year is
precisely that. I do not think we are going to see a
revitalization of our securitization markets unless we have a
new foundation of regulation that permits transparency in the
system, restores honesty and integrity to the process that was
so sorely lacking in the last bit of time.
So I think that, in our judgment, we need to move quickly
on financial regulatory reform. We need to have transparency in
the securitization structures. We need to improve regulation of
credit rating agencies building on the 2006 law. We need to
make sure we take care of the systemic risk problem and
consumer protection. And we really have to move in a way that
it is demonstrable to the markets that we are serious about
reform.
Senator Shelby. Thank you.
Senator Reed. Thank you very much, Senator Shelby.
Senator Schumer.
Senator Schumer. Thank you. Thank you, Mr. Chairman. I want
to thank you for holding this hearing. Thanks, Secretary Barr,
for coming. Thanks, Senator Shelby, for asking that extra
question. I appreciate it.
I have a little statement with a little proposal in there,
and I am going to ask your opinion of it.
We had hoped, when we passed the Credit Rating Agency Act
of 2006, the reform act of 2006, which required registration
and oversight of credit rating agencies, that the rating
agencies would be one of the cornerstones of strong credit
markets. Instead, as has been said before, the credit rating
agencies turned out to be one of the weakest links, and those
need to be fixed, as you just said.
What we found out was that rating systems were filled with
conflicts of interest. The worst of these conflicts were that
issuers went shopping for ratings like they were shopping for
used cars. If they did not like the answer they heard, they
went somewhere else. Because the revenues of the rating
agencies grew with the massive expansion of the securitization
market, the rating agencies had every incentive to help issuers
structure their products to get the ratings they wanted. The
result: Rating agencies rubber stamped complex products they
did not understand as investment grade, using flawed analytical
models and methodologies with inadequate historical data that
did not include the possibility of high mortgage defaults.
We cannot overestimate the impact this had on the financial
crisis. Losses in structured finance securities alone led to
$1.47 trillion in writedowns and losses at the largest
financial institutions. And Senator Reed, our Chairman here,
has introduced a bill on credit rating agencies, and the
Administration has proposed new rules to address some of these
conflicts of interest and the inability to evaluate ratings.
And they are important proposals, but I wonder if the message
is getting through.
Last month, I read an article how Moody's downgraded--after
Moody's downgraded a collateralized debt obligation because the
default rate of loans in the CDO rose 7 percent. Morgan Stanley
repackaged it into new securities with AAA ratings. How can you
get a AAA rating based on a CDO that has just been downgraded
six levels? Where are the checks in the system?
That is why I am proposing, in addition to Senator Reed's
bill and the Administration's proposal, which I think are very
good, that for every ten rated products, the SEC would randomly
assign a different rating agency, another rating agency to
issue a second rating. I understand that issuers get two
ratings, but this randomly assigned rating agency would act as
a check on the first rating agency.
Furthermore, this check would help discourage ratings
shopping and other conflicts of interest inherent in the
system. We would learn who is better at ratings and who is
worse and get rid of at least the conflicts of interest. I
would not want to do it for every issue. That is too many, but
just a certain amount. We propose one out of ten, maybe it
should be a little less, a little more, but a significant
amount so we get a pool of knowledge. And I think it would be
prophylactic. If an agency knew that there was a one in ten
chance when they got paid by the issuer that someone else was
doing an independent rating, they would be more careful.
So the ratings are too much a part of our financial system
to abandon them, but it is clear the system as it exists is
broken, and I want to look forward to working with Chairman
Dodd, Senator Reed on his excellent proposal, and the
Administration to make sure that we can have faith that a AAA
rating means what it says.
So my only question to you, Assistant Secretary, is: What
do you think of this proposal of having the SEC randomly
assigning a second rating agency? That would be done, by the
way, concurrently with the first and come out at about the same
time.
Mr. Barr. Senator Schumer, thank you for your longstanding
work in this area. I would say we share the conceptual goal of
having more than one agency rate issuance, particularly--it is
a particularly acute problem in the structured finance area,
but it exists elsewhere.
In our proposal, we suggest that one way to do that
consistent with the direction of the SEC's proposal is to
require that every issuer provide full information about their
issuance to all the other credit rating agencies as a way of
enhancing competition in the rating. There are significant
incentives on the competitors to want to demonstrate their own
prowess in rating in relation to their competitor who has been
selected.
I think that one tradeoff that one might consider with
respect to an assignment process is whether that assignment
might provide a kind of seal of approval to the rating that
would not be intended, it would be counter to the general
thrust of what the Committee has been trying to do in this
area. So that might be a competing concern on the other side
with mandatory as opposed to competition for the rating.
Senator Schumer. Yes, but, OK, two points I would make. My
time is up. But, number one, it would be done on a random basis
and secretly, number one. And the pool would probably be a lot
greater than just the Big Three. So you would have new entries
with some incentive to just get it right and get it honest.
And, second, your proposal, of course, is not mandatory,
and simply giving the information, if everyone is in the same
boat--and just a few of them doing the same practice might
prove to have the same discouraging effect of sort of paying
for a good rating. That is what I would say. My time is up, but
I would certainly want an answer----
Mr. Barr. I am happy to work with you.
Senator Schumer. ----to look at that.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Schumer, and I have
conferred with the Ranking Member, and, Mr. Secretary, I think
we are ready to move to the next panel. Thank you very much.
Mr. Barr. Thank you so much for your time.
Senator Reed. Thank you.
I would like to ask the second panel to come forward,
please. Thank you, gentlemen. Let me introduce the panel and
then begin to recognize our witnesses.
Our first witness is Mr. Stephen W. Joynt. He is the
President and CEO of Fitch Ratings as well as the CEO of Fitch
Group, Inc., the parent company of Fitch Ratings Algorithmics
and Fitch Training.
Our next witness is Mr. James H. Gellert. He is the
President and CEO of Rapid Ratings.
Our next witness is Professor John C. Coffee, Jr., the
Adolf A. Berle Professor of Law at Columbia University Law
School. He has testified before this Committee on numerous
occasions and has been a valuable source of counsel in many
different situations. Thank you, Professor Coffee.
Our next witness is Dr. Lawrence J. White. Dr. White is the
Arthur E. Imperatore Professor of Economics at New York
University Stern School of Business, as well as Deputy Chair of
the Economics Department at Stern. He has served on the senior
staff of the President's Council of Economic Advisers and as
the Director of the Economic Policy Office, Antitrust Division
of the United States Department of Justice. Thank you, Doctor.
Finally, our last witness is Mr. Mark Froeba. Mr. Froeba is
the principal at PF2 Securities Evaluations, Inc. He has served
as senior vice president with Moody's Derivatives Group and as
vice president and senior credit officer at Moody's. Thank you
very much, Mr. Froeba.
Mr. Joynt, your testimony, please. Could you turn the
microphone on, please, and lean in?
STATEMENT OF STEPHEN W. JOYNT, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FITCH RATINGS
Mr. Joynt. Thank you, Senator Reed, Senator Shelby, Members
of the Committee. Thank you for the opportunity to appear at
the hearing today. I would like to spend a few minutes
summarizing my prepared statement.
While overall macroeconomic conditions remain difficult, it
seems the period of the most intense market stress has passed.
This is due to both a variety of Government initiatives here
and abroad aimed at restoring financial market stability as
well as actions taken by companies individually to shore up
their balance sheets and reduce risk.
Having said that, important sectors in the fixed-income
markets remain effectively closed, and certain asset classes,
such as commercial mortgage-backed securities, are experiencing
greater performance strain on their underlying assets.
During this time, the focus of Fitch Ratings has been on
implementing a broad range of initiatives that enhance the
reliability and transparency of our opinions and related
analytics. More specifically, our primary focus is on
vigorously reviewing our analytical approaches and changing
ratings to reflect the current risk profile of the securities
that we rate. In many cases, that continues to generate
significant numbers of downgrades in structured securities, but
also affects other sectors, such as banks and insurance.
We are releasing our updated ratings and research
transparently and publicly, and we are communicating directly
with the market the latest information and analysis that we
have.
In parallel, we have been introducing a range of new
policies and procedures--and updating existing ones--to reflect
the evolving regulatory frameworks within which credit rating
agencies operate globally. In each of these areas, we have been
as transparent as possible, broadly engaging with all market
participants, including policy makers and regulators. I am
happy to expand on these topics as we proceed.
That said, the focus of today's hearing is clearly on where
do we go forward from here. Senator Reed has introduced a bill,
which we are happy to speak to. The House held a hearing in
May. The SEC, I think, considered important new rules at their
roundtable discussion in April. There is a Treasury proposal
that we will speak about, and also outside the U.S., we have
been in discussions with the EU, and they have recently enacted
a registration and oversight system as well that applies to
rating agencies.
As this Committee considers these topics, we would like to
offer our perspective on several important issues. Let me
reiterate that we are committed to engaging on all of these
matters in a thoughtful, balanced, constructive, and non-self-
serving manner. At the same time, some perceptions and
proposals continue to circulate that could use clarification.
Transparency is a recurring theme of the discussions about
rating agencies, and at Fitch, we are committed to being as
transparent in everything we do. All of Fitch's ratings'
supporting rationale and assumptions and related methodologies
and a good portion of our research are freely available to the
market in real time. We do not believe that everyone should
agree with all of our opinions, but we are committed to
ensuring the market has the opportunity to discuss them.
Some market participants have noted that limits on the
amount of information that is disclosed to the market by
issuers and underwriters has made the market overreliant on
rating agencies, particularly for analysis and evaluation of
structured securities. The argument follows that the market
would benefit if additional information on structured
securities were made broadly and readily available to all
investors, thereby enabling them to have access to the same
information as mandated rating agencies in developing their own
thinking and research.
Fitch fully supports the concept of greater disclosure of
such information. We also believe that responsibility for
disclosing that information should rest with issuers and
underwriters. It is their transactions, and they should be
disclosing all the pertinent information to all investors.
A related benefit of additional issuer disclosure is that
it addresses the issue of rating shopping. Greater disclosure
would enable nonmandated NRSROs to issue ratings on structured
securities if they so choose, providing the market with a
greater variety of opinion and an important check on perceived
ratings inflation.
Discussion of additional information is of questionable
value without accuracy and reliability of the information. That
goes to this question of due diligence. We have taken, rating
agencies, a number of steps to increase our assessments of the
quality of the information that we are provided with, and we
have adopted policies that we will not rate issues if we deem
the quality of the information to be insufficient. The burden
of due diligence, in my opinion, though, belongs with issuers
and underwriters. Congress should mandate that the SEC enact
rules that require issuers and underwriters to perform such due
diligence and make public their findings and enforce the rules
that they enact.
In terms of regulation more broadly, Fitch supports fair
and balanced oversight and registration of credit rating
agencies and believes the market will benefit from globally
consistent rules for credit rating agencies that foster
transparency, disclosure of ratings and methodologies. We
believe that oversight requirements should be applied
consistently and equally to all NRSROs.
One theme in the discussion of additional regulation is the
desire to impose more accountability on rating agencies. While
ultimately the market imposes accountability for our ratings,
for the reliability and performance of our ratings and our
research, if the market does not have confidence in us, the
value of Fitch's franchise will be diminished.
While we understand and agree with the notion that we
should be accountable for what we do, we disagree with the idea
that the imposition of greater liability will achieve that.
Some of the discussion on liability is based on misperceptions.
Rating agencies today, like accountants and officers and
directors and securities analysts, may be held liable for
securities fraud to the extent rating agencies intentionally or
recklessly make material misstatements or omissions.
Beyond the standard of existing securities law that applies
to all fundamentally, we struggle with the notion of what it is
we should be liable for. Specifically a credit rating is an
opinion about future events, and the likelihood of an issuer
that he might meet his credit obligations. Imposing a specific
liability standard for failing to accurately predict the future
strikes us as an unwise approach.
Congress should also consider some practical consequences
of imposing additional liability. They were mentioned earlier.
Expanded competition might be inhibited from smaller agencies,
but that may be addressed. All rating agencies also may be
motivated to just try to provide the lowest securities ratings
just to mitigate liability, which does not encourage accuracy.
I see I am past my time.
Senator Reed. Thank you very much, Mr. Joynt.
Let me also say that all your statements will be made part
of the record, and if you would like to summarize them, that is
perfectly fine. And the statements of the Members will be made
part of the record.
Mr. Gellert, please.
STATEMENT OF JAMES H. GELLERT, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, RAPID RATINGS INTERNATIONAL, INC.
Mr. Gellert. Thank you. Senators, thank you for inviting us
to join you today. Rapid Ratings is a subscriber-paid firm or
otherwise known as an investor-paid firm. We utilize a
proprietary software-based system to rate the financial health
of thousands of public and private companies and financial
institutions quarterly. We use only financial statements, no
market inputs, no analysts, and have no contact in the rating
process with issuers, with bankers, or with advisers. Our
ratings far outperformed the traditional issuer-paid rating
agencies in innumerable cases such as Enron, GM, Delphi,
Pilgrim's Pride, the entire U.S. homebuilding industry, and
others.
Currently, we are not a NRSRO. We have not applied for the
NRSRO status, and we do not have immediate plans to do so. At
present, there are too many mixed messages coming from the SEC,
Treasury, and Congress for me to recommend to our shareholders
that the designation is in their best interests.
Of course, the Treasury proposal's requirement that all
ratings firms must register is an unwelcomed development. It
runs counter to the goal of positive change for the industry,
not to mention elements of the Credit Rating Agency Reform Act
of 2006.
We do believe that reform in our industry is necessary and
must happen with a sense of urgency. But we caution that, if
not done properly, this reform may have counterproductive and
unintended consequences.
We also believe that competition in this industry, and the
level playing field for current and new players, is essential.
Equivalent disclosure of information is needed. Rules that do
not disproportionately penalize small players are needed. An
environment where the new innovate and where the old can have
their behavior modified is needed. All should be primary goals
of legislation.
The SEC has been wrestling with new rules and rule
amendments and has made some headway in areas curbing the
issuer-paid conflicts. We do not agree with all of the elements
of the SEC's initiatives, but the Commission has taken some
positive steps to stop the more egregious behavior of the
issuer-paid agencies. As detailed in my written submission, our
views on the new Treasury proposal are not quite as balanced.
Together, the SEC and Treasury initiatives are positively
addressing rating shopping, conflict and fee disclosure,
transparency issues, and are at least flirting with removing
the NRSRO designation from SEC regulations. For our complete
comment on these, again, I would like to refer you to our
written submission.
On the critical side, the recent Treasury proposal, despite
its positives, threatens to erect more hurdles to competition
in this industry, further solidifying the entrenched position
held by S&P, Moody's, and Fitch. A few items.
Methodology disclosure: Rules in the Treasury proposal on
transparency of ratings methodology could come dangerously
close to meaning ratings firms would have no intellectual
property protection.
Ratings disclosure: Requiring subscriber-based rating
agencies to disclose their history of ratings and ratings
actions can undermine the subscriber-based business model,
which is predicated on selling current and past ratings to
investors. The Treasury proposal covers all types of rating
agencies and for 100 percent of their ratings. This erects a
major barrier for subscriber-paid firms by interfering with
their revenue model.
Requiring NRSRO registration: Requiring registration of all
companies issuing ratings is perhaps the most counterproductive
initiative of all. Not only does forcing registration run
counter to the 2006 Act, it could create a flood of new NRSROs
captured by the sweeping dragnet. Investors will not have the
inclination to look at all of these firms and will tend to
remain with the providers they know best, the Big Three.
Further, registration would impose all of the increased
direct and indirect costs on firms that would otherwise choose
not to be an NRSRO. This will force some out of business, it
will create disincentives for new entrants, and it will stifle
potential innovation and positive competition.
So the Treasury proposal would require firms to register,
subject them to high compliance costs, put at risk some firms'
intellectual property, and hinder their revenue-generating
ability. All in all, regulatory protection for S&P, Moody's,
and Fitch, and anything but a level playing field.
The Big Three agencies have lobbied heavily to promote the
notion that one-size-fits-all regulation is fair because all
business models carry conflicts of interest and that theirs is
no worse than any other. Can conflicts occur in other business
models? Sure, theoretically. Have conflicts in subscriber-paid
models contributed to any financial disasters? No. This red
herring cannot drive new legislation. The problem is not the
potential behavior of the subscriber-paid rating agencies.
Rather, it is the misbehaviors of the issuer-paid rating
agencies that have already occurred.
Effective legislation and regulatory framework must focus
on reforming the issuer-paid model and the model's most
negative features, providing oversight of the NRSROs that
prevent the self-interested behavior that contributed to the
current financial crisis and creating an even playing field for
competition. The latter has two major components, fostering, or
at least not inhibiting, new players, methodologies, and
innovation; and equivalent disclosure of data used by issuer-
paid agencies.
For true reform to have a fighting chance, these themes
must be protected by the legislative framework for the ratings
industry. We must be critically aware of how the unintended
consequences of poorly implemented regulations can leave us
with a broken system that has proven it is not so deserving of
protection. Innovation and responsible alternatives to a status
quo have been hallmarks of the American financial system. These
should be fostered by those looking to return confidence and
integrity to this industry. Thank you.
Senator Reed. Thank you very much, Mr. Gellert. I would
just take the opportunity that your comment about registration
of all rating agencies is the Treasury proposal, it is not my
proposal.
Mr. Gellert. Excuse me.
Senator Reed. Just clarifying.
[Laughter.]
Mr. Gellert. Fair enough.
Senator Reed. The privilege of the Chair. Forgive me.
Mr. Gellert. Well exercised.
Senator Reed. Professor Coffee.
STATEMENT OF JOHN C. COFFEE, Jr., ADOLF A. BERLE PROFESSOR OF
LAW, COLUMBIA UNIVERSITY LAW SCHOOL
Mr. Coffee. I am honored, Chairman Reed and fellow Members
of the Committee, to be back before this Committee, but I am in
the very embarrassing position of having to begin by commending
and congratulating the Chairman, because what we are looking at
in the Treasury bill is 95 percent what was in the Reed bill.
The Reed bill, introduced in April, was substantial,
constructive, well crafted, and I think it does just about
everything that you can do through administrative regulation to
deal with this problem.
The problem is, there are dimensions to this whole area
that are beyond simply administrative regulation and that is
what the Treasury bill in particular leaves out. Thus,
because--there is a shortfall, because not all of the
provisions in the Reed bill are in the Treasury bill and
because there needs to be a consideration of some issues beyond
administrative regulation. I would have to say there is a
shortfall in the Treasury regulation, and I would have to
predict that we will see a persistence of the status quo,
dysfunctional and perverse as it is, if all we do is what is in
the Treasury bill.
In this regard, I think there are two distinctive critical
features about credit rating agencies which distinguish them
from all of the other gatekeepers in the financial markets that
have to be focused on.
One, credit rating agencies do not perform due diligence.
Accountants are bean counters. They go out and count the beans.
Credit rating agencies give ratings based on hypothetical
assumed facts, and thus you are getting hypothetical ratings. I
think that has to be corrected.
Second, the credit rating agencies today do not face any
meaningful risk of liability. Because, as I look at the future,
even though I wish to encourage the user-pay system, I think
the issuer-pays model will persist and predominate. There is
going to remain a built-in conflict of interest, and when you
have a built-in conflict of interest, the other professions
have found that the only thing that keeps the professional
honest is the threat of litigation. The accountants have
learned, painfully, how to steer a course between acquiescence
to the client and maintaining high integrity and litigation is
one of the forces that maintains that equilibrium.
Therefore, based on that diagnosis, what do I think we
should do? I think the first thing we have to focus on is how
to encourage third-party due diligence. The Treasury bill does
this, largely adopting many of your provisions. The problem is
that it does this by requiring disclosure when you decide to
use a third-party due diligence firm, and it requires
certification by that firm to the SEC.
That raises the cost of using a third-party due diligence
firm and I think there would be many underwriters, at least if
we get back into a bull market at some point in the future,
that will simply opt not to use the third-party due diligence
firm. They did this in the past. These due diligence firms were
widely employed in the 1990s, and as the market grew bubbly,
they dropped their use because they kept learning disquieting
facts that they didn't want to hear about. So you can put in
boilerplate disclosure that says, we are not using a third-
party due diligence firm, and hope that in that more favorable
market, you can get away with this, and I think you probably
would be able to get away with this.
How, then, should we deal with encouraging third-party due
diligence? I would suggest that we look here at a different
level of regulation. No one has been talking much about
regulating the users of this information, and the users now are
closely regulated by rules that I think are over-broad and ill
conceived. Let me give you one example.
Rule 2(a)(7) of the SEC under the Investment Company Act
tells money market funds that they cannot buy securities unless
they are eligible securities, and to be an eligible security,
you have to have a requisite rating from an NRSRO rating
agency. We could deregulate much of that, but many of the users
of this information do want to rely on an NRSRO rating. They
have made that very clear to the SEC.
What I think we should say is that to the extent you choose
to rely on an NRSRO rating, it has to be a rating that is based
upon third-party due diligence that verified the essential
facts. That way, we have at least something that is not
illusory, that is not a hypothetical rating, and that way--
because this rule already exists. I am not proposing new rules.
I am proposing making the existing rule meaningful by making it
based on third-party due diligence.
There are other of these rules, but they are in my
statement and I won't take it further. The point in doing this
is by focusing on the user, we are not regulating the rating
agency and that allows us to sidestep some arguable
constitutional problems about whether we are overly regulating
commercial speech. I don't think we are, but we aren't doing it
at all if we regulate the user and say, you only get the right
to do this if you use one of these techniques and you have good
due diligence.
Now, let me move on to this issue of liability because I
see the business-pays model as persisting. I think we need some
risk. In 10 seconds, let me just say that my proposal is not to
open the flood gates. It is really your proposal. I think you
struck a very sensible compromise, because it doesn't really
increase the likelihood of litigated outcomes.
It simply says, your proposal, your bill in April contains
a provision that says if credit rating agencies--they can be
found to have acted recklessly if they give an opinion, a
rating, without conducting some due diligence or receiving due
diligence from a third-party expert. This does not subject them
to liability. It just tells them there is one easy, safe
strategy for avoiding liability and that is to make sure that
the underwriter pays for and gives you a third-party due
diligence report that covers the critical facts in your model.
This will not produce a rash of litigation. It will produce
behavior that avoids litigation and thus this is another
technique to get the critical core of due diligence back into
the ratings process.
Thank you. I apologize for overstepping my time.
Senator Reed. Thank you, Professor Coffee.
Professor White.
STATEMENT OF LAWRENCE J. WHITE, LEONARD E. IMPERATORE PROFESSOR
OF ECONOMICS, NEW YORK UNIVERSITY
Mr. White. Thank you, Mr. Chairman, Members of the
Committee. My name is Lawrence J. White. I am a Professor of
Economics at the NYU Stern School of Business. During 1986 to
1989, I was a board member on the Federal Home Loan Bank Board.
Thank you for the opportunity to testify today on this
important topic.
I have appended to the statement for the Committee a longer
statement that I delivered at the Securities and Exchange
Commission's roundtable on the credit rating agencies on April
15, 2009, which I would like to have incorporated for the
record into the statement that I am presenting today.
The three large U.S.-based credit rating agencies--Moody's,
Standard and Poor's, and Fitch--and their excessively
optimistic ratings of subprime residential mortgage-backed
securities in the middle years of this decade clearly played a
central role in the financial debacle of the past 2 years.
Given this context, it is understandable that there would be
strong political sentiment, as expressed in the proposals by
the Obama administration as well as by others, for more
extensive regulation of the credit rating agencies in hopes 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, 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, some of which have
been talked about earlier this morning, and it may not even
achieve the goal of inducing better rating from the agencies.
It may well be a fool's errand. Ironically, it will also likely
create a new protective barrier around the incumbent rating
agencies.
There is a better route. That route starts with a
recognition that the centrality of the three major rating
agencies for the bond information process was mandated by more
than 70 years--it goes back to the 1930s--of prudential
financial regulation of banks and other financial institutions,
in essence, regulatory reliance on ratings, in essence, an
outsourcing or delegating of safety judgments to these third-
party credit rating agencies.
For example, the prohibition on banks holding speculative
bonds, as determined by the rating agencies' ratings, imbued
these third-party judgments about the creditworthiness of bonds
with the force of law. This problem was compounded when the SEC
created the category of Nationally Recognized Statistical
Rating Organization, NRSRO, in 1975, and then the SEC
subsequently became a barrier to entry into the rating
business.
As of year-end 2000, there were only three NRSROs: Moody's,
Standard and Poor's, and Fitch. It should thus come as no
surprise that when this literal handful of rating firms
stumbled, and stumbled badly, in their excessively optimistic
ratings of the subprime residential mortgage-backed securities,
the consequences were quite serious.
The recognition of the role of financial regulation
enforcing the centrality of the major rating agencies then
leads to an alternative prescription. Eliminate the regulatory
reliance on ratings, as Senator Bunning suggested earlier this
morning. Eliminate their force of law, and bring market forces
to bear.
Since the bond markets are primarily institutional markets,
as Assistant Secretary Barr mentioned earlier today, and not a
retail securities market, where retail customers do 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 superstructure could be dismantled, and the NRSRO
category could be eliminated.
Now, let us be clear. The regulatory requirements that
prudentially regulated financial institutions must maintain
safe bond portfolios should remain in force. That is
terrifically important. 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 advisors who might be the incumbent
rating agencies, or might be new firms that none of us have
discovered yet, but could come forth in this more open
environment.
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 and new ideas in ways that have not been
possible since the 1930s.
Now, my longer statement goes into greater detail, but
since it was done on April 15, before the Obama
administration's proposals were proposed, I just want to
mention a few things about those proposals. I will be very
brief, Mr. Chairman.
Senator Reed. Thank you, Professor.
Mr. White. Again, it is understandable they want to do
something, but I think the efforts go in the wrong direction
and the dangers are substantial because they are going to raise
barriers to entry and reduce innovation, reduce the possibility
of new ideas. Something that is especially dangerous is
something that Mr. Gellert mentioned a few minutes ago: the
requirement that all credit rating agencies, whether you are
just an independent guy offering some advice to a hedge fund or
whether you are a fixed-income analyst at a financial services
firm, must register as an NRSRO. This strikes me as something
that is going to discourage entry, discourage those new ideas,
and that can't be a direction we want to go.
So let me just say again that the proposals really are
wrong-headed and that we really do have a superior route to go,
which is a greater reliance on the market for information which
an institutional bond market can use and use effectively.
Thank you for this opportunity, and I will be happy to
answer any questions.
Senator Reed. Thank you.
Mr. Froeba.
STATEMENT OF MARK FROEBA, J.D., PRINCIPAL, PF2 SECURITIES
EVALUATIONS, INC.
Mr. Froeba. Senator Reed, Senator Shelby, and Members of
the Committee, my name is Mark Froeba. Thank you for giving me
this opportunity to talk about rating agency reform.
Let me give you a brief summary of my background. I am a
1990 graduate of the Harvard Law School. Barack Obama was 1
year behind me. What a difference a year makes.
[Laughter.]
Mr. Froeba. In 1997, I left the tax group at Skadden, Arps
in New York where I had been working in part on structured
finance securities to join the CDO group at Moody's and I
worked there for just over 10 years, all of that time in the
CDO group.
Since the beginning of the subprime crisis, there have been
many proposals for rating agency reform. Most of them are well
intentioned. However, few seem likely to accomplish real
reform. Real reform, in my opinion, must achieve two clear
policy goals. It must first prevent another rating-related
financial crisis like the subprime crisis, and it must also
restore investor confidence in the quality and reliability of
credit ratings.
In my opinion, the rating agency reform provisions of the
Investor Protection Act of 2009 are not sufficient in
themselves to accomplish either of these goals. However, the
Act's rulemaking authority could be used to expand their
effectiveness.
Why are the reform provisions in themselves, in my opinion,
insufficient? First, they are not the product of a complete
investigation into what actually happened at the rating
agencies. Without a proper investigation of what happened, not
conducted on a theoretical level or in discussions with senior
managers, but with the analysts who actually assigned the
problem ratings in question, we cannot be sure the proposed
legislation provides solutions designed to fix the problems.
The best way to illustrate my second reason for questioning
the sufficiency of this proposal is to ask you a simple
question. If the Investor Protection Act of 2009 had been
enacted just as it is 5 years ago, do you think it would have
prevented the subprime crisis? In my opinion, the answer to
this question is no. That does not mean that the proposals are
bad, it just means that they do not advance what should be the
central policy goal of reform, preventing a future crisis.
If these proposals are uncertain to prevent a future crisis
and restore confidence in credit ratings, what reforms could
achieve these goals? I have, you will not be surprised to hear,
six proposals, and I am going to speak really fast or skip
some.
First, put a firewall around rating analysis. The agencies
have already separated their rating and nonrating businesses.
This is fine, but not enough. The agencies must also separate
the rating business from rating analysis. Investors need to
believe that rating analysis generates a pure opinion about
credit quality, not one even potentially influenced by business
goals, like building market share. Even if business goals have
never corrupted a single rating, the potential for corruption
demands a complete separation of rating analysis from bottom-
line analysis.
Investors should see that rating analysis is kept safe from
interference by any agenda other than getting the answer right,
and the best reform proposal will exclude business managers
from involvement in any aspect of rating analysis and
critically also from any role in decisions about analyst pay,
performance, or promotions.
Second, prohibit employee stock ownership and change the
way rating analysts are compensated. There is a reason why we
don't want judges to have a stake in the matters before them,
and it is not just to make sure judges are fair. We do this so
litigants have confidence in the system and trust its results.
We do this even if some or all judges could decide cases fairly
without such a rule.
The same should be true for ratings. Even if employee stock
ownership has never actually affected a single rating, it
provokes doubt that the ratings are disinterested and
undermines investor confidence. Investors should have no cause
to question whether the interests of rating agency employees
align more closely with agency shareholders than investors.
Reform should ban all forms of employee stock ownership, direct
and indirect, by anyone involved in rating analysis.
The same concerns arise with respect to annual bonus
compensation and 401(k) contributions. As long as these forms
of compensation are allowed to be based upon how well the
company performs and are not limited to how well the analyst
performs, there will always be doubts about how the rating
analyst's interests align.
Third, create a remedy for unreasonably bad ratings.
Essentially, expand the liability of the agencies. I am going
to skip my discussion of that because some of that discussion
has already occurred.
My fourth proposal is to change the antitrust laws so
agencies can cooperate on standards. When rating agencies
compete over rating standards, everybody loses. Giving them the
capacity to get together to talk about rating standards may
expand our ability to prevent the kind of problems that we have
had. Imagine how different the world would be today if the
agencies could have joined forces 3 years ago to refuse to
securitize the worst of the subprime mortgages.
My other proposals are to create an independent
professional organization for rating analysts, and also to
introduce investor-pay incentives into the issuer-pay
framework, neither of which I have time to discuss, but they
are described in my statement. Thank you.
Senator Reed. Thank you very much, Mr. Froeba.
Thank you all. This has been a very, I think, informative
panel.
Let me pose a question to all the panel members. I think I
know Dr. White's answer.
[Laughter.]
Senator Reed. The Investor Working Group chaired by former
SEC Chairman Donaldson and Arthur Levitt has recommended that
myriad statutes and rules that require a certain investor to
hold only securities with specific ratings should be eliminated
over time to clarify that reliance on a rating does not satisfy
due diligence efforts. I think Secretary Barr suggested that in
one of his responses, and this is an issue, frankly, that
Senator Bunning has raised directly, which is the reliance on
these ratings, and the Secretary suggests that on a case by
case, they were going to walk through the statutes. Just your
reaction, Mr. Joynt, and down the line.
Mr. Joynt. So this has come up in the SEC hearings, as
well, and my response there, the same response today, which is
I think it is healthy to go back and look at each of the
regulations individually. I think it would not be helpful to
have some kind of a blanket dismissal of all uses of ratings
and regulations.
I think, and I have been around a long time, I can think of
why some of those ratings were put into regulation and they
were for positive and constructive reasons, to try to limit
risk and to be used as handy benchmarks for other regulators
and boards of directors and other things. But to not go back
and look at them, I think is a mistake. To look at them may
help eliminate some of the use of ratings in regulation or even
update them, because ratings have changed over time. They don't
necessarily all mean the same things to all the same people.
I still believe, though, that if ratings were eliminated in
regulation, they will be often and frequently used by many
institutional investors, boards of directors, and investors,
because I believe they have value independent of whether they
are forced to be used by regulation.
Senator Reed. Thank you.
Mr. Gellert.
Mr. Gellert. I think looking at removing the NRSRO
designation and regulations is actually quite a good idea. I
agree that they can't all just be stripped out immediately
because that can be disruptive, but looked at in a methodical
way relatively expeditiously is probably a benefit. I think the
Treasury plan calls for a 30-month review of this. I think that
is probably a bit more time than anyone really needs to get
started or at least to be able to make the statement that this
is a road we are marching down.
But I would point out that it is not just that there is a
tendency for institutional investors to overrely, or a
potential for them to overrely and essentially outsource their
own credit work. It presents an opportunity to arbitrage the
system, because a security that meets a certain standard by
their regulatory oversight but has a higher yield, as we saw
during this crisis, is something that they can buy and will buy
because it is beneficial to them for returns. So, in a handful
of ways, it can be complicated, but I do think it is a good
initiative.
Senator Reed. Professor Coffee.
Mr. Coffee. I was sort of discussing this in my remarks,
because I gave you the example of Rule 2(a)(7), which says
money market funds, you can only buy eligible securities and
they have to have an investment-grade rating from an NRSRO. I
would change that. I would change it in the following way. I
would not wholly abolish the rule, because we can't dare
deregulate all money market funds that came this close to
failure last fall. There have to be some restrictions.
Professor White also, I think, agreed with that.
I would give institutional investors----
Mr. White. There you are, putting words in my mouth again,
Jack.
[Laughter.]
Mr. Coffee. Anyway, I would give institutional investors a
choice. They could do it themselves. They could say, we are
going to conduct our own due diligence and we will have our own
prudent man fiduciary obligations when we do that, or we can
rely on a credit rating, but only a credit rating that is
supported by due diligence so that the critical facts on which
the model relies have been verified by someone who is a
professional.
I know what will happen if given this choice. All of the
smaller institutions would prefer to rely on the rating agency
because the SEC proposed this last fall, and when they proposed
this, they nearly got assaulted with pitchforks by the
institutional investor community, which said, we don't want to
take personal liability. But I think they should have the
choice.
I think to encourage competition, we should say, you can do
your own form of due diligence, but you have greater legal
responsibility if you do it yourself, or you can rely on those
NRSRO ratings which are supported by legitimate verification.
Given that choice, I think the world will be better off and I
think it would encourage some competition.
Senator Reed. Professor White, I think I know where you
come down on the big issue, but let me pose a slightly
different question, and if my time runs out, we will do a
second round, but I want to recognize Ranking Member Shelby.
There is an economic, I think, advantage, particularly for
a small entity, that the Treasurer of Pawtucket, Rhode Island,
who wants to make an investment, to have something that is
shorthand, you know, triple-A, A-minus, et cetera, and I would
think systemically and throughout the economy that the rating
agencies have provided some value over time. It is not just a
complete sort of desert out there.
So just the issue of--I mean, I think the approach is sort
of sequentially looking where we can change, and then a final
point tying into what Professor Coffee said is that even if we
eliminate the requirements, the presumption would be that
issuers would still probably be paying and that, given the
choice, most people would go to the rating agencies. So just
your quick comment on that.
Mr. White. All right. Thank you, Senator. First, you know,
your larger issue, the larger question you asked about should
we strip out the regulatory reliance on ratings, and my short
answer is, as my grandmother would have said, from your lips to
God's ear, or perhaps President Obama's ear.
But let me now address the issue you just raised. When I
advocate eliminating regulatory reliance, first, it can't be
done overnight. That is right. Of course, you need notice and
comment, et cetera. But also, it would be replaced by placing
the direct burden on the bond manager at a bank, at a pension
fund, at a money market mutual fund, to justify the safety of
his or her bond portfolio. That is terrifically important.
And the bond manager justifies the safety of the bond
portfolio to the regulator either by doing the research him or
herself, but not everybody is going to be able to do that,
especially the smaller institution, or relying on an advisor.
The advisor could be one of the incumbent rating firms. It
might be a paid consultant. It might be a special advisory firm
that comes into the market. Of course, that reliance ought to
be approved by the regulator, but you open up the process.
Now, those money market mutual fund responses to the SEC's
proposals, ah, they were bleating and saying, oh, not us. Not
us. We couldn't do the research ourselves. OK, fine. You can't
do the research yourself, but if you don't even have the
expertise to be able to figure out who is a reliable advisor
and who is not, you shouldn't be running a bond fund in the
first place and the SEC ought to use its regulatory powers to
remove somebody who does not have the expertise even to figure
out who is a reliable advisor or who is not. Again, this is an
institutional market. It is not a retail market.
Senator Reed. Thank you, Mr. Froeba. I have a question, but
it will be in the second round. Thank you.
Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Mr. Joynt, one of the issues that was identified by the SEC
staff in last year's report on credit rating agencies was that
the growth and complexity of complex structured products
overwhelmed the rating agencies. What steps have you taken to
ensure that the next complex product--and there will be some--
that is sold in the financial markets does not outpace perhaps
your firm's analytic capabilities in the way that the CDOs and
the CLOs did?
Mr. Joynt. A complex question, but in today's market
environment, there is very little in the way of new complex
instruments being issued. So in some way we have sort of a time
to reassess.
Some of the most complex instruments in the markets, CDO-
squared and CPDOs, I think we took almost 6 months to analyze
CPDOs before deciding that we could not rate them with our
highest rating, and that was a very difficult process of
analysts, modelers, and experienced people with judgment trying
to think about the subjective aspects of the risk.
It was mentioned earlier ratings have reflected the
probability of loss, but some of these products where it was
more important to think about the severity of the loss, how
much you might lose when they go bad, and ratings were not and
had not and have not been structured to address that, and maybe
they need to be. We are working on that now as well.
So I would say we have a healthy degree of skepticism about
the complexity of the instruments. Today we have been asked to
rate some resecuritizations that were mentioned earlier as
well. We have only been willing to rate one class of security
rather than tranche securities because in the tranching process
they are creating strips that, if the probability of loss is
wrong, you will have great severity. So we are uncomfortable
assigning ratings of that type today.
So today I would say we are pausing and reassessing how we
do the analysis and what the ratings mean.
Senator Shelby. OK. Professor White, you pointed out that
credit rating agencies include disclaimers with their ratings,
telling users not to rely on credit rating agencies in making
investment decisions. Likewise, the SEC has directed money
market funds not to rely solely on ratings by Nationally
Recognized Statistical Rating Organizations in making their
investment decisions.
Does the fact that regulations require ratings send a
signal that contradicts these disclaimers?
Mr. White. It sure sounds and looks like a contradiction to
me. On the one hand, you have regulations that say pay
attention to the ratings, and on the other hand, you have the
kind of disclaimer--I will quote it directly. This is the S&P
disclaimer. ``Any user of the information contained herein
should not rely on any credit rating or other opinion contained
herein in making any investment decision.''
Senator Shelby. Well, why do you want them then if----
Mr. White. Well, I do not know whether to laugh or cry, and
that is why I would step away, and say ``do not rely.'' If you
want to voluntarily do so, fine, and you get to decide. Since
you are an institutional investor, you have some memory, you
have some judgment. You can figure out who has been the
reliable provider of information, and who has not; who has the
business model that you can trust and who, oh, I am not so
sure.
That is something that institutional investors should be
expected to be able to do.
Senator Shelby. Professor Coffee, do you have a comment on
that?
Mr. Coffee. Well, my great fear is that the status quo will
persist, and the way in which it is most likely to persist is
if we deregulate some of these rules, what we will get is most
institutional investors continue to rely on NRSRO ratings,
figuring that is the safest if they ever were to get sued.
What I think we should do simultaneously is give them more
options. Let them do it themselves or go to consultants. But to
the extent that they are relying on the NRSRO alternative, we
should upgrade that alternative by insisting on due diligence
so it is not an illusory opinion. That way you give them more
options, but they are higher-quality options.
Senator Shelby. Professor White, Mr. Joynt defends ratings
as a common, independent risk benchmark that should be retained
in regulations. Do the failures of the rating agencies over the
last several years call into question their value as a
benchmark?
Mr. White. Even the executives of the ratings agencies
acknowledge they made mistakes, they stumbled badly. So
certainly over the past few years, they have not been very
good.
Quite honestly, I am agnostic about the whole issue of what
business model, whether it is investor pay or issuer pay, is
the right model. I think that is something that the
institutional bond investor can figure out.
It is important to remember that the issuer-pay model had
been around for 30 years, from the early 1970s, and really
there had not been major problems.
Senator Shelby. What happened?
Mr. White. And then comes the whole structured finance
market where there are only a handful of issuers, only a
handful of NRSROs that the issuers can go to. The money is very
good, and they stumbled, they succumbed. They got careless.
Senator Shelby. Greed?
Mr. White. Greed was there all the time. But there was
concern about reputation before, and somehow that got swamped.
The model failed this time around. But it worked for 30 years.
That is why I am agnostic. This is something that institutional
participants can figure out on their own, with oversight by the
prudential regulators to make sure that at the end of the day
they have safe and sound bond portfolios.
Senator Shelby. Is it possible that ratings for certain
instruments, such as more traditional bonds we have talked
about, have a greater value as benchmarks than ratings provided
for more complex and newer structured products, such as CDOs
and CLOs?
Mr. White. They are clearly simpler to rate. The entities
are more transparent, and the problems were fewer. So, yes,
certainly the history tells us they were better benchmarks.
Senator Shelby. Mr. Gellert, I have a question for you. You
note that the inclusion of ratings in regulations, quote, your
language, ``has given the Big Three a de facto legal and
statutory power over many institutional investors and other
financial institutions.'' You recommend that references be
removed from regulations. We have been getting into this.
Do you believe that the Government's removal of ratings
from its regulations would create incentives for the private
sector to conduct better or greater due diligence?
Mr. Gellert. I think it absolutely will. Just outside of
the legal liability issue, there will be the marketing issues
and the investor reporting issues for these institutions,
because the focus will come on them to understand better what
types of credit work they are doing internally. This ability to
arbitrage the system would go away to some extent. But there is
no question that by embedding, really the Big Three's, but the
NRSROs in various regulations gives them undue power over the
investment decisions and risk management decisions of the
institutional investor community.
Senator Shelby. How do we bring securitization back? How do
we do this? I mean, it is based on trust, and maybe it is a
brick at a time. But it worked so well for so long. Professor
Coffee, do you have a comment?
Mr. Coffee. I think this is a case where innovation was
corrupted. We had a much simpler kind of asset-backed
securitization in the 1990s----
Senator Shelby. And it worked, didn't it?
Mr. Coffee. It worked better when it was simpler. Once we
started bringing in the CDO-squared, no one could understand
it. And if there is one rule I would suggest to you, it is that
if it is too opaque to be understood, it really should not be
issued. And I think the market is going to insist on that. We
will probably have simpler kinds of asset-backed
securitizations which are more credible and which the rating
agency can more credibly signal and sample the quality of the
underlying collateral. Otherwise, we will see frozen housing
finance----
Senator Shelby. Without that, there is no trust out there,
is there?
Mr. Coffee. There is no trust because everyone can see that
no one understands this, including the rating agency.
Senator Shelby. Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Shelby.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank each
of you for your testimony. I really think it has been most
enlightening. I think each of you have shed a little different
light on the issue, and I really appreciate that, especially on
this issue.
Mr. Joynt, you probably deserve a badge of courage in
showing up. I want to thank you for that. And I also want to
thank you for taking time in your offices to walk through the
issue with us. I know that in a market economy this has
affected you guys downwardly. I know a lot of employees have
left the firm as a result just to less work, and I know this is
not a good time for rating agencies. But I want to ask this
question.
If you listened, I think we were all sort of shocked that
there was no due diligence really performed, and I think each
person has alluded to that in a different way. What is the
value proposition that the credit agencies, the three large
ones, provide the public?
Mr. Joynt. So the dialogue about due diligence, if we focus
on corporate issuers, I think if you think about the rating
agencies that have recently started up or become NRSROs, almost
all of them are focused on corporate issuers. None are focused
on structured finance, Realpoint only on CMBS. I think that is
because there is disclosure of good information; they are able
to do ratings and get investors to pay. They do not need any
special information.
So that is the process I think about when I think about
securitization and structured finance as well. There should be
enough public disclosure for many rating agencies, and
investors also, to be able to use the public information, that
it should be reputable, that an issuer and/or his banker has
put together as a part of arranging a financing. And so I see
them as having the due diligence.
The function of the rating agency, Fitch's rating agency,
is to analyze that information, think forward about the
potential risk of default and ramifications for investors, and
try to order that for investors through our rating system, and
then publish our research that tells them all the factors.
I think that function--which allows many investors that
cannot analyze the wide variety of financings that we can
because we have a staff of 1,900 people--and I think that
provides a valuable function. So it should not be the only
thing that investors should be looking at. I certainly agree
with the idea that investors are responsible for their own
analysis.
Senator Corker. So one of the things we talked about in
your office was really to focus on the toxic asset issue, which
has kind of come and gone, but how do you actually value those?
That is where we spent most of our time. And you guys shared
with me that you could tell by zip codes what the default rates
were going to be and all of those kinds of things.
So moving away from the corporate side and looking at the
CDOs and these other instruments we are talking about, those
kind of things were not done on the other hand when you rated
these particular securities. Is that correct?
Mr. Joynt. No. For mortgage-backed securities, that is the
kind of analysis we would do. We would not go out and verify
the individual loan information provided in the package. But in
looking at the history and frequency of defaults and severities
and problems, we could do that as a part of our modeling.
Unfortunately, the history is not representative of what
was going to happen and has subsequently happened.
Senator Corker. But on those, then, understanding that you
look at corporate financial statements and those kind of
things, but on these other types of asset-backed securities, it
is hard to understand, in fairness, what the value proposition
is that you offer if they are not really being offered by a
company and you are not actually going out and checking the
parts of the country that they are being offered from. It is
hard to understand that there is really any value proposition
that is being offered by the credit rating agency.
Mr. Joynt. I do not see it that way, so I think originators
and servicers put together financial packages and package them
into transactions that we can look at the companies, the
origination, the servicer, the accounting firm that signed off
on their financials, and try to think about whether those are
representative of what is being presented and then analyze that
compared to the history and what we would project the losses to
be.
Senator Corker. So it is really more--the companies, of
course, have no skin in the game. They are out of there after
it is done, mostly. I know some of them have kept pieces, but
the companies--so when you look at the companies, they are not
standing behind it like might be the case with a covered bond.
So----
Mr. Joynt. That is true.
Senator Corker. OK.
Mr. Joynt. But I do not think they are not--it has not been
my experience, although we have had quite bad experience that
some of the large important financial institutions doing
securitizations are not appreciative of the fact that their
name is on the securitization if they would have originated the
product. And so I think they are quite involved and/or are
servicing the product. So I believe they have--not all firms,
and some firms, of course, have entirely disappeared, so
obviously they were doing quite a poor job and either did not
care about their reputation or just failed.
Senator Corker. Mr. Chairman, I am going to ask one more
question if that is OK.
We are going to miss Senator Bunning in about a year-and-a-
half.
[Laughter.]
Senator Bunning. What makes you think I will be missed?
Senator Corker. I am going to miss you.
The whole issue, I think one of the things that we have
talked about some in the past is the business model, and that
is that in the event you actually had to do due diligence and
have these third-party efforts take place--which, by the way, I
think should have to happen if somebody is going to rely upon
it. But, in essence, it would really price you ought to the
market in a way, would it not? Would you speak to that a little
bit? And if you had to really do due diligence and you had to
really know what was in that package, you could not charge the
fee that you now charge and make any money. And I think you
alluded to that in our conversations that that would be very
problematic.
Mr. Joynt. Well, we are not staffed in that way to go audit
or check every one of the loan packages put together on every
single family loan that would go into a financing. So we are
not staffed that was at all. We are not staffed with a national
network of auditors or even a system of local auditors. So that
is certainly true.
For CMBS, it is a little bit different where we have been
able to send analysts to look at large properties. We are still
not conducting what--I am very careful about this word ``due
diligence'' around lawyers, because I am not a lawyer, but we
certainly conduct an amount of diligent investigation into what
we are looking at for individual properties in commercial real
estate. But for consumer assets, broadly spread, we have used a
more actuarial approach, assuming that the facts in the files
are correct.
Senator Corker. And everyone on the panel agrees that there
should be no regulatory mandate to have to use, even State
government, city government, any type of government entity
should not be mandated to have to have a rating to buy a
security. Does everyone agree with that? Everybody agrees
with----
Mr. Coffee. I think that there could be other options.
Senator Corker. But we should not build in having to use
credit rating agencies and automatically causing people to
believe that some work was actually done, due diligence-wise?
Mr. Coffee. I think that what some of us are saying is that
you could certainly have alternatives that did not involve the
use of an NRSRO agency. But to the extent that there already is
this reputational capital out there in the public's mind and
they are going to want you to have an NRSRO rating, some of us
want to make that real and not illusory by insisting on due
diligence. And that due diligence, to answer your earlier
question, would probably be paid for by the underwriters. If
the underwriters could get this market jump-started again, they
would be happy to pay the cost of due diligence.
Senator Corker. Thank you all. I appreciate it.
Senator Reed. Thank you, Senator Corker.
Senator Bunning.
Senator Bunning. Thank you. Five minutes turns into 10 in a
big hurry up here, and that is the only reason--since some of
us have another meeting to go to.
This is for anyone who would like to answer it. During the
housing boom--the boom--rating agencies rated mortgage-backed
securities without verifying any of the information about the
mortgages. If they had, maybe they would have detected some of
the fraud and bad lending practices.
Do you think rating agencies should be required to verify
the information provided to them by the issuer? And I am going
to give you a caveat. The first mortgage that I ever took, I
had to take three of my Federal tax returns in with me to
verify that I had the income that I wrote on my application.
You do not have to do any of those things right now, and I am
asking if you think we ought to have a little more verification
of what is on the list that the person who is looking for the
mortgage at the time--and that is how we got into all this
mischief with mortgage-backed securities being sold into the
market without any verification, even though they were AAA
rated.
Mr. Coffee. Let me say you are right, Senator. You probably
wanted to hear that. You are right. And I have some charts in
my statement that show that the percentage of liar loans, no-
document and low-document loans, in subprime mortgages went
from in the year 2001 about 28 percent to the year 2006 about
51 percent. That is a very sharp jump, and no one noticed
because no one really wanted to look. The loan originators had
no interest because they got rid of the entire loan.
Senator Bunning. But the Federal Reserve was responsible
for overseeing the banks that made those loans, and/or the
mortgage brokers, we gave that power to the Fed and just
because they did not write any regulations, we ran into all
this mischief. And so the housing bubble and the bursting of it
was caused by some not doing their homework.
Mr. Coffee. Again, you are right, Senator.
Senator Bunning. Well, I do not want to be right, because
we are in a hell of a mess. If we were to require issuers to
disclose information to all rating agencies, should that
disclosure apply to securities that have already been rated so
that we can get more opinions on the toxic securities already
in the system? Please.
Mr. Gellert. The short answer is yes. The percentage of new
issues, particularly in the structured business now, is
infinitesimal compared to what is outstanding and on people's
books. So back to your prior questions of how do we get the
securitization market moving again, we have to be able to
provide to the market greater insight into what is already out
there. And to just provide the detailed due diligence
information and supporting information of structured products
that come to market today is insufficient.
And I would just add that one of the areas that gets short
shrift when we discuss structured products is the
collateralized loan obligation asset class. It is equally if
not more important than the CDOs and other securitized, or
structured products, and the information availability is much
smaller. And it is much more tightly controlled by the rating
agencies that currently do rate----
Senator Bunning. I only have 5 minutes. I am not trying to
cut you off, but I want to ask--because do you think--this is a
question for anybody. Do you think the rating agencies should
be able to be sued for errors in their ratings?
Mr. Coffee. Because I am probably the one most associated
with saying there has to be some litigation remedy, let me say
I do not think it should go that far. I do not think there
should be a cause of action for negligence. I do not think
misjudgments should produce litigation. I think it should be
for being reckless. And when you give a rating with knowing any
facts at all, then it is reckless.
Senator Bunning. Well, then, that is a cause of----
Mr. Coffee. I think you went beyond that and said should
you just be sued because you made a misjudgment.
Senator Bunning. No, no. If you find negligence, then there
is a cause of action.
Mr. Coffee. Well, not under the Federal securities laws,
and I do not think we should try to increase anything in
Federal law that would create a negligence-based cause of
action against the rating agencies.
Senator Bunning. OK. Then, how about this question: Do you
think that issuers who relied on flawed ratings to sell their
product should be able to be sued for using those flawed
ratings?
Mr. Coffee. I think they are going to be sued directly
because they made fraudulent misstatements, and that is how
they are being sued. I do not think--I think the plaintiffs'
bar regards the rating agencies as a possible additional party
to throw in, but they have very modest expectations of what
they can get from them, and they have not gotten any
significant settlements.
Senator Bunning. Well, the question--I am over time. Thank
you.
Senator Reed. If you want to take some more time?
Senator Bunning. Well, the only thing I wanted to ask is if
here we have a situation where they were not given enough
information or they did not investigate far enough with the
mortgage-backed securities, and they accepted the fact that
these were legitimate mortgage-backed securities by the banks,
then I see where they would not be held responsible. But if
they did not go into the details of what kind of mortgages they
were selling or were being sold, then I think they should be
held responsible.
Mr. Coffee. And I think that is the line between negligence
and recklessness.
Senator Bunning. Thank you. Thank you very much.
Senator Reed. Thank you, Senator Bunning.
Mr. Froeba, again, thank you for your testimony but also
for your insights, because you actually were sort of there in
the middle of this while at an opportune level, not at the top,
not at the bottom, but right where the work was being done.
You mentioned of your six proposals--you suggested the
test, and it is interesting test: Would it avert the problems
we saw? And you have suggested that the proposals before us
will not accomplish that. Of those six, what is the most
critical thing that from your view we would have to--or one or
two that we would have to incorporate in our reforms?
Mr. Froeba. In some ways, the most important would be the
hardest to implement, and that is the idea that you separate
the analytical function from the management function. Just as
in the court system or at a university, you want your
professors, you want your judges to be independent of the
people who are sort of managing the process. At the rating
agency, you want the analysis to be independent of the business
decisions. And I think that is probably the key, also the most
difficult.
Another really important one is affecting the way analysts
are paid. I think analysts should not be--their pay, their
compensation, their reward should not have anything to do with
how the company does, because the best answer from the analysts
may impact company revenue negatively. You want to encourage
them to give that negative answer despite the impact it may
have to their own financial situation. So those two are
important. I think expanding liability is key.
And, finally, the one that is probably, forgive me for
saying it so informally--the weirdest proposal is that the
rating agencies be allowed to cooperate. If the rating agencies
had gotten together 5 years ago and said we are not going to
allow for the securitization of liar loans, if they had been
able to get together and agree that they were all going to do
that and they would not feel undercut by the competitors, I
think we would have seen much of this subprime crisis averted.
Senator Reed. Thank you.
Professor Coffee, I just wanted to follow up on Senator
Bunning's line of questioning about liability. As you pointed
out, the standard for liability under the securities laws is
essentially recklessness, it is a very----
Mr. Coffee. ``Extreme recklessness.''
Senator Reed. ``Extreme recklessness.'' It is a very high
threshold, as it should be. The proposal I have made is not to
change that liability standard but to change explicitly the
pleading standard. And I wanted you to--if that is your
understanding since you have looked at the legislation, if that
is the case. And, also, the rationale is that until you get to
discovery, it is awful hard to understand what was done on a
factual basis, and just your comments on that.
Mr. Coffee. I agree with what you are saying, and I think
it is a sound proposal. I also think that it will produce very
few litigated losses for the credit rating agencies because you
give them in your statute a kind of safe harbor. If they get
independent due diligence done by a professional, they are
going to be safe. So it tells them they can avoid litigation if
they do what we want them to do, which is bring in due
diligence. But everything you said is correct.
Senator Reed. Let me, another point, too, and I think it is
important, because we specifically point out that their ratings
would not be considered a forward-looking statement for
purposes of Section 21(e) of the Securities Act, which is the
same protection we give to accountants, et cetera. That is, I
think, important because without that they are a liability for
``projecting the future forecasting'' would be, I think,
inordinate. Is that another point you would----
Mr. Coffee. I agree with that, too, because we are really
talking about historical information. If you knew, or should
have known if you had looked, that half these mortgages were
already in default, that is not forward-looking. That is really
historical facts.
Senator Reed. Secretary Barr suggested one issue, which
would be suits by corporate issuers against a rating agency for
a downgrade. And I guess the question--that was one reason why
he suggested the Administration has not incorporated this
proposal. Let me link two questions together. How likely is
that, or your comments on that? But, second, you know, one of
the issues, I think, in response to the exchange with Mr.
Gellert was this notion of there are a lot of mortgage-backed
securities out there, we should share the information with the
rating agencies. I would think that the accountants who have to
certify would have a responsibility at this juncture to do
exactly what the rating agencies might be able to do, which is
to go in there and say, ``My God, none of these loans are
paying,'' and we have to mark down this item.
So two comments to that, and then, Mr. Gellert, you can
comment.
Mr. Coffee. Well, let me say on the first point, which is
the litigation question about the corporate issuer, I know a
lot about this kind of litigation. Those suits were originally
brought as defamation suits, and they all lost. And that is
when courts started talking about the First Amendment because
defamation triggers the First Amendment. None of those suits
have won at all. And in the securities law area, there are
other problems. The issuer did not purchase or sell. It does
not have 10(b)-5 standing. And the issuer did not really rely
on this because the issuer knows more about itself than anyone
else, so it cannot say it was misled by the rating.
That is, I think, a phantom fear that issuers will be able
to sue rating agencies, but if you are concerned about it, you
can expressly deal with that and make sure the statute does not
apply to them.
Senator Reed. Mr. Gellert, just a quick point about the
accountants. Maybe I am imprecise in my analysis, but shouldn't
they have a responsibility now if it is publicly traded, if the
bank is holding this mortgage-backed security and it is
underwater, don't they have to write it down?
Mr. Gellert. Responsibilities of accountants, sir, are well
beyond my expertise.
Senator Reed. OK. That is fair.
Mr. Gellert. And certainly have been well covered over the
past years. I certainly understand the point, and I certainly
believe that the more information that is available, the more
parties can be involved in opining, and that may extend and
possibly should extend beyond those who are in, these
intermediary roles and should extend all the way to the
institutional investors who ultimately are making decisions and
buying these instruments.
Senator Reed. That is a fair point. Thank you. Thank you
all.
Senator Corker, do you have a question?
Senator Corker. Yes, sir. I again thank all of your for
your testimony. Mr. Joynt, back to you again.
There has been some discussion about changing the
compensation, and, by the way, I want you to know I am one of
those that is slow to sort of mandate how we do those kind of
things. But just going to the business model side of it, is
that something that is far-fetched? Or do you think any of the
credit rating agencies have thought, well, you know, we will
take a bigger fee, but we will take it over time based on
performance? Has any of that had any kind of serious discussion
at all at your company level or, to your knowledge, Standard &
Poor or others?
Mr. Joynt. So the best discussion about that I think was at
the SEC hearing, and then maybe in subsequent conversations
where they are trying to think about a better or different
payment model. It is very difficult for me and our firm to
think about how we would adopt a separate kind of payment or
fee structure without having it coordinated with others, so it
would be quite problematic.
You might not realize, but today, when we rate structured
financings, for example, we do not take in all the income
immediately. We defer a portion of the fee into the future to
pay for surveillance, continuing surveillance, because if we
are not rating any new issues, we still have analysts to follow
the outstanding transactions. So that could be changed into
some kind of success fee or some--there are alternatives, I
think, that the SEC continues to progress and try to think
about what could be workable.
Senator Corker. So then in answering the question that way,
you actually would not be opposed to that being mandated by the
Government or the SEC, as long as everyone was doing it.
Mr. Joynt. I am open to the dialogue about it. Each time we
get a dialogue, there have been weaknesses in each one of the
other ideas, and, of course, it could be quite a dramatic
change in kind of the profile for an agency like Fitch. So, for
example, in the roulette wheel alternative, if ten rating
agencies decide they would like to rate a structured financing,
I guess each one would only get chosen one-tenth of the time.
That is quite different from today's business dynamic for our
firm.
So I think, you know, while we are open to the dialogue, I
would have to at least consider how it would impact our
business fortunes.
Senator Corker. Professor Coffee, when Professor White--and
I have enjoyed all the dialogue a great deal. But when he was
talking about the particular bond manager assuming the
liability of--you were shaking your head in the opposite
direction his was shaking, and I just wondered if you wanted to
respond to that.
Mr. Coffee. I mean, I don't really want to delay this
hearing further. The change to an issuer-pays model was the
early 1970s. Asset-backed securitizations don't really become
significant before about 1990. What was happening was that the
Big Two back then--Fitch wasn't really one of the Big Three at
that point--really were break-even marginal companies, and as
the cost became more expensive--let us forget the structure of
finance--the cost could be as high as three-quarters of a
million dollars to rate a very complicated structured finance
offering, or at least that is the fee charged in a slightly
competitive market.
That is such a high cost that I don't think that can easily
be dealt with under a user-pay system. You can't put all that
front-end work in hoping you will get paid later on as a
developing startup company. That is why they have primarily
focused on corporate bonds rather than on this complex
structured finance field.
But all I was just agreeing with is why the system broke
down. It broke down well before structured finance, and
frankly, every other gatekeeper you can think of, accountants,
investment bankers, lawyers, they are paid by their client,
also. It has got certain efficient properties.
Senator Corker. So it was obviously magnified and
multiplied with all of these complex securities, but when you
say it broke down well before, expand on that a little bit.
Mr. Coffee. Around 1972 or 1973, Moody's and Standard and
Poor's started insisting that issuers pay them for the rating
process. In the old days, Moody's put out a book, Moody's
Bible, and in the world we get into by the 1970s, that is a
very slow process of publishing a book and there is what the
economists would call a public goods problem here or a free
rider problem. If you sell just one copy of the book, 10,000
people can read it and they gain the same information. So you
had to find some way that you could force people to subscribe
to you and the marketplace didn't react well to insisting upon
you pay a subscription fee.
Senator Corker. And yet you have said that you know that is
not going to change.
Mr. Coffee. I think the issuer-pays model, which is the
model we moved to in the 1970s, will be the predominant model
as far forward as I can see. I certainly wish to encourage
user-pays. I think they are a very important check and balance
on the system. But I think they will primarily be a check and
balance on the system and most of the business will be done
under an issuer-pays business model.
Mr. Gellert. A comment, Senator?
Senator Corker. Yes, sir?
Mr. Gellert. I would just like to point out that if you
look at the newer agencies, or firms, be they NRSROs or not,
they are almost entirely subscription-based or user-based
businesses. No one else is coming into the market and saying,
let us startup a new issuer-paid. And the reason for that is
that the market share is so unbelievably tightly held by three
players. So for competitive reasons, for all of the regulatory
reasons that we have already discussed, breaking into that
business as a new player is a relatively futile effort.
But I would just add to Professor Coffee's comments that
one of the reasons that we start out as--a firm like us, like
Rapid Ratings--starts out rating individual corporations, is,
yes, they are simpler than trying to rate structured products,
but the availability of information is completely different. We
rate entirely based on disclosed, publicly available financial
information for public companies, and private companies, it is
the data that is provided to us by our customers under contract
and confidentiality agreement, with full understanding on a
bilateral basis that we are not conducting due diligence for
them, but if they are a bank that has a lending relationship,
they supply that information, if it is a corporation that has a
counterparty risk relationship, they are receiving that
information, they supply it to us. It is about availability of
information.
So new competitors, regardless of the revenue model, are
not going to break into--with a couple of very small
exceptions, and Real Point happens to be one of them--are going
to break into the structured business when the payment, as
Professor Coffee just mentioned, needs to be a front-loaded
payment and the information is simply not being shared.
Senator Corker. I appreciate your comments earlier about
the unintended consequences of making everyone register. I
think that was a valuable contribution. But let us move down
that path just a little bit, the one you are on.
We visited the offices of Second Market. I know that they
are setting up a sort of a public auction process for
securities and they are doing a great job and they are being
very successful, and I hope they are because they have come up
with a brilliant idea. At the same time, as I looked at what
they were disclosing on some of these--again, as you have just
mentioned, there is not as much information as one would like--
if one--and I have read op-eds recently and publications where
disclosure on these securities ought to be broadly given--if
that was the case, are you saying that an entity like yours
actually would rate many of these more complex securities? I
mean, that is a lot of work for all these securities being
offered. Is that something you say you would pursue?
Mr. Gellert. I am saying that we would have the choice, and
that would be a business choice that we would have, and we
would make it as we make any other business choice. There are
other independent, non-NRSRO research firms that are staffed
not in an analytical, quantitative way that we are, but staffed
with enough people to be able to execute that type of
analysis--not on all structured products, of course, but on
individual asset class by asset class, CLOs being one of them--
and be able to provide an extremely good alternative despite
the fact that not all of us would be staffed and certainly
would be able to say, day one, we will go ahead and we will get
into the market to do all of--to wholesale--get into the
structured product rating business.
Senator Corker. You wanted to mention something.
Mr. Froeba. Yes. I just wanted to say you can combine
issuer-pay and investor-pay. They don't have to be exclusive.
And you would do it by simply giving the investors the
opportunity to pick which agency an issuer uses. It is the
power of the issuer to decide who would rate that became the
source of, I think the big problems in the last few years. They
could pit the agencies against each other. And if you just take
that power away from them, much of the problem is solved.
Combine the two. It can't be done. I don't think it would be
insurmountable.
Senator Corker. Mr. Chairman, thank you, and each of you.
One of the great privileges we have here is to hear from
intelligent people like you often and we thank you very much. I
appreciate it.
Senator Reed. Thank you, Senator Corker.
Gentlemen, thank you for excellent testimony. My colleagues
may have additional questions and I would ask them to submit
them by August 12 and ask you to respond as quickly as you can.
All statements of my colleagues will be made part of the record
and your statements will be made fully part of the record.
Thank you very much, and the hearing is adjourned.
[Whereupon, at 12:17 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Thank you, Mr. Chairman.
The nature of today's credit rating industry reflects decades of
regulatory missteps rather than market preferences. Over the years, the
Government granted special regulatory status to a small number of
rating agencies and protected those firms from potential competitors.
Beginning in 1975, the Securities and Exchange Commission began
embedding NRSRO ratings into certain key regulations. Once credit
ratings acquired regulatory status, they crept into State regulations
and private investment guidelines.
The staff of the SEC controlled access to the prized ``nationally
recognized statistical rating organization'' or NRSRO designation by
subjecting potential entrants to a vague set of criteria and an
incredibly slow time line.
The SEC did little to oversee NRSROs once so designated.
Nevertheless, because of the doors they opened, ratings from an NRSRO
became an excuse for some investors to stop doing their own due
diligence.
Widespread overreliance on ratings meant that the effects of poor
quality or inadequately updated ratings could ripple through the
markets.
By encouraging reliance on a small number of big credit rating
agencies, bureaucrats at the SEC exposed the economic system to
tremendous risk.
Our current financial crisis, which was caused in part by the
credit rating agencies' failure to appreciate the risks associated with
complex structured products, demonstrates just how big that systemic
risk was.
The troubles caused by the SEC's flawed regime, however, did not
come as a surprise.
When I was Chairman of this Committee, we acted to address the
problem after the SEC failed to take action on its own. I felt that the
industry's heavy concentration and high profits were symptoms of an
industry in serious need of reform.
We then passed the Credit Rating Agency Reform Act of 2006. The Act
set forth clear standards for the NRSRO application process. It also
gave the SEC authority to regulate disclosures and conflicts of
interest, as well as unfair and abusive practices.
Unfortunately, the law that we passed in 2006 did not have time to
take root before the problems that they were intended to remedy took
their toll.
The SEC adopted rules pursuant to that legislation in June of 2007.
Over the following months, the number of NRSROs doubled, just as the
performance of many ``highly rated'' subprime securities revealed that
such securities were not as safe as the rating agencies said they were.
Today, we will consider a legislative proposal by the
Administration to revisit the regulation of credit rating agencies.
In determining whether new legislative steps are required, we
should keep in mind that the 2006 reforms are still working their way
through the system. That doesn't mean, however, that we shouldn't
consider further changes. Every option should be on the table.
One option is to remove rating mandates from regulations. Another
is materially improving disclosure. As with any regulatory reform,
however, we must also be mindful of unintended consequences.
I strongly believe that the credit rating agencies played a pivotal
role in the collapse of our financial markets. Any regulatory reform
effort must take that into consideration.
Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF SENATOR JACK REED
I am very pleased Chairman Dodd and Ranking Member Shelby have
chosen to have a hearing examining proposals to enhance the regulation
of credit rating agencies. I want to thank all of our witnesses for
taking time out of their busy schedules today to testify on this
important issue.
As most of you know, in late May I introduced S. 1073, the Rating
Accountability and Transparency Enhancement (RATE) Act. The purpose of
the RATE Act is to strengthen the Securities and Exchange Commission's
(SEC) oversight of credit rating agencies and improve the
accountability and accuracy of credit ratings.
Credit ratings have taken on systemic importance in our financial
system, and have become critical to capital formation, investor
confidence, and the efficient performance of the United States economy.
However, during the past year we have witnessed a significant amount of
market instability stemming in part from the failure of these agencies
to accurately measure the risks associated with mortgage-backed
securities and other more complex products.
As the Chairman of the Securities, Insurance, and Investment
Subcommittee, I held a hearing in September of 2007 to examine the role
of credit rating agencies in the mortgage crisis, and these issues were
also addressed at a hearing by the full Committee last year. From these
hearings, it is clear that problems at credit rating agencies
contributed to the significant financial sector instability our country
has been experiencing. In fact, an SEC investigation last summer found
that credit rating agencies such as Moody's, Standard & Poor's, and
Fitch Ratings conducted weak analyses and failed to maintain
appropriate independence from the issuers whose securities they rated.
According to a mortgage industry trade publication, the three major
credit rating agencies have each downgraded more than half of the
subprime mortgage-backed securities they originally rated between 2005
and 2007. Ratings agencies made these mistakes in part because of
conflicts of interest and other problems with internal controls,
underscoring the need for enhanced oversight of this industry.
Credit rating agencies are in the business of providing investors
with unbiased analysis, but the current incentive structure gives them
too much leeway to hand out unjustifiably favorable ratings. Let's be
clear: Not every rating is suspect and these firms provide crucial
information for investors and the marketplace, but credit rating
agencies like any other industry should be held accountable if they
knowingly or recklessly mislead investors. My bill includes carefully
crafted language that provides investors and other credit rating users
with the ability to pursue 10(b)5 fraud claims under Federal securities
laws. As we will discuss at this morning's hearing, my bill does not
change the fraud standard. Rather it tailors the pleading standard so
that investors can take action when a rating agency recklessly fails to
review key information in developing the rating.
The RATE Act would also give the SEC strong new authority to
oversee and hold rating agencies accountable for conflicts of interest
and other internal control deficiencies that have weakened ratings in
the past.
It also enhances disclosure requirements to allow investors and
others to learn about the methodologies, assumptions, fees, and amount
of due diligence associated with ratings. And it requires rating
agencies to notify users and promptly update ratings when model or
methodology changes occur. Finally, the bill requires ratings agencies
to have independent compliance officers, and to take other actions to
prevent potential conflicts of interest.
I am pleased that the credit rating agency draft legislation that
the Administration has transmitted to Congress includes many of my
provisions to improve the accountability and transparency of credit
ratings, and I look forward to working with everyone on the Committee
on this issue as we move forward with drafting a regulatory
modernization bill.
______
PREPARED STATEMENT OF MICHAEL S. BARR
Assistant Secretary for Financial Institutions,
Department of the Treasury
August 5, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
thank you for the opportunity to testify before you today about the
Administration's plan for financial regulatory reform.
On June 17, President Obama unveiled a sweeping set of regulatory
reforms to lay the foundation for a safer, more stable financial
system; one that properly delivers the benefits of market-driven
financial innovation while safeguarding against the dangers of market-
driven excess.
In the weeks since the release of those proposals, the
Administration has worked with Congress in testimony and briefings with
your staff to explain and refine our legislation.
Today, I want to first speak in broad terms about the forces that
led us into the current crisis and the key objectives of our reform
proposal. I will then turn to discuss the role that third party credit
ratings and rating agencies played in creating a system where risks
built up without being accounted for or properly understood. And how
these ratings contributed to a system that proved far too fragile in
the face of changes in the economic outlook and uncertainty in
financial markets.
This Committee provided strong leadership to enact the first
registration and regulation of rating agencies in 2006, and the
proposals that I will discuss today build on that foundation.
Where Our Economy Stands Today
President Obama inherited an economic and financial crisis more
serious than any President since Franklin Roosevelt. Over the last 7
months, the President has responded forcefully with a historic economic
stimulus package, with a multiprong effort to stabilize our financial
and housing sectors, and, in June, with a sweeping set of reforms to
make the financial system more stable, more resilient, and safer for
consumers and investors.
We cannot be complacent; the history of major financial crises
includes many false dawns and periods of optimism even in the midst of
the worst downturns. But I think you will agree that the sense of free
fall that surrounded the economic statistics earlier this spring has
now abated. Even amidst much continued uncertainty, we must reflect on
the extraordinary path our economy and financial system have taken over
the past 2 years, and take this opportunity to restore confidence in
the system through fundamental reform. We cannot afford to wait.
Forces Leading to the Crisis
At many turns in our history, we have seen a pattern of tremendous
growth supported by financial innovation. As we consider financial
reform, we need to be mindful of the fact that those markets with the
most innovation and the fastest growth seemed to be at the center of
the current crisis.
But in this cycle, as in many cycles past, growth often hid key
underlying risks, and innovation often outpaced the capacity of risk
managers, boards of directors, regulators, rating agencies, and the
market as a whole to understand and respond.
Securitization helped banks move credit risk off of their books and
supply more capital to housing markets. It also widened the gaps
between borrowers, lenders, and investors--as lenders lowered
underwriting standards since the securitized loans would be sold to
others in the market, while market demand for securitized assets
lowered the incentives for due diligence.
Rapidly expanding markets for hedging and risk protection allowed
for better management of corporate balance sheets, enabling businesses
to focus on their core missions; credit protection allowed financial
institutions to provide more capital to business and families that
needed it, but a lack of transparency hid the movement of exposures.
When the downturn suddenly exposed liquidity vulnerabilities and large
unmanaged counterparty risks, the uncertainty disrupted even the most
deeply liquid and highly collateralized markets at the center of our
financial system.
It is useful to think about our response to this crisis in terms of
cycles of innovation. New products develop slowly while market
participants are unsure of their value or their risks. As they grow,
however, the excitement and enthusiasm can overwhelm normal risk
management systems. Participants assume too soon that they really
``know how they work,'' and these new products, applied widely without
thought to new contexts--and often carrying more risk--flood the
market. The cycle turns, as this one did, with a vengeance, when that
lack of understanding and that excess is exposed. But past experience
shows that innovation survives and thrives again after reform of the
regulatory infrastructure renews investor confidence.
Innovation creates products that serve the needs of consumers, and
growth brings new players into the system. But innovation demands a
system of regulation that protects our financial system from
catastrophic failure, protects consumers and investors from widespread
harm and ensures that they have the information they need to make
appropriate choices.
Rather than focus on the old, ``more regulation'' versus ``less
regulation'' debate, the questions we have asked are: why have certain
types of innovation contributed in certain contexts to outsized risks?
Why was our system ill-equipped to monitor, mitigate and respond to
those risks?
Our system failed to provide transparency in key markets,
especially fast developing ones. Rapid growth hid misaligned incentives
that people didn't recognize. Throughout our system we had inadequate
capital and liquidity buffers--as both market participants and
regulators failed to account for new risks appropriately. The apparent
short-term rewards in new products and rapidly growing markets created
incentives for risk-taking that overwhelmed private sector gatekeepers,
and swamped those parts of the system that were supposed to mitigate
risk. And households took on risks that they did not fully understand
and could ill-afford.
Our proposals identify sweeping reforms to the regulation of our
financial system, to address an underlying crisis of confidence--for
consumers and for market participants. We must create a financial
system that is safer and fairer; more stable and more resilient.
Protecting Consumers
We need strong and consistent regulation and supervision of
consumer financial services and investment markets to restore consumer
confidence. In early July, we delivered the first major portion of our
legislative proposals to the Congress, proposing to create a Consumer
Financial Protection Agency (CFPA).
We all aspire to the same objectives for consumer protection
regulation: independence, accountability, effectiveness, and balance--a
system that promotes financial inclusion and preserves choice. The
question is how to achieve that. A successful regulatory structure for
consumer protection requires mission focus, marketwide coverage, and
consolidated authority.
Today's system has none of these qualities. It fragments
jurisdiction and authority for consumer protection over many Federal
regulators, which have higher priorities than protecting consumers.
Banks can choose the least restrictive supervisor among several
different banking agencies. Nonbank providers avoid Federal supervision
altogether; no Federal consumer compliance examiner ever lands at their
doorsteps. Fragmentation of rule writing, supervision, and enforcement
leads to finger-pointing in place of action and makes actions taken
less effective.
The President's proposal for one agency for one marketplace with
one mission--protecting consumers--will resolve these problems. The
Consumer Financial Protection Agency will create a level playing field
for all providers, regardless of their charter or corporate form. It
will ensure high and uniform standards across the market. It will
support financial literacy for all Americans. It will prohibit
misleading sales pitches and hidden traps, but there will be profits
made on a level playing field where banks and nonbanks can compete on
the basis of price and quality.
If we create one Federal regulator with consolidated authority,
then we will be able to leave behind regulatory arbitrage and
interagency finger pointing. And we will be assured of accountability.
Our proposal ensures, not limits, consumer choice; preserves, not
stifles, innovation; strengthens, not weakens, depository institutions;
reduces, not increases, regulatory costs; empowers, not undermines,
consumers; and increases, not reduces, national regulatory uniformity.
Systemic Risk
Much of the discussion of reform over the past 2 years--both in our
proposals and among other commentators--has focused on both the nature
of and proper response to systemic risk.
To address these risks, our proposals focus on three major tasks:
(1) providing an effective system for monitoring risks as they arise
and coordinating a response; (2) creating a single point of
accountability for tougher and more consistent supervision of the
largest and most interconnected institutions; and (3) tailoring the
system of regulation to cover the full range of risks and actors in the
financial system, so that risks can no longer build up completely
outside of supervision and monitoring.
Many have asked whether we need a ``systemic risk regulator'' or a
``super regulator'' that can look out for new risks and immediately
take action to address them or order other regulators to do so. That is
not what we are proposing. We cannot have a system that depends on the
foresight of a single institution or a single person to identify and
prevent risks. That's why we have proposed that the critical role of
monitoring for emerging risks and coordinating policy responses be
vested in a Financial Services Oversight Council.
At the same time, a council of independent regulators with
divergent missions will not have operational coherence and cannot be
held accountable for supervision of individual financial firms. That's
why we propose an evolution in the Federal Reserve's power to provide
consolidated supervision and regulation of any financial firm whose
combination of size, leverage, and interconnectedness could pose a
threat to financial stability if it failed. The financial crisis has
demonstrated the crucial importance of having a consolidated supervisor
and regulator for all ``Tier 1 Financial Holding Companies,'' with the
regulator having the authority and responsibility to regulate these
firms not just to protect their individual safety and soundness but to
protect the entire financial system.
This crisis has also clearly demonstrated that risks to the system
can emerge from all corners of the financial markets and from any of
our financial institutions. Our approach is to bring these institutions
and markets into a comprehensive system of regulation, where risks are
disclosed and monitored by regulators as necessary. Secretary Geithner
has testified about the need to bring all over-the-counter derivatives
markets into a comprehensive regulatory framework. In the next few days
we will deliver legislative text to this Committee that would
accomplish that goal. We have delivered proposed legislation that would
strengthen the regulation of securitization markets, expand regulatory
authority for clearing, payment, and settlement systems, and require
registration of hedge funds.
Basic Reform of Capital, Supervision, and Resolution Authority
As Secretary Geithner has said, the three most important things to
lower risk in the financial system are ``capital, capital, capital.''
We need to make our financial system safer and more resilient. We
cannot rely on perfect foresight--whether of regulators or firms.
Higher capital charges can insulate the system from the build-up of
risk without limiting activities in the markets. That's why we have
launched a review of the capital regime and have proposed raising
capital and liquidity standards across the board, including higher
standards for financial holding companies, and even higher standards
for Tier 1 Financial Holding Companies--to account for the additional
risk that the largest and most interconnected firms could pose to our
system.
Making the system safe for innovation means financial firms should
raise the amount of capital that they hold as a buffer against
potential future losses. It also means creating a more uniform system
of regulation so that risks cannot build up due to inadequate
regulatory oversight. To strengthen banking regulation, we propose
removing the central source of arbitrage among depository institutions.
Our proposed National Bank Supervisor would consolidate the Office of
Thrift Supervision and the Office of the Comptroller of the Currency.
We will also close loopholes in the Bank Holding Company Act that allow
firms to own insured depository institutions yet escape consolidated
supervision and regulation.
Financial activity involves risk, and the fact is that we will not
be able to identify all risks or prevent all future crises. We learned
through painful experience that during times of great stress, the
disorderly failure of a large, interconnected institution can threaten
the stability of the entire financial system. While we have a tested
and effective system for resolving failing banks, there is still no
effective legal mechanism to resolve a nonbank financial institution or
bank holding company. We have proposed to fill this gap in our legal
framework with a mechanism modeled on our existing system under the We
have proposed to fill this gap in our legal framework with a mechanism
modeled on our existing system under the Federal Deposit Insurance
Corporation (FDIC).
Finally, both our financial system and this crisis have been global
in scope. Our solutions have been and must continue to be global.
International reforms must support our efforts at home, including
strengthening the capital framework; improving oversight of global
financial markets; coordinating supervision of internationally active
firms; and enhancing crisis management tools. We will not wait for the
international community to act before we reform at home, but nor will
we be satisfied with an international race to the bottom on regulatory
standards.
Credit Ratings and Fragility
It's worthwhile to begin our discussion on credit ratings with a
basic explanation of the role that they play in our economy. Rating
agencies solve a basic market failure. In a market with borrowers and
lenders, borrowers know more about their own financial prospects than
lenders do. Especially in the capital markets, where a lender is likely
purchasing just a small portion of the borrower's debt in the form of a
bond or asset-backed security--it can be inefficient, difficult and
costly for a lender to get all the information they need to evaluate
the credit worthiness of the borrower. And therefore lenders will not
lend as much as they could, especially to lesser known borrowers such
as smaller municipalities; or lenders will offer higher rates to offset
the uncertainty. Credit rating agencies provide a third party rating
based on access to more information about the borrower than a lender
may be able to access, and on accumulated experience in evaluating
credit. By issuing a rating of the creditworthiness of a borrower, they
can validate due diligence performed by lenders and enhance the ability
of borrowers to raise funds. Further, the fact the credit rating
agencies rate a wide variety of credit instruments and companies
allowed debt investors to have the benefit of a consistent, relative
assessment of credit risk across different potential investments.
This role is critical to municipalities and companies to access the
capital markets, and rating agencies have facilitated the growth of
securitization markets, increasing the availability of mortgages, auto
loans, and small business loans.
Credit ratings also played an enabling role in the buildup of risk
and contributed to the deep fragility that was exposed in the past 2
years. As I discussed before, the current crisis had many causes but a
major theme in each was that risk--complex and often misunderstood--was
allowed to build up in ways that the supervisors and regulators were
unable to monitor, prevent or respond to effectively. Earnings from
rapid growth driven by innovation overwhelmed the will or ability to
maintain robust internal risk management systems.
As the Members of this Committee know, the highest rating given by
rating agencies is ``triple-A.'' An easy way to understand the
importance of a triple-A rating for a borrower or an investor is that
this label is the same one given to the U.S. Government. It means that
the rating agency estimates that the probability of default--or the
debt investor losing money--in the following year is extremely remote.
The ``triple-A'' designation was therefore highly valued, but
perversely, rather than preserve this designation for the few, the
amount of securities and borrowers that were granted this designation
became much more prevalent as borrowers and issuers were able to
convince the rating agencies that innovation in the structured credit
market allowed for the creation of nearly riskless credit investments.
Market practices such as ``ratings shopping'' before contracting for a
rating, and the creation of consulting relationships may have
contributed to conflicts of interest and upward pressure on ratings.
Rating agencies have a long track record evaluating the risks of
corporate, municipal, and sovereign bonds. These ratings are based on
the judgment of rating agencies about the credit worthiness of a
borrower and are usually based on confidential information that is not
generally available to the market, including an assessment of the
borrower's income, ability to meet payments, and their track record for
doing so.
Evaluating a structured finance product is a fundamentally
different type of analysis. Asset-backed securities represent a right
to the cash flows from a large bundle of smaller assets. In this way an
investor can finance a small portion of hundreds or thousands of loans,
rather than directly lending to a single borrower. This structure
diversifies the investor's risk with respect to a given borrower's
default and averages out the performance of the investment to be equal
to a more general class of borrowers. It also allows more investors to
participate in the market, since the investor's capital no longer needs
to be tied to the origination of a loan.
Certain asset-backed securities also relied on a process of
``tranching''--slicing up the distribution of potential losses to
further modify the return of the security to meet the needs of
different investors. This process relied on quantitative models and
therefore could produce any probability of default. Credit ratings
lacked transparency with regard to the true risks that a rating
measured, the core assumptions that informed the rating and the
potential conflicts of interest in the generation of that rating. This
was particularly acute for ratings on asset-backed securities, where
the concentrated systematic risk of senior tranches and
resecuritizations are quite different from the more idiosyncratic risks
of corporate bonds. As we discovered in the past 2 years, the risks of
asset-backed securities are much more highly correlated to general
economic performance than other types of bonds. The more complicated
products are also sensitive to the assumptions in the quantitative
models used to create these products.
Investors, as described earlier, relied on the rating agencies'
ability to assess risk on a similar scale across instruments. They
therefore saw highly rated instruments and borrowers as generally
similar even though the investments themselves ranged from basic
corporate bonds to highly complex bonds backed by loans or other asset-
backed securities. Investors, and even regulatory bodies, rather than
using ratings as one of many tools in their credit decisions, began to
rely entirely on the ratings and performed little or no due diligence.
Further, investors ventured into products they understood less and less
because they carried the ``seal of approval'' from the rating agencies.
This reliance gave the ratings agencies an extraordinary amount of
influence over the fixed income markets and the stability of these
markets came to depend, to a large degree, on the robustness of these
ratings.
Ultimately, this led to a toxic combination of overreliance on a
system for rating credit that was not transparent and highly
conflicted. Many of the initial ratings made during this period turned
out to be overly optimistic. When it became clear that ``triple A''
securities were not as riskless as advertised, it caused a great amount
of disruption in the fixed income markets.
One of the central examples of these problems is in the market for
Collateralized Debt Obligations or ``CDOs.'' These products are created
by pooling a group of debt instruments, often mortgage loans, then
slicing up the economic value of the cash flows to create tailored
combinations of risk and return. The senior tranches would have the
first right to payments, while the most junior tranche--often called
the ``equity'' tranche--would not be paid until all others had been
paid first. These new products were highly complex and difficult for
most investors to evaluate on their own. Rating agencies stepped into
this gap and provided validation for the sale of these products,
because their quantitative models and assumptions often determined that
the most senior tranches could be rated triple-A. Without this
designation, many pension funds, insurance companies, mutual funds, and
banks would never have been willing to invest. Many investors did not
realize that the ratings were highly dependent on the economic cycle or
that the ratings for many CDOs backed by subprime mortgage bonds
assumed that there would never be a nationwide decline in housing
prices. This complexity was often ignored as the quarterly issuance of
CDOs more than quadrupled from 2004 to mid-2007, reaching $140 billion
in the second quarter of 2007. \1\ But following a wave of CDO
downgrades in July 2007, the market for CDOs dried up and new issuance
collapsed as investors lost confidence in the rating agencies and
investors realized they themselves did not understand these
investments.
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\1\ SIFMA, CDO Global Issuance Data.
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The reforms proposed by this Administration recognize the market
failure that the credit rating agencies help to remedy, but also
address the deep problems caused by the manner in which these agencies
operated and the overreliance on their judgments.
Reform of the Credit Rating System
This Committee, under the leadership of Senator Shelby, Senator
Dodd, and others, took strong steps to improve regulation of rating
agencies in 2006. That legislation succeeded in increasing competition
in the industry, in giving much more explicit authority to the SEC to
require agencies to manage and disclose conflicts of interest, and
helping ensure the existence and compliance with internal controls by
the agencies.
This authority has already been used by the SEC over the past year
to strengthen regulation and enforcement. The Administration strongly
supports the actions that the SEC has taken and we will continue to
work closely with the SEC to support strong regulation of credit rating
agencies.
But flaws and conflicts revealed in the current crisis highlight
the need for us to go further as more needs to be done.
Our legislative proposal directly addresses three primary problems
in the role of credit rating agencies: lack of transparency, ratings
shopping, and conflicts of interest. It also recognizes the problem of
overreliance on credit ratings and calls for additional study on this
matter as well as reducing the overreliance on ratings. While there
were clear failures in credit rating agency methodologies, our
proposals continue to endorse the divide established by this Committee
in 2006: The Government should not be in the business of regulating or
evaluating the methodologies themselves, or the performance of ratings.
To do so would put the Government in the position of validating private
sector actors and would likely exacerbate over-reliance on ratings.
However, the Government should make sure that rating agencies perform
the services that they claim to perform and our proposal authorizes the
SEC to audit the rating agencies to make sure that they are complying
with their own stated procedures.
Lack of Transparency
The lack of transparency in credit rating methodologies and risks
weakened the ability of investors to perform due diligence, while broad
acceptance of ratings as suitable guidelines for investment weakened
the incentives to do so. These two trends contributed significantly to
the fragility of the financial system.
Our proposals address transparency both in the context of rating
agency disclosure as well as stronger disclosure requirements in
securitization markets more generally. An agency determines a rating
with a proprietary risk model that takes account of a large number of
factors. While we do not advocate the release of the proprietary
models, we do believe that all rating agencies should be required to
give investors a clear sense of the variety of risk factors considered
and assumptions made.
For instance, there are a number of ways to obtain a high rating
for an asset-backed security that are not transparent to investors.
First, there is the quality of the underlying assets--a bundle of prime
mortgage loans will have higher credit worthiness than a bundle of
subprime mortgage loans, all things being equal. Second, the rating
agency could consider the quality and reliability of the data--fully
documented mortgages or consumer credit instruments with a longer
performance history (like auto loans) give greater certainty to the
rating. Finally, if the security uses tranching or subordination, then
giving a greater proportion of the economic value to a certain class of
investors will raise the credit rating for that class. In the current
system, there is no requirement that these factors be disclosed or
compared for investors along with the credit rating.
Our proposals would require far more transparency of both
qualitative and quantitative information so that investors can carry
out their own due diligence more effectively. To facilitate investor
analysis, we will require that each rating be supported by a public
report containing assessments of data reliability, the probability of
default, the estimated severity of loss in the event of default, and
the sensitivity of a rating to changes in assumptions. The format of
this report will make it easy to compare these data across different
securities and institutions. The reports will increase market
discipline by providing clearer estimates of the risks posed by
different investments.
The history of rating agencies assessments in corporate, municipal,
and sovereign bonds allowed them to expand their business models to
evaluate structured finance products without proving that they had the
necessary expertise to evaluate those products. The use of an identical
rating system for corporate, sovereign, and structured securities
allowed investors to purchase these products under their existing
investment standards with respect to ratings. The identical rating
systems also allowed regulators to use existing guidelines without the
need to consider the different risks posed by these new financial
instruments. Our proposals address the disparate risks directly by
requiring that rating agencies use ratings symbols that distinguish
between structured and unstructured financial products. It is our hope
that this will cause supervisors and investors to examine carefully
their guidelines to ensure that their investment strategy is
appropriate and specific.
Ratings Shopping
Currently, an issuer may attempt to ``shop'' among rating agencies
by soliciting ``preliminary ratings'' from multiple agencies and
enlisting the agency that provides the highest preliminary rating.
Consistently, this agency also provides a high final rating.
A number of commentators have argued that either the existence or
threat of such ``ratings shopping'' by issuers played an important role
in structured products leading up to the crisis. A recent Harvard
University study contains supporting evidence, finding that structured
finance issues that were only rated by a single rating agency have been
more likely to be downgraded than issues that were rated by two or more
agencies. \2\ Our proposal would shed light on this practice by
requiring an issuer to disclose all of the preliminary ratings it had
received from different credit rating agencies so that investors could
see how much the issuer had ``shopped'' and whether the final rating
exceeded one or more preliminary ratings. The prospect of such
disclosures should also deter ratings shopping in the first place. In
addition, the SEC has proposed a beneficial rule that would require
agencies to disclose the rating history--of upgrades and downgrades--so
that the market can assess the long-term quality of ratings.
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\2\ Benmelech and Dlugosz 2009, ``The Credit Rating Crisis.''
---------------------------------------------------------------------------
As an additional check against rating shopping, the Administration
supports a proposed SEC rule that would require issuers to provide the
same data they provide to one credit rating agency as the basis of a
contracted rating to all other credit rating agencies. This will allow
other credit rating agencies to provide additional, independent
analyses of the issuer to the market. Such ``unsolicited'' ratings,
have been ineffective because investors understand that these
unsolicited ratings are not based on the same information as the fully
contracted ratings, especially for structured products that are often
complex and require detailed information to assess. By requiring full
disclosure to all rating agencies, this rule would limit any potential
benefit from rating shopping and should increase the amount of
informed, but independent, research on credit instruments.
Conflicts of Interest
Our proposals include strong provisions to prevent and manage
conflicts of interest, which we identify as a major problem of the
current regime. Many of our proposals are aligned with specific
provisions proposed by Senator Reed. Our approach is to solve these
problems within the current framework rather than prohibiting specific
models of rating agency compensation as some have advocated. Both
issuer pay and investor pay models exist today and we do not believe it
is the place of Government to prescribe allowable business models in
the free market. Our proposal will make it simple for investors to
understand the conflicts in any rating that they read and allow them to
make their own judgment of its relevance to their investment decision.
Most directly, we would ban rating agencies from providing
consulting services to issuers that they also rate. While these
consulting contracts do not currently form a huge proportion of the
revenue of the top rating agencies, they are an undeniable source of
conflict since they allow for issuers and raters to work closely
together and develop economic ties that are not related to the direct
rating of securities. For instance, today a rating agency may consult
with an issuer on how to structure and evaluate asset-backed
securities, and then separately be paid by the issuer to rate the same
securities created. This Committee was at the center of a similar
effort that banned these types of cross-relationships for audit firms
in the passage of the Sarbanes-Oxley Act of 2002, which also required a
study of issues with credit rating agencies. Today, we propose that
these cross-relationships be simply prohibited.
Our proposals also strengthen disclosure and management of
conflicts of interest. The legislation will prohibit or require the
management and disclosure of conflicts arising from the way a rating
agency is paid, its business relationships, its affiliations, or other
sources. Each rating will be required to include a disclosure of the
fees paid for the particular rating, as well as the total fees paid to
the rating agency by the issuer in the previous 2 years. This
disclosure will give the market the information it needs to assess
potential bias of the rating agency. The legislation also requires
agencies to designate a compliance officer, with explicit requirements
that this officer report directly to the board or the senior officer,
and that the compliance officer have the authority to address any
conflicts that arise within the agency. Rating agencies will be
required to institute reviews of ratings in cases where their employees
go work for issuers, to reduce potential conflicts from a ``revolving
door.''
Strengthen and Build on SEC Supervision
Under the authority created by this Committee in 2006, the SEC has
already begun to address many problems with rating agencies. The
Treasury supports these actions and has included in our legislative
proposal additional authority to strengthen and support SEC regulation
of rating agencies.
The Commission has allocated resources to establish a branch of
examiners dedicated specifically to conducting examination oversight of
credit rating agencies, which would conduct routine, special, and cause
examinations. Our proposed legislation would strengthen this effort and
create a dedicated office for supervision of rating agencies within the
Commission. Under the legislation, the SEC will require each rating
agency to establish and document its internal controls and processes--
and will examine each rating agency for compliance.
In line with the principle of consistent regulation and
enforcement, our proposal will make registration mandatory for all
credit rating agencies--ensuring that these firms cannot evade our
efforts to strengthen regulation.
In response to the credit market turmoil, in February the SEC took
a series of actions with the goal of enhancing the usefulness of rating
agencies' disclosures to investors, strengthening the integrity of the
ratings process, and more effectively addressing the potential for
conflicts of interest inherent in the ratings process for structured
finance products.
Specifically, the SEC adopted several measures designed to increase
the transparency of the rating agencies' rating methodologies,
strengthen the rating agencies' disclosure of ratings performance,
prohibit the rating agencies from engaging in certain practices that
create conflicts of interest, and enhance the rating agencies'
recordkeeping and reporting obligations to assist the SEC in performing
its regulatory and oversight functions. We support these measures.
Conclusion
In the weeks since we released our plan for reform, we have been
criticized by some for going too far and by some for not going far
enough. These charges are stuck in a debate that presumes that
regulation--and efficient and innovative markets--are at odds. In fact,
the opposite is true. Markets rely on faith and trust. We must restore
honesty and integrity to our financial system. These proposals maintain
space for growth, innovation, and change, but require that regulation
and oversight adapt as well. Markets require clear rules of the road.
Consumers' confidence is based on the trust and fair dealing of
financial institutions. Regulation must be consistent, comprehensive,
and accountable. The President's plan lays a new foundation for
financial regulation that will once again help to make our markets
vital and strong.
Thank you very much.
PREPARED STATEMENT OF STEPHEN W. JOYNT
President and Chief Executive Officer,
Fitch Ratings
August 5, 2009
While overall macroeconomic conditions remain difficult, it seems
the period of the most intense market stress has passed. This is due to
both a variety of Government initiatives here and abroad aimed at
restoring financial market stability as well actions taken by companies
individually to shore up their balance sheets and reduce risk. Having
said that, important sectors in the fixed income markets remain
effectively closed and certain sectors, such as commercial mortgage-
backed securities, are experiencing greater performance strain on their
underlying assets.
During this time, the focus of Fitch Ratings has been on
implementing a broad and deep range of initiatives that enhance the
reliability and transparency of our rating opinions and related
analytics. More specifically, our primary focus is on vigorously
reviewing our analytical approaches and changing ratings to reflect the
current risk profile of securities we rate. In many cases, that
continues to generate a significant number of downgrades in structured
securities, but also affects other sectors, such as banks and
insurance. We are releasing our updated ratings and research
transparently and publicly and we are communicating directly with the
market the latest information and analysis we have.
In parallel, we have been introducing a range of new policies and
procedures--and updating existing ones--to reflect the evolving
regulatory frameworks within which credit rating agencies operate
globally.
In each of these areas, we have been as transparent as possible and
broadly engaged with a wide range of market participants, including
policy makers and regulators. We are happy to expand upon any of these
topics.
That said, the primary focus of today's hearing is to examine
proposals to enhance the regulation of credit rating agencies, or
``where do we go from here.'' Clearly, credit rating agencies continue
to be a topic of interest in the market and in the regulatory
communities. Senator Reed has introduced a bill this year--the ``Rating
Accountability and Transparency Enhancement Act of 2009.'' The House
Financial Services Committee held a hearing in May 2009 on topics
similar to today's hearing. The SEC has issued new rules and considered
many important questions in its roundtable discussion in April. Most
recently the Treasury sent legislation to Congress that reflected the
Administration's perspectives on credit rating agency reform. Outside
of the U.S., the EU recently enacted a registration and oversight
system and related rules for credit rating agencies. Other nations are
considering similar measures.
As this Committee considers these topics, we would like to offer
our perspective on several important issues. The bodies referenced
above have touched on many of these themes in their proposals and
discussions. Let me reiterate that Fitch is committed to engaging on
all of these matters in a thoughtful, balanced, constructive, and non-
self-serving manner. At the same time, some perceptions and proposals
continue to circulate that warrant further consideration,
clarification, or in some cases ``reality checking.''
Managing Conflicts of Interest. The majority of Fitch's revenues
are fees paid by issuers for assigning and maintaining ratings. This is
supplemented by fees paid by a variety of market participants for
research subscriptions. The primary benefit of this model is that it
enables Fitch to be in a position to offer analytical coverage on every
asset class in every capital market--and to make our rating opinions
freely available to the market in real time, thus enabling the market
to freely and fully assess the quality of our work. Fitch has long
acknowledged the potential conflicts of being an issuer-paid rating
agency. Fitch believes that the potential conflicts of interest in the
``issuer pays'' model have been, and continue to be, effectively
managed through a broad range of policies, procedures, and
organizational structures aimed at reinforcing the objectivity,
integrity, and independence of its credit ratings, combined with
enhanced and ongoing regulatory oversight. In recent months, Fitch has
introduced new policies, and revised many existing ones, focused on
these issues. A few examples of our relevant policies and procedures
are below:
Business development is separated from credit analysis, to
keep each group focused on its core task.
Employees involved in the assignment of the resulting
ratings do not handle fees discussions for an issuer or
transaction.
No analyst or group of analysts is directly compensated on
the revenues related to their ratings.
Rating analysts are prohibited from advising issuers and
underwriters on structuring transactions and focus solely on
developing and communicating our opinion on the credit
fundamentals associated with a given structure.
Ratings are determined using a committee structure, not by
a single analyst. These committees include a mandatory
independent member.
Cross-group committees and an independent internal review
function review all ratings criteria.
Fitch has introduced the new role of group credit officer
in each of its rating groups.
Fitch has established and enforces a Code of Conduct
(consistent with IOSCO's and updated in February 2009) and
ancillary policies to specifically address potential conflicts.
Fitch has relocated all of its nonrating operations into a
separate division, Fitch Solutions, which operates behind a
firewall.
No payment model would be completely immune to conflicts of
interest, whether from investors, issuers, governments, or regulators.
An ``investor pays'' model also contains direct conflicts, given that
most major investors have a vested financial interest in the level of
ratings and many are rated entities. A move to a complete ``investor
pays'' model, by definition making the ratings a subscription product,
could also remove ratings from the public domain. This would conflict
with investor and policy makers' call for ratings to be broadly
available, thereby allowing the market to openly judge ratings
performance.
Disclosure of Ratings Methodologies. The definitions for all of
Fitch's ratings and rating scales are regularly reviewed and updated,
publicly disclosed and freely available on our Web site. The most
recent update to our ratings definitions is set forth in a March 2009
report entitled ``Definitions of Ratings and Other Scales.'' In
addition, the criteria that details Fitch's analytical approach to
rating issues and issuers in every region and asset class are also
regularly reviewed and updated, and freely available on our Web site on
a centralized ``criteria homepage.'' In select cases where Fitch is
considering what it believes to be a material shift in our thinking
regarding our analytical approach to a given sector, we normally
release our thinking to the market as an ``exposure draft.'' In such a
case, we solicit feedback from market participants and engage in
transparent discussions about our approach--such as one-on-one
meetings, webcasts and conference calls--and we have done so repeatedly
in the last few years. In addition, the processes we follow internally
in developing and approving such methodology updates are also fully
codified, consistent with SEC and IOSCO rules, and freely available.
Finally, we develop and publish an enormous number of rating
commentaries (over 15,000 in 2008) and research reports that summarize
our opinions on issues, issuers and market sectors as part of our
efforts to ensure the market is aware of our perspective. Those in the
market that allege that our ratings are a ``black box'' must not be
fully aware of the information we make available, or they do not fully
appreciate the concept that the rating itself is not a simplistic
mathematical output, but rather a committee decision based on a range
of quantitative and qualitative factors. For every rating action we
take, we publish the corresponding rationale and make that freely
available to the market. We do not believe that everyone will agree
with all of our opinions, but we are committed to ensuring the market
has the opportunity to discuss them.
Issuer Disclosure and Due Diligence in Structured Finance. Some
market participants, in reviewing the performance of ratings in
structured finance markets, have noted that limits on the amount of
information that is disclosed to the market by issuers and underwriters
has made the market over-reliant on rating agencies for analysis and
evaluation of structured securities. The argument follows that the
market would benefit if additional information on structured securities
(such as asset specific data on residential and commercial mortgage
backed securities) were made broadly and readily available to
investors, thereby enabling them to have access to the same information
that mandated rating agencies have in developing and maintaining our
rating opinions. Fitch fully supports the concept of greater disclosure
of such information. A related benefit of additional issuer disclosure
is that it addresses the issue of ratings shopping. Greater disclosure
would enable nonmandated NRSROs to issue ratings on structured
securities if they so choose, thus providing the market with greater
variety of opinion and an important check on any perceived ``ratings
inflation.'' We also believe that responsibility for disclosing such
information should rest fully with the issuers and the underwriters,
not with rating agencies. Quite simply, it is their information on
their transactions, so they should disclose it.
Furthermore, Fitch notes that the disclosure of additional
information is of questionable value if the accuracy and reliability of
the information is suspect. That goes to the issue of due diligence.
While rating agencies have taken a number of steps to increase our
assessments of the quality of the information we are provided in
assigning our ratings, including adopting policies that state that we
will not rate issues if we deem the quality of the information to be
insufficient, due diligence is a specific and defined legal concept.
Due diligence is not currently, nor should be, the responsibility of
credit rating agencies. Consistent with existing securities laws, the
burden of due diligence belongs on issuers and underwriters. In that
regard, we support the concept that issuers and underwriters ought to
be required to conduct rigorous due diligence on the underlying assets
that comprise asset backed and mortgage backed securities offered or
sold in the U.S. Fitch believes Congress should consider amending the
securities law to require such due diligence on underlying assets for
all ABS and MBS securities offered or sold in the U.S., whether or not
the securities are registered under Section 5 or sold pursuant to an
exemption from such registration. Congress ought not to hold rating
agencies responsible for such due diligence or for requiring that
others do it. Rather, Congress should mandate that the SEC enact rules
to require issuers and underwriters to perform such due diligence--make
public the findings--and enforce the rules they enact.
Regulation and Transparency. Stated simply and clearly, Fitch
supports fair and balanced oversight and registration of credit rating
agencies and believes the market will benefit from globally consistent
rules for credit rating agencies that foster transparency, disclosure
of ratings and methodologies, and management of conflicts of interest.
The dialogue on changes to rating agency regulation continues to
follow two primary--and not necessarily consistent--themes. The first
is the imposition of additional rules and regulations that are
manifested in a range of new or enhanced policies and procedures. This
has been the primary thrust of recent SEC rulemaking and of the
recently passed EU rules. Fitch is or will be fully compliant with
these new rules.
At the same time, a number of commentators have spoken on the topic
of the market's perceived over-reliance on credit ratings. To a certain
extent, we agree with this premise, insofar as some market participants
clearly used ratings as a substitute for--as opposed to a complement
to--their own fundamental credit analysis. One proposed remedy for this
is to eliminate the use of ratings in regulation or to eliminate the
NRSRO concept altogether. While deceivingly simple, we believe this
proposal warrants several comments. Ratings have been used
constructively in many places in regulation, as they are an important
common benchmark. From a regulatory point of view, the question of what
would be used in place of credit ratings is rarely answered
satisfactorily. Simply having regulators ``do it themselves'' has a
range of practical implications and unintended consequences. As does
the notion of allowing regulated financial entities to assess the
credit risk of the securities completely on their own without reference
to any independent external risk benchmarks. In many cases, if you
eliminate the use of ``NRSRO'' ratings in regulation, company and
industry participants will likely develop or maintain their own
guidelines and use credit ratings anyway. We believe they will default
to the largest ``brand name'' rating agencies (Moody's and S&P), which
is not a positive if one of your objectives is increasing competition
and thereby fostering a better work product. Note that the SEC proposed
a variation on this theme in 2008 with respect to money market funds
and their use of ratings but chose not to move forward, in part based
on significant feedback supporting the use of ratings in money market
regulations from the fund industry itself. Some have suggested
replacing ratings with market prices for debt--either bond spreads or
CDS spreads. While these may reflect the market's sense of price at a
given point, recall from the events of the last 2 years that not all
securities are liquid, that bid-ask spreads can widen materially in
times of stress and that market prices by definition are inherently
more volatile than a fundamentally driven credit rating. However, if
one is serious about eliminating ratings in regulation, we suggest you
transition to elimination over an intermediate time frame with careful
consideration of each regulation, rather than wholesale elimination. A
better solution is continued recognition and oversight of NRSROs with
the goal of improving the performance and usefulness of ratings.
Speaking of competition and regulation, the SEC also has approved a
wide range of new NRSROs. Some are established with global reach,
resources and coverage, while others are focused geographically or by
sector, have modest resources, and/or coverage and ratings history that
are more limited. Given the divergent profiles, it is quite a challenge
to consider the issues we are discussing today. For example, we do not
believe the definitions and meanings of ratings are all the same among
NRSROs, let alone the levels of the ratings themselves. We also believe
it is significant that a verifiable record of performance is not
publicly available from all NRSROs and that not all ratings are
publicly available in real time. Specifically, the market benefits from
the differences of opinion as expressed by the different ratings
assigned by credit rating agencies. Usually, the initial rating
assigned by Fitch will be proven reliable. The same is of course true
of any other agency. However, if some NRSROs need not disclose all of
their ratings, that dynamic merely allows them to ``cherry-pick'' the
selected ratings where they believe they were ``first'' or ``better''
without the obligation to provide the information that enables the
market to fully compare and contrast the opinions and performance of
the NRSROs based on all of their ratings. If a goal is improvement of
the reliability of credit ratings through increased competition and
transparency, we believe all oversight requirements should be applied
consistently and equally to all NRSROs.
A final point on regulation: The Treasury's proposal includes the
concept of mandatory registration for credit rating agencies. Fitch,
along with the other recognized NRSROs, is already registered and
subject to explicit SEC regulatory oversight. We believe the mandatory
registration concept is unnecessary and unwarranted and is not
consistent with basic free speech principals. \1\
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\1\ See, Written Statement of Eugene Volokh, Gary T. Schwartz
Professor of Law, University of California, Los Angeles, School of Law
before Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises of the House Committee on Financial Services at
Approaches To Improving Credit Rating Agency Regulation, May 19, 2009,
at pp. 9-10 available at http://www.house.gov/apps/list/hearing/
financialsvcs_dem/volokh.pdf (``Professor Volokh Statement'').
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Accountability and Liability. While we understand and agree with
the notion that we should be accountable for what we do, we disagree
with the idea that the imposition of greater liability will achieve
that. Some of the discussion on liability is based on misperceptions,
and those points are noted below. More fundamentally, we struggle with
the notion of what it is that we should be held liable for.
Specifically, a credit rating is an opinion about future events--the
likelihood that an issue or issuer will meet its credit obligations as
they come due. Imposing a specific liability standard for failing to
accurately predict the future in every case strikes us as an unwise
approach.
The first misconception is that rating agencies are free from
liability and hide behind the First Amendment to shield them from
legitimate securities law liability. Rating agencies may be held liable
for securities fraud just as any person or entity may be (including
accountants, lawyers, officers, directors, and securities analysts) to
the extent that a rating agency intentionally or recklessly makes a
material misstatement or omission in connection with the purchase or
sale of a security. Of course, a plaintiff must prove securities fraud
against a rating agency just as against any other defendant. The
reality of U.S. securities law is that any plaintiff may make a claim
against a rating agency under the antifraud provisions of the
securities law, just as they can against accountants, lawyers,
officers, directors and securities analysts, but they must prove their
claims to the standard required under the securities law.
Some also have criticized rating agencies for what they perceive as
taking undue advantage of the First Amendment and its protection of
free speech. We believe this is an overblown argument that fails to
acknowledge key facts about the nature of ratings. We publish all of
our ratings, accompanied by detailed published commentary about the
companies and securities we rate. Fitch's ratings are available free to
anyone who has access to the Internet. The companies and securities we
rate are of significant interest to investors of all types and other
parties interested in the securities and the capital markets. Hundreds
of investors, fiduciaries, government entities and other interested
parties subscribe to our published commentary and thousands access our
Web site daily. We believe Fitch enjoys the same free-speech rights as
any other person or entity to comment on matters of public interest and
to ``make informed, thoughtful predictions about the future. That is no
different from what newspapers or scholars do.'' \2\ We further believe
that the manner in which we are paid and the nature of the securities
we rate do not affect the essence of what we do or the free-speech
rights we enjoy in connection with our work. \3\
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\2\ Nathan Koppel, ``Credit Raters Plead the First; Will It Fly?''
The Wall Street Journal, April 21, 2009, C1 (quoting Professor Eugene
Volokh).
\3\ See, Professor Volokh Statement, at pp. 2-3.
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A second misconception centers on where the responsibility for full
and complete disclosure about companies and securities, and appropriate
due diligence to ensure the accuracy and adequacy thereof, should be
placed. As discussed above, these obligations are today, and have been
since the enactment of the earliest U.S. securities law, the sole
responsibility of issuers, their officers and directors and
underwriters. The obligation to enforce these responsibilities falls
squarely on the shoulders of the Securities and Exchange Commission and
the courts.
Some have proposed that rating agencies should be liable not merely
for material misstatement, but for the investigation of rated
securities and the verification of information. In one proposed bill,
rating agencies would be liable for knowingly or recklessly failing to
conduct such investigation or verification, which will cause rating
agencies to be judged by whether, in hindsight, they could have
reasonably done more. Because a plaintiff could base a claim on ``you
had to have known more could be done,'' the effect is negligence based
private rights of action. Even a requirement to plead with
particularity might not be at all protective in this context. In
hindsight, it will always look like a rating agency could have
reasonably foreseen future problems with different assumptions and
stress testing.
While we believe some proposals are ill advised, Fitch has been and
will continue to be constructively engaged with policy makers and
regulators as they consider important ideas and questions about the
oversight of credit rating agencies. Fitch has taken a number of
important analytical and procedural steps already and we acknowledge
there is more to do. We remain committed to enhancing the reliability
and transparency of our ratings, and welcome all worthwhile ideas that
aim to help us achieve that.
______
PREPARED STATEMENT OF JAMES H. GELLERT
President and Chief Executive Officer,
Rapid Ratings International, Inc.
August 5, 2009
Overview
Rapid Ratings International, Inc. (Rapid Ratings) would like to
thank the U.S. Senate Committee on Banking, Housing, and Urban Affairs
for inviting us to provide testimony to the critical subject of Rating
Agency regulation.
This is an essential topic for the global financial markets, U.S.
citizens and residents who have been directly and indirectly affected
by the actions of the large, incumbent rating agencies, and those newer
ratings firms, like ours, that have built a viable alternative to the
status quo.
Rapid Ratings is a subscriber-paid firm. We utilize a proprietary,
software-based system to rate the financial health of thousands of
public and private companies and financial institutions quarterly. We
use only financial statements, no market inputs, no analysts, and have
no contact in the rating process with issuers, bankers or advisors. Our
ratings far outperformed the traditional issuer-paid rating agencies in
innumerable cases such as Enron, GM, Delphi, Parmalat, LyondellBasell,
Pilgrim's Pride, Linens 'N Things, and almost the entire U.S.
Homebuilding industry.
Currently, we are not a Nationally Recognized Statistical Rating
Organization (NRSRO). We have not applied for the NRSRO status and do
not have immediate plans to do so. At present, there are too many mixed
messages coming from the SEC, Treasury and Congress for me to recommend
to our shareholder that the designation is in their best interests. The
Treasury proposal's requirement that all ratings firms would be
required to register is another curve ball in an already changing
playing field.
That said, we believe that reform in our industry is necessary and
must happen with a sense of urgency. However, we caution that speed for
speed's sake may have significant, and counterproductive, unintended
consequences.
U.S. legislation and regulations have both global and national
effects, hard lessons reinforced over the last 2 years. Despite years
of legislative action on corporate governance, Sarbanes Oxley (2002),
and the Credit Rating Agency Reform Act (2006), through a combination
of conflict of interest, self-interest and, unfortunately, entrenched
regulatory protection, issuer-paid rating agencies (principally S&P,
Moody's, and Fitch (the ``Big Three'')) facilitated a toxic asset flood
that deluged the global markets, contributing to the worst economic
crisis in 80 years.
The SEC has been wrestling with new rules and rule amendments and
has made some headway in areas of curbing conflicts of interest. Though
not attacking and seeking to end the clearly conflicted issuer-pay
revenue model, the Commission is taking some positive initiatives to
curb the more egregious behavior evidenced by these conflicts. The new
Department of Treasury proposal, however, takes multiple steps in the
wrong direction and threatens to further solidify the entrenched
position held by the Big Three, erecting further hurdles to competition
in this industry. The Treasury proposals are misdirected in 5 areas:
1. One-size does not fit all: Proposals designed to fix major
deficiencies in the issuer-paid business model should not be
loaded indiscriminately on to subscriber-paid agencies, thus
increasing their costs, increasing barriers to entry, and
reducing competition.
2. Disclosure rules affecting intellectual property: The new rules
must avoid requiring the forced disclosure of proprietary
intellectual property. Appropriate safeguards must be
introduced to protect intellectual property.
3. Accuracy: It is unreasonable to believe the SEC can effectively
be the arbiter on accuracy in the ratings industry. The market
will decide very effectively which ratings are more accurate
through usage of competing credit rating agencies (CRAs), as
long as there are not barriers to entry protecting S&P,
Moody's, and Fitch, and disadvantaging new entrants or small
rating agencies.
4. Forcing NRSRO registration on all companies issuing ratings will
force compliance costs on new CRAs thus erecting further
barriers, potentially force small CRAs out of business and
deter potential new capital sources entering this industry, all
thereby undermining the growth of innovative and more accurate
ratings technology. The vast number of firms captured by this
sweeping net would not only confuse users of ratings,
potentially hundreds of new agencies would be designated that
would not have qualified as NRSROs under the Credit Rating
Agency Reform Act of 2006. All of these would fuel the use of
the largest brand names, and solidify regulatory protection of
S&P, Moody's, and Fitch.
5. Rating Disclosure: Requiring subscriber-based rating agencies to
disclose their history of ratings can undermine the subscriber-
based business model which is predicated on selling current and
past ratings to investors. The Treasury proposal covers all
types of rating agencies and for 100 percent of their ratings.
This erects a major barrier to competition by subscriber-based
CRAs against the issuer-paid CRAs by stripping them of their
revenues. This proposal may violate antitrust laws because the
proposal undermines competition. \1\
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\1\ Spectrum Sports, Inc. v. McQuillan: ``The purpose of the
[Sherman] Act is not to protect businesses from the working of the
market; it is to protect the public from the failure of the market. The
law directs itself not against conduct which is competitive, even
severely so, but against conduct which unfairly tends to destroy
competition itself.''
The Big Three have lobbied heavily to promote the notion that all
business models carry conflicts of interest and therefore that theirs
is no worse than any other. Can conflicts occur in other business
models? Sure. Have conflicts in other business models contributed to a
catastrophic financial disaster that taxpayers will be paying for
dearly for years to come? No. This red herring cannot drive new
legislation. The problem is not the potential behavior of the
subscriber-paid rating agencies; rather it is the misbehaviors of the
issuer-paid rating agencies that have already occurred.
Effective legislation and regulatory framework must focus on
reforming the issuer-paid model's most negative features, providing
oversight of the NRSROs that prevent the self-interested behavior that
contributed to the current financial crises and creating an even
playing field for competition. The latter has two major components:
fostering (or at least not inhibiting) new players, methodologies, and
innovation; and, equivalent disclosure of data used by other NRSROs for
rating the highly complex instruments The Big Three have demonstrated
are in dire need of alternative sources of opinion.
Innovation and responsible alternatives to a status quo are both
highly American traits. For true reform to have a fighting chance,
these themes must be protected by the legislative framework for the
ratings industry and we must be critically aware of how the unintended
consequences of poorly implemented regulations can leave us with a
broken system that has proven it is not deserving of protection.
Much of the current legislative effort, including the SEC's newest
Rule Amendments, reproposed rule amendments, Treasury's proposal and
initiatives which we understand are underway on the Hill, are all
concentrating on largely the same group of issues:
Ratings shopping
The consultative relationships between the issuer-paid
rating agencies and issuers and their bankers
Access to the information used in due diligence of
structured products
Disclosure of ratings history and actions
Ratings symbology for structured product ratings
New payment structures for ratings
What entities should register as NRSROs
The existence of ratings in regulations
Largely neglected in the proposals, rules and acts are the following:
Should the issuer-paid revenue model be abolished?
The consequences of rules targeting essentially three
issuer-paid firms on the subscriber-paid businesses that are
growing to provide competition and alternatives to investors
Accuracy of ratings
______
PREPARED STATEMENT OF JOHN C. COFFEE, Jr.
Adolf A. Berle Professor of Law,
Columbia University Law School
August 5, 2009
Chairman Dodd, Ranking Member Shelby, and fellow Senators: I am
honored to be back before this Committee to discuss the proposed
``Investor Protection Act of 2009'' and its provisions in Subtitle C
(Improvement to the Regulation of Credit Rating Agencies). Frankly, I
have Yogi Berra's sense of ``deja vu all over again'' in reviewing this
legislation, because it borrows very heavily from legislation
introduced earlier this year by Senator Reed, which he called the
``Rating Accountability and Transparency Enhancement Act of 2009.''
Senator Reed (and his staff) crafted an important and constructive
piece of legislation, and the Administration has wisely adopted most of
it.
Nonetheless, there are two respects in which the Administration's
proposals in my judgment fall short. Unless these two problems are
better addressed, I am afraid that the current and unsatisfactory
status quo will persist. Credit rating agencies are unlike the other
major gatekeepers of the financial markets (e.g., accountants,
investment banks, and securities analysts) in two critical respects:
1. Unlike other gatekeepers, the credit rating agencies do not
perform due diligence or make its performance a precondition of
their ratings. In contrast, accountants are, quite literally,
bean counters who do conduct audits. But the credit rating
agencies do not make any significant effort to verify the facts
on which their models rely (as they freely conceded to this
Committee in earlier testimony here). Rather, they simply
accept the representations and data provided them by issuers,
loan originators, and underwriters. The problem this presents
is obvious and fundamental: no model, however well designed,
can outperform its information inputs--``Garbage In-Garbage
Out.'' Although the Administration's bill does address the need
for due diligence, its current form (unlike the Reed bill) may
actually discourage third party due diligence. Ultimately,
unless the users of credit ratings believe that ratings are
based on the real facts and not just a hypothetical set of
facts, the credibility of ratings, particularly in the field of
structured finance, will remain tarnished, and private housing
finance in the U.S. will remain starved and underfunded because
it will be denied access to the broader capital markets.
2. Credit rating agencies have long and uniquely been immune from
liability to their users. Unlike accountants or investment
banks, they have never been held liable. At the same time,
because the ``issuer pays'' business model of the ratings
agencies seems likely to persist (despite the creative efforts
of many who have sought to develop a feasible ``user pays''
model), we have to face the simple reality that the rating
agencies have a built-in bias: they are a watchdog paid by the
entities they are expected to watch. Because the ratings
agencies receive an estimated 90 percent of their revenues from
issuers who are paying for their ratings, \1\ the agencies will
predictably continue to have a strong desire to please the
client who pays them. Moreover, the market for ratings has
become more competitive, and the latest empirical research
finds that, with greater competition, there has come an
increased tendency to inflate ratings. \2\ This is
predictable--unless there is some countervailing pressure on
the gatekeeper. In the case of accountants and underwriters,
there clearly is such countervailing pressure in the form of
the threat of liability under the Federal securities laws. But
that threat has never had any discernable impact on the credit
rating agencies. Let me make clear that I do not want to
subject credit rating agencies to class action litigation every
time a rating proves to be inaccurate. Rather, the goal should
be more modest: to use a litigation threat to induce the rating
agencies not to remain willfully ignorant and to insist that
due diligence be conducted and certified to them with regard to
structured finance offerings.
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\1\ See, Frank Partnoy, ``How and Why Credit Rating Agencies Are
Not Like Other Gatekeepers'', (http://ssrn.com/abstract=900257) (May
2006).
\2\ See, Bo Becker and Todd J. Milbourn, ``Reputation and
Competition: Evidence From the Credit Rating Industry'', (Harv. Bus.
School Fin. Working Paper No. 09-051) (2008) (available at http://
ssrn.com/abstract=1278150) (finding that the percentage of investment
grade ratings went up and the percentage of noninvestment grade ratings
went down after competition intensified in the industry, beginning in
the late 1990s).
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I. The Disappearance of Due Diligence
A rapid deterioration in underwriting standards for subprime
mortgage loans occurred over a very short period, beginning around
2001. As the chart set forth below shows, low or no-document loans
(also known in today's parlance as ``liar's loans'') rose from 28.5
percent in 2001 to 50.7 percent in 2005. \3\
---------------------------------------------------------------------------
\3\ See, Allen Ferrell, Jennifer Bethel, and Gang Hu, ``Legal and
Economic Issues in Litigation Arising From the 2007-2008 Credit
Crisis'', (Harvard Law & Economics Discussion Paper No. 612, Harvard
Law School Program in Risk Regulation Research Paper No. 08-5) at Table
4.
Concomitantly, interest-only loans (on which no amortization of
principal occurred) rose from 0 percent in 2001 to 37.8 percent in
2005. These changes should have prompted the ratings agencies to
downgrade their ratings on securitizations based on such loans--but
they didn't. As the housing bubble inflated, the ratings agencies
slept.
Two explanations are possible for their lack of response: (1) the
ratings agencies willfully ignored this change, or (2) they managed not
to learn about this decline, because issuers did not tell them and they
made no independent inquiry. Prior to 2000, the ratings agencies did
have a reliable source of information about the quality of the
collateral in securitization pools. During this period prior to 2000,
investment banks did considerable due diligence on asset-backed
securitizations by outsourcing this task to specialized ``due
diligence'' firms. These firms (of which Clayton Holdings, Inc. was
probably the best known) would send squads of loan reviewers (sometimes
a dozen or more) to sample the loans in a securitized portfolio,
checking credit scores and documentation. But the intensity of this due
diligence review declined over recent years. The Los Angeles Times
quotes the CEO of Clayton Holdings to the effect that:
Early in the decade, a securities firm might have asked Clayton
to review 25 percent to 40 percent of the subprime loans in a
pool, compared with typically 10 percent in 2006 . . . \4\
---------------------------------------------------------------------------
\4\ See, E. Scott Reckard, ``Subprime Mortgage Watchdogs Kept on
Leash; Loan Checkers Say Their Warnings of Risk Were Met With
Indifference'', Los Angeles Times, March 17, 2008, at C-1.
The President of a leading rival due diligence firm, the Bohan Group,
---------------------------------------------------------------------------
made an even more revealing comparison:
By contrast, loan buyers who kept the mortgages as an
investment instead of packaging them into securities would have
50 percent to 100 percent of the loans examined, Bohan
President Mark Hughes said. \5\
---------------------------------------------------------------------------
\5\ Id.
In short, lenders who retained the loans checked the borrowers
carefully, but the investment banks decreased their investment in due
diligence, making only an increasingly cursory effort as the bubble
inflated.
The actual loan reviewers employed by these firms also told the
above-quoted Los Angeles Times reporter that supervisors in these firms
would often change documentation in order to avoid ``red-flagging
mortgages.'' These employees also report regularly encountering
inflated documentation and ``liar's loans,'' but, even when they
rejected loans, ``loan buyers often bought the rejected mortgages
anyway.'' \6\ In short, even when the watchdog barked, no one at the
investment banks truly paid attention, and no one told the rating
agencies.
---------------------------------------------------------------------------
\6\ Id.
---------------------------------------------------------------------------
If mortgage-backed securitizations are again to become credible,
ratings agencies must be able to distinguish (and verify) whether an
asset pool consists mainly of ``liar's loans'' or is instead composed
of loans made to creditworthy borrowers. This requires the restoration
of due diligence--presumably by independent, third party due diligence
firms.
Both the Administration bill and the earlier Reed bill make an
effort to restore due diligence, but the impact of the Administration's
bill is uncertain and possibly even counterproductive. In proposed
Section 932(s)(3)(D) (``Transparency of Credit Rating Methodologies and
Information Reviewed''), the Administration bill requires disclosure
of:
whether and to what extent third party due diligence services
have been utilized, and a description of the information that
such thirty party reviewed in conducting due diligence
services.
Then, in Section 932(s)(5) (Due Diligence Services), the Administration
bill requires that where
third-party due diligence services are employed by a nationally
recognized statistical rating organization or an issuer or
underwriter, the firm providing the due diligence services
shall provide to the [NRSRO] written certification of the due
diligence, which shall be subject to review by the Commission.
This makes great sense--except for the fact that it is optional.
The issuer or underwriter (who will likely be the parties retaining and
compensating the due diligence firm) may decide that it is easier not
to retain such an outside firm than to have to describe its procedures
and the information it reviewed and then provide a certification to the
ratings agency. In full compliance with 932(s)(3)(D), it could answer
that third party firms were not used. To make this appear more
palatable, the underwriter might describe some internal review
procedures that were followed by its own staff (which would not trigger
any mandatory certification to the rating agency). In short, given the
choice, issuers and underwriters might prefer the easier course of
doing nothing, and thus the current opacity surrounding structured
finance offerings would persist. To be sure, some rating agencies might
insist on third party due diligence (at least for a period of time),
but they might thereby place themselves at a competitive disadvantage
and lose business until they gave in.
How then can the use of third party due diligence be more
effectively encouraged? One very feasible approach might be to focus on
the users of credit ratings, for example by instructing mutual funds
and other institutional investors that they could not rely on a rating
issued by an NRSRO for purposes of their own need to comply with their
own ``prudent man'' fiduciary obligations unless the ratings was
explicitly based on third party due diligence. This would avoid any
conceivable Constitutional issue, because Congress would not be
mandating procedures for the NRSRO, but instead would be telling
institutional investors what they needed to rely upon. To illustrate
this approach, let me give two examples: Under current Rule 3a-7 under
the Investment Company Act exempts fixed-income securities issued by a
special purpose vehicle from the Investment Company Act if, at the time
of sale, the securities are rated in one of four highest categories of
investment quality by an NRSRO. \7\ Congress could simply instruct the
SEC that such an exemption should also require that the requisite
investment grade rating be based on third party due diligence that was
certified to the rating agency pursuant to Section 932(s)(5).
Similarly, Rule 2a-7 (``Money Market Funds'') under the same Act
defines an ``Eligible Security'' as one that has a specified rating
given by an NRSRO. \8\ If this rule required that the rating be based
in addition on a due diligence certification, money market funds would
be effectively required to demand that NRSROs receive such
certifications. The attraction of this approach is that it does not
mandate what the NRSRO must do, but instead tells the users of ratings
what they must have. Effectively, issuers, underwriters and NRSROs
would know that they had to use a due diligence firm to verify the
critical information assumed by the rating agency's model in they
intended to sell the offering to these institutions.
---------------------------------------------------------------------------
\7\ See, 17 C.F.R. 270.3a-7.
\8\ See, 17 C.F.R. 270.2a-7.
---------------------------------------------------------------------------
A second approach to this same end could be achieved through the
reformulation of liability rules, as next described.
II. Using Liability To Compel Due Diligence
The most serious failing in the proposed legislation is that it
ducks the issue of enforcement and relies solely on SEC monitoring and
disclosure. Even if we assume that the SEC will always be vigilant
(which may be a heroic assumption after the Madoff debacle), the SEC is
not given any clear authority to mandate due diligence. Moreover, over
the last decade, we have seen the rating agencies behave in a manner
that approached willful ignorance about changes in the credit
environment that were clear to almost everyone else.
Here, a balance must be struck. Ratings agencies appear never to
have been held liable under the Federal securities laws. \9\ Even in
the Enron litigation, a proceeding in which underwriters paid over $7
billion in settlements, the credit rating agencies escaped liability.
\10\ Although it is not possible to be aware of every possible
settlement in Federal or State court, recent surveys by legal scholars
continue to reach this same conclusion. See, e.g., Frank Partnoy,
Rethinking Regulation of Credit Rating Agencies: An Institutional
Investor Perspective (Council of Institutional Investors White Paper
April 2009) at 14-15; Kenneth Kettering,`` Securitization and Its
Discontents: The Dynamics of Financial Product Development'', 29
Cardozo L. Rev. 1553, 1687-93 (2008); Arthur R. Pinto, ``Control and
Responsibility of Credit Rating Agencies in the U.S.'', 54 Am. J. Comp.
L. 341, 351-356 (2006). As a Congressional staff study found in 2002,
the rating agencies that qualify as NRSROs are legislatively shielded
from liability under the Federal securities laws. \11\ The First
Amendment defense is only one of many defenses relied upon by the
industry, and probably not the most important. Yet, although many tort
law theories have been attempted by plaintiffs, ``the only common
element . . . is that the rating agencies win.'' \12\ Since the 2006
legislation, the ratings industry now takes the position that that
legislation preempted State tort law and thus precludes even fraud
actions based on the common law. \13\ In short, while a settlement may
have been paid somewhere in the recent flurry of litigation, the risk
of liability for ratings agencies remains remote.
---------------------------------------------------------------------------
\9\ Recently, a number of securities class actions have included
rating agencies as defendants. In a few cases, Federal courts have
refused to grant motions to dismiss sought by the ratings agency. See,
e.g., In re Moody's Corp. Sec. Litig., 599 F. Supp. 2d 493 (S.D.N.Y.
2009); In re National Century Financial Enterprises Inc. Invest.
Litig., 580 F. Supp. 2d 630 (S.D. Ohio 2008). But this simply means
that the plaintiff has survived the first round in a long fight. My
discussions with plaintiffs attorneys suggest that they see the
underwriters as the ``deep pocket'' defendant in these cases and are
not expecting significant contributions from the rating agencies, given
the many legal obstacles to suing them.
\10\ See, Newby v. Enron Corporation, 511 F. Supp. 2d 741, 815-817
(S.D. Tex. 2005).
\11\ See, Staff of the S. Comm. on Governmental Affairs, 107
Cong., Report: Financial Oversight of Enron: The SEC and Private-Sector
Watchdogs (Comm. Print Oct. 8, 2002) at 104-05. In particular, Rule
436(g) under the Securities Act of 1933 specifically exempts the
ratings agencies from liability as an expert under Section 11 of that
Act.
\12\ See, Frank Partnoy, ``The Paradox of Credit Ratings'', In
Ratings, Rating Agencies, and the Global Financial System, (Richard
Levich, et al., eds. 2002) at 79; See, also First Equity Corp. v.
Standard & Poor's Corp., 869 F.3d 175 (2d Cir. 1999) (rejecting common
law theories under New York and Florida law).
\13\ See, Section 15E(c)(2) of the Securities Exchange Act of 1934
(discussed infra), 15 U.S.C. 78o-7(c)(2).
---------------------------------------------------------------------------
This does not mean, however, that we should seek to maximize
liability. Clearly, the rating agencies cannot be insurers of credit
quality and could conceivably be drowned under a sea of liability if
the liability rules were greatly liberalized. Precisely for that
reason, Senator Reed's bill struck a very sensible compromise in my
judgment. It created a standard of liability for the rating agencies,
but one with which they easily could comply (if they tried).
Specifically, his bill contained a Section 4 (``State of Mind in
Private Actions'') that permitted an action against a credit rating
agency where:
the complaint shall state with particularity facts giving rise
to a strong inference that the [rating agency] knowingly or
recklessly failed either to conduct a reasonable investigation
of the rated security with respect to the factual elements
relied upon by its own methodology for evaluating credit risk,
or to obtain reasonable verification of such factual elements
(which verification may be based on a sampling technique that
does not amount to an audit) from other sources that it
considered to be competent and that were independent of the
issuer and underwriter.
This language does not truly expose rating agencies to any serious risk
of liability--at least if they either conduct a reasonable
investigation themselves or obtain verification from others (such as a
due diligence firm) that they reasonably believed to be competent and
independent.
Given the express certification requirement in the proposed
legislation, this language could be picked up and incorporated into an
updated revision of the above language in the Reed bill, so that a
rating agency would be fully protected when it received such a
certification from an independent due diligence firm that covered the
basic factual elements in its model. Arguably, this entire liability
provision could be limited to structured finance offerings, which is
where the real problems lie.
The case for this limited litigation threat is that it is unsafe
and unsound to let rating agencies remain willfully ignorant. Over the
last decade, they have essentially been issuing hypothetical ratings in
structured finance transactions based on hypothetical assumed facts
provided them by issuers and underwriters. Such conduct is inherently
reckless; the damage that it caused is self-evident, and the proposed
language would end this state of affairs (without creating anything
approaching liability for negligence).
III. Drafting Suggestions
There are some ambiguities and inconsistencies in the draft bill
that should be corrected:
1. First, there is a clear inconsistency between the amendment to
Section 15E(c)(2), which would continue to state that:
Notwithstanding any other provision of law, neither the
Commission nor any State (or political subdivision thereof) may
regulate the substance of credit ratings or the procedures and
methodologies by which any [NRSRO] determines credit ratings.
and proposed Section 932(r), which provides that:
The Commission shall prescribe rules . . . with respect to the
procedures and methodologies, including qualitative and
quantitative models, used by [NRSROs] that require each [NRSRO]
to . . .
This conflict is dangerous, and it might be cured in part by stating in
15E(c)(2) that: ``except as otherwise specifically provided in this
title, neither the Commission nor any State . . . may regulate . . .
.'' Even more importantly, Congress should realize that, whatever it
may have intended, the ratings industry is arguing in court that this
language in Section 15E(c) also preempts common law claims for fraud
and negligence. If Congress did not intend to preempt the common law,
it should correct this looming misinterpretation and limits its
preemption provision so that it does not reach the common law. If fraud
can be proven under State law or Blue Sky statutes, such an action
should not be preempted.
2. Under existing Section 15E(d), the SEC may censure, suspend (and
now fine) an NRSRO for limited reasons only. The last and residual
clause (Section 15E(d)(5)) says that such discipline or suspension may
be invoked if the NRSRO ``fails to maintain adequate financial and
managerial resources to consistently produce credit ratings with
integrity.'' This is too high a standard and also too narrow a
standard. With the revisions to be made by this legislation, an NRSRO
will also be expected to maintain conflict of interest policies and to
comply with the SEC's new procedural and disclosure rules under
Sections 932 and 933. Hence, this Section should be broadened to read:
(5) failed to (i) operate in substantial compliance with the
rules promulgated by the Commission, (ii) maintain adequate
financial and managerial resources to consistently produce
credit ratings with integrity, or (iii) demonstrate sufficient
competence or accuracy to justify continued reliance by
investors upon its ratings.
The last clause would also entitle the Commission to discipline,
suspend, or revoke the registration of a ratings agency that was
systematically inaccurate or inferior over a sustained period. An
incompetent ratings agency does not merit tenure.
3. Proposed 934 requires the SEC to adopt rules requiring issuers
to disclose ``preliminary credit ratings received'' from NRSROs.
Because the term ``preliminary credit rating'' is not defined, this
rule could be easily sidestepped if the NRSRO gave the issuer instead a
general (or even a specific) description of how it would evaluate the
issuer's credit, but not an actual or tentative rating. Hence, it would
be advisable to broaden this section so that it required disclosure of
``preliminary credit ratings or any other assessment or information
that informed the issuer of the likely range within which it would be
rated or the likely outcome of the rating process.''
4. If we want the ratings agency to rely on more than the facts
provided by the issuer or underwriter, consideration should be given to
expanding the required disclosures under 932(s)(3)(E). For example,
the new form specified by that Section should require disclosure of:
(E) a description of all relevant data, from whatever source
learned or received, about any obligor, issuer, security, or
money market instrument that was used and relied upon, or
considered but not relied upon, for the purpose of determining
the credit rating, indicating the source of such information;
This is an admittedly broad provision, but aimed at making it more
difficult for the rating agency to ignore information from third
parties.
5. Consideration should be given to requiring the new compliance
officer (which each NRSRO will be required to employ under this
legislation) to provide any credible information that it learns
indicating fraudulent or unlawful behavior to an appropriate law
enforcement agency and/or the SEC. This is in effect a mandatory
whistle-blowing provision, and exceptions could be created to cover
circumstances when the compliance officer concluded that the
information was false or unreliable.
______
PREPARED STATEMENT OF LAWRENCE J. WHITE
Leonard E. Imperatore Professor of Economics,
New York University
August 5, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee:
My name is Lawrence J. White, and I am a Professor of Economics at the
NYU Stern School of Business. During 1986-1989 I served as a Board
Member on the Federal Home Loan Bank Board. Thank you for the
opportunity to testify today on this important topic. I have appended
to this statement for the Committee a longer Statement that I delivered
at the Securities and Exchange Commission's (SEC) ``Roundtable'' on the
credit rating agencies on April 15, 2009, which I would like to have
incorporated for the record into the statement that I am presenting
today.
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 (RMBS) 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
proposals by the Obama administration, as well as by others--for more
extensive regulation of the credit rating agencies in hopes of
forestalling future such debacles. The advocates of such regulation
want (figuratively) to grab the rating agencies by the lapels, shake
them, and shout ``Do a better job!''
This urge for greater regulation is understandable--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, and 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 credit rating agencies.
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 was 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' holding ``speculative'' bonds, as determined by the rating
agencies' ratings--imbued these third-party judgments about the
creditworthiness of bonds with the force of law! This problem was
compounded when the SEC created the category of ``nationally recognized
statistical rating organization'' (NRSRO) 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.
\1\
---------------------------------------------------------------------------
\1\ Because of subsequent prodding by the Congress, and then the
specific barrier-reduction provisions of the Credit Rating Agency
Reform Act of 2006, there are now ten NRSROs.
---------------------------------------------------------------------------
It should thus 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 role of financial regulation in forcing the
centrality of the major rating agencies then leads to an alternative
prescription: Eliminate regulatory reliance on ratings--eliminate the
ratings' force of law--and bring market forces to bear. Since the bond
markets are primarily institutional markets (and not a retail
securities market, 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
superstructure could be dismantled, and the NRSRO category could be
eliminated.
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 advisors. 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 1930s.
My appended April 15 Statement for the SEC provides greater
elaboration on many of these points. Since that Statement preceded the
Obama administration's specific proposals for further regulation of the
credit rating agencies, I will expand here on the drawbacks of those
proposals.
The proposals--as found initially in the Administration's Financial
Regulatory Reform: A New Foundation (p. 46) that was released in mid
June, and then in the specific legislative proposals that were released
on July 21--are devoted primarily to efforts to increase the
transparency of ratings and to address issues of conflicts of interest.
The latter arise largely from the major rating agencies' business model
of relying on payments from the bond issuers in return for rating their
bonds. \2\ These proposals expand and elaborate on a set of regulations
that the SEC has recently implemented.
---------------------------------------------------------------------------
\2\ It is worth noting that three smaller U.S.-based NRSRO rating
agencies have ``investor pays'' business models and that the ``investor
pays'' model was the original model for John Moody and for the industry
more generally, until the major rating agencies switched to the
``issuer pays'' model in the early 1970s.
---------------------------------------------------------------------------
Again, the underlying urge to ``do something'' in the wake of the
mistakes of the major credit rating agencies during the middle years of
this decade is understandable. Further, the ``issuer pays'' business
model of those rating agencies presents an obvious set of potential
conflict-of-interest problems that appear to be crying out for
correction. \3\
---------------------------------------------------------------------------
\3\ It is important to remember, however, that the major credit
rating agencies switched to the ``issuer pays'' model in the early
1970s, and that the serious problems only arose three decades later.
Apparently, the agencies' concerns for their long-run reputations and
the transparency and multiplicity of issuers prior to the current
decade all served to keep the potential conflict-of-interest problems
in check during those three intervening decades.
---------------------------------------------------------------------------
Nevertheless, the dangers of the proposals are substantial. They
ask the SEC to delve ever deeper into the processes and procedures and
methodologies of credit ratings--of providing judgments about the
creditworthiness of bonds and bond issuers. In so doing, the proposals
(if enacted) are likely to rigidify the industry along the lines of
whatever specific implementing regulations that the SEC devises, as
well as raising the costs of being a credit rating agency. In so doing,
the proposals will discourage entry and innovation in new ways of
gathering and assessing information, in new methodologies, in new
technologies, and in new models--including new business models.
There is one especially worrisome provision in the specific
legislation that was proposed in July (and that was absent in the
earlier June proposals) that is guaranteed to discourage entry: the
requirement that all credit rating agencies should register as NRSROs
with the SEC. This requirement would seem to encompass the independent
consultant who offers bond investment recommendations to clients (such
as hedge funds or bond mutual funds), as well as any financial services
company that employs fixed income analysts whose recommendations become
part of the services that the company offers to clients.
This provision, if enacted, will surely discourage entry into the
broader bond information business, as well as encouraging the exit of
existing providers of information. Ironically, it will likely become a
new protective barrier around the incumbent credit rating agencies
(when, again ironically, the Credit Rating Agency Reform Act of 2006
was intended to tear down the earlier barrier to entry that the SEC had
erected when it create the NRSRO category in 1975). This can't be a
good way of encouraging new and better information for the bond market.
Further, it is far from clear that the proposals will actually
achieve their goal of improving ratings. One common complaint against
the large agencies is that they are slow to adjust their ratings in
response to new information. \4\ But this appears to be a business
culture phenomenon for the agencies (which was present, as well, in the
pre-1970's era when the rating agencies had an ``investor pays''
business model). As for the kind of over-optimism about the RMBS in
this decade that subsequently created such serious problems, the rating
agencies were far from alone in ``drinking the Kool-Aid'' that housing
prices could only increase and that even subprime mortgages
consequently would not have problems. It is far from clear that the
proposed regulations would have curbed such herd behavior. Also, the
incumbent rating agencies are quite aware of the damage to their
reputations that have occurred and have announced measures--including
increased transparency and enhanced efforts to address potential
conflicts--to repair that damage.
---------------------------------------------------------------------------
\4\ This complaint has been present for decades. It surfaced
strongly in the wake of the Enron bankruptcy in November 2001, with the
revelation that the major rating agencies had maintained ``investment
grade'' ratings on Enron's debt until 5 days before that company's
bankruptcy filing. More recently, the major agencies had ``investment
grade'' ratings on Lehman Brothers' debt on the day that it filed for
bankruptcy.
---------------------------------------------------------------------------
The Obama administration's proposals do--briefly--entertain the
possibility of reducing regulatory reliance on ratings. But this seems
to be largely lip service, embodied in promises that the Administration
will examine the possibilities. The only specific provision on this
point in the proposed legislation is a requirement for the U.S.
Government Accountability Office (GAO) to undertake a study and deliver
a report. Also, the reference in the proposals is to ``reduction''
rather than to elimination; and there seems to be no recognition that
even a reduction of regulatory reliance on ratings would represent a
movement in the opposite direction from increasing the regulation of
the credit rating agencies.
In sum, the proposals of the Obama administration with respect to
the reform of the credit rating agencies are deeply flawed and
wrongheaded. There is a better route: Eliminate regulatory reliance on
ratings--eliminate the force of law that has been accorded to these
third-party judgments. The institutional participants in the bond
markets could then more readily (with appropriate oversight by
financial regulators) make use of a wider set of providers of
information, and the bond information market would be opened to new
ideas and new entry in a way that has not been possible for over 70
years.
Thank you again for the opportunity to appear before this
Committee, and I would be happy to respond to any questions from the
Committee.
Attachment
Statement by Lawrence J. White* for the Securities and Exchange
Commission ``Roundtable To Examine Oversight of Credit Rating
Agencies''
Washington, DC----April 15, 2009
Summary
The three major credit rating agencies--Moody's, Standard & Poor's,
and Fitch--played a central role in the subprime mortgage debacle of
2007-2008. That centrality was not accidental. Seven decades of
financial regulation propelled these rating agencies into the center of
the bond information market, by elevating their judgments about the
creditworthiness of bonds so that those judgments attained the force of
law. The Securities and Exchange Commission exacerbated this problem by
erecting a barrier to entry into the credit rating business in 1975.
Understanding this history is crucial for any reasoned debate about the
future course of public policy with respect to the rating agencies.
---------------------------------------------------------------------------
* Lawrence J. White is professor of economics at the NYU Stern
School of Business. During 1986-1989 he was a board member on the
Federal Home Loan Bank Board. This statement draws heavily on a
forthcoming article, ``The Credit Rating Agencies and the Subprime
Debacle'', in the journal Critical Review.
---------------------------------------------------------------------------
The Securities and Exchange Commission has recently (in December
2008) taken modest steps to expand its regulation of the industry.
Further regulatory efforts by the SEC and/or the Congress would not be
surprising.
There is, however, another direction in which public policy could
proceed: Financial regulators could withdraw their delegation of safety
judgments to the credit rating agencies. The goal of safe bond
portfolios for regulated financial institutions would remain. But the
financial institutions would bear the burden of justifying the safety
of their bond portfolios to their regulators. The bond information
market would be opened to new ideas about rating methodologies,
technologies, and business models and to new entry in ways that have
not been possible since the 1930s.
``an insured State savings association . . . may not acquire or
retain any corporate debt securities not of investment grade.''
12 Code of Federal Regulations 362.11
``any user of the information contained herein should not rely
on any credit rating or other opinion contained herein in
making any investment decision.'' The usual disclaimer that is
printed at the bottom of Standard & Poor's credit ratings
Introduction
The U.S. subprime residential mortgage debacle of 2007-2008, and
the world financial crisis that has followed, will surely be seen as a
defining event for the U.S. economy--and for much of the world economy
as well--for many decades in the future. Among the central players in
that debacle were the three large U.S.-based credit rating agencies:
Moody's, Standard & Poor's (S&P), and Fitch.
These three agencies' initially favorable ratings were crucial for
the successful sale of the bonds that were securitized from subprime
residential mortgages and other debt obligations. The sale of these
bonds, in turn, were an important underpinning for the U.S. housing
boom of 1998-2006--with a self-reinforcing price-rise bubble. When
house prices ceased rising in mid 2006 and then began to decline, the
default rates on the mortgages underlying these bonds rose sharply, and
those initial ratings proved to be excessively optimistic--especially
for the bonds that were based on mortgages that were originated in 2005
and 2006. The mortgage bonds collapsed, bringing down the U.S.
financial system and many other countries' financial systems as well.
The role of the major rating agencies has received a considerable
amount of attention in Congressional hearings and in the media. Less
attention has been paid to the specifics of the regulatory structure
that propelled these companies to the center of the U.S. bond markets.
But an understanding of that structure is essential for any reasoned
debate about the future course of public policy with respect to the
rating agencies. \1\
---------------------------------------------------------------------------
\1\ Overviews of the credit rating industry can be found in, e.g.,
Cantor and Packer (1995), Partnoy (1999, 2002), Richardson and White
(2009), Sylla (2002), and White (2002, 2002-2003, 2006, 2007).
---------------------------------------------------------------------------
Background
A central concern of any lender--including investors in bonds--is
whether a potential or actual borrower is likely to repay the loan.
Lenders therefore usually spend considerable amounts of time and effort
in gathering information about the creditworthiness of prospective
borrowers and also in gathering information about the actions of
borrowers after loans have been made.
The credit rating agencies offer judgments--they prefer the word
``opinions'' \2\--about the credit quality of bonds that are issued by
corporations, governments (including U.S. State and local governments,
as well as ``sovereign'' issuers abroad), and (most recently) mortgage
securitizers. These judgments come in the form of ratings, which are
usually a letter grade. The best known scale is that used by S&P and
some other rating agencies: AAA, AA, A, BBB, BB, etc., with pluses and
minuses as well. \3\ Credit rating agencies are thus one potential
source of such information for bond investors; but they are far from
the only potential source.
---------------------------------------------------------------------------
\2\ The rating agencies favor that term because it allows them to
claim that they are ``publishers'' and thus enjoy the protections of
the First Amendment of the U.S. Constitution (e.g., when the agencies
are sued by investors and issuers who claim that they have been injured
by the actions of the agencies).
\3\ For short-term obligations, such as commercial paper, a
separate set of ratings is used.
---------------------------------------------------------------------------
The history of the credit rating agencies and their interactions
with financial regulators is crucial for an understanding of how the
agencies attained their current central position in the market for bond
information.
Some History
John Moody published the first publicly available bond ratings
(mostly concerning railroad bonds) in 1909. Moody's firm \4\ was
followed by Poor's Publishing Company in 1916, the Standard Statistics
Company in 1922, \5\ and the Fitch Publishing Company in 1924. \6\
These firms' bond ratings were sold to bond investors, in thick rating
manuals. In the language of modern corporate strategy, their ``business
model'' was one of ``investor pays.'' In an era before the Securities
and Exchange Commission (SEC) was created (in 1934) and began requiring
corporations to issue standardized financial statements, Moody and the
firms that subsequently entered were clearly meeting a market demand
for their information services.
---------------------------------------------------------------------------
\4\ Dun & Bradstreet bought Moody's firm in 1962; subsequently, in
2000, Dun & Bradstreet spun off Moody's as a free-standing corporation.
\5\ Poor's and Standard merged in 1941, to form S&P; S&P was
absorbed by McGraw-Hill in 1966.
\6\ Fitch merged with IBCA (a British firm) in 1997, and the
combined firm was subsequently bought by FIMILAC, a French business
services conglomerate.
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A major change in the relationship between the credit rating
agencies and the U.S. bond markets occurred in the 1930s. Eager to
encourage banks to invest only in safe bonds, bank regulators issued a
set of regulations that culminated in a 1936 decree that prohibited
banks from investing in ``speculative investment securities'' as
determined by ``recognized rating manuals.'' ``Speculative'' securities
were bonds that were below ``investment grade.'' Thus, banks were
restricted to holding only bonds that were ``investment grade'' (e.g.,
bonds that were rated BBB or better on the S&P scale). \7\
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\7\ This rule still applies to banks today. This rule did not
apply to savings institutions until 1989. Its application to savings
institutions in 1989 forced them to sell substantial holdings of ``junk
bonds'' (i.e., below investment grade) at the time, causing a major
slump in the junk bond market.
---------------------------------------------------------------------------
This regulatory action importantly changed the dynamic of the bond
information market. Banks were no longer free to act on information
about bonds from any source that they deemed reliable (albeit within
constraints imposed by oversight by bank regulators). They were instead
forced to use the judgments of the publishers of the ``recognized
rating manuals'' (i.e., Moody's, Poor's, Standard, and Fitch). Further,
since banks were important participants in the bond markets, perforce
other participants would want to pay attention to the bond raters'
pronouncements as well.
On the regulatory side of this process, rather than the bank
regulators' using their own internal resources to form judgments about
the safety of the bonds held by banks (which the bank regulators
continued to do with respect to the other kinds of loans made by
banks), the regulators had effectively delegated--``outsourced'' (again
using the language of modern corporate strategy)--to the rating
agencies their safety judgments about bonds that were suitable for
banks' portfolios. Equivalently, the creditworthiness judgments of
these third-party raters had attained the force of law.
In the following decades, the insurance regulators of the 48 (and
eventually 50) States followed a similar path: The State regulators
wanted their regulated insurance companies to have adequate capital (in
essence, net worth) that was commensurate with the riskiness of the
companies' investments. To achieve this goal, the regulators
established minimum capital requirements that were geared to the
ratings on the bonds in which the insurance companies invested--the
ratings, of course, coming from that same small group of rating
agencies. Once again, an important set of regulators had delegated
their safety decisions to the credit rating agencies. And in the 1970s,
Federal pension regulators pursued a similar strategy.
These additional delegations of safety judgments to the rating
agencies meant that the latter's centrality for bond market information
was further strengthened.
The SEC crystallized the rating agencies' centrality in 1975. In
that year the SEC decided to set minimum capital requirements for
broker-dealers (i.e., securities firms). Following the pattern of the
other financial regulators, it wanted those capital requirements to be
sensitive to the riskiness of the broker-dealers' asset portfolios and
hence wanted to use bond ratings as the indicators of risk. But it
worried that references to ``recognized rating manuals'' were too vague
and that a ``bogus'' rating firm might arise that would promise ``AAA''
ratings to those companies that would suitably reward it and ``DDD''
ratings to those that would not; and if a broker-dealer chose to claim
that those ratings were ``recognized,'' the SEC might have difficulties
challenging this assertion.
To deal with this problem, the SEC created a wholly new category--
``nationally recognized statistical rating organization'' (NRSRO)--and
immediately ``grandfathered'' Moody's, S&P, and Fitch into the
category. The SEC declared that only the ratings of NRSROs were valid
for the determination of the broker-dealers' capital requirements. The
other financial regulators soon adopted the SEC's NRSRO category and
the rating agencies within it as the relevant sources of the ratings
that were required for evaluations of the bond portfolios of their
regulated financial institutions. \8\
---------------------------------------------------------------------------
\8\ Also, in the early 1990s, the SEC again made use of the
NRSROs' ratings when it established safety requirements for the short-
term bonds (e.g., commercial paper) that are held by money market
mutual funds.
---------------------------------------------------------------------------
Over the next 25 years the SEC designated only four additional
firms as NRSROs; \9\ but mergers among the entrants and with Fitch
caused the number of NRSROs to return to the original three by year-end
2000. In essence, the SEC had become a significant barrier to entry
into the bond rating business, because the NRSRO designation was
important for any potential entrant. Without the NRSRO designation, any
would-be bond rater would likely be ignored by most financial
institutions; and, since the financial institutions would ignore the
would-be bond rater, so would bond issuers. \10\
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\9\ The SEC bestowed the NRSRO designation on Duff & Phelps in
1982, on McCarthy, Crisanti & Maffei in 1983, on IBCA in 1991, and on
Thomson BankWatch in 1992.
\10\ The SEC's barriers were not absolute. A few smaller rating
firms--notably KMV, Egan-Jones, and Lace Financial--were able to
survive, despite the absence of NRSRO designations. KMV was absorbed by
Moody's in 2000.
---------------------------------------------------------------------------
In addition, the SEC was remarkably opaque in its designation
process. It never established criteria for a firm to be designated as a
NRSRO, never established a formal application and review process, and
never provided any justification or explanation for why it ``anointed''
some firms with the designation and refused to do so for others.
One other piece of history is important: In the early 1970s the
basic business model of the large rating agencies changed. In place of
the ``investor pays'' model that had been established by John Moody in
1909, the agencies converted to an ``issuer pays'' model, whereby the
entity that is issuing the bonds also pays the rating firm to rate the
bonds.
The reasons for this change of business model have not been
established definitively. Among the candidates are:
a. The rating firms feared that their sales of rating manuals would
suffer from the consequences of the high-speed photocopy
machine (which was just entering widespread use), which would
allow too many investors to free-ride by obtaining photocopies
from their friends;
b. The bankruptcy of the Penn-Central Railroad in 1970 shocked the
bond markets and made issuers more conscious of the need to
assure bond investors that they (the issuers) really were low
risk, and they were willing to pay the credit rating firms for
the opportunity to have the latter vouch for them (but that
same shock should have also made investors more willing to pay
to find out which bonds were really safer, and which were not);
c. The bond rating firms may have belatedly realized that the
financial regulations described above meant that bond issuers
needed the ``blessing'' of one or more NRSROs in order to get
their bonds into the portfolios of financial institutions, and
the issuers should be willing to pay for the privilege; and
d. The bond rating business, like many information industries,
involves a ``two-sided market,'' where payments can come from
one or both sides of the market; in such markets, which side
actually pays can be quite idiosyncratic. \11\
---------------------------------------------------------------------------
\11\ Other examples of ``two-sided'' information markets include
newspapers and magazines, where business models range from
``subscription revenues only'' (e.g., Consumer Reports) to ``a mix of
subscription revenues plus advertising revenues'' (most newspapers and
magazines) to ``advertising revenues only'' (e.g., The Village Voice,
some metropolitan ``giveaway'' daily newspapers, and some suburban
weekly ``shoppers'').
Regardless of the reason, the change to the ``issuer pays''
business model opened the door to potential conflicts of interest: A
rating agency might shade its rating upward so as to keep the issuer
happy and forestall the issuer's taking its rating business to a
different rating agency. \12\
---------------------------------------------------------------------------
\12\ Skreta and Veldkamp (2008) develop a model in which the
ability of issuers to choose among potential raters leads to overly
optimistic ratings, even if the raters are all trying honestly to
estimate the creditworthiness of the issuers. In their model, the
raters can only make estimates of the creditworthiness of the issuers,
which means that their estimates will have errors. If the estimates are
(on average) correct and the errors are distributed symmetrically
(i.e., the raters are honest but less than perfect), but the issuers
can choose which rating to purchase, the issuers will systematically
choose the most optimistic. In an important sense, it is the issuers'
ability to select the rater that creates the conflict of interest.
---------------------------------------------------------------------------
Recent Events of the Current Decade
The NRSRO system was one of the less-well-known features of Federal
financial regulation, and it might have remained in that semisecretive
state had the Enron bankruptcy of November 2001 not occurred. In the
wake of the Enron bankruptcy, however, the media and then Congressional
staffers noticed that the three major rating agencies had maintained
``investment grade'' ratings on Enron's bonds until 5 days before that
company declared bankruptcy. This notoriety led to the Congress's
``discovery'' of the NRSRO system and to Congressional hearings in
which the SEC and the rating agencies were repeatedly asked how the
latter could have been so slow to recognize Enron's weakened financial
condition. \13\
---------------------------------------------------------------------------
\13\ The rating agencies were similarly slow to recognize the
weakened financial condition of WorldCom, and were subsequently grilled
about that as well.
---------------------------------------------------------------------------
The Sarbanes-Oxley Act of 2002 included a provision that required
the SEC to send a report to Congress on the credit rating industry and
the NRSRO system. The SEC duly did so; but the report simply raised a
series of questions rather than directly addressing the issues of the
SEC as a barrier to entry and the enhanced role of the three incumbent
credit rating agencies, which (as explained above) was due to the
financial regulators' delegations of safety judgments (and which the
SEC's NRSRO framework had strengthened).
In early 2003 the SEC designated a fourth NRSRO (Dominion Bond
Rating Services, a Canadian credit rating firm), and in early 2005 the
SEC designated a fifth NRSRO (A.M. Best, an insurance company rating
specialist). The SEC's procedures remained opaque, however, and there
were still no announced criteria for the designation of a NRSRO.
Tiring of the SEC's persistence as a barrier to entry (and also the
SEC's opaqueness in procedure), the Congress passed the Credit Rating
Agency Reform Act (CRARA), which was signed into law in September 2006.
The Act specifically instructed the SEC to cease being a barrier to
entry, specified the criteria that the SEC should use in designating
new NRSROs, insisted on transparency and due process in the SEC's
decisions with respect to NRSRO designations, and provided the SEC with
limited powers to oversee the incumbent NRSROs--but specifically
forbade the SEC from influencing the ratings or the business models of
the NRSROs.
In response to the legislation, the SEC designated three new NRSROs
in 2007 (Japan Credit Rating Agency; Rating and Information, Inc. [of
Japan]; and Egan-Jones) and another two NRSROs in 2008 (Lace Financial,
and Realpoint). The total number of NRSROs is currently ten.
Finally, in response to the growing criticism (in the media and in
Congressional hearings) of the three large bond raters' errors in their
initial, excessively optimistic ratings of the complex mortgage-related
securities (especially for the securities that were issued and rated in
2005 and 2006) and their subsequent tardiness in downgrading those
securities, the SEC in December 2008 promulgated regulations that
placed mild restrictions on the conflicts of interest that can arise
under the rating agencies' ``issuer pays'' business model and that
required greater transparency in the construction of ratings. \14\
Political pressures to do more--possibly even to ban legislatively the
``issuer pays'' model--remain strong.
---------------------------------------------------------------------------
\14\ See, Federal Register, 74 (February 9, 2009), pp. 6456-6484.
---------------------------------------------------------------------------
An Assessment
It is clear that the three dominant credit rating firms have
received a considerable boost from financial regulators. Starting in
the 1930s, financial regulators insisted that the credit rating firms
be the central source of information about the creditworthiness of
bonds in U.S. financial markets. Reinforcing this centrality was the
SEC's creation of the NRSRO category in 1975 and the SEC's subsequent
protective barrier around the incumbent NRSROs, which effectively
ensured the dominance of Moody's, S&P, and Fitch. Further, the
industry's change to the ``issuer pays'' business model in the early
1970s meant that potential problems of conflict of interest were likely
to arise, sooner or later. Finally, the major agencies' tardiness in
changing their ratings--best exemplified by the Enron incident
mentioned above \15\--has been an additional source of periodic
concern. \16\
---------------------------------------------------------------------------
\15\ Most recently, the major rating agencies still had
``investment grade'' ratings on Lehman Brothers' commercial paper on
the day that Lehman declared bankruptcy in September 2008.
\16\ This delay in changing ratings has been a deliberate strategy
by the major rating agencies. They profess to try to provide a long-
term perspective--to ``rate through the cycle''--rather than providing
an up-to-the-minute assessment. But this means that these rating
agencies will always be slow to identify a secular trend in a bond's
creditworthiness, since there will always be a delay in perceiving that
any particular movement isn't just the initial part of a reversible
cycle but instead is the beginning of a sustained decline or
improvement. It may be that this sluggishness is a response to the
desires of their investor clients to avoid frequent (and costly)
adjustments in their portfolios; See, e.g., Altman and Rijken (2004,
2006); those adjustments, however, might well be mandated by the
regulatory requirements discussed above. It may also be the case that
the agencies' ratings changes are sluggish (especially downward) so as
not to anger issuers (which is another aspect of the potential
conflict-of-interest problem). And the absence of frequent changes also
allows the agencies to maintain smaller staffs. Except for the
regulatory mandates, however, the agencies' sluggishness would be
inconsequential, since the credit default swap (CDS) market provides
real time market-based judgments about the credit quality of bonds.
---------------------------------------------------------------------------
The regulatory boosts that the major rating agencies received,
starting in the 1930s, were certainly not the only reason for the
persistent fewness in the credit rating industry. The market for bond
information is one where economies of scale, the advantages of
experience, and brand name reputation are important features. The
credit rating industry was never going to be a commodity business of
thousands (or even just hundreds) of small-scale producers, akin to
wheat farming or textiles. Nevertheless, the regulatory history
recounted above surely contributed heavily to the dominance of the
three major rating agencies. The SEC's belated efforts to allow wider
entry during the current decade were too little and too late. The
advantages of the ``Big Three's'' incumbency could not quickly be
overcome by the entrants (three of which were headquartered outside the
U.S., one of which was a U.S. insurance company specialist, and three
of which were small U.S. firms).
It is not surprising that a tight, protected oligopoly might become
lazy and complacent. The ``issuer pays'' model opened the door to
potential abuses. Though this potential problem had been present in the
industry since the early 1970s, the relative transparency of the
corporations and governments whose debt was being rated apparently kept
the problem in check. Also, there were thousands of corporate and
Government bond issuers, so the threat of any single issuer (if it was
displeased by an agency's rating) to take its business to a different
rating agency was not potent.
The complexity and opaqueness of the mortgage-related securities
that required ratings in the current decade, however, created new
opportunities and apparently irresistible temptations. \17\ Further,
the rating agencies were much more involved in the creation of these
mortgage-related securities: The agencies' decisions as to what kinds
of mortgages (and other kinds of debt) would earn what levels of
ratings for what sizes of ``tranches'' (or slices) of these securities
were crucial for determining the levels of profitability of these
securitizations for their issuers. Finally, unlike the market for
rating corporate and Government debt, the market for rating mortgage-
related securities involved only a handful of investment banks as
securitizers with high volumes. An investment bank that was displeased
with an agency's rating on any specific security had a more powerful
threat--to move all of its securitization business to a different
rating agency--than would any individual corporate or Government
issuer.
---------------------------------------------------------------------------
\17\ The Skreta and Veldkamp (2008) model predicts that greater
complexity of rated bonds leads to a greater range of errors among
(even honest) raters and thus to the ability of the issuers to select
raters that are even more optimistic.
---------------------------------------------------------------------------
Fueling the Subprime Debacle
The U.S. housing boom that began in the late 1990s and ran through
mid 2006 was fueled, to a substantial extent, by subprime mortgage
lending. \18\ In turn, the securitization of the subprime mortgage
loans, in collateralized debt obligations (CDOs) and other mortgage-
related securities, importantly encouraged the subprime lending. \19\
And crucial for the securitization were the favorable ratings that were
bestowed on these mortgage-related securities.
---------------------------------------------------------------------------
\18\ The debacle is discussed extensively in Gorton (2008),
Acharya and Richardson (2009), Coval, et al. (2009), and Mayer, et al.
(2009).
\19\ This importance extended to the development of other
financing structures, such as ``structured investment vehicles''
(SIVs), whereby a financial institution might sponsor the creation of
an entity that bought tranches of the CDOs and financed their purchase
through the issuance of short-term ``asset-backed'' commercial paper
(ABCP). If the CDO tranches in a SIV were highly rated, then the ABCP
could also be highly rated. (Interest rate risk and liquidity risk were
apparently ignored in the ratings.)
---------------------------------------------------------------------------
Favorable ratings were important for at least two reasons: First,
as has been discussed above, ratings had the force of law with respect
to regulated financial institutions' abilities and incentives (via
capital requirements) to invest in bonds. \20\ More favorable ratings
on larger fractions of the tranches that flowed from any given package
of mortgage securities thus meant that these larger fractions could
more readily be bought by regulated financial institutions Second, the
generally favorable reputations that the credit rating agencies had
established in their corporate and Government bond ratings meant that
many bond purchasers--regulated and nonregulated--were inclined to
trust the agencies' ratings on the mortgage-related, even (or, perhaps,
especially) if the market yields on the mortgage-related securities
were higher than on comparably rated corporate bonds.
---------------------------------------------------------------------------
\20\ For banks and savings institutions, in addition to the
absolute prohibition on holding bonds that were below investment grade,
there was a further important impact of ratings: Mortgage-backed
securities (MBS)--including CDOs--that were issued by nongovernmental
entities and rated AA or better qualified for the same reduced capital
requirements (1.6 percent of asset value) as applied to the MBS issued
by Fannie Mae and Freddie Mac the instead of the higher (4 percent)
capital requirements that applied to mortgages and lower rated mortgage
securities.
---------------------------------------------------------------------------
Driving all of this, of course, was the profit model of the
securitizers (packagers) of the mortgages: For any given package of
underlying mortgages (with their contractually specified yields) to be
securitized, the securitizers made higher profits if they attained
higher ratings on a larger percentage of the tranches of securities
that were issued against those mortgages. This was so because the
higher rated tranches would carry lower interest rates that needed to
be paid to the purchasers of/investors in those tranches, leaving a
greater spread for the securitizers. It is not surprising, then, that
the securitizers would be prepared to pressure the rating agencies,
including threats to choose a different agency, to deliver those
favorable ratings.
A Counterfactual Musing
It is worth ``musing'' about how the bond information industry's
structure would look today if financial regulators hadn't succumbed
(starting in the 1930s) to the temptation to outsource their safety
decisions and thus allowing the credit rating agencies' judgments to
attain the force of law. Suppose, instead, that regulators had
persisted in their goals of having safe bonds in the portfolios of
their regulated institutions (or that, as in the case of insurance
companies and broker-dealers, an institution's capital requirement
would be geared to the riskiness of the bonds that it held) but that
those safety judgments remained the responsibility of the regulated
institution, with oversight by regulators. \21\
---------------------------------------------------------------------------
\21\ This oversight would be an appropriate aspect of the safety-
and-soundness regulation of such institutions. For a justification of
safety-and-soundness regulation for these kinds of institutions, see,
White (1991).
---------------------------------------------------------------------------
In this counterfactual world, banks (and insurance companies, etc.)
would have a far wider choice as to where and from whom they could seek
advice as to the safety of bonds that they might hold in their
portfolios. Some institutions might choose to do the necessary research
on bonds themselves, or rely primarily on the information yielded by
the credit default swap market. Or they might turn to outside advisors
that they considered to be reliable--based on the track record of the
advisor, the business model of the advisor (including the possibilities
of conflicts of interest), the other activities of the advisor (which
might pose potential conflicts), and anything else that the institution
considered relevant. Such advisors might include the credit rating
agencies. But the category of advisors might also expand to include
investment banks (if they could erect credible ``Chinese walls'') or
industry analysts or upstart advisory firms that are currently unknown.
The end-result--the safety of the institution's bond portfolio--
would continue to be subject to review by the institution's regulator.
\22\ That review might also include a review of the institution's
choice of bond-information advisor (or the choice to do the research
in-house)--although that choice is (at best) a secondary matter, since
the safety of the bond portfolio itself (regardless of where the
information comes from) is the primary goal of the regulator.
Nevertheless, it seems highly likely that the bond information market
would be opened to new ideas--about ratings business models,
methodologies, and technologies--and to new entry in ways that have not
actually been possible since the 1930s.
---------------------------------------------------------------------------
\22\ Again, this is necessary because the regulator has the goal
that the regulated institution should maintain a safe bond portfolio
(or have appropriate capital for the risks).
---------------------------------------------------------------------------
It is also worth asking whether, in this counterfactual world, the
``issuer pays'' business model could survive. The answer rests on
whether bond buyers are able to ascertain which advisors do provide
reliable advice (as does any model short of relying on Government
regulation to ensure accurate ratings). If the bond buyers can so
ascertain, \23\ then they would be willing to pay higher prices (and
thus accept lower interest yields) on the bonds of any given underlying
quality that are ``rated'' by these reliable advisors. In turn,
issuers--even in an ``issuer pays'' framework--would seek to hire these
recognized-to-be-reliable advisers, since the issuers would thereby be
able to pay lower interest rates on the bonds that they issue.
---------------------------------------------------------------------------
\23\ This seems a reasonable assumption, since the bond market is,
for the most part, one where financial institutions are the major
buying and selling entities. It is not a market where ``widows and
orphans'' are likely to be major participants.
---------------------------------------------------------------------------
That the ``issuer pays'' business model could survive in this
counterfactual world is no guarantee that it would survive. That
outcome would be determined by the competitive process.
Conclusion
Whither the credit rating industry and its regulation? The central
role--forced by seven decades of financial regulation--that the three
major credit rating agencies played in the subprime debacle has brought
extensive public attention to the industry and its practices. The
Securities and Exchange Commission has recently (in December 2008)
taken modest steps to expand its regulation of the industry. Further
regulatory efforts by the SEC and/or the Congress would not be
surprising.
There is, however, another direction in which public policy could
proceed. That direction is suggested by the ``counterfactual musing''
of the previous section: Financial regulators could withdraw their
delegation of safety judgments to the credit rating agencies. \24\ The
policy goal of safe bond portfolios for regulated financial
institutions would remain. But the financial institutions would bear
the burden of justifying the safety of their bond portfolios to their
regulators. The bond information market would be opened to new ideas
about rating methodologies, technologies, and business models and to
new entry in ways that have not been possible since the 1930s.
---------------------------------------------------------------------------
\24\ The SEC proposed regulations along these lines in July 2008;
See, Federal Register, 73 (July 11, 2008), pp. 40088-40106, 40106-
40124, and 40124-40142. No final action has been taken on these
proposals.
---------------------------------------------------------------------------
Participants in this public policy debate should ask themselves the
following questions: Is a regulatory system that delegates important
safety judgments about bonds to third parties in the best interests of
the regulated institutions and of the bond markets more generally? Will
more extensive SEC regulation of the rating agencies actually succeed
in forcing the rating agencies to make better judgments in the future?
Would such regulation have consequences for flexibility, innovation,
and entry in the bond information market? Or instead, could the
financial institutions be trusted to seek their own sources of
information about the creditworthiness of bonds, so long as financial
regulators oversee the safety of those bond portfolios?
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Acharya, Viral, and Matthew Richardson, eds., Restoring Financial
Stability: How To Repair a Failed System. New York: Wiley, 2009.
Altman, Edward I., and Herbert A. Rijken, ``How Rating Agencies Achieve
Rating Stability'', Journal of Banking & Finance, 28 (November
2004), pp. 2679-2714.
Altman, Edward I., and Herbert A. Rijken, ``A Point-in-Time Perspective
on Through-the-Cycle Ratings'', Financial Analysts Journal, 62
(January-February 2006), pp. 54-70.
Cantor, Richard, and Frank Packer, ``The Credit Rating Industry'',
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Coval, Joshua, Jakub Jurek, and Erik Stafford, ``The Economics of
Structured Finance'', Journal of Economic Perspectives, 23 (Winter
2009), pp. 3-25.
Gorton, Gary B., ``The Panic of 2007'', NBER Working Paper #14358,
September 2008; available at http://www.nber.org/papers/w14358.
Mayer, Christopher, Karen Pence, and Shane M. Sherlund, ``The Rise in
Mortgage Defaults'', Journal of Economic Perspectives, 23 (Winter
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Partnoy, Frank, ``The Siskel and Ebert of Financial Markets: Two Thumbs
Down for the Credit Rating Agencies'', Washington University Law
Quarterly, 77 No. 3 (1999), pp. 619-712.
Partnoy, Frank, ``The Paradox of Credit Ratings'', In Richard M.
Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings,
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2002, pp. 65-84.
Richardson, Matthew C., and Lawrence J. White, ``The Rating Agencies:
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Complexity: A Theory of Ratings Inflation'', Working Paper #EC-08-
28, Stern School of Business, New York University, October 2008.
Sylla, Richard, ``An Historical Primer on the Business of Credit
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Majnoni, eds., Ratings, Rating Agencies, and the Global Financial
System. Boston: Kluwer, 2002, pp. 19-40.
White, Lawrence J., The S&L Debacle: Public Policy Lessons for Bank and
Thrift Regulation. New York: Oxford University Press, 1991.
White, Lawrence J., ``The Credit Rating Industry: An Industrial
Organization Analysis'', In Richard M. Levich, Carmen Reinhart, and
Giovanni Majnoni, eds., Ratings, Rating Agencies, and the Global
Financial System. Boston: Kluwer, 2002, pp. 41-63.
White, Lawrence J., ``The SEC's Other Problem'', Regulation, 25 (Winter
2002-2003), pp. 38-42.
White, Lawrence J., ``Good Intentions Gone Awry: A Policy Analysis of
the SEC's Regulation of the Bond Rating Industry'', Policy Brief
#2006-PB-05, Networks Financial Institute, Indiana State
University, 2006.
White, Lawrence J., ``A New Law for the Bond Rating Industry'',
Regulation, 30 (Spring 2007), pp. 48-52.
PREPARED STATEMENT OF MARK FROEBA, J.D.
Principal, PF2 Securities Evaluations, Inc.
August 5, 2009
Chairman Dodd, Senator Shelby, and Members of the Committee: My
name is Mark Froeba and I am a lawyer based in New York City. I am
pleased to be here today and it is an honor to testify before you on
the important topic of rating agency reform. Thank you for giving me
this opportunity. \1\
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\1\ The opinions and views expressed in this document are those of
Mark Froeba, who is appearing before the Committee on his own behalf
and as a private citizen, and are not intended to represent the views
or opinions of any organization.
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Let me give you a brief summary of my background. I am a 1990
graduate of the Harvard Law School. In 1997, I left the tax group at
Skadden, Arps in New York, where I had been working in part on
structured finance securities, to join the CDO group at Moody's. I
worked at Moody's for just over 10 years, all of that time in the CDO
group. I left Moody's in 2007 as a Senior Vice President. At that time,
I was Team Leader of the CLO team, cochair of most CLO rating
committees and jointly responsible for evaluating all new CLO rating
guidelines.
Since the beginning of the subprime crisis, there have been many
proposals for rating agency reform. Most of these proposals are well-
intentioned and would probably do little harm. However, few seem likely
to accomplish real reform. Real reform must achieve two clear policy
goals:
PREVENT another rating-related financial crisis like the
subprime crisis;
RESTORE investor confidence in the quality and reliability
of credit ratings.
In my opinion, the rating agency reform provisions of the Investor
Protection Act of 2009 are not sufficient--in themselves--to accomplish
either of these goals. However, the Act's rule-making authority could
be used to expand their effectiveness. Why are the reform provisions in
themselves insufficient?
First, they are not the product of a complete investigation into
what actually happened at the rating agencies. If you repair damage to
a ceiling caused by a leaky roof but don't repair the roof, the damage
will just keep coming back. In this case, as long as we do not have a
precise understanding of how things went so wrong, we cannot really be
confident the reform proposals will do what is needed to prevent things
from going wrong again. (Of course, this cuts both ways. Just as we do
not know without an investigation whether the reform proposals go far
enough, we also do not know whether they go too far.)
It is true that some work has been done to discover what actually
happened at each of the rating agencies, but much could still be
learned, especially from the analysts who assigned the problem ratings.
Any thorough investigation must include confidential interviews with as
many of these analysts as possible from each of the major rating
agencies. By these interviews, investigators will gain an intimate
knowledge of how each rating agency actually worked, not how it was
supposed to work on paper. More importantly, they will uncover exactly
what the people closest to the process think caused so many ratings to
be so significantly wrong. What questions should be asked?
Who is responsible for what happened and why?
Was there ever any pressure exerted upon you or your
colleagues, direct or indirect, to subordinate rating analysis
to business considerations?
If so, how was the pressure exerted?
Even if these questions seem to insinuate malfeasance, they are
questions the rating agencies will welcome because the answers they
expect will do much to restore confidence in their integrity.
In summary, without a proper investigation of what happened--not
conducted on a theoretical level, or in discussions with senior
managers but with the analysts who actually assigned the ratings in
question--we cannot be sure the proposed legislation provides solutions
designed to fix the real problems.
The best way to illustrate my second reason for questioning the
sufficiency of this proposal is to ask you a simple question. If
Investor Protection Act of 2009 had been enacted, just as it is, 5
years ago, do you think it would have prevented the subprime crisis? In
my view, the answer to this question is very clearly ``No.'' That does
not mean that these proposals are bad. It just means that they do not
advance what should be one of the central policy goals of rating agency
reform: preventing a future crisis in the financial system triggered at
least in part by problem credit ratings.
If these reform proposals are uncertain to prevent a future crisis
and to restore confidence in the credit ratings, what reforms could
achieve these goals?
To answer this question, we should first consider the regulatory
context in which the rating agencies found themselves just before the
subprime crisis. First, they enjoyed an effective monopoly on the sale
of credit opinions. Second, and more importantly, they enjoyed the
benefit of very substantial Government-sanctioned demand for their
monopoly product. (A buggy whip monopoly is a lot more valuable if
Government safety regulations require one in every new car). Third, the
agencies enjoyed nearly complete immunity from liability for injuries
caused by their monopoly product. Fourth, worried about the monopoly
power created by the regulations of one branch of Government, another
branch encouraged vigorous competition among the rating agencies. This
mix of regulatory ``carrots'' and ``sticks'' in the period leading up
to the subprime meltdown may have contributed to making it worse than
it might have been. Thus, a third goal of rating agency reform should
be to untangle these conflicting regulatory incentives. Here are some
proposals that I believe will help with all three reform goals.
First, put a ``fire wall'' around ratings analysis. The agencies
have already separated their rating and nonrating businesses. This is
fine but not enough. The agencies must also separate the rating
business from rating analysis. Investors need to believe that rating
analysis generates a pure opinion about credit quality, not one even
potentially influenced by business goals (like building market share).
Even if business goals have never corrupted a single rating, the
potential for corruption demands a complete separation of rating
analysis from bottom-line analysis. Investors should see that rating
analysis is virtually barricaded into an ``ivory tower,'' and kept safe
from interference by any agenda other than getting the answer right.
The best reform proposal must exclude business managers from
involvement in any aspect of rating analysis and, critically also, from
any role in decisions about analyst pay, performance, and promotions.
Second, prohibit employee stock ownership and change the way rating
analysts are compensated. There's a reason why we don't want judges to
have a stake in the matters before them and it's not just to make sure
judges are fair. We do this so that litigants have confidence in the
system and trust its results. We do this even if some or all judges
could decide cases fairly without the rule. The same should be true for
ratings. Even if employee stock ownership has never actually affected a
single rating, it provokes doubt that ratings are disinterested and
undermines investor confidence. Investors should have no cause to
question whether the interests of rating agency employees align more
closely with agency shareholders than investors. Reform should ban all
forms of employee stock ownership (direct and indirect) by anyone
involved in rating analysis. These same concerns arise with respect to
annual bonus compensation and 401(K) contributions. As long as these
forms of compensation are allowed to be based upon how well the company
performs (and are not limited to how well the analyst performs), there
will always be doubts about how the rating analysts' interests align.
Third, create a remedy for unreasonably bad ratings. As noted
above, the rating agencies have long understood (based upon decisions
of the courts) that they will not be held liable for injuries caused by
``bad'' ratings. Investors know this. Why change the law to create a
remedy if bad ratings arguably cause huge losses? The goal is not to
give aggrieved investors a cash ``windfall.'' The goal is to restore
confidence--especially in sophisticated investors--that the agencies
cannot assign bad ratings with impunity. The current system allows the
cost of bad ratings to be shifted to parties other than the agencies
(ultimately to taxpayers). Reform must shift the cost of unreasonably
bad ratings back to the agencies and their shareholders. If investors
believe that the agencies fear the cost of assigning unreasonably bad
ratings, then they will trust self interest (even if not integrity) to
produce ratings that are reasonably good.
My former Moody's colleague, Dr. Gary Witt of Temple University,
believes that a special system of penalties might also be useful for
certain types of rated instruments. Where a governmental body relies
upon ratings for regulatory risk assessment of financial institutions--
e.g., the SEC (broker-dealers and money funds), the Federal Reserve
(banks), the NAIC (insurance companies) and other regulatory
organizations within and outside the U.S.--the Government has a
compelling interest and an affirmative duty to regulate the performance
of such ratings. Even if other types of ratings might be protected from
lawsuits by the first amendment, these ratings are published
specifically for use by the Government in assessing risk of regulated
financial institutions and should be subject to special oversight,
including the measurement of rating accuracy and the imposition of
financial penalties for poor performance.
Fourth, change the antitrust laws so agencies can cooperate on
standards. When rating agencies compete over rating standards,
everybody loses (even them). Eight years ago, one rating agency was
compelled to plead guilty to felony obstruction of justice. The
criminal conduct at issue there related back to practices (assigning
unsolicited ratings) actually worth reconsidering today. Once viewed as
anticompetitive, this and other practices, if properly regulated, might
help the agencies resist competition over rating standards. Indeed, the
rating problems that arose in the subprime crisis are almost
inconceivable in an environment where antitrust rules do not interfere
with rating agency cooperation over standards. Imagine how different
the world would be today if the agencies could have joined forces 3
years ago to refuse to securitize the worst of the subprime mortgages.
Of course, cooperation over rating analysis would not apply to business
management which should remain fully subject to all antitrust
limitations.
Fifth, create an independent professional organization for rating
analysts. Every rating agency employs ``rating analysts'' but there are
no independent standards governing this ``profession'': there are no
minimum educational requirements, there is no common code of ethical
conduct, and there is no continuing education obligation. Even where
each agency has its own standards for these things, the standards
differ widely from agency to agency. One agency may assign a senior
analyst with a Ph.D. in statistics to rate a complex transaction;
another might assign a junior analyst with a BA in international
relations to the same transaction. The staffing decision might appear
to investors as yet another tool to manipulate the rating outcome.
Creating one independent professional organization to which rating
analysts from all rating agencies must belong will ensure uniform
standards--especially ethical standards--across all the rating
agencies. It would also provide a forum external to the agencies where
rating analysts might bring confidential complaints about ethical
concerns. An independent organization could track and report the nature
and number of these complaints and alert regulators if there are
patterns in the complaints, problems at particular agencies, and even
whether there are problems with particular managers at one rating
agency. Finally, such an organization should have the power to
discipline analysts for unethical behavior.
Sixth, introduce ``investor-pay'' incentives into an ``issuer-pay''
framework. Students of the history of rating agencies know that, at one
point, rating agencies were paid by investors not by issuers of the
securities rated by the agency. Investors subscribed to periodic rating
reports and these subscription fees paid for the ratings. By the late
1960s this business model was not working and the agencies gradually
shifted away from an investor-pay model to an issuer-pay model. In this
model, the party or entity applying for a rating pays for the rating.
Critics fault this model because it shifts the attention (and
allegedly, the allegiance) of the rating agencies not only away from
the ultimate consumer of the rating, the investor, but also toward the
party whose interests may strongly conflict with the investor, the
issuer. According to this view of the process, the power of the issuer
to take the rating business to a competitor became the tool by which
the rating agencies were induced to compete with each other on rating
standards. For example, an issuer tells rating agency (X) that its
competitor (Y) has lowered its subordination levels for some structured
security, e.g., from 4.5 percent to 4.3 percent. The issuer urges X to
change its standards or lose the issuer's business. Of course, at the
same time, the issuer is telling Y that X has lowered subordination
levels and urging Y to adopt the lower standards. It isn't hard to see
how a spiral of declining rating standards could be triggered under
this model.
There are those who believe that real rating agency reform requires
a return to an investor-pay model. But there may be a third way, a
business model that preserves the issuer-pay ``delivery system'' (the
issuer still gets the bill for the rating) but incorporates the
incentives of the investor-pay model. How would this work?
First, issuers seeking a credit rating would be required to provide
the same information to every rating agency that has ``registered'' to
rate a particular type of security or transaction. Thus, if there are
five rating agencies registered to rate CDOs, all five would receive
exactly the same information about a new CDO from the issuer. Second,
the potential investors in the new security or transaction would decide
which agencies get paid to rate the security. During the marketing
phase of the transaction, investors would compare the ratings proposed
by all of the rating agencies and the investors would then select the
agencies to rate the transaction. It would be at this point that the
rating agencies would once again be competing with each other for the
interest of the investors. The issuers' power to corrupt the process by
selecting the rating agency would be eliminated. Finally, every rating
agency would be free to publish ratings of the transaction, regardless
of whether it was selected to be paid for the rating by investors.
It would also be possible to use such a system to create demand for
ratings from new rating agencies. To do so, investors (or issuers if
they are still making the selection) would be required to pick two
agencies for every transaction: (1) only one from the list of agencies
with more than 50 percent market share for the asset type in question
and (2) one or more from the list of agencies with less than 50 percent
market share for the asset type in question. In this way, newer
agencies would have an easier time breaking into a business with
extremely high barriers to entry.
These and other reforms are necessary not only to restore investor
confidence in ratings (without regard to whether they actually redress
past malfeasance) but also to prevent future ratings-related financial
crises.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM MICHAEL S. BARR
Q.1. Pursuant to proposed section 1002(9) of the President's
White Paper on Financial Regulatory Reform, would CFPA's
authority extend to those who market financial products and
services? For example, could a newspaper be covered under the
``direct or indirect'' language if it allows an advertisement
for a financial activity to be placed within it? Similarly,
would a Web site Portal (such as Yahoo!) be covered if it
features advertising of financial products or services? Lastly,
would a broker be covered if it provided a list to a financial
institution for direct marketing purposes?
A.1. Under the proposed CFPA Act, the CFPA would have limited
jurisdiction to regulate persons engaged in a ``financial
activity, in connection with the provision of a consumer
financial product or service.'' The wide range of persons and
entities described in your questions typically are currently
subject to Federal regulation and enforcement by the Federal
Trade Commission (FTC) under the FTC Act or must comply with
``enumerated consumer laws,'' authorities that would be
transferred to the CFPA. In this way, the proposed CFPA Act
would not alter the basic landscape governing existing Federal
laws regarding consumer financial products or services that
currently apply to those persons and entities.
We believe that reform of the Federal regulatory structure
for consumer protection for financial products and services
requires three elements: mission focus, marketwide coverage,
and consolidated authority. The authorities for rulemaking,
supervision, and enforcement for consumer financial products
and services are presently scattered among a number of
different Federal agencies, including the Board of Governors of
the Federal Reserve System (Federal Reserve Board), the Federal
Deposit Insurance Corporation, the Federal Trade Commission,
the Department of Housing and Urban Development, the Office of
the Comptroller of the Currency (OCC), the Office of Thrift
Supervision, and the National Credit Union Administration.
Our proposal to establish the CFPA is not designed to
establish a new layer of Federal authority on top of this
presently balkanized Federal structure. Rather, the proposed
CFPA Act is intended to consolidate Federal authority over the
marketplace for consumer financial products and services to
ensure consistent standards and a level playing field across
the marketplace.
Accordingly, many of the persons or entities described in
your question would be ``covered persons'' in connection with
the provision of consumer financial products or services. For
example, banks that extend credit to consumers to be used
primarily for personal, family, or household purposes would be
``providing consumer financial products and services'' within
the meaning of the proposed CFPA Act. Likewise, a consumer
reporting agency would be a covered person when providing
consumer reports (including credit scores) or ``identity theft
products,'' such as credit monitoring services--both of which
would be ``financial product[s] or service[s]'' under the
proposed CFPA Act--to consumers to be used primarily for
personal, family, or household purposes. Similarly, under our
proposal, a retailer that sells ``prepaid gift cards'' (which
would be a type of ``stored value'' product) to consumers to be
used primarily for personal, family, or household purposes
would be a ``covered person'' with respect to that activity,
but not with respect to the sale of other, nonfinancial
products or services.
In general, the following entities, as described in your
question, would be subject to the jurisdiction of the CFPA
under an ``enumerated consumer law,'' under the proposed CFPA
Act in connection with providing a covered financial product or
service to consumers to be used primarily for personal, family,
or household purposes, or under two or more of those laws, with
respect to the following products or services: banks (deposit
products (CDs; savings accounts); demand deposit accounts; home
mortgage loans (first or second liens, as well as home equity
loans); credit card loans; financial lease structures; personal
loans; student loans; vehicle financing (auto, motorcycle, and
boat loans); sales of credit insurance products; sales of
mortgage life insurance products; financial advice and
educational publications; appraisal services; money transfer
and payments; ACH activity; checks and check processing; and
reporting information about customers to other lenders);
retailers (credit card loans; other unsecured loans (e.g.,
deferred payment plans); financial leasing arrangements;
leasing of property to consumers to be used primarily for
personal, family, or household purposes, including
communication equipment, photocopies, vehicles, audio-visual
equipment, subject to certain conditions as described in the
proposed CFPA Act; sale of prepaid gift cards; and ATM
services); retailers or specialized merchandise and services
(secured financing; unsecured financing; extended payment
plans; and financial leasing of real and personal property);
consumer reporting agencies (consumer reports; identity theft
products (e.g., monitoring) and processing and transmission of
credit scores); insurance companies and insurance agents
(credit insurance products; financial advice and publications;
sales of covered insurance products; and financial advice,
unless an insurance company or insurance agent is subject to an
exemption as a person regulated by the Securities and Exchange
Commission (SEC) or a person regulated by the Commodity Futures
Trading Commission (CFTC)); stockbrokers, if not subject to an
exemption under the proposed CFPA Act as a person regulated by
the SEC or a person regulated by the CFTC (financial advice;
brokering loans (e.g., home mortgages to clients); brokering
deposits; sweeps; and sales of unregistered or exempt
securities); attorneys (providing financial advice, which we
presume is outside the scope of the attorney-client
relationship; real estate settlement services conduct outside
the scope of the attorney-client relationship; and acting as
custodians); manufacturers (financing of products (e.g., homes;
automobiles and other vehicles; appliances; computers); and
leasing of real and personal property to consumers to be used
primarily for personal, family, or household purposes, subject
to certain conditions as described in the proposed CFPA Act);
real estate agents (financial advice; financing assistance and
referrals; title insurance agency and underwriting; and
providing real estate settlement services); educational
institutions (originating/brokering student loans; providing
financial advice to individual consumers, as described in the
proposed CFPA Act); hospitals, physicians, and other medical
service providers (arranging for financing of medical services;
collection of unpaid bills, to the extent that the debt
collection relates to a consumer financial product or service,
such as a credit extended by the medical service provider
itself to finance the medical services; dealing in or
transmitting consumer credit information; and leasing of
medical equipment to consumers to be used primarily for
personal, family, or household purposes, subject to certain
conditions as described in the proposed CFPA Act); accountants
(providing tax planning and/or personal tax-preparation
services).
Although the proposed CFPA would be authorized to regulate
essential aspects of the marketplace for ``consumer financial
products and services,'' the CFPA would not have unlimited
authority under the proposed CFPA Act and there would be no
basis for many of the entities described in your question to be
regulated as ``covered persons.'' For example, the proposed
CFPA Act would not regulate retailers with respect to the
provision of typical ``refer-a-friend'' programs, which
customarily involve only the processing of personally
identifiable information, such as an e-mail address, disclosed
by a consumer herself for marketing purposes, and do not
involve the provision of ``financial data processing'' services
by retailers to consumers. Neither lay-away plans nor extended
warranties, which typically are governed under State laws as
part of sales transactions for the products themselves, are
listed in the Act's definition of ``financial activity.''
Attorneys who communicate with consumers as agents of financial
services providers (and are not providing services to consumers
such as acting as a mortgage broker) would not be subject to
the jurisdiction of the CFPA because, in that capacity, the
attorneys would be providing services to the providers, not to
consumers. Moreover, the provision of real estate settlement
services by an attorney to a consumer within the scope of the
attorney-client relationship should not be regulated by the
CFPA because the proposed CFPA Act is not intended to alter the
regulation of the practice of law by the State courts. Even
though an educational institution that originates or brokers
loans to students to be used primarily for personal, family or
household purposes would be a ``covered person'' with respect
to those activities, processing ``grant applications'' or
offering ``study abroad programs'' are activities outside the
scope of the proposed CFPA Act.
In addition, the following entities, as described in your
question, would not be subject to the jurisdiction of the CFPA,
either under either an enumerated consumer law or under the
proposed CFPA Act, with respect to the following products or
services: banks (factoring; sales of annuities; and sales of
investment products (other than interest-bearing deposits, such
as CDs)); retailers (consumer deposits, assuming that a
retailer is prohibited by law from accepting ``deposits'' and
that the deposits described in your question refer to a deposit
for the purchase of a commercial product or service; refer a
friend programs; exchanges of customer lists, unless such an
exchange is covered by the requirements under the Gramm-Leach-
Bliley Act (GLBA); the use of ``vanity'' cards or similar
payment plans, including ``lay-away'' plans; and discount
cards) retailers or specialized merchandise and services;
insurance companies and insurance agents (except with respect
to credit insurance products, financial advice and
publications, sales of covered insurance products, and
financial advice, as discussed above); stockbrokers, if covered
by an exemption under the proposed CFPA Act as a person
regulated by the SEC or a person regulated by the CFTC
(financial advice; brokering deposits in money market mutual
funds, such as sweeps products; and sales of unregistered or
exempt securities); attorneys (real estate settlement services
conducted within the scope of the attorney-client relationship;
collection of own debts, unless the debt collection relates to
a consumer financial product or service, such as a credit
extended by an attorney herself to finance her legal services;
takers and holders of deposits, assuming that an attorney is
prohibited by law from accepting ``deposits'' and that the
deposits described in your letter refer to deposits in
connection with purchases of legal services; and subletting
office space); manufacturers (deposit-taking activities,
assuming that a manufacturer is prohibited by law from
accepting ``deposits'' and that the deposit-taking activities
described in your letter refer to deposits for purchases of
commercial products or services); real estate agents (sales of
real property; ``deposit taking activities,'' assuming that a
real estate agent is prohibited by law from accepting
``deposits'' and that the deposit-taking activities described
in your letter refer to the receipt of deposits for purchases
of property, such as receipt of a check of a consumer-payor as
a deposit for the consumer's purchase of a house); educational
institutions (providing financial literacy training/information
to students, unless the training is provided to a particular
consumer on individual financial matters, as described in the
proposed CFPA Act; study abroad programs; processing grant
applications; and tuition/scholarship grants); hospitals,
physicians, and other medical service providers (deposit-taking
activities, assuming that a hospital, physician, or medical
service provider is prohibited by law from accepting
``deposits'' and that the deposit-taking activities described
in your letter refer to the receipt of deposits for purchases
of medical services; and processing insurance-related payments
and activities); accountants (except with respect to providing
tax planning and/or personal tax-preparation services, as
described above).
The CFPA will not regulate the media or subject the media
to fees.
A ``broker'' providing a ``list to a financial institution
for direct marketing purposes'' (or another party not
affiliated with the broker) would be covered by the notice and
opt-out requirements of the GLBA, as applicable, if the list
contains nonpublic personal information about consumers, and
potentially may be subject to the Fair Credit Reporting Act
(FCRA) for such activity.
Q.2. Under proposed section 1002(9), would a credit card
payment processor, or money transmitter, that arranges a
payment in connection with the delivery of a financial product
or service that violates a regulation promulgated by CFPA be
liable for monetary damages or any other punitive action? Does
one need to establish scienter on the part of the transmitter
or processor, or is mere involvement in the processing a
sufficient nexus?
A.2. Under the proposed CFPA Act, the CFPA would be authorized
to enforce the requirements of the CFPA Act with respect to a
credit card payment processor or money transmitter, each a
``covered person,'' in accordance with the provisions of the
CFPA Act, which would include civil money penalties for
violations under certain circumstances. However, the proposed
CFPA Act expressly provides that ``[n]othing [in the section
regarding remedies] shall be construed as authorizing the
imposition of exemplary or punitive damages.'' Depending on the
circumstances of a violation, or the remedies sought, ``mere
involvement'' by a covered person in a violation should not be
a sufficient basis to support the imposition of a sanction
under the proposed CFPA Act.
Q.3. The ``business of insurance'' appears to be excluded from
the definition of ``financial activity'' in the bill, though
the exceptions from that exclusion (credit insurance, mortgage
insurance, and title insurance) suggest that the CFPA would
still have jurisdiction over conventional insurance companies
if their business includes financial activities enumerated in
proposed section 1002(18)(0). Is that correct? Please specify
to what extent, if at all, a conventional insurance company
would still find itself subject to potential regulation by the
CFPA.
A.3. Under the proposed CFPA Act, a conventional insurance
company would be subject to the jurisdiction of the CFPA with
respect to the provision of credit, mortgage, or title
insurance products or services to consumers to be used
primarily for personal, family or household purposes. In
addition, a conventional insurance company would be subject to
the jurisdiction of the CFPA, like any other person, if the
insurance company engages in activities ``in connection with
the provision of a consumer financial product or service,''
such as extending credit or providing other consumer financial
products or services to consumers to be used primarily for
personal, family or household purposes, or otherwise falls
within the definition of a ``covered person.''
Q.4. In establishing the CFPA, the proposal seeks `` . . . to
promote transparency, simplicity, fairness, accountability, and
access in the market for consumer financial products or
services.'' (Section 1021(a)). Yet the definitional reach of
``consumer financial products or services'' is broad, in that
it includes ``any financial product or services to be used by a
consumer primarily for personal, family or household
purposes.'' (Section 1002(8)). A ``financial product or
service,'' in turn, ``means any product or service that,
directly or indirectly, results from or is related to engaging
in 1 or more financial activities'' (Section 1002(19)), while
the definition of ``financial activities,'' includes:
Deposit-taking;
Extending credit and servicing loans;
Check-guaranty services;
Collecting, analyzing, maintaining, and providing
consumer report information;
Collection of any debts;
Providing real estate settlement services;
Leasing personal or real property or acting as
agent, broker, or adviser relating thereto;
Acting as an investment adviser;
Acting as a financial adviser;
Financial data processing;
Money transmitting;
Sale or issuance of stored value cards;
Acting as a money services business;
Acting as a custodian;
``Any other activity that the Agency defines, by
regulation, as a financial activity.'' (Section
1002(18)).
In light of the potentially all-encompassing nature of the
regulatory regime to be established by the proposed CFPA, I
would ask for clarifications on the precise nature of the
services and products to be included within the scope of the
jurisdictional ambit of this new proposal. To this end, I
respectfully request guidance as to whether the following
activities are intended to be within the regulatory oversight
of the CFPA.
A. In the case of banks: I would ask for confirmation that all
the following activities would be covered:
Deposit products (CD's; savings accounts)
Demand deposit accounts
Home mortgage loans (fist, second, home equity)
Credit card loans
Financial lease structures
Personal loans; student loans
Vehicle financing (auto, motorcycle, and boat
loans)
Sales of annuities
Sales of investment products
Sales of credit insurance products
Sales of mortgage life insurance products
Financial advice and educational publications
Appraisal services
Factoring
Money transfer and payments
ACH activity
Checks and check processing
Reporting information about customers to other
lenders
B. In the case of retailers (general merchandise; convenience
stores; service stations): it would be helpful to know if the
following would be covered, as well as to understand if further
examples of possible jurisdiction may exist:
Credit card loans
Other unsecured loans (e.g., layaway and other
deferred payment plans)
Financial leasing arrangements
Consumer deposits
Refer a friend programs
Exchanges of customer lists
Retailers who use ``vanity'' cards and any other
payment plans, including ``lay-away'' plans
Leasing of property, including communication
equipment, photocopies, vehicles, audio-visual
equipment
Sale of prepaid gift cards
Discount cards
ATM services
C. In the case of retailers of specialized merchandise and
services (e.g., automobiles and other vehicles, new and used;
home improvements; home security devices; computers; cell
phones): please explain if these products would, in fact, be
covered, and whether other examples of possible jurisdiction
should be considered:
Secured financing
Unsecured financing; extended payment plans
Financial leasing of real and personal property
Extended product warranties
D. In the case of credit reporting agencies: please specify
whether other areas of activity beyond the following should be
deemed covered:
Consumer reports
Identity theft products (e.g., monitoring)
Processing and transmission of Credit scores
E. For insurance companies and insurance agents: please advise
if additional activities need to be studied as within the scope
of H.R. 3126:
Credit insurance products
Financial advice and publications
Sales of covered insurance products
Financial advice
F. In the case of stockbrokers: please provide examples of the
following potentially covered activities:
Financial advice
Brokering loans (e.g., home mortgages to clients)
Brokering deposits; sweeps
Sales of unregistered or exempt securities
G. For attorneys: please explain if there may be areas of
additional activity that may be regulated by the CFPA:
Communicating with consumers as agents of financial
services providers
Providing financial advice or education
Real estate settlement services
Collection of own debts
Takers and holders of deposits
Acting as custodians
Subletting office space
H. For manufacturers: please confirm and expand, as may be
needed, on the following areas of conduct that may be regaled
under the terms of H.R. 3126:
Financing of products (e.g., homes; automobiles and
other vehicles; appliances; computers)
Extended warranties
Leasing of real and personal property
Deposit-taking activities
I. In the case of real estate agents: please confirm that the
following constitute certain topics for possible regulation by
the CFPA:
Sales
Financial advice
Financing assistance and referrals
Deposit-taking activities
Title insurance agency and underwriting
Providing real estate settlement services
J. For educational institutions: please provide further
specific examples beyond those areas of activity set forth
below:
Originating/brokering student loans
Providing financial literacy training/information
to students
Providing financial advice
Study abroad programs
Tuition/scholarship, student loan financing
programs
Grant applications
K. In cases of hospitals, physicians, and other medical service
providers: please provide guidance in confirming that these
activities may be subject to regulatory scrutiny by the Agency,
and please also advise me of additional areas of potential
activity under H.R. 3126:
Arranging for financing of medical services
Collection of unpaid bills
Deposit-taking activities
Dealing in or transmitting consumer credit
information
Processing insurance-related payments and
activities
Leasing of medical equipment
L. For accountants: please confirm whether the following
constitute certain topics for possible regulation by the CFPA:
Providing tax planning and/or personal tax-
preparation services
A.4. Please see response to Question 1 above.
Q.5. Under proposed section 1012, the governing board of the
CFPA would be composed of five members serving staggered terms,
all appointed by the President, without any requirement that
they represent any political party other than that of the
President. Please provide the public policy justification for
this departure from the practice of the Securities and Exchange
Commission (SEC) and the Federal Trade Commission.
A.5. Under the proposed CFPA Act, the five-member Board of the
CFPA would be comprised of four members appointed by the
President for terms of 5 years, by and with the consent of the
Senate, and the head of the agency responsible for regulating
national banks. The proposal recommends this structure so that
the focus on appointing Board members can be on expertise in
the consumer financial marketplace, rather than be constrained
by party affiliation. The requirement of advice and consent of
the Senate will help balance the Board. The 5-year terms of the
Board members would be staggered, which will help ensure
continuity across different administrations. The CFPA Board
would be similar in structure to the Federal Reserve Board,
whose members serve for staggered terms and are not subject to
requirements relating to political affiliation.
Q.6. Under proposed section 1018(c), a ``Victims Relief Fund''
is set up within the Treasury, into which civil penalties paid
to the Treasury pursuant to CFPA enforcement actions would be
placed and from which the CFPA could withdraw funds for
distribution to ``victims'' at its sole discretion. Please
provide precedents for this provision.
A.6. Current Federal laws may not provide an exact precedent
for the CFPA Civil Penalty Fund. However, the fund is designed
to compensate victims of misconduct in the provision of
consumer financial products or services which is the subject of
judicial or administrative actions taken by the CFPA and which
result in civil penalties being assessed against covered
persons. Civil penalties could be imposed by the CFPA under the
proposed CFPA Act, the authorities transferred from other
Federal agencies, or the enumerated consumer laws which the
CFPA would be authorized to enforce.
Q.7. Under proposed section 1054, the CFPA would be authorized
to represent itself in Federal or State court, including the
U.S. Supreme Court. Please confirm that Attorney General Holder
has agreed with this policy and provide a list of other
independent agencies that also have the authority to represent
themselves in the same fashion. Also, does ``all appropriate
legal or equitable relief'' (Section 1054(a)) contemplate
seeking monetary damages in addition to civil penalties? If so,
why is this language different (in that the word ``monetary''
is used) from the language that applies to State Attorneys
General in proposed section 1042(a)(1)?
A.7. The Office of the Comptroller of the Currency (``OCC'' or
``Comptroller'') and the Federal Reserve Board are authorized
to represent themselves in Federal or State courts. Federal law
currently authorizes the OCC to ``act in the Comptroller's own
name and through the Comptroller's own attorneys in enforcing
any provision of this title, regulations thereunder, or any
other law or regulation, or in any action, suit, or proceeding
to which the [Comptroller] is a party.'' 12 U.S.C. 93(d).
Similarly, the Federal Reserve Board is authorized to ``act in
its own name and through its own attorneys in enforcing any
provision of this title, regulations promulgated hereunder, or
any other law or regulation, or in any action, suit, or
proceeding to which the [Federal Reserve Board] is a party and
which involves the [Federal Reserve Board's] regulation or
supervision of any bank, bank holding company . . . or other
entity, or the administration of its operations.'' 12 U.S.C.
248(p).
Section 154(a) of the proposed CFPA Act would authorize the
CFPA to ``seek all appropriate legal or equitable relief,'' but
``monetary damages,'' as customarily awarded under the common
law, should not be available to the CFPA because the agency
typically would not be able to plead and prove an injury to the
agency itself that would warrant such damages. However, section
155(a)(2) of the proposed CFPA Act contemplates that the CFPA
could seek, and a court may mandate, the ``payment of
damages,'' such as to a consumer, arising from a violation. The
use of the word ``monetary'' in section 142 is intended to
generally describe a category of relief available for a State
attorney general or State regulator to recover under applicable
State law, such as a civil money penalty.
Q.8. Proposed Subtitle D of the legislative proposal does not
include an express prohibition against private rights of action
and/or class actions, yet section 1064(l) of the bill includes
a ban on private rights of action for transferred employees.
Would either or both remedies be possible under this proposal?
A.8. The proposed CFPA Act does not afford a private right of
action against a covered person, including through a class
action.
Q.9. Proposed section 1025 would authorize the CFPA to
``prohibit or impose conditions or limitations'' on existing
arbitration agreements if, in the exercise of its sole
discretion, the CFPA were to determine that such agreements are
not ``in the public interest'' or ``for the protection of
consumers.'' What specific legal standards would apply in order
to decide what constitutes ``the public interest'' or the
``protection of consumers'' under this proposed section?
A.9. Under the proposed CFPA Act, the CFPA, through the notice-
and-comment rulemaking process, would establish the standards
for the ``public interest'' and the ``protection of consumers''
relevant to the type or class of binding arbitration agreement
regarding future disputes, as would be further defined by the
CFPA, that may warrant an appropriate condition, limitation, or
prohibition, if any.
Q.10. We note that proposed Section 1022 appears to provide an
exception to coverage by the CFPA for ``a person regulated by''
the SEC. Please confirm that this exception is effective only
with respect to the ``functions'' of the covered entity that
are actually regulated by the SEC.
A.10. Section 101(27) of the proposed CFPA Act provides that
the term ``person regulated by the Securities and Exchange
Commission'' is limited ``only to the extent that the person
acts in a registered capacity.''
Q.11. In proposed section 1023, the CFPA reserves to itself the
authority to issue regulations that determine ``the
confidential treatment of information'' it obtains pursuant to
its duties as outlined in the bill. Does that authority extend
to the possible public release of proprietary information
gathered from ``covered persons'' and/or otherwise confidential
financial information obtained under proposed section 1022 or
any other provision of this proposal?
A.11. We expect that under the proposed CFPA Act the CFPA will
adopt strong confidentiality rules designed to strictly limit
the disclosure of confidential information about a covered
person, consistent with the standards adopted by the banking
agencies to protect confidential supervisory information.
Moreover, section 123(b) is not intended to override the
application of the Freedom of Information Act (FOIA); as a
result, the CFPA, like the Federal banking agencies, generally
would be required to disclose information relating to a covered
person in accordance with the FOIA, but would be permitted by
the FOIA to withhold information relating to a covered person
that falls within an exemption of the FOIA, such as the
exemption for information contained in or related to
examination reports of the covered person. Nevertheless, under
section 123(b) of the proposed CFPA Act, the CFPA may, in
accordance with confidentiality rules prescribed by the agency,
publicly disclose proprietary information obtained from
``covered persons'' in connection with the exercise of the
agency's authorities under the proposed CFPA Act.
Q.12. Please clarify the extent to which online and offline
privacy regulation would fall within the jurisdictional
responsibility of the CFPA. Please provide specifics relative
to what privacy statutes would be subject to CFPA supervision
and regulation and which ones would not.
A.12. The proposed CFPA Act would transfer to the CFPA
responsibility for rulemaking and primary enforcement of the
notice and opt-out provisions of the GLBA, 15 U.S.C. 6802-
6809, but not the data security provisions of section 501 of
the GLBA. 15 U.S.C. 6801. The proposed CFPA Act calls for
these financial privacy issues to transfer to the CFPA because
it will have exclusive authority over a wide range of issues
involving notices that are provided to consumers in connection
with obtaining financial products or services. Accordingly,
transferring to the CFPA the authority to administer these
parts of the GLBA privacy provisions will facilitate the
purpose of consolidating Federal authority over notices for
consumer financial products and services, including issues
relating to disclosures of personally identifiable financial
information. In addition, to the extent that the FCRA is
characterized as a privacy statute, the proposed CFPA Act would
transfer to the CFPA responsibility for rulemaking and primary
enforcement of the ``privacy'' provisions of the FCRA, such as
the limits on use of information by affiliates for marketing
purposes under section 624. 15 U.S.C. 1681s-3. However, the
data security provisions of the FCRA, such as the disposal
requirements under section 628, 15 U.S.C. 1681w, would not be
transferred from the Federal Trade Commission and the Federal
functional regulators to the CFPA under the proposed CFPA Act.
Q.13. With respect to ``financial data processing,'' as defined
in proposed section 1002(18)(J), does any level of direct or
indirect involvement in the transmission or processing of this
data suffice for purposes of being subject to the terms of H.R.
3126?
A.13. Not all persons that process financial data would be
``covered persons'' under the proposed CFPA Act. More
specifically, even though a person that engages in ``financial
data processing'' would be engaging in a financial activity
covered under the proposed CFPA Act, that activity, by itself,
is not sufficient to be covered by the Act. For example, a
person that performs data processing activities for persons for
business purposes (as opposed to personal, family, or household
purposes) would be acting outside the scope of the proposed
CFPA Act. On the other hand, a person engaged in ``financial
data processing'' would be a ``covered person'' under the
proposed CFPA Act if the activity is ``in connection with the
provision of a consumer financial product or service.'' A
person also would be covered if it provides financial data
processing to a covered person, ``in connection with the
provision of a consumer financial product or service,'' and
``provides a material service to, or processes a transaction on
behalf of, [that covered person].''
Q.14. The proposal goes to great length to underscore the
active involvement of the States, both with respect to
enforcing the law, as reflected in this proposal, and with
respect to initiating their own efforts at consumer protection.
Since Federal preemption currently exists, under certain
circumstances, and since any such preemption would be abolished
under this proposal, would this bill, in effect, reinstate any
preexisting State laws and/or regulations that have been set
aside or rendered inapplicable by virtue of Federal preemption?
A.14. In large measure, the Administration's proposed CFPA Act
would preserve the status quo with respect to the relation of
State laws to Federal laws governing the provision of consumer
financial products and services. In general, the proposed CFPA
Act would not annul, alter, or affect the application of a
State law, except to the extent that a State law is
inconsistent with the Act, and then only to the extent of such
an inconsistency. A State law that affords greater protection
to consumers would not be inconsistent with the proposed CFPA
Act and, therefore, would continue to apply.
Since the adoption of the first major Federal financial
consumer protection law, the Truth in Lending Act, in 1969,
Congress has with limited exceptions explicitly allowed the
States to adopt laws to protect financial consumers so long as
these laws do not conflict with Federal statutes or
regulations. Federal law thus establishes a floor, not a
ceiling. We propose to preserve that arrangement. It reflects a
decades-long judgment of Congress, which we share, that States
should retain authority to protect the welfare of their
citizens with respect to consumer financial services. Federal
law ensures all citizens a minimum standard of protection
wherever they reside. Citizens of a State, however, should be
able to provide themselves--through their legislators and
governors--more protection.
The continued ability of citizens to protect themselves
through their States is crucial to ensuring a strong Federal
standard. Because Washington, DC, is not the source of all
wisdom, State initiatives can be an important signal to
Congress and Federal regulators of a need for action at the
Federal level. Even with the best of intentions and the best of
staff, it is impossible to simply mandate that Federal laws or
rules remain updated, since practices change so quickly. States
are much closer to abuses as they develop, and are able to move
much more quickly when necessary. For example, the States were
far ahead of the Federal Government in regulating subprime
mortgages. If States were not permitted to take initiative, the
Federal Government would lose a critical source of information
and incentive to adjust standards over time to address emerging
issues.
If the CFPA is created and endowed with the authorities we
have proposed, we expect it will promote regulatory consistency
even while it respects the role of the States. Many of the
State laws that have created the concern for nonuniformity can
be attributed in large part to the absence of Federal
leadership. The Federal Reserve had authority to regulate
subprime mortgages since 1994. It signaled publicly in 2001,
however, that it was willing to regulate only a small portion
of the subprime market. It is hardly surprising that more than
one half of the States then moved to adopt their own predatory
mortgage lending laws.
We believe a strong and independent CFPA that is assigned a
clear mission to keep protections up-to-date with changes in
the marketplace will reduce the need for State action and
increase legal uniformity. If States retain the ability to keep
the CFPA on its toes and the CFPA has the authority it needs to
follow the market and keep protections up-to-date, then the
CFPA will be more likely to set a high standard that will
satisfy a substantial majority of States.
To be sure, federally chartered institutions have recently
enjoyed immunity from certain State consumer protection laws,
and we propose to change that to ensure a level playing field.
National banks must already comply with a host of State laws,
such as those dealing with foreclosures, debt collection,
privacy, and discrimination. Under our proposal, federally
chartered depository institutions and their State-incorporated
subsidiaries would be subject to nondiscriminatory State
consumer protection and civil rights laws to the same extent as
other financial institutions. We also propose that States be
able to enforce these laws, as well as regulations of the CFPA,
with respect to federally chartered institutions, subject to
appropriate arrangements with prudential supervisors.
We would preserve preemption where it is critical to the
Federal charter. Our proposal explicitly does not permit the
States to discriminate against federally chartered
institutions. Discriminatory State laws would continue to be
preempted. Moreover, we do not seek to overturn preemption of
State laws limiting interest rates and fees (the Smiley and
Marquette decisions). National banks would continue to enjoy an
effective immunity from State usury laws. Nor do we seek to
disturb the OCC's exclusive authority over national banks with
respect to prudential regulation and supervision. In this way,
we would preserve the value of the national bank charter.
We would be happy to work with Congress to establish a
reasonable transition period for implementation of the new
National Bank Act preemption standards.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM STEPHEN W. JOYNT
Q.1. As we move forward on strengthening the regulation of
credit rating agencies, it is important that we do not take any
action to weaken pleading and liability standards of the
Private Securities Litigation Reform Act of 1995. This
Committee worked long and hard, and in a completely bipartisan
fashion, to craft litigation that would help prevent abusive
``strike'' suits by trial lawyers. These suits benefited no one
but the lawyers who orchestrated these suits. This was a real
problem then, and could become a real problem again if we
dilute the current standard that applies to all market
participants. Perpetrators of securities fraud, and those who
act recklessly, can be sued under the law we passed in 1995.
Is there any justification for now altering this standard
just for credit rating agencies?
A.1. No. Altering the pleading and liability standards of the
PSLRA just for credit rating agencies is neither warranted nor
justified. In passing the PSLRA in 1995, Congress struck a
delicate balance between two important competing goals: to curb
frivolous, lawyer-driven litigation while preserving investors'
ability to recover on meritorious claims. Consistent with these
principles, under current law, credit rating agencies are
liable for securities fraud. A claim for securities fraud
levied against a credit rating agency by an investor will
survive a motion to dismiss provided the investor is able to
plead the elements of securities fraud, in particular facts
from which a reasonable person could strongly infer the agency
acted intentionally or recklessly to a degree sufficient to
meet the scienter requirement as interpreted by the courts.
Q.2. Will the threat of class action litigation, and the costs
of endless discovery, be at cross-purpose with the goal of
fostering greater competition in credit rating markets?
A.2. Amending the pleading standards of the PSLRA to allow
strike suits against credit rating agencies is most certainly
at cross-purpose with the goal of fostering greater competition
in credit rating markets. Congress adopted the PSLRA to curb
the practice of plaintiffs filing complaints for securities
fraud against firms whether or not there was evidence of fraud
in the hope that they would find evidence to support their
claims through the discovery process.
Congress acted in recognition of the fact that such
lawsuits require firms to expend huge sums defending or
settling claims of securities fraud, regardless of guilt, among
other things, making it more difficult for smaller firms to
compete. Rolling back the PSLRA reforms as they apply to credit
rating agencies will place a substantial burden on all
agencies, and possibly overwhelm newer entrants to the market.
Ratings are forward-looking assessments of future performance.
Whenever actual performance is out of line with a forward-
looking assessment, in hindsight, to an investor it will always
look like the NRSRO could have reasonably foreseen future
problems with better stress testing, etc.
Q.3. Would this potential create a disproportionate burden for
smaller players in the industry?
A.3. The burden placed on any one agency will depend on the
size of agency's revenue base, the volume and types of credit
rating products offered by the agency, and the markets in which
it operates. Agencies with a smaller revenue base are typically
able to support a smaller cost base and consequently are likely
to bear a disproportionate burden.
Q.4. Do you believe that the threat of harassment litigation
could act as a barrier to entry to those considering entry into
the rating agency business?
A.4. Yes. Smaller agencies considering application for NRSRO
status reasonably can be expected to be deterred by the threat
of excessive litigation costs. The threat of harassment
litigation can also reasonably be expected to have a chilling
effect on agencies seeking to better serve investors through
the assignment of agency initiated ratings.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM JAMES H. GELLERT
Q.1. As we move forward on strengthening the regulation of
credit rating agencies, it is important that we do not take any
action to weaken pleading and liability standards of the
Private Securities Litigation Reform Act of 1995. This
Committee worked long and hard, and in a completely bipartisan
fashion, to craft litigation that would help prevent abusive
``strike'' suits by trial lawyers. These suits benefited no one
but the lawyers who orchestrated these suits. This was a real
problem then, and could become a real problem again if we
dilute the current standard that applies to all market
participants. Perpetrators of securities fraud, and those who
act recklessly, can be sued under the law we passed in 1995.
Is there any justification for now altering this standard
just for credit rating agencies?
A.1. Senator Bennett, I agree that there are broad implications
for the treatment of liability standards for the ratings
agencies, and more widely for participants in the securities
industry. The rating agencies are popular targets currently and
the popular ground swell for them to be accountable for their
alleged mistakes leading to the subprime crises is likely to
grow, not diminish.
I believe the focus on liability runs the risk of being
disproportionately central to attempts to ``fix'' the ratings
business. This isn't to say that malfeasance or negligence
should be acceptable; it is simply to note that the threat of
liability has rarely been an effective deterrent for bad
behavior in the finance industries.
Q.2. Will the threat of class action litigation, and the costs
of endless discovery, be at cross-purpose with the goal of
fostering greater competition in credit rating markets?
A.2. Anything that increases the costs of entering the ratings
business has the risk of hindering competition. A basic
challenge to building any new business is projecting costs. The
specter of the costs associated with internal and external
counsel necessary to protect against class action litigation
and discovery is ominous and difficult to project. Ironically,
the firms that benefit the most from a new and more litigious
ratings environment are the Big Three, S&P, Moody's and Fitch,
and these are the ones theoretically most in the crosshairs of
this initiative. All three of these firms continue to generate
large profits from their businesses and two of the three have
massive multination corporations backing them. Increased legal
costs are rounding errors in their businesses and are cheap
prices for them to pay for further solidifying their oligopoly.
Q.3. Would this potential create a disproportionate burden for
smaller players in the industry?
A.3. The costs of insurance, not to mention actual legal costs,
could exponentially increase the costs of running a competing
firm in the earlier years of development. It would almost
certainly become the largest cost line-item in our firm's
budget, since we use no analysts and do not have the
commensurately high personnel costs that a traditional firm
would have.
As I have outlined in my written testimony, the NRSRO
designation is currently the supposed carrot on the stick for
aspiring ratings firms. All of the direct and contingent costs
associated with increased legal liability create further
disincentive to firms like Rapid Ratings and make applying for
NRSRO status less appealing. This isn't to avoid
responsibility, this is to avoid the potentially punishing
costs to which we'd be subject with the NRSRO status. This is a
dramatic unintended consequence of the currently contemplated
increased liability standards and other rule revisions being
contemplated.
Q.4. Do you believe that the threat of harassment litigation
could act as a barrier to entry to those considering entry into
the rating agency business?
A.4. Absolutely.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM JOHN C. COFFEE, Jr.
Q.1. As we move forward on strengthening the regulation of
credit rating agencies, it is important that we do not take any
action to weaken pleading and liability standards of the
Private Securities Litigation Reform Act of 1995. This
Committee worked long and hard, and in a completely bipartisan
fashion, to craft litigation that would help prevent abusive
``strike'' suits by trial lawyers. These suits benefited no one
but the lawyers who orchestrated these suits. This was a real
problem then, and could become a real problem again if we
dilute the current standard that applies to all market
participants. Perpetrators of securities fraud, and those who
act recklessly, can be sued under the law we passed in 1995.
Is there any justification for now altering this standard
just for credit rating agencies?
A.1. Answer not received by time of publication.
Q.2. Will the threat of class action litigation, and the costs
of endless discovery, be at cross-purpose with the goal of
fostering greater competition in credit rating markets?
A.2. Answer not received by time of publication.
Q.3. Would this potential create a disproportionate burden for
smaller players in the industry?
A.3. Answer not received by time of publication.
Q.4. Do you believe that the threat of harassment litigation
could act as a barrier to entry to those considering entry into
the rating agency business?
A.4. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM LAWRENCE J. WHITE
Q.1. As we move forward on strengthening the regulation of
credit rating agencies, it is important that we do not take any
action to weaken pleading and liability standards of the
Private Securities Litigation Reform Act of 1995. This
Committee worked long and hard, and in a completely bipartisan
fashion, to craft litigation that would help prevent abusive
``strike'' suits by trial lawyers. These suits benefited no one
but the lawyers who orchestrated these suits. This was a real
problem then, and could become a real problem again if we
dilute the current standard that applies to all market
participants. Perpetrators of securities fraud, and those who
act recklessly, can be sued under the law we passed in 1995.
Is there any justification for now altering this standard
just for credit rating agencies?
Will the threat of class action litigation, and the costs
of endless discovery, be at cross-purpose with the goal of
fostering greater competition in credit rating markets?
Would this potential create a disproportionate burden for
smaller players in the industry?
Do you believe that the threat of harassment litigation
could act as a barrier to entry to those considering entry into
the rating agency business?
A.1. Since I am not a lawyer (and do not practice law without a
license) and I have only a modest familiarity with the Private
Securities Litigation Reform Act of 1995, I am really not
qualified to answer these questions. However, I do believe that
a blanket First Amendment protection for rating agencies is too
broad--while I recognize that an increased level of liability
to damages from lawsuits will make life more difficult for
credit rating agencies, especially smaller firms and potential
entrants. Accordingly, there needs to be a better balance than
is present now in encouraging rating agencies to take the
appropriate level of care in supporting their judgments.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM MARK FROEBA
Q.1. As we move forward on strengthening the regulation of
credit rating agencies, it is important that we do not take any
action to weaken pleading and liability standards of the
Private Securities Litigation Reform Act of 1995. This
Committee worked long and hard, and in a completely bipartisan
fashion, to craft litigation that would help prevent abusive
``strike'' suits by trial lawyers. These suits benefited no one
but the lawyers who orchestrated these suits. This was a real
problem then, and could become a real problem again if we
dilute the current standard that applies to all market
participants. Perpetrators of securities fraud, and those who
act recklessly, can be sued under the law we passed in 1995.
Is there any justification for now altering this standard
just for credit rating agencies?
A.1. Yes, there is ample justification for altering the
pleading and liability standards just for the credit rating
agencies. Here are three arguments in support of changing these
standards.
First, the major rating agencies have enjoyed the privilege
of a Government-sponsored monopoly for many years. In order to
reduce the negative consequences of this monopoly, the
Government also encouraged competition among the agencies.
There is overwhelming circumstantial evidence that the agencies
responded by competing with each other not on price or
efficiency or productivity or quality but, instead, on rating
standards, revising rating methodologies and standards whenever
necessary to build or maintain market share and revenue.
Changing pleading and liability standards for the agencies
would provide a key restraint should rating standards ever
again end up in competitive free fall. Fear of liability will
curb the appetite for market share, dampen the negative effects
of competition, improve rating quality and, thereby, ultimately
make lawsuits less necessary. The rating agencies, in exchange
for continuing to enjoy the privilege of a Government-sponsored
monopoly, should be subjected to easier pleading and liability
standards at least where litigants claim that bad ratings have
injured them.
Second, when the rating agencies generate bad credit
opinions, they have nothing at risk except their reputations.
Other market participants involved in the transactions that
failed in the subprime crisis, e.g., investment banks,
investors, and collateral managers, all had some financial
stake in these transactions. When these participants got it
wrong, they were punished by financial losses, in some cases
even to the point of bankruptcy. Having a significant financial
risk is enough to warrant separate pleading and liability
standards for these market participants. If reputation risk
alone once provided the rating agencies with the same kind of
incentives as financial risk, Enron taught them a new lesson.
The bankruptcy of Enron within only days of losing its
investment-grade ratings did severe damage to the reputation of
the agencies but did little to hurt their business. In the
aftermath of Enron, the rating agencies enjoyed some of their
most profitable years ever. Thus, fear of reputation damage
after Enron did nothing to check the ratings that caused the
subprime crisis. It would be very difficult now to overstate
the damage that the subprime crisis has done to the reputation
of the rating agencies. If they all survive the current crisis
unscathed--as seems almost certain--they will be taught a
lesson very dangerous to world financial system: no matter how
bad their ratings, no matter how damaged their reputations,
they will not fail and the rating business will not go away
because there is nowhere else for it to go. Without incentives
that are far more potent than reputation risk, we cannot expect
the rating agencies to reform themselves and impose greater
quality and accuracy on their ratings.
Third, the rating agencies have long enjoyed near complete
immunity from liability for bad ratings. This immunity is based
upon an old line of cases that found the rating business--
assigning and reporting ratings--to be a form of journalism
subject to free speech protections. More than 40 years ago,
this finding had some merit. The rating agencies assigned
ratings to bonds and then reported all of their ratings in
periodicals sold to subscriber/investors. Bond issuers paid the
rating agencies nothing. However, the rating agencies largely
abandoned this model 40 years ago. The new model shifts the
cost of the rating from subscriber/investors (eager for the
most accurate rating) to bond issuers (eager for the highest
rating). It is easy to see how the new model changed the rating
agencies' incentives. It is also difficult to imagine how real
journalism could make a similar business-model switch. (It
would be as if each newspaper story were commissioned by the
subject of the story, based solely upon facts submitted by the
subject, and published only upon the subject's approval of the
story and payment of a fee for its writing and publication.)
Eventually, the courts will discover that the credit rating
business is no longer anything like a form of journalism and
should not be entitled to free speech protections. This will
not happen overnight and may be a long and expensive process.
In the meantime, the financial markets need help restoring
their confidence in the quality and integrity of credit ratings
assigned today. Changing the pleading and liability standards
just for the agencies is an important first step in this
process.
Q.2. Will the threat of class action litigation, and the costs
of endless discovery, be at cross-purpose with the goal of
fostering greater competition in credit rating markets?
A.2. No. Some of the newly formed rating agencies are adopting
an investor-pay business model. These new agencies will enjoy
the same free speech protections that have so far shielded the
major rating agencies from litigation. If investor-pay rating
agencies continue to enjoy this protection while issuer-pay
agencies lose it, the result will be a very strong incentive
for new agencies to adopt the investor pay model. Second, even
now the rating business enjoys very high profit margins. Unlike
other businesses with such high profit margins, the rating
business has virtually no costs for research and development or
advertising. Even if current profit margins were cut in half by
litigation costs, they would remain very attractive compared to
other businesses and a strong enticement to the creation of new
rating agencies. If the risk of litigation materially improves
rating quality and integrity (and thereby prevents another
ratings driven financial crisis like the second subprime
crisis), this benefit will far outweigh whatever costs
litigation imposes.
Q.3. Would this potential create a disproportionate burden for
smaller players in the industry?
A.3. No. Small players will not be attractive targets for
harassment litigation not only because they do not have the
``deep pockets'' attractive to such litigation but also because
they have no history of bad ratings. They will only be at risk
of such litigation during the next Enron or subprime crises. In
a normal rating environment, it often takes years for a
transaction to go bad and for ratings to appear wrong. New
agencies should not face a litigation burden for quite some
time. In the meantime, the biggest burden for smaller players
in the industry will be lack of demand for their ratings.
Unless Government policy vigorously encourages the use of
ratings from new rating agencies, the new agencies may never
survive long enough to suffer the litigation burden implied by
this question.
Q.4. Do you believe that the threat of harassment litigation
could act as a barrier to entry to those considering entry into
the rating agency business?
A.4. No. The threat of harassment litigation will do two
things. First, as noted above, it will create a strong
incentive for new agencies to adopt the investor-pay model.
Under this model, rating agencies should continue to enjoy
significant free speech protection against liability for
ratings and considerable immunity from litigation. Thus, the
potential for harassment litigation could have the positive
effect of inducing more new agencies to adopt the issue-pay
model. Second, litigation targeting the rating agencies will be
related to bad ratings assigned in the past. New agencies will
not be subject to such litigation. Thus, in theory they will
have a competitive advantage over existing rating agencies
which must incorporate the cost of this litigation into their
rating fees.
Additional Material Supplied for the Record
Hearings Before the Committee on Banking, Housing, and Urban Affairs
(January-August 2009) Date Hearing TitleJanuary 13................... Nomination of Shaun Donovan
January 15................... Nominations of Mary Schapiro, Christina
D. Romer, Austan D. Goolsbee, Cecilia E.
Rouse, and Daniel K. Tarullo
January 27................... The Madoff Investment Securities Fraud:
Regulatory and Oversight Concerns and
the Need for Reform
February 4................... Modernizing the U.S. Financial Regulatory
System
February 5................... Pulling Back the TARP: Oversight of the
Financial Rescue Program
February 10.................. Oversight of the Financial Rescue
Program: A New Plan for the TARP
February 12.................. Modernizing Consumer Protection in the
Financial Regulatory System:
Strengthening Credit Card Protections
February 24.................. Federal Reserve's First Monetary Policy
Report for 2009
February 26.................. Homeowner Affordability and Stability
Plan
March 3...................... Consumer Protections in Financial
Services: Past Problems, Future
Solutions
March 5...................... American International Group: Examining
What Went Wrong, Government
Intervention, and Implications for
Future Regulation
March 10..................... Enhancing Investor Protection and the
Regulation of Securities Markets--Part I
March 12..................... Sustainable Transportation Solutions:
Investing in Transit To Meet 21st
Century Challenges
March 17..................... Perspectives on Modernizing Insurance
Regulation
March 18..................... Lessons Learned in Risk Management
Oversight at Federal Financial
Regulators
March 19..................... Modernizing Bank Supervision and
Regulation--Part I
March 19..................... Current Issues in Deposit Insurance
March 24..................... Modernizing Bank Supervision and
Regulation--Part II
March 26..................... Enhancing Investor Protection and the
Regulation of Securities Markets--Part
II
March 31..................... Lessons From the New Deal
April 16..................... A 21st Century Transportation System:
Reducing Gridlock, Tackling Climate
Change, and Growing Connecticut's
Economy
April 23..................... Nominations of Ronald Sims, Fred P.
Hochberg, Helen R. Kanovsky, David H.
Stevens, Peter Kovar, John D. Trasvina,
and David S. Cohen
May 6........................ Regulating and Resolving Institutions
Considered ``Too Big To Fail''
May 7........................ Strengthening the SEC's Vital Enforcement
Responsibilities
May 13....................... Manufacturing and the Credit Crisis
May 13....................... Nominations of Peter M. Rogoff, Francisco
J. Sanchez, Raphael W. Bostic, Sandra
Henriquez, Mercedes Marquez, and Michael
S. Barr
May 20....................... Oversight of the Troubled Assets Relief
Program
June 3....................... A Fresh Start for New Starts
June 4....................... Nomination of Herbert M. Allison, Jr.
June 10...................... The State of the Domestic Automobile
Industry: Impact of Federal Assistance
June 16...................... Greener Communities, Greater
Opportunities: New Ideas for Sustainable
Development and Economic Growth
June 18...................... The Administration's Proposal To
Modernize the Financial Regulatory
System
June 22...................... Over-the-Counter Derivatives: Modernizing
Oversight To Increase Transparency and
Reduce Risks
July 7....................... Public Transportation: A Core Climate
Solution
July 8....................... The Effects of the Economic Crisis on
Community Banks and Credit Unions in
Rural Communities
July 14...................... Creating a Consumer Financial Protection
Agency: A Cornerstone of America's New
Economic Foundation
July 15...................... Regulating Hedge Funds and Other Private
Investment Pools
July 16...................... Preserving Homeownership: Progress Needed
To Prevent Foreclosures
July 17...................... The U.S. as Global Competitor: What Are
the Elements of a National Manufacturing
Strategy?
July 22...................... Federal Reserve's Second Monetary Policy
Report for 2009
July 22...................... Nomination of Deborah Matz
July 23...................... Establishing a Framework for Systemic
Risk Regulation
July 28...................... Regulatory Modernization: Perspectives on
Insurance
July 29...................... Protecting Shareholders and Enhancing
Public Confidence by Improving Corporate
Governance
July 30...................... Minimizing Potential Threats From Iran:
Assessing Economic Sanctions and Other
U.S. Policy Options
August 4..................... Strengthening and Streamlining Prudential
Bank Supervision--Part I
August 4..................... Rail Modernization: Getting Transit
Funding Back on Track
August 5..................... Examining Proposals To Enhance the
Regulation of Credit Rating Agencies