[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

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html







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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

                              ----------                              

                       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

                              ----------                              


                       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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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'').
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
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\
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     \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.
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     \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.
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     \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.
---------------------------------------------------------------------------
    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\
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     \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\
---------------------------------------------------------------------------
     \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\
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     \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\
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     \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.
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     \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.
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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\
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     \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?
References
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'', 
    Journal of Fixed Income, 5 (December 1995), pp. 10-34.
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 
    2009), pp. 27-50.
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, 
    Rating Agencies, and the Global Financial System. Boston: Kluwer, 
    2002, pp. 65-84.
Richardson, Matthew C., and Lawrence J. White, ``The Rating Agencies: 
    Is Regulation the Answer?'' In Viral Acharya and Matthew C. 
    Richardson, eds., Restoring Financial Stability: How To Repair a 
    Failed System. New York: Wiley, 2009, pp. 101-115.
Skreta, Vasiliki, and Laura Veldkamp, ``Ratings Shopping and Asset 
    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 
    Ratings'', In Richard M. Levich, Carmen Reinhart, and Giovanni 
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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
                                



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