    [House Hearing, 117 Congress]
    [From the U.S. Government Publishing Office]

                        BOND RATING AGENCIES: EXAMINING
                         THE ``NATIONALLY RECOGNIZED''
                        STATISTICAL RATING ORGANIZATIONS

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

                                 HYBRID HEARING

                                   BEFORE THE

                      SUBCOMMITTEE ON INVESTOR PROTECTION,

                     ENTREPRENEURSHIP, AND CAPITAL MARKETS

                                     OF THE

                        COMMITTEE ON FINANCIAL SERVICES

                         U.S. HOUSE OF REPRESENTATIVES

                        ONE HUNDRED SEVENTEENTH CONGRESS

                                 FIRST SESSION

                                   __________

                                 JULY 21, 2021

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 117-42

    [GRAPHIC NOT AVAILABLE IN TIFF FORMAT]

                                  __________

                        U.S. GOVERNMENT PUBLISHING OFFICE
    45-509 PDF                 WASHINGTON : 2021

    -----------------------------------------------------------------------------------

                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                     MAXINE WATERS, California, Chairwoman

    CAROLYN B. MALONEY, New York         PATRICK McHENRY, North Carolina,
    NYDIA M. VELAZQUEZ, New York             Ranking Member
    BRAD SHERMAN, California             FRANK D. LUCAS, Oklahoma
    GREGORY W. MEEKS, New York           BILL POSEY, Florida
    DAVID SCOTT, Georgia                 BLAINE LUETKEMEYER, Missouri
    AL GREEN, Texas                      BILL HUIZENGA, Michigan
    EMANUEL CLEAVER, Missouri            ANN WAGNER, Missouri
    ED PERLMUTTER, Colorado              ANDY BARR, Kentucky
    JIM A. HIMES, Connecticut            ROGER WILLIAMS, Texas
    BILL FOSTER, Illinois                FRENCH HILL, Arkansas
    JOYCE BEATTY, Ohio                   TOM EMMER, Minnesota
    JUAN VARGAS, California              LEE M. ZELDIN, New York
    JOSH GOTTHEIMER, New Jersey          BARRY LOUDERMILK, Georgia
    VICENTE GONZALEZ, Texas              ALEXANDER X. MOONEY, West Virginia
    AL LAWSON, Florida                   WARREN DAVIDSON, Ohio
    MICHAEL SAN NICOLAS, Guam            TED BUDD, North Carolina
    CINDY AXNE, Iowa                     DAVID KUSTOFF, Tennessee
    SEAN CASTEN, Illinois                TREY HOLLINGSWORTH, Indiana
    AYANNA PRESSLEY, Massachusetts       ANTHONY GONZALEZ, Ohio
    RITCHIE TORRES, New York             JOHN ROSE, Tennessee
    STEPHEN F. LYNCH, Massachusetts      BRYAN STEIL, Wisconsin
    ALMA ADAMS, North Carolina           LANCE GOODEN, Texas
    RASHIDA TLAIB, Michigan              WILLIAM TIMMONS, South Carolina
    MADELEINE DEAN, Pennsylvania         VAN TAYLOR, Texas
    ALEXANDRIA OCASIO-CORTEZ, New York   PETE SESSIONS, Texas
    JESUS ``CHUY'' GARCIA, Illinois
    SYLVIA GARCIA, Texas
    NIKEMA WILLIAMS, Georgia
    JAKE AUCHINCLOSS, Massachusetts

                       Charla Ouertatani, Staff Director
            Subcommittee on Investor Protection, Entrepreneurship,
                              and Capital Markets

                       BRAD SHERMAN, California, Chairman

    CAROLYN B. MALONEY, New York         BILL HUIZENGA, Michigan, Ranking
    DAVID SCOTT, Georgia                     Member
    JIM A. HIMES, Connecticut            ANN WAGNER, Missouri
    BILL FOSTER, Illinois                FRENCH HILL, Arkansas
    GREGORY W. MEEKS, New York           TOM EMMER, Minnesota
    JUAN VARGAS, California              ALEXANDER X. MOONEY, West Virginia
    JOSH GOTTHEIMER. New Jersey          WARREN DAVIDSON, Ohio
    VICENTE GONZALEZ, Texas              TREY HOLLINGSWORTH, Indiana, Vice
    MICHAEL SAN NICOLAS, Guam                Ranking Member
    CINDY AXNE, Iowa                     ANTHONY GONZALEZ, Ohio
    SEAN CASTEN, Illinois                BRYAN STEIL, Wisconsin
    EMANUEL CLEAVER, Missouri            VAN TAYLOR, Texas

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        July 21, 2021................................................     1
    Appendix:
        July 21, 2021................................................    37

                                   WITNESSES
                            Wednesday, July 21, 2021

    Bright, Michael R., Chief Executive Officer, The Structured
      Finance Association (SFA)......................................    11
    Linnell, Ian, President, Fitch Ratings...........................     6
    McGarrity, Amy Copeland, Chief Investment Officer, Colorado
      Public Employees' Retirement Association (PERA)................     5
    Nadler, Jim, President and CEO, Kroll Bond Rating Agency (KBRA)..     8
    Rhee, Robert J., Professor, University of Florida Law School.....    10

                                    APPENDIX

    Prepared statements:
        Bright, Michael R............................................    38
        Linnell, Ian.................................................    47
        McGarrity, Amy Copeland......................................    57
        Nadler, Jim..................................................    70
        Rhee, Robert J...............................................    76

                  Additional Material Submitted for the Record

    McHenry, Hon. Patrick:
        Written statement of the Loan Syndications & Trading
          Association (LSTA).........................................    89
        Written statement of the National Association of Corporate
          Treasurers (NACT)..........................................    93
    Vargas, Hon. Juan:
        Written responses to questions for the record submitted to
          Ian Linnell................................................    96

                        BOND RATING AGENCIES: EXAMINING
                         THE ``NATIONALLY RECOGNIZED''
                        STATISTICAL RATING ORGANIZATIONS

                                  ----------

                            Wednesday, July 21, 2021

                 U.S. House of Representatives,
                   Subcommittee on Investor Protection,
                 Entrepreneurship, and Capital Markets,
                               Committee on Financial Services,
                                                       Washington, D.C.
        The subcommittee met, pursuant to notice, at 3:25 p.m., in
    room 2128, Rayburn House Office Building, Hon. Brad Sherman
    [chairman of the subcommittee] presiding.
        Members present: Representatives Sherman, Foster, Vargas,
    Gottheimer, Axne, Casten, Cleaver; Huizenga, Wagner, Hill,
    Mooney, Hollingsworth, and Taylor.
        Ex officio present: Representative Waters.
        Also present: Representatives Pressley and Adams.
        Chairman Sherman. The Subcommittee on Investor Protection,
    Entrepreneurship, and Capital Markets will come to order.
        Without objection, the Chair is authorized to declare a
    recess of the subcommittee at any time. Also, without
    objection, members of the full Financial Services Committee who
    are not members of the subcommittee are authorized to
    participate in today's hearing.
        Today's hearing is entitled, ``Bond Rating Agencies:
    Examining the `Nationally Recognized' Statistical Rating
    Organizations.''
        I want to thank the witnesses and Members for accommodating
    the votes on the Floor, and convening at a different time. And
    I want to mention that quite a number of bills and discussion
    drafts have been listed as being under consideration at today's
    hearing. I notice that some of those bills are Democratic, put
    forth by Democratic authors, and some are bipartisan, and I
    would encourage my Republican colleagues to submit bills to be
    considered at our various subcommittee hearings.
        I will now recognize myself for 4 minutes for an opening
    statement.
        Americans say the economy is the most important thing. In a
    free market system, the allocation of capital is the most
    important thing in the economy. That is why we call it
    capitalism.
        The people think that the most important institutions at
    the national level are the President and Congress. I believe
    that they are the Federal Reserve, the Financial Accounting
    Standards Board (FASB), and the bond rating agencies. Notice I
    use the term, ``bond rating agencies,'' because I don't want to
    use the term, ``credit rating agencies,'' and confuse them with
    those who rate the creditworthiness of individuals. And the
    term, ``nationally recognized statistical rating organizations
    (NRSROs)'' is a misnomer, since what they do is hardly just
    statistical, or as objective as a statistician.
        The allocation of capital is of critical importance. About
    $250 trillion in capital is allocated through our equity
    markets, which provides $250 trillion to businesses to conduct
    business. Twenty times as much money flows through the debt
    instruments that are rated by the bond rating agencies:
    corporate bonds; commercial paper; asset-backed securities; and
    municipal bonds. Those ratings determine what gets funded, and
    at what interest rate. If the rating is too low, the bond will
    yield a high rate of interest, the project won't pencil out,
    and the factory will not be built. If the bond rating for a
    package of mortgages is too low and the interest rate is too
    high, you will not qualify for the loan.
        Bond rating agencies earn roughly $14 billion from our
    society to do their work. Their ratings are confusing, except
    to the insiders. They should be clear to outsiders. From the
    largest agency, the fifth-best rating is A+. Why would ordinary
    people think that A+ is the fifth-best? And, of course, the
    fourth-best from the other agency is Aa3.
        Not only that, the ratings are not defined. What is the
    estimated risk of loss with an A+ rating? We don't know. There
    is an unchecked conflict of interest. The issuer selects the
    credit rating agency and pays them, say, $1 million to give
    them a grade. Trust me, if you pay me $1 million, I will give
    you a good grade.
        And we saw them give very high grades to first and second
    mortgages for people who couldn't afford to make the payments,
    and that is why the Financial Crisis Inquiry Commission stated
    that the inflated ratings given to mortgage-backed securities
    were a primary cause of the greatest economic catastrophe I
    have lived through.
        I call it an unchecked conflict of interest, because there
    is no liability. In every other field, a professional who
    conducts malpractice gets sued. In this case, there is no check
    on the desire to give a higher rating and make the issuer happy
    because of the protections from liability.
        In the Dodd-Frank Act, we ruled that at least with regard
    to asset-backed securities (ABS), there would be liability. And
    the bond rating agencies went on strike. The SEC issued a no-
    action letter declaring that they wouldn't enforce our law, and
    the bond rating agencies won, proving that they are, indeed,
    more powerful than Congress.
        I now yield to the ranking member of the subcommittee, Mr.
    Huizenga, for 5 minutes for an opening statement.
        Mr. Huizenga. Thank you, Chairman Sherman.
        Well, I am afraid, respectfully, that this hearing is
    another example of dusting off outdated ideas in search of a
    problem. Everyone here today agrees that investors'
    overreliance on credit ratings is one of the many factors that
    led to the 2008 financial crisis. And the Dodd-Frank Act
    significantly expanded the scope of regulation and
    accountability of rating agencies.
        Since we last had this discussion a number of years ago, it
    is important that we separate a few facts from the fiction.
        Fact: Credit rating agencies face potential conflicts of
    interest, regardless of whether issuers, investors, or
    governments pay for those ratings. This idea that there is a
    model that does not present a conflict of any sort is just
    false. As long as there is a party interested in the outcome of
    a rating, there is going to be a potential conflict, and the
    Federal Government can certainly be a conflicted interested
    party as well.
        Fact: Nearly 10 years ago, the Democrat-led SEC studied
    many potential credit rating agency compensation models, as
    well as the feasibility and desirability of standardizing the
    credit rating industry as required by Dodd-Frank. After a
    thorough review, public comment, and a public roundtable, the
    SEC staff did not mandate any structural changes to the issuer
    pay model.
        Fact: The SEC's more recent examinations indicate that
    rating agencies are managing potential conflicts and producing
    ratings that benefit investors and issuers. If credit rating
    agencies fail to do so, the SEC has the right tools to
    intervene when necessary, and, parenthetically I might add,
    that if someone is doing something purely because they are
    getting paid for it, there are some legal responsibilities and
    obligations that need to be pursued and there should be
    ramifications for that. So to imply that anyone can just get
    bought in this is a sad state of affairs and they need to be
    gone after.
        Fact: During the pandemic, the rating agencies responded to
    evolving market and economic conditions promptly, and
    effectively performed their role as independent providers of
    forward-looking information.
        Given these facts, you may be asking yourself, why are we
    here today? The answer, I am afraid, is somewhat to relitigate
    Dodd-Frank, a bill that they jammed through more than a decade
    ago, without so much as even acknowledging what has transpired
    over the past decade.
        Former Democrat Commissioner Roel Campos said it best, ``It
    is not the time for an untested government-engineered credit
    ratings market. The credit markets and resulting information to
    investors is too important for laboratory experiments.''
        I will echo yet another voice from the Progressive Policy
    Institute, which is fairly left wing and not one that I would
    normally cite, but the Progressive Policy Institute had this to
    say, ``The credit ratings market based on the issuer pay model
    seems to have a way to consistently produce high-quality and
    more accurate ratings that give strong and useful signals to
    market participants. Nobody has been able to come up with an
    alternative compensation model that is clearly better.''
        I urge my colleagues to focus our efforts on modern
    problems, and not just rehash a fight that is over a decade
    old. I know there are some who are trying to say that there are
    a number of problems, that there are issues, that somehow
    having institutional investors do their own due diligence is
    indicative of their lack of trust in the ratings that are
    there. Well, credit ratings are designed to augment and to be a
    tool, not simply to replace separate analysis, and it would
    seem to me that as we go and tackle some of these issues, we
    all realize and understand there is no one singular source that
    we can go to to get all of this crystal ball read in a manner
    that is perfect. We don't live in a perfect world.
        The COVID situation is a great example of that, where
    people were guessing what the future was going to look like,
    and they were having to do their best estimates with what they
    were dealing with.
        So with that, I would like to yield back the rest of my
    time.
        Chairman Sherman. I now recognize the Chair of the full
    Financial Services Committee, the gentlewoman from California,
    Chairwoman Waters, for 1 minute.
        Chairwoman Waters. Thank you, Mr. Chairman.
        In the lead-up to the 2008 financial crisis, the bond
    rating agencies assigned AAA ratings to worthless mortgage-
    backed securities and complex products created by Wall Street,
    all the while knowing that retirees, cities and towns, and
    investors around the world relied on their ratings to make
    investment decisions. Their ratings brought our financial
    system to its knees. Millions of people lost their jobs, their
    homes, and their life savings, not to mention costing the
    economy trillions of dollars.
        Eleven years later, many of the Dodd-Frank reforms for
    rating agencies remain unfinished, including addressing a
    central conflict of interest wherein the same companies selling
    securities continue to shop around for their preferred ratings.
    With the financial risk that climate change and the pandemic
    now pose, investors need objective and reliable ratings more
    than ever.
        So, I look forward to this discussion. I want to thank Mr.
    Sherman for putting the time and attention on this issue that
    is certainly needed. And I am looking forward to seeing how we
    can improve this critical part of our capital market.
        I yield back.
        Chairman Sherman. Thank you.
        Before introducing our witnesses, let me introduce the two
    witnesses who refused to be here: Douglas Peterson, president
    and CEO of S&P Global; and Rob Fauber, president and CEO of
    Moody's Corporation. Even when they realized they didn't even
    have to use any commute time to be here, they refused our
    request.
        That is why I am appreciative of the witnesses who are
    here: Amy Copeland McGarrity, chief investment officer of the
    Colorado Public Employees' Retirement Association; Ian Linnell,
    president of Fitch Ratings, the third-largest agency, who is
    showing a respect for Congress by being here that I really
    appreciate; Jim Nadler, president and CEO of Kroll Bond Rating
    Agency; Robert J. Rhee, a professor with the University of
    Florida Law School; and Michael Bright, chief executive officer
    of The Structured Finance Association.
        Witnesses are reminded that their oral testimony will be
    limited to 5 minutes. You should be able to see a timer on the
    desk in front of you or indicated on your screen that will
    indicate how much time you have left. When you have 1 minute
    remaining, a yellow light should appear. I would ask that you
    be mindful of the timer, and when the red light appears, wrap
    up very quickly, so that we can be respectful of everyone's
    time.
        And without objection, your written statements will be made
    a part of the record.
        Ms. McGarrity, you are now recognized for 5 minutes.

    STATEMENT OF AMY COPELAND MCGARRITY, CHIEF INVESTMENT OFFICER,
        COLORADO PUBLIC EMPLOYEES' RETIREMENT ASSOCIATION (PERA)

        Ms. McGarrity. Chairman Sherman, Ranking Member Huizenga,
    and members of the subcommittee, thank you for the opportunity
    to speak with you today.
        My name is Amy McGarrity, and I serve as the chief
    investment officer for the Colorado Public Employees'
    Retirement Association, which we call PERA. I am going to
    summarize my written remarks, and I ask for them to be included
    in the hearing record.
        PERA is a public pension plan serving more than 620,000
    current and former public employees and their beneficiaries,
    with over $60 billion in assets. Unlike many other pensions, we
    manage over 60 percent of our assets in-house, so we are
    allocating to asset classes while also selecting specific
    securities. In fact, our more than $12 billion in fixed income
    assets are managed entirely in-house by our investment
    professionals.
        PERA's investors typically look well beyond the credit
    ratings and other assessments of securities provided by the
    rating agencies. Thus, while a particular credit rating may be
    a component of our investment decision-making process, our team
    also conducts proprietary fundamental and relative value
    analysis in order to derive our investment decisions.
        Put simply, we try to look beyond the ratings because we
    don't always have confidence in them, and we typically have the
    ability and resources to do so. Credit ratings also impact our
    investments indirectly, such as being used as a screen for
    inclusion or exclusion due to a particular portfolio benchmark
    index.
        Lastly, our portfolios have internal guidelines which may
    refer to credit ratings and allowed securities.
        But let's remember the purpose of credit ratings. Credit
    ratings are intended to provide investors and other market
    participants with accurate assessments of the risk of defaults.
    That credit risk could arise from any reason, ranging from
    traditional business risks, a global pandemic, or simply having
    trouble filling orders because of microchip or worker
    shortages.
        Further, to the extent that credit ratings provided by
    NRSROs may be inaccurate, that may lead some investors to
    mispricing their risks and inefficiently allocating their
    capital. This will impact different investors differently.
        Make no mistake, large sophisticated market participants
    with the resources and expertise needed to make accurate credit
    risk assessments may benefit from the mispricing of assets by
    those who may be more dependent upon ratings for their pricing
    determinations.
        By now, we all know that tens of thousands of asset-backed
    securities were rated AAA in the run-up to the GSEs, and
    thousands of them would be relatively quickly downgraded to
    junk status and huge percentages of them actually defaulted.
    Clearly, something was wrong.
        Several government investigations and enforcement actions,
    numerous civil lawsuits, and widespread press reports
    essentially all confirmed what many of us now accept: The
    ratings weren't reliable. Bipartisan efforts to reform the
    industry and improve ratings' accuracy were floated, and
    ultimately a school of reforms was included in the Dodd-Frank
    Act. However, significant questions regarding rating agency
    independence remain, and the ratings marketplace remains highly
    concentrated.
        While much work has been done, the SEC never adopted a
    ratings assignment system, nor did it propose changes to the
    issuer pay model. I have spent much time in the last few years
    exploring these problems.
        In addition to my role at PERA, I have had the honor of
    being appointed by then-SEC Chairman Clayton to serve on the
    SEC's Fixed Income Market Structure Advisory Committee
    (FIMSAC), and was asked to Chair its Credit Ratings
    Subcommittee. In our subcommittee, we explored the issuer pay
    business model and ways to address that clear conflict of
    interest, as well as other ways to improve credit ratings
    quality. As part of that process, the Credit Ratings
    Subcommittee released a draft discussion document that would
    have created an assignment process to reduce the issuer pay
    conflict of interest.
        While we ultimately could not get consensus on that issue
    amongst the members of the FIMSAC, we nevertheless were able to
    get consensus on other recommendations, including increasing
    rating agency disclosures regarding models and deviations,
    enhancing issuer disclosures for how they select ratings firms
    to assess both corporate securities and securitized products,
    and establishing a mechanism for bondholders to vote on the
    issuer-selected ratings firms.
        These are valuable proposed reforms, but in my opinion, are
    not nearly enough. The core of the issue with credit ratings
    remains the conflicts of interest associated with issuers both
    choosing and paying for their own ratings. The SEC should
    consider establishing a ratings assignment process that would
    offer enhanced opportunities for smaller rating agencies and
    reduce incentive for rating inflation. And there should also be
    greater efforts to ensure rating agency accountability.
        I appreciate that this subcommittee and the SEC are again
    exploring ways to improve the accuracy of ratings to better
    protect investors, but also to drive more fair, orderly, and
    efficient markets. Less-conflicted and higher-quality credit
    ratings would benefit PERA and the markets overall.
        Thank you for the opportunity to speak with you today, and
    I look forward to answering your questions.
        [The prepared statement of Ms. McGarrity can be found on
    page 57 of the appendix,]
        Chairman Sherman. Thank you. And thank you for your
    brevity.
        We will now hear from Mr. Linnell.

           STATEMENT OF IAN LINNELL, PRESIDENT, FITCH RATINGS

        Mr. Linnell. Thank you.
        Chairman Sherman, Ranking Member Huizenga, and
    distinguished members of the subcommittee, my name is Ian
    Linnell, and I am the president of Fitch Ratings. I appreciate
    the invitation to appear before you to talk about Fitch Ratings
    and the role of credit rating agencies in the capital markets.
    Credit ratings provide a forward-looking and relative opinion
    on credit risk, namely, how likely it is that investors will be
    repaid in full and on time. Credit risk is an important factor
    when considering whether to buy a bond. Unfortunately, for a
    variety of reasons, some investors do not adequately assess
    credit risk.
        Fitch helps to make sense of credit risk with ratings based
    on a simple letter scale. ``AAA'' is the highest rating,
    indicating the least credit risk, and ``D'' is the lowest
    rating. We have over 2,000 employees working in over 30
    countries, including over 1,250 analysts. Fitch, which is part
    of the Fitch Group, and a wholly-owned subsidiary of Hearst
    Corporation, is dedicated to providing the financial markets
    with timely, independent, and objective credit ratings.
        In the wake of the 2007 financial crisis, Congress passed
    the Dodd-Frank Act in 2010. Congress designed many of the
    provisions of Dodd-Frank to address concerns about the credit
    rating process that regulators believed contributed to the
    financial crisis.
        Even before Dodd-Frank's requirements went into effect,
    Fitch implemented a variety of changes to its business design
    to address many of the same concerns, including separating the
    analysts who evaluate credit risk and prepare our ratings from
    those employees who manage our business relationships with
    issuers; establishing a compliance department to ensure we are
    following our procedures in developing ratings; appointing a
    chief credit officer who is independent of the analysts to
    oversee the development and updating of our methodologies; and
    putting in place an independent review of our criteria.
        The changes made in advance of Dodd-Frank positioned Fitch
    well to comply with the requirements of the new law.
        Dodd-Frank also created the Office of Credit Ratings (OCR),
    that the Securities and Exchange Commission launched in June
    2012. The Commission charged the OCR with administering the
    rules of the Commission and overseeing the practices of NRSROs,
    promoting accuracy in credit ratings, and working to ensure
    that they are not unduly influenced by conflicts of interest.
        The OCR conducts annual and other examinations of NRSROs to
    assess and promote compliance with statutory and Commission
    requirements, and routinely monitors the activities of NRSROs.
    The OCR and its staff are solely dedicated to the oversight,
    examination, and supervision of credit rating agencies.
        In addition to U.S. regulations, credit rating agencies are
    subject to the regulatory mandates outside of the U.S.,
    including in the European Securities and Markets Authority and
    the U.K.'s Financial Conduct Authority. The EU has enacted its
    own registration and oversight system and related rules for
    rating agencies. Other nations have adopted similar measures.
    As a result, Fitch, along with the other global rating
    agencies, is subject to regulation and examination in every
    single country in which it operates.
        Fitch believes that the global regulatory framework created
    since Dodd-Frank has brought greater transparency and rigor to
    the credit rating process. The regulations respect the
    analytical independence of rating agencies by being procedural
    and not substantive in nature. The current law strikes the
    right balance between ensuring proper government oversight,
    while maintaining the rating agencies' ability to express their
    opinions without undue government interference, and free
    competition and choice in the marketplace.
        We appreciate that there is interest in Congress to expand
    on the framework of Dodd-Frank with further regulation related
    to credit ratings. Fitch welcomes changes that would improve
    the public's understanding of and confidence in credit ratings.
    However, the proposals that we understand are under
    consideration are concerning to us and could, in our view, have
    negative consequences for securities markets, NRSROs, and
    investors who rely on our ratings for an independent assessment
    of risk.
        I address these concerns more fully in my written
    testimony.
        Thank you for your time and for the work that you do for
    the United States, and I welcome any questions that you may
    have.
        Thank you.
        [The prepared statement of Mr. Linnell can be found on page
    47 of the appendix.]
        Chairman Sherman. Thank you.
        We now move on to Mr. Nadler, president and CEO of Kroll
    Bond Rating Agency.

     STATEMENT OF JIM NADLER, PRESIDENT AND CEO, KROLL BOND RATING
                             AGENCY (KBRA)

        Mr. Nadler. Chairman Sherman, Ranking Member Huizenga, and
    members of the subcommittee, thank you for the opportunity to
    testify today. I am Jim Nadler, the CEO of Kroll Bond Rating
    Agency (KBRA).
        KBRA was founded on the premise that open competition helps
    protect investors and can increase market liquidity. KBRA is a
    full-service rating agency, and one of the five largest rating
    agencies globally, and the largest rating agency established
    since the financial crisis.
        We believe that KBRA's entry into the market has been
    hugely positive for investors. Two excellent examples of the
    positive impact of competition and our innovation are in the
    community banks and in the Environmental, Social, and Corporate
    Governance (ESG) spaces.
        Despite our success over the past 10 years, we still face
    barriers to competition. The three largest NRSROs still command
    over 95-percent market share, and are written into the plumbing
    of the financial system. An example of this includes the
    investment guidelines of institutional investors that
    specifically name only the incumbent agencies. We believe that
    all investor guidelines across financial markets should permit
    the use of any SEC-registered NRSROs.
        Another example is the recent Federal Reserve Emergency
    Lending Facilities, which initially required the use of the
    ratings by one of only three large rating agencies. As a result
    of the intervention of members of this committee, the House
    passed legislation requiring the Federal Reserve and the
    Treasury to accept securities rated by any NRSRO registered
    with the SEC. We support broadening that legislation to ensure
    that no government agency can limit competition.
        I would also like to offer input to the Commercial Credit
    Rating Reform Act that is being discussed today. We appreciate
    Representative Sherman's long-standing leadership on issue of
    competition and NRSROs.
        That said, we have concerns regarding unintended
    consequences of this legislation. While government assignment
    of ratings would increase the market share of smaller NRSROs
    like mine, it would discourage thorough research. If an NRSROs
    is assured of receiving regular rating assignments via a
    government panel, some might not devote resources to quality
    research. That would be detrimental to investors who would lose
    access to diverse, transparent, and thorough market
    information.
        Mr. Chairman, we believe that many components of the Dodd-
    Frank Act have been highly successful and have all served to
    improve outcomes for investors, including increased disclosure,
    the required development of internal controls, and supervision
    and annual examination by the SEC.
        In addition, the requirement that NRSROs publicly post
    their methodologies and substantive changes thereto allows
    investors to familiarize themselves and scrutinize
    methodologies and determine which methodologies align with
    their viewpoint. This is a positive change that protects
    investors and allows them to play an active role in pushing
    NRSROs to maintain high and relevant standards.
        We understand that some policymakers, including members of
    this subcommittee, have questions about potential conflicts of
    interest in the issuer pay model. As a general matter, I
    believe it is not possible to completely eliminate all
    potential conflicts in the NRSROs space, regardless of the
    issuer pay or investor pay model, and that the current SEC
    disclosure requirements mitigate potential risks in this area.
    We are concerned that views on the issuer pay model were also
    driven partly by a false narrative regarding rating inflation
    and competition in the structured finance space that is based
    on incomplete data and poor media reporting. Our data shows
    that competition improved research and ratings and does not
    inflate ratings.
        We also have concerns that the investor pay model would
    disadvantage smaller investors. The benefit of issuer-pay
    ratings is that the issuers typically make those ratings
    publicly available to all investors, large and small, that can
    benefit from the ratings and research published by the NRSRO.
    We believe that the investor-pay model would solely benefit the
    largest institutional investors who could afford to pay for
    multiple ratings and the best research available.
        Finally, Mr. Chairman, we believe that the current SEC
    regulatory framework provides the appropriate level of
    liability for NRSROs.
        I thank you and the subcommittee for the opportunity to
    testify today, and I look forward to any questions.
        [The prepared statement of Mr. Nadler can be found on page
    70 of the appendix.]
        Chairman Sherman. Thank you for disrupting the oligopoly.
        And I now want to move on to Robert Rhee, a professor at
    the University of Florida Law School.

     STATEMENT OF ROBERT J. RHEE, PROFESSOR, UNIVERSITY OF FLORIDA
                               LAW SCHOOL

        Mr. Rhee. My name is Robert Rhee, and I am here at your
    invitation to testify as a witness. I thank the subcommittee
    for the opportunity to be heard.
        Reform of the credit rating industry is an important
    subject of Congress' attention. Rating agencies are important
    market institutions and gatekeepers. The perceived problems of
    rating agencies have long percolated. Critics have argued that
    they have long underperformed with little accountability.
        The proper functioning of rating agencies is not only a
    matter of markets and money; it is a matter of national
    security. Economic stability is a matter of national security.
    No country is immune to instability in the credit market.
        Also, due to many factors, including the COVID-19 pandemic,
    countries are more brittle and vulnerable than before. We can
    ill-afford another financial crisis.
        The importance of rating agencies is underscored by the
    fact that they pose a deep problem on public policy. A survey
    of scholarly literature shows a strong line of thought about
    the nature of the problem.
        First, many commentators have identified the issuer pay
    model. Second, many commentators have identified the industry
    concentration. These factors compound to produce bad outcomes.
        The rating industry is not competitive, and the incentives
    are poor. The goal, the policy goal, should be to elicit a race
    to the top, which means a competition for the most accurate
    bias-free ratings. Competitiveness depends on the right
    incentives. The incentives currently are not robust.
        In the staff memorandum, five draft bills were identified
    for discussion today. I believe that each of these proposed
    bills has merit and good purpose. I will comment briefly on
    each.
        The Commercial Credit Rating Reform Act mandates a lottery
    system of engagement, with consideration given to certain
    merit-based factors. This proposed bill has much merit. It
    represents a sharp move away from the problematic issuer pay
    model, and reduces poor incentives.
        The Uniform Treatment of NRSROs Act permits the Federal
    Reserve to not use credit ratings if they are unreliable, or
    not in the public interest. This exception recognizes that
    ordinary credit analysis may not be relevant in transitory
    periods of high uncertainty or exogenous shock, where ordinary
    market values and information signals may not be reliable. The
    Federal Reserve should have the ultimate discretion to use or
    not use credit ratings based on the public interest.
        The Transparency and Accountability of NRSROs Act would
    prohibit the current SEC practice of shielding the identity of
    noncomplying firms. This bill would impose no regulatory cost
    on the industry. Because the number of credit ratings is an
    independent factor, meaning that deficiencies of individual
    firms would not affect the demand for credit ratings, the
    regulatory and economic effect on the industry would be nil.
        The Restoring NRSRO Accountability Act would nullify a no-
    action letter issued by the SEC that shields rating agencies
    from Section 11 liability under the Securities Act of 1933.
    Despite a clear mandate in the Dodd-Frank Act, the SEC provided
    in no-action letters permitting the deemed exclusion of credit
    ratings from registration statements. While the issue of
    enhanced liability is complex, I believe that exposure to
    Section 11 liability would result in the expenditure of greater
    care and due diligence by the ratings agencies.
        Lastly, the Accurate Climate Risk Information Act requires
    disclosure of climate risk. A disclosure approach is
    compelling. Rating agencies should consider climate risk, or
    explain to regulators and the public why they believe climate
    risk is immaterial to credit risk. Ultimately, a climate risk
    disclosure may influence the efficient allocation of capital in
    the capital markets in an era of climate change.
        So, in summary, past reform of the credit rating industry
    has been incomplete. The five proposed bills contemplated by
    the subcommittee advance the goal towards a more complete
    reform of the credit rating industry.
        Thank you for the opportunity to be heard, and for your
    attention.
        [The prepared statement of Professor Rhee can be found on
    page 76 of the appendix.
        Chairman Sherman. Thank you.
        And now, our final witness, Michael Bright.

     STATEMENT OF MICHAEL R. BRIGHT, CHIEF EXECUTIVE OFFICER, THE
                  STRUCTURED FINANCE ASSOCIATION (SFA)

        Mr. Bright. Chairman Sherman, Ranking Member Huizenga, and
    members of the subcommittee, my name is Michael Bright, and I
    am the CEO of the Structured Finance Association, or SFA. On
    behalf of the member companies of SFA, I thank you for inviting
    me to testify today.
        The Structured Finance Association is a consensus-driven
    trade association with over 370 institutional members. We
    represent the entire value chain of the securitization market
    from loan origination to secondary market trading. This market
    provides over $15 trillion of capital to consumers and
    businesses. Our members facilitate credit and capital
    information across a wide breadth of asset classes, such as
    auto loans, mortgage loans, student loans, commercial real
    estate, and business loans. Our members include issuers and
    investors, rating agencies, data and analytical firms, law
    firms, servicers, accounting firms, and trustees, among others.
    Our investor members are fiduciaries to their clients.
        Before we take any advocacy position, our governance
    requires us to achieve consensus by agreement rather than a
    simple majority vote, ensuring that the perspectives of all of
    our diverse membership are included in our policy views. As a
    trade association, we also take a leading role in helping to
    craft best practices across the institutions and asset classes
    that we represent.
        Turning to the NRSRO process itself, some of the discussion
    drafts provided to us in conjunction with today's hearing would
    possibly represent a sea change in how our capital markets
    operate. It will take some time for our members to analyze
    these discussion draft provisions, and we are happy to convene
    our issuer and investor members to discuss them further. As
    always, we will do so in a methodical and dispassionate way.
        Importantly, our members believe that it is straightforward
    to understand and conclude that the issuer pay model creates a
    potential for conflicts of interest. When assessing what rating
    agency to engage, our members know that issuers consider a
    variety of factors. These include the rating agency's criteria
    and historical performance, the historical volatility of the
    rating agency's ratings, and investor demand for the rating,
    among others.
        Our members also appreciate the comprehensive changes to
    the oversight regime for NRSROs that have been adopted since
    the financial crisis. We hope that the focus for regulators can
    be to continue to build upon the transparency and the controls
    put into place over the past decade.
        In response to the SEC's FIMSAC discussion papers last
    year, our members ruminated at length over the pros and cons of
    alternative compensation schemes for new issue securities. We
    discussed an investor subscription model and an assignment
    model. In both cases, issuers and investors both found that
    those alternative models presented new potential conflicts of
    interest while not materially improving the credit rating
    process overall.
        Nevertheless, SFA members welcome continued dialog to
    consider additional means that could further strengthen
    disclosure practices so that investors can be armed with all of
    the information needed to make informed investment decisions on
    behalf of their customers.
        For example, investors are always receptive to additional
    information for issuers on how and why they selected a
    particular NRSRO. An area where SFA is also working closely
    with our issuers, investors, and rating agencies is around ESG
    disclosure for our markets, sometimes called sustainable
    investing, or impact investing. We have seen a major influx of
    retail investor demand for products that can be labeled with
    these terms.
        Our primary concern at the moment is that the markets must
    keep up with the demand without degrading standards. To that
    end, SFA is working hard to build best practices for
    disclosures and reporting that can be used by the
    securitization markets. We very much look forward to working
    with this committee on these issues in the years to come.
        In conclusion, it is important to make abundantly clear
    that the members of the Structured Finance Association are
    committed to being part of the healthy progression of our
    markets and their regulatory infrastructure. We aim to provide
    responsible lending and investment opportunities for all
    American communities, households, and businesses.
        We are absolutely determined to bring more gender and
    racial diversity to the decision-making corridors of our
    industry, as we see this as essential to the functioning and
    continued evolution of our markets and of our economy. And we
    support all efforts to debate and discuss ways to enhance the
    regulation and transparency of our industry and the markets it
    serves.
        Our members take seriously the role that they play in the
    American as well as the global economy. We know that the
    decisions we make, models we employ, and controls we build have
    a direct and meaningful impact on the lives of millions of
    people.
        For those reasons, I thank you, again, for the opportunity
    to discuss this important issue with you today, and I look
    forward to answering any questions you may have.
        [The prepared statement of Mr. Bright can be found on page
    38 of the appendix.]
        Chairman Sherman. Thank you.
        Without objection, we will enter into the record a letter
    from Better Markets in support of a system in which there would
    be a panel of bond rating agencies and the SEC would select
    which one is applicable.
        Without objection, it is so ordered.
        I will now recognize myself for 5 minutes for questions.
        We are told by those who want no reform at all that the
    answer is simple: Just ignore the bond rating. That begs the
    question why we as a society are paying $14 billion for ratings
    we are not supposed to rely on, but it also is incredibly
    unfair to the individual investor. If you have $50,000 to
    invest, how are you supposed to select which bonds to invest in
    if you can't rely on the bond rating? Are you really supposed
    to go out and visit the company?
        Likewise, if you are trying to choose which bond fund to
    invest in, and both of them average a AA rating on their
    portfolio, and one yields 2.1 and one yields 2.2, on what basis
    would you not just invest in the one with the higher yield and
    the same rating? Are you really supposed to review the 400 or
    500 portfolio holdings of each bond fund, and decide on your
    own the appropriate rating of each one of those bonds? The fact
    is, we need bond rating agencies and we need reliable ones.
        I agree with the ranking member when he says that when
    people screw up, there should be ramifications. And I want to,
    again, point out that the Financial Crisis Inquiry Commission,
    established by Congress to look at the greatest economic
    disaster in our history, the history of those of us born after
    1933, found that the rating agencies inflated mortgage-backed
    securities and other asset-based securities, and that this was
    a primary cause of the 2008 financial crisis.
        All I can say is that the system we have now would be for
    baseball as if the home team selected the umpire, and each
    umpire was paid $1 million per game. Under such circumstances,
    every time Clayton Kershaw pitched the ball, it would be a
    strike.
        Now, Congress tried, in Dodd-Frank, to require the bond
    rating agencies to accept some liability. I have a proposal
    that actually is less severe in terms of the liability, in that
    it would apply liability only if there was a showing of gross
    negligence.
        Mr. Nadler, if, for you to do business, you had to accept
    that you would be sued if there was a showing of gross
    negligence, would you stay in business, or would you go on
    strike the way the bond rating agencies did in 2010?
        Mr. Nadler. I would have to look at that more carefully. I
    think that the point you are making is that there needs to be
    consequences for bad behavior. And as I outlined in my written
    comments, and I tried to talk about in my opening statement,
    for us, it looks as though the framework that Dodd-Frank has
    set up, added, in conjunction with the 1933 Act, the 1934 Act,
    and the 1940 Act, are sufficient to create an environment where
    rating agencies are encouraged and could realize that there are
    penalties--
        Chairman Sherman. I'm sorry. Thank you for your answer. I
    am going to try and squeeze in one more question.
        Mr. Linnell, this is an easier question, because it won't
    cost you a penny or subject you to any liability. Right now,
    for one of the rating agencies, the biggest, their fifth-best
    rating is an A+. For another one, the fourth-best rating is
    Aa3. Now, if my kids come home from school with, ``A13 omega
    epsilon,'' I am not going to know what it is, even though the
    educators might know.
        Do you see any harm--or what harm do you see if every
    credit rating agency gave an A+ to the best, and then an A, and
    an A-, and a B+, so that the ratings could be understood by
    somebody who is a parent, not somebody who apparently works on
    Wall Street?
        Mr. Linnell. I think there are probably a few answers to
    that, but the main one is our credit ratings are meant for
    professional investors. They are not met for the retail level
    with a man or woman on the street. And the professional
    investor pretty much understands the ratings definitions and
    the rating scales that we provide because we--
        Chairman Sherman. My time has expired. I will simply say
    that as an investor, I am paying you the $14 billion, and I
    deserve something I can understand.
        I will now recognize the gentleman from Michigan, the
    ranking member, Mr. Huizenga.
        Mr. Huizenga. Thanks, Mr. Chairman.
        Mr. Linnell, Mr. Nadler, I think you are the only two
    practitioners on the panel who actually operate a rating
    agency. I am curious, what is your price?
        Mr. Linnell. Did you say, what is your price?
        Mr. Huizenga. Yes. What is your price, because it has been
    implied that for $1 million, a rating agency will pass and put
    a good rating on, much like if you paid the umpire $1 million,
    they would throw a game? So, I am just curious if you are for
    sale?
        Mr. Linnell. If I may take the first stab at that--
        Mr. Huizenga. It can be a short stab. It can be a yes or a
    no. Are you going to throw your ratings based on what you get
    paid?
        Mr. Linnell. There is no price you can pay that is high
    enough to compromise the quality and the reputation of those in
    the ratings agencies.
        Mr. Huizenga. Okay. How about Mr. Nadler with Kroll?
        Mr. Nadler. I have the exact same answer. And I would add
    one thing, which is that if the games were televised, people
    would very quickly stop watching them.
        Mr. Huizenga. Okay. I think you are right.
        Mr. Nadler, I would like to stick with you, because I think
    in your written testimony--and I am summarizing it here, but I
    just want you to expound on it maybe a little bit. You are
    saying that some sort of rotational system, which you, I
    believe, as the fifth-largest, but a bit smaller than the
    others, would actually help your business. But what I heard is
    that it wouldn't necessarily help your profession, is that
    correct?
        Mr. Nadler. I think that is right. I think that competition
    has been one of the driving force for better transparency,
    better research, and I can talk about a number of areas where
    we have led the industry toward better research through being a
    viable competitor.
        Mr. Huizenga. Great. Thank you.
        And, by the way, I am happy to hear that you are not for
    sale and you are not going to throw your ratings, no matter
    what that price tag is, because that is certainly what has been
    discussed. And if that is the case, in my mind, that is illegal
    and it should be punished.
        I want to move on.
        Mr. Bright, you have been involved on all sides of the
    market for a number of years, and I am curious, there has been
    lots of discussion about 2008 and the crash, and the effects in
    2009 and into 2010. So very, very briefly, what has changed
    between 2008 and today?
        Mr. Bright. An understanding that the underlying asset
    prices can go down. That was probably the number-one mistake
    made by everyone, bank regulators to securities regulators,
    prior to 2008. I think we have better knowledgeable
    assumptions, coupled with a lot of changes in regulation and
    the passage of time.
        Mr. Huizenga. Okay. And do you believe that investors have
    an adequate voice in these discussions?
        Mr. Bright. We try to make sure they do.
        Mr. Huizenga. What do you hear from your members who buy
    bonds daily?
        Mr. Bright. I would definitely say that they will tell you
    that they have a very good dialogue with both the issuers and
    the rating agencies. I think the rating agencies almost see the
    investor as their customer quite a bit, so they subject
    themselves to as many qualitative questions as they can answer
    from them.
        Mr. Huizenga. And do you believe that fixed income markets
    are working efficiently? And do they believe in the integrity
    and resiliency of the ratings?
        Mr. Bright. Certainly, substantially more so now. A lot of
    fixed income investments in the United States are currently
    purchased by the Fed, but a lot has changed in the last 10
    years, for sure.
        Mr. Huizenga. Okay. Mr. Linnell, as former Democrat SEC
    Commissioner Roel Campos stated regarding the potential system
    of new government-supervised ratings, ``Such a system would not
    necessarily be preferable to dealing with the existing CRA
    conflicts of interests through today's careful supervision by
    the SEC where investors pay for ratings that affect their
    portfolio values.''
        How would a government entity assess the performance of
    credit ratings?
        Mr. Linnell. I feel that is a perennial challenge for any
    policymaker or regulator, given the very nature of credit
    ratings being opinions. But the way that the market has
    traditionally gotten around that is by looking at the level of
    transparency that agencies give around the performance of their
    credit ratings over a period of time.
        So, you will see now that there is substantially additional
    disclosure, at a very granular level, around the performance of
    credit ratings, default statistics, migration statistics, a
    huge amount of information that is available, and most of it is
    freely available on websites. So, transparency and disclosure
    around performance is the typical way that the market assesses
    the relative performance of rating agencies.
        Chairman Sherman. The gentleman's time has expired.
        The gentleman from Illinois, who is also the Chair of our
    Artificial Intelligence Task Force, Mr. Foster, is now
    recognized for 5 minutes.
        Mr. Foster. Thank you, Mr. Chairman, and thank you for your
    attention to this important subject, which is one of the
    unfinished items left over from Dodd-Frank.
        First, could anyone explain to me what the downside of
    standardizing the three-letter ratings would be, and
    potentially associating e-trading with a range of default
    probabilities under industry-standard stress scenarios? Why is
    that a bad idea? How would that hurt things?
        Mr. Nadler. I believe the standardization, in and of
    itself, won't change anything, and I don't see anything
    particularly wrong with standardization. I think that the
    rating agencies do a good job of putting information and
    descriptions around each of the ratings that talk about default
    frequency assigned to certain ratings. But I think that is
    already part of the system. But from standardization, I don't
    see--I think it would be something that would be benign for the
    industry.
        Mr. Foster. And what about assigning default probabilities
    under industry-standard stress scenarios so you can actually
    hold up after a crisis has occurred, compare the prediction
    with what actually happened in terms of the observed default
    rates following a crisis?
        It is my understanding that that was done in the past, I
    think prior to maybe the mid-1990s, or something like that.
    There used to be default probabilities associated with ratings,
    and somehow that doesn't seem to happen anymore, and I was
    wondering why returning to that, --as well as standardization,
    might be a bad idea?
        Mr. Linnell. If I may add, rating agencies do publish quite
    comprehensive probability of default (PD) data, default data
    associated with each of its ratings and ratings categories, but
    the agencies don't define those ratings according to those PDs.
    And the reason why you don't define them according to a
    specific PD set is because you are trying to look through
    economic cycles, and obviously, default rates will change with
    recycles and that the ratings become part volatile you will
    exacerbate procyclicality. But many users do indeed find the PD
    rates associated with a given rating level as being very useful
    in their decision-making process, and that is why the rating
    agencies provide them in a very granular and detailed way. As I
    said before, it is freely available.
        So, to a large extent, investors are getting the best of
    both worlds. They are getting the qualitative rating scale that
    the credit rating agency scale traditionally provides as well
    as the transparency and inside performance on a PD basis.
        Mr. Foster. That is interesting. I was unaware that you
    could actually predict what the default rate was going to be
    based on--if you have some portfolio bonds that you could
    actually go and look at the three letter ratings and say,
    therefore, it should hold up this well under this scenario for
    an economic downturn.
        I think at the end of this, the ultimate answer may be to
    publish the models and predict how individual classes of bonds
    with a certain rating might perform under certain well-defined
    stress scenarios, very much the way big banks go through a
    variety of stress tests, and they make sure that their overall
    capitalization is robust against a variety of stress scenarios
    that is providing that sort of information to users, and
    potentially just letting them run an app that looks at their
    bond portfolios, run the models provided by the industry,
    should ultimately allow them to know whatever portfolio they
    are holding, how you guys predict it should hold up. And then,
    if they see a big difference, actually be able to have
    something to discuss after that.
        What are the possibilities that people have discussed for
    putting some skin in the game, for example, by requiring rating
    agencies to simply carry insurance against the possibility that
    their ratings turn out to be so not good? The insurance payout,
    for example, would be going to the investors that have been
    harmed by bad ratings. It seems to me that would provide--
    whoever provided that insurance with a really well-motivated,
    independent look at the accuracy of your ratings, and their
    best guess as to how accurate they are. Are there mechanisms
    like that that have been proposed to make sure that there is
    really an independent set of eyes, and give a profit motive to
    finding mistakes that your industry is making?
        Any observations of all of the different mechanisms of
    people to--
        Mr. Linnell. Yes, if I may, I would say that the ultimate
    sanction on poor performance of ratings from a rating agency is
    that that rating agency would or should be fairly quickly out
    of business. The only asset a rating agency has is its
    reputation for the quality of the ratings it provides and its
    associated and supporting analytics.
        In terms of any punitive regime, as I mentioned before, we
    are very heavily-regulated now in nearly every single country
    that we operate in and all of those regulators--
        Chairman Sherman. The time has expired, and actually, more
    than expired. I hate to cut you off, but you can add to the
    record with the rest of your answer.
        The gentlewoman from Missouri, Mrs. Wagner, is recognized
    for 5 minutes.
        Mrs. Wagner. Thank you, Mr. Chairman.
        One of the factors that led to the 2008 financial crisis
    was investors' overreliance on credit ratings to evaluate the
    risk of structured finance products. However, credit rating
    agencies are just one of many, many causes of the financial
    crisis. Between 2008 and 2009, the 3 largest rating agencies
    undertook a number of steps to reform the ratings process,
    including reviews of originator due diligence, improved ratings
    methodologies, and increased disclosures to investors regarding
    their ratings.
        In 2010, with the passage of Dodd-Frank, these nationally
    recognized statistical rating organizations, or NRSROs, were
    hit with new requirements aimed at enhancing their disclosures
    and transparency. Unfortunately, this blanket approach to
    annual reporting requirements mandated under Section 932 of
    Dodd-Frank placed unnecessary burdens and compliance costs on
    small credit rating agencies that were in no way responsible
    for the financial crisis.
        After the Office of Credit Ratings was created in 2012, and
    the new requirements went into place, smaller credit rating
    agencies have been prevented from entering the marketplace, and
    providing necessary competition. Contrary to what some may
    think, more regulation does not solve everything. That is why
    this week I have reintroduced the Risk-Based Credit Examination
    Act, with Congressman Foster, and this bill makes the criteria
    required for annual reporting by the NRSROs just that: risk-
    based.
        A move to a risk-based model will alleviate the burden on
    small credit rating agencies while continuing to maintain
    oversight and transparency over the industry. The marketplace
    needs this fix.
        Former SEC Chair Mary Jo White has spoken in support of the
    SEC moving to a risk-based approach. Likewise, former SEC
    Commissioner Gallagher has also previously highlighted how
    burdensome the Dodd-Frank regulatory requirements will be. And
    as a result, smaller credit rating agencies have to devote more
    resources to compliance than the largest credit rating
    agencies.
        I want to be clear: This bill does not eliminate reporting
    requirements for credit rating agencies. Instead it simply
    makes the criteria required in annual reports risk-based.
    Credit rating agencies will still be held accountable while
    allowing real competition in the market.
        I want to thank Congressman Foster for his support of this
    issue since, frankly, the 114th Congress.
        Mr. Linnell, in my limited time, will you describe the
    environment in the rating industry since the 2008 financial
    crisis? Is it more competitive or less competitive?
        Mr. Linnell. Simply put, more competitive, and before the
    financial crisis, Fitch was the biggest and most traditional
    competitor to what was really seen by many participants as the
    duopoly of S&P and Moody's. And Fitch has grown substantially
    since 1997 through a series of mergers, acquisitions, and
    substantial organic investment.
        So, we were the main competitor in the market, but since
    then, we have seen the growth of other agencies. And, in fact,
    until recently, there were six very active rating agencies in
    the structured finance space, for example. So six recently,
    because we are now down to five following the merger of DBRS
    and Morningstar, but Kroll and DBRS are now taking a 20-percent
    market share. It is a very competitive market.
        Mrs. Wagner. Thank you, Mr. Linnell.
        Mr. Bright, in 2011, the SEC approved more than 500 pages
    of proposed rules to implement the provisions in Dodd-Frank for
    NRSROs. The proposed rules required NRSROs to have effective
    internal governance mechanisms related to how the NRSRO
    determined the credit ratings and to provide annual reports to
    the SEC.
        Since then, can you describe the performance of credit
    ratings?
        Mr. Bright. Especially looking at the recent COVID crisis,
    the volatility of them has substantially decreased, since these
    initiatives have taken place.
        Mrs. Wagner. Have they improved since--
        Mr. Bright. That would be the way I would define
    improvement, yes, is that they are more reliable, especially in
    the face of a major economic event such as the COVID-19 crisis.
        Mrs. Wagner. My time has expired. Mr. Chairman, I yield
    back. And I thank the witnesses.
        Chairman Sherman. Thank you.
        I now recognize the Vice Chair of the subcommittee, Mr.
    Casten, for 5 minutes.
        Mr. Casten. Thank you, Mr. Chairman. And thank you to all
    of our witnesses.
        I want to talk a little bit about climate risk. I have been
    spending a lot of time thinking about the risks to our
    financial system that climate poses. And I want to start, if I
    could, with you, Mr. Nadler, because you mentioned that in your
    written testimony. And I want to be clear. I don't know the
    answer to any of the questions I am about to ask, and I
    recognize that you all are focused on the dead end of the
    financial system. We have a lot of other moving pieces. But I
    would like to understand to what degree the private sector is
    already doing calculations we don't need to repeat and to what
    degree there may be some gaps, so that is sort of the spirit of
    the question.
        Mr. Nadler, in your written testimony, you said, ``I would
    like to provide some views on climate risk and credit ratings.
    KBRA fully incorporates ESG risks.'' I just want to understand,
    do you evaluate climate risks in your products independent of
    ESG or is it only as a subset of ESG?
        Mr. Nadler. We evaluate anything, including climate risk,
    that impacts the credit rating. We include that in the analysis
    of the credit rating. We also are working with issuers across-
    the-board, financial institutions, structured finance credit
    rating, to begin to include more disclosure around ESG risk,
    including all ESG risk--climate change, social risk, governance
    risk--that may not impact the credit today, but could have an
    impact on the credit in the future or could impact the market
    liquidity of the bonds in the future.
        So we are looking at both, including factors that directly
    affect the credit, but also working with issuers to include
    more disclosure across--more around ESG.
        Mr. Casten. Okay. And I want to separate from ESG, because
    with ESG, you might be improving on, ``E,'' but are worse on,
    ``S,'' and now you have a complication of how you score it. So
    looking just at climate risk, do you differentiate between
    transition risks and physical risks? In other words, you are
    exposed to flooding, which is one set of risks, and you are
    exposed to loss of market to cleaner technologies, which is
    another risk. Do you differentiate between those in your
    analysis?
        Mr. Nadler. We do.
        Mr. Casten. Mr. Linnell, do you include climate risk, and
    do you differentiate between transition and physical?
        Mr. Linnell. We don't--the focus of our analysis is, do the
    ESG factors affect the full pay of the future risk of the
    company? And if we think it is a credit issue, then it is
    incorporated into the analysis. This is obviously a very fast-
    moving space. We actually assign what we call ESG relevant
    scores, from a scale of 1 where--
        Mr. Casten. I'm sorry, because I just want to stay on
    topic. I just want to focus on climate, not ESG. In other
    words--
        Mr. Linnell. Okay.
        Mr. Casten. --there are parts of the country that are at
    physical risk of climate that we know where those are. And I am
    just asking, do you include that in your analysis?
        Mr. Linnell. Yes. And we score it between 1 and 5. Five
    means it has been a key rating driver, and one means it is
    irrelevant.
        Mr. Casten. Okay. So back to Mr. Nadler, if you are
    including those physical risks, leaving aside the transitional,
    are there geographies in the United States where you are
    downgrading in the absence of some greater insurance product at
    this point that we should be sensitive to as we think about
    capital movements around the country?
        Mr. Nadler. We haven't seen downgrades yet. What we have
    seen is that there is more attention both on the positive side,
    where we are seeing issuers that are much more interested in
    the changes that are taking place and they are putting in
    motion particular procedures or setting aside money to take
    care of that. And we are also having better conversations among
    issuers about those risks now that we incorporate them in the
    current rating.
        I do think as this climate risk becomes more
    understandable, we are going to see a divergence in ratings for
    cities, towns that are more resilient--
        Mr. Casten. I am sorry to cut you off, but we are getting
    to the end of my time. I am really not asking a judgment
    question, but we are sitting here with wildfires raging across
    the country, with huge flooding events. And are you telling me
    that knowing what we know, knowing that is coming, that we are
    not yet downgrading any of those credits or we are not yet
    requiring greater insurance? So, who bears that risk of loss
    right now? Do investors understand that in your ratings?
        Mr. Nadler. KBRA doesn't yet have a broad portfolio of
    municipal ratings, so I would defer to the rating agencies that
    have large municipal ratings throughout the country.
        Mr. Casten. Thank you. I am out of time, but I would love
    to continue the conversation.
        I yield back.
        Chairman Sherman. The gentleman from Arkansas, Mr. Hill, is
    now recognized for 5 minutes.
        Mr. Hill. I thank the chairman. I appreciate his calling
    this hearing and I know of his significant passion and work on
    this issue for improvements for many, many years. And I
    appreciate the expertise of our witnesses.
        Mr. Bright, as I look at the draft legislation that we have
    before us, explain to me some of the limitations, in your view,
    of using this rotational model to try to assign credit ratings?
        Mr. Bright. I think a dynamic that we want to harness and
    build upon--and to be clear, we do support as much additional
    transparency and governance and controls as possible, as
    feasible, to ensure that rating agencies are publishing
    criteria and any changes of criteria and selection process
    issuers are using. So, just as a baseline.
        But there is a very healthy tension that is built into a
    system of issuers having to sell their bond to an investor with
    a particular rating, and then the rating agency needing to
    explain to their investor the methodology that they used, the
    criteria that they used. And the investors very much appreciate
    that discussion and that dialogue. And it can be two-way
    feedback, which helps make sure that they are not making
    criteria too conservative, just to cover themselves, or too
    weak, just to run a business. It is more of a discussion that
    brings to bear a lot of market forces. And I think that you
    want to build upon that tension to continue to improve the
    process.
        If it was simply a selection criteria, where once you meet
    some basic minimum threshold, all of a sudden you are now in
    this rotation system, I would worry. And I know that, more
    importantly, our investors would worry that that would
    eliminate the incentive for the rating agency to work with them
    to improve the quality of the ratings and the reliability of
    their model.
        Mr. Hill. Thanks for that. That is helpful, and it makes me
    think about my work in investment banking. I have a great
    associate who worked for me, who is training at Bank of
    America, and Merrill Lynch. And in all of our experiences, one
    of those deals before they go public that was just a primary
    objective was that any true deal had to have two ratings from
    the big three agencies or the public investing community
    wouldn't take the transaction seriously.
        So, Mr. Linnell, can you speak to this? It is in addition
    to what I asked Mr. Bright. Can you specifically talk about how
    the rotational model that would only produce one rating would
    undercut that opportunity to have two independent looks at a
    particular investment for investors?
        Mr. Linnell. I think the reason why people went to two
    ratings from the big agencies is because they wanted to see
    high-quality ratings, which typically comes from those
    agencies, and they have a demonstrable track record, they have
    large coverage, and they have execution capability to give what
    the issuer and the investor requires.
        I think when we look at the proposal that is on the table,
    we continue to believe that investors are best served by
    agencies competing with each other on the quality of the work
    that they actually do, making the ratings as predictive as
    possible, having them supported by high-quality analytics and
    research, not allocated by a particular board or body. And it
    is by competing in this way that standards improve and that
    transparency improves. That way, the users of ratings
    understand how they are being determined, and what they mean.
    And it is this transparency in performance that ultimately
    eliminates ratings shopping and not allocation from the board.
        Mr. Hill. Yes. That is helpful. And I am always dubious
    about a one-size-fits-all sort of governmental solution without
    that market touch and that market competition. So, that is kind
    of where I come from on this. But there is an ongoing
    responsibility that these credit rating agencies have and
    perform in our capital market system.
        Mr. Nadler, can you discuss the important role that the
    credit rating process plays in surveilling the companies or the
    issuers that they have actually rated, so that ongoing
    surveillance responsibility?
        Mr. Nadler. One of the most important aspects of what
    rating agencies do is this ongoing surveillance. And I think
    that was one of the breakdowns in the financial crisis, was
    this feedback loop of looking at what is going on during the
    surveillance period and using that to help you with your
    primary research. So, this role in surveilling is critical .
    And I think that one of the things you worry about in an
    assigning rating regime is that rating agencies will spend less
    time and less money on this surveillance aspect.
        Mr. Hill. Thank you.
        Mr. Chairman, I appreciate the time and the witnesses'
    expertise. And I yield back.
        Chairman Sherman. Thank you.
        And I do want to clarify for the record that the
    legislative proposal before us does not prevent an issuer from
    getting a second rating from any rating agency they like.
        With that, I recognize the gentleman from Missouri, Mr.
    Cleaver, who is also the Chair of our Subcommittee on Housing,
    Community Development, and Insurance, for 5 minutes.
        Mr. Cleaver. Thank you, Mr. Chairman. And thank you for
    holding this hearing. I think it is important.
        I want to follow up on Mr. Foster's questioning because it
    intrigued me. I have been on the Housing and Insurance
    Subcommittee for almost 18 years. And he raised a question
    about insuring your ratings and what happens in terms of
    insurance, if things go as they did in 2008, that the ratings
    go awry, and we have an economic collapse. What would be wrong
    with requiring that you insure your ratings?
        Not all at once. Go ahead, please?
        Mr. Linnell. I was just going to say that credit ratings
    are essentially a prediction of the future, what is going to
    happen in 10 years, or 15 years, or 20 years. We do our best
    job to do that, make sure people understand how we have come to
    that decision, and what is supporting our analysis and the
    credit rating. But it is essentially a prediction about the
    future. So, I would probably find that insurance company to
    insure your predictions with 100-percent accuracy is going to
    be prohibitively expensive. I just don't think it would
    necessarily work from a practical perspective.
        Mr. Cleaver. Yes. I was on this committee--I probably am
    the only one in here who was here when we had the credit rating
    agencies sitting here in 2008--or actually maybe--yes, 2008,
    and everything was great. And so, we took your prediction
    literally and ended up in trouble. Plus, no insurance company
    in the world would do the insurance, as you probably know. They
    would want to have a government backstop, which wouldn't happen
    either.
        Mr. Rhee, you mentioned in your testimony that there should
    be vigorous competition for the most accurate and bias-free
    ratings, and that we have not included in any kind of
    legislation anything that would incentivize the industry to be
    a little more active, but careful. in their bias-free ratings.
    And then, you also said that it is not robust at the present
    time.
        I would like to ask you and Ms. McGarrity, what else do we
    need to do? If you could write something out for Congress to
    do, a to-do list on these credit rating agencies, what would it
    be? What is not there that we should have there?
        Mr. Rhee. The fundamental structure of the credit rating
    agency, I don't believe has really changed that much from 2008
    to now. You look at the dominance of the rating agencies, you
    look at the compensation model; they are essentially the same.
    And so, there is a question of whether or not we want to
    promote a race to the top or a race to the bottom. I think
    competition needs to be defined in terms of competition for
    what, competition for revenues or competition for the best
    quality?
        So I think, to answer your question, Congressman, I would
    like to see a competition for a link between compensation and
    performance; in other words, pay for performance. That would be
    my answer.
        Mr. Cleaver. Ms. McGarrity?
        Ms. McGarrity. From my perspective, I put forward a number
    of ideas through my written testimony. But at the heart of the
    problem, in my opinion, is the issuer pay models. So, I support
    also pay for performance and generating additional competition
    in the industry and reduce the oligopoly or the market
    segmentation that doesn't exist, the market fragmentation that
    doesn't exist, and support the smaller market players.
        Mr. Cleaver. I had to get into it, Mr. Chairman. My time is
    running out, so I will yield back the balance of my time.
        Chairman Sherman. Thank you.
        The Chair now recognizes the gentleman from Texas, Mr.
    Taylor.
        Mr. Taylor. Thank you, Mr. Chairman. I think this is an
    important topic. And I appreciate the opportunity to visit it.
    I think we should visit it more often.
        I guess I will start with a comment that ratings are
    important, but it is imperfect. I think that two different
    people, very bright, capable people can look at the exact same
    data set and come to different conclusions. And so, analytics
    is ultimately imperfect because it is human. I think we should
    begin with that.
        I guess where I grow concerned is when the analytics become
    groupthink. And I will go back to the commercial mortgage-
    backed securities (CMBS) industry, something I am familiar
    with, where you looked at the subordination levels so the AAA
    piece got bigger and bigger and bigger going into 2008. And
    that allowed for more aggressive pricing of loan products to
    the borrowers and higher leverage levels, the underwriting was
    weakened, and then you came into a crisis in 2008.
        One thing, as I was going through the written testimony for
    Mr. Nadler, you said, ``a false narrative regarding ratings
    inflation and competition, incomplete data, and poor
    reporting.'' Could you clarify for me what you mean by that?
    Because I certainly, in my business experience, have seen
    groupthink. And I think what we saw with CMBS and other
    products was you just saw subordination levels declining, so
    the rating agencies basically fell down on the job.
        Mr. Nadler. What I was referring to was an article that was
    written about pre-crisis and post-crisis, and the narrative of
    the article was that rating agencies post-crisis competition
    had created rating inflation. And it was specifically talking
    about the commercial mortgage-backed securities market and the
    part of the market where they put together a group of
    commercial loans. And, in fact, the data doesn't support that.
        But before the crisis, there were ostensibly three rating
    agencies, and the average BBB credit enhancement level or what
    you would call the BBB risk assignment or default probability
    was about 3.5 to 4 percent.
        Post-crisis, when there were six rating agencies--now there
    are five--that number doubled, and leverage in the industry has
    gone down. The same is true of the BBB tranche during the pre-
    crisis when there were fewer rating agencies, from today, today
    it is about double what it was post-crisis.
        Mr. Taylor. Okay. I think I understand.
        Mr. Nadler. It is hard for me to understand how they made--
        Mr. Taylor. I understand where you are going. And I guess I
    would again iterate that it isn't so much that you are going to
    be imperfect in your ratings, and I get that. No one is perfect
    in their ratings because it is ultimately a human endeavor.
        My concern is when there is groupthink and you watch
    subordination levels decline, and then you set up investors to
    go into a product that is not correctly structured, and then
    your pricing goes wrong.
        And I will make this comment. The real estate crises of the
    1980s and in 2008 were both presaged by overlending and
    overborrowing. And at some level, the poor rating efforts led
    to the overlending, because the lower subordination levels
    allowed for lower pricing and weaker underwriting. And the
    underwriting agencies, on some level--I am looking to you to
    tell me, yes, these guys were underwriting less effectively. I
    don't know if you want to defend yourselves on that point. But
    that was my experience of what I saw in the markets leading up
    to the crisis in 2008.
        Mr. Linnell. May I add one or two comments on these points?
        Mr. Taylor. Sure.
        Mr. Linnell. I will just say that there is always a danger
    of groupthink. And that is why I think efforts to harmonize too
    much between criteria and rating agency scales and so on could
    actually increase systemic risk in the financial system. But
    there are actually significant differences between rating
    agencies, sometimes to aggregate its statistics to go and show
    a different story. But going into the financial crisis, for
    example, we were actually tightening the amount of credit
    enhancement that was required in the U.S. residential-backed
    securities. We weren't active in the structured investment
    vehicle market because we wouldn't rate higher than single A.
    It was a AAA market, with a very small share in the CDO market,
    in synthetic CDOs, because our criteria was more conservative
    and so was our subprime RMBS--
        Mr. Taylor. I apologize. Our time--I am sorry to cut you
    off.
        Chairman Sherman. Your time has expired.
        Mr. Taylor. I yield back.
        Chairman Sherman. I now recognize Mr. Vargas for 5 minutes.
        Mr. Vargas. Thank you very much, Mr. Chairman, for holding
    this hearing. I know you have a deep interest in this. I
    appreciate it very much.
        I guess I would start with this. We had the honor of
    meeting my good friend, Mr. Huizenga's, son today. It was a
    thrill. That was very nice to meet your son today. That was
    great. He asked a question. He said, ``What has changed from
    2008 to 2010?'' And, Mr. Bright, I think you answered that you
    found out the prices and values can go down, and then something
    about Dodd-Frank also, there are some changes in there.
        I would say that--prospectively, what are the things that
    could potentially be on the horizon. I would say two. One, the
    issue of climate change in particular, and also, cybersecurity
    or cybercrime. Those are the two that really would get me. I
    would add those on.
        But I would ask this. It was interesting that my good
    friend, Mr. Casten, asked the question, are you downgrading any
    parts of the country in--geographical parts of the country with
    respect to either transitional risk or physical risks. And I
    think you all said--well, not all, but the two who are actually
    involved in the rating agency said, ``No.''
        But I looked up Fitch ratings here, from March 2021, with
    respect to Pacific Gas and Electric (PG&E). And you did
    downgrade PG&E in the Bay Area because of the wildfires, the
    catastrophic wildfires. And they filed Chapter 11, as you know,
    back in--what was it--2019, because of the potential liability.
    And I would associate those wildfires with climate change,
    climate risk.
        So that being said, maybe you haven't downgraded
    geographical areas, but I think you certainly have taken a look
    at companies. Is that not the case, Mr. Linnell?
        Mr. Linnell. Yes. I actually did say that we assessed
    environmental, social, and governance (ESG) factors that
    specifically reflect and affect credit risk in companies. And
    we actually score them, where 1 is, it is irrelevant and 5 is,
    it has been a key rating driver. And we have changed many
    ratings as a result of companies being given a 5 in the
    environmental issues.
        But, actually, when you look at the whole ESG spectrum,
    social issues and poor governance are typically more
    significant rating factors that you see often than
    environmental factors. So, all three of those issues are
    important when you are looking at credit risk.
        Mr. Vargas. I am glad you said that, because I had a bill
    that we passed out of here that dealt exactly with ESG. Next
    time, we will remember to add you onto the list of those
    witnesses. So, thank you for testifying. I appreciate it. I
    will remember you, of course. And thank you for your bravery of
    being here. I guess the other ones chickened out.
        I would ask this then: How should we incorporate ESG?
        Mr. Bright, I saw here that you write almost entirely about
    investors demanding this, that we do ESG. It is not really
    driven by politics, or you call it regulatory fiat. I would say
    that there are some of us who are very interested in this. So,
    how would you incorporate it? Because I think it is one of the
    issues that we are going to have to face. And dramatically, if
    you take a look at PG&E, how it was downgraded, I think
    appropriately so, because there is this risk of wildfire that
    is associated--I don't care what anybody says--it is associated
    with climate change. We do have climate change and it is
    dangerous.
        Go ahead?
        Mr. Bright. Really quickly, for this committee, something
    you can do is have FEMA update the National Flood Insurancec
    Program (NFIP) maps, which is something that really keeps
    getting punted. So, since I never miss an opportunity to upset
    the REALTORS, I figured I would mention that while I was here
    today.
        Mr. Vargas. Fair enough.
        Mr. Bright. But the ESG work that we are doing, and I think
    the point that I was making is that younger investors have this
    insatiable demand for sustainable certified asset investments.
    And I think that is a really great thing.
        Mr. Vargas. Me, too.
        Mr. Bright. Absolutely. The concern that we have is that it
    is almost so big that it sounds comical. You look at numbers
    like $74 trillion of U.S. domiciled assets are labeled as
    sustainable, and that just seems completely bogus. It can't be.
        So what I am worried about is that these things degrade so
    much and people are putting stamps on something that aren't
    actually meaningful, and then investors become cynical and we
    lose this opportunity to certify it. So, there is a regulatory
    role, a legislative role, and a market role, in my opinion.
        Mr. Vargas. My time is almost over, so I just have to
    reclaim it. I would agree with everything you said, with the
    exception that potentially, it is not comical. If you take a
    look at what happened in Germany, if you take a look at what is
    happening out in the West, it is real, and it is big, and it is
    dangerous, and the numbers are gigantic.
        Again, I thank you very much for being here.
        My time has expired. I yield back. Thank you.
        Chairman Sherman. Thank you.
        I now recognize the very patient gentleman from Wisconsin,
    Mr. Steil.
        Mr. Steil. Thank you very much, Mr. Chairman.
        Just to follow up, if I can, Mr. Linnell, really quickly to
    my previous colleague's comments discussing what is in and what
    is out of the ratings analysis, do you have a materiality
    standard for what you include and what you don't include in
    those ratings?
        Mr. Linnell. In terms of the, ``E,'' or just in the credit
    ratings in general?
        Mr. Steil. Just in your credit ratings in general, as you
    look at things that you are considering inside that radius, the
    materiality threshold for you.
        Mr. Linnell. Yes. That is entirely the matter of the credit
    committee, and the credit committee is composed of--
        Mr. Steil. For sure. I am not trying to get deeper into the
    weeds, but there is a materiality threshold as you look at some
    of these factors in your--it is just, I think, a relevant point
    for this committee to always keep in mind the importance of
    materiality.
        I am going to continue on, because I have limited time, but
    I will stick with you, if I can, Mr. Linnell.
        In your testimony, you outline some of the changes made to
    the ratings industry after 2008 that have improved the
    reliability of those ratings. And last year, those reforms were
    really tested as our economy experienced a severe contraction
    due to the global pandemic. The circumstances were obviously
    very different than the previous recession, but the NRSROs were
    also on probably a more solid footing. And the SEC noted in a
    July 2020 statement by their COVID-19 working group that, ``In
    addition to substantially different economic conditions and
    stresses, the relevant analytical assumptions and methodologies
    used by rating agencies in that period were also substantially
    different.''
        Could you highlight what changes had the biggest impact on
    your firm's performance through 2020?
        Mr. Linnell. I think, post-Dodd-Frank, there was a huge
    amount of changes, obviously as I have mentioned before, where
    they are heavily regulated, subject to annual inspections, and
    we have 30 different regulators around the world. But Dodd-
    Frank also meant that we significantly invested in our controls
    and procedures around the rating policies, and also invested in
    procedures around managing conflicts of interest.
        And in addition to that, away from just the control
    infrastructure, we invested a lot of time and effort in really
    trying to explain to investors and to issuers what were the key
    rating drivers, what are the key rating sensitivities. So, a
    lot more effort to try and explain what were the driving risk
    factors behind credit ratings. We also made--
        Mr. Steil. Thank you. I am at risk of letting you go on for
    the whole time. I just appreciate you highlighting a few of
    those.
        Mr. Linnell. Yes.
        Mr. Steil. I am going to shift gears, if I can, to Mr.
    Bright.
        Much of today's conversations focused on the issues, the
    potential conflict of interest inherent in the selection
    process for NRSROs. We all recognize that conflicts of interest
    can be a problem, but we can hopefully also mitigate these with
    good oversight.
        How do market participants account for the potential bias
    arising from some of the conflicts of interest? Can you shed
    some light on this for us?
        Mr. Bright. Our investors, first off, have a dialogue with
    the rating agencies, and they will very gladly point out when
    they think something is wrong. And then, they vote with their
    feet and with their money. I have read some studies that show
    that certain rating agencies or certain tranches that have only
    a single rating are issued at higher yields, which is what you
    would expect if the process is not working.
        So, we want to make sure that there is as much governance
    internally but as much transparency as investors said that they
    need in order to understand why a rating agency was selected.
    They do that in a variety of ways right now. And that is what I
    would focus on.
        Mr. Steil. To shift gears on that, if you look at the
    market share for existing NRSROs, it is clear that some
    specialize in analyzing certain industries or asset classes.
    For instance, AM Best, which accounts for less than half of 1
    percent of all credit ratings, issues about 34, call it about a
    third of ratings in the insurance industry, more than S&P,
    Moody's, or Fitch. Would an assignment model, which is being
    discussed here, that really seems to ignore the specialization
    or other relevant factors, lead to a more or a less reliable
    credit rating?
        Mr. Bright. We believe strongly that it would be less
    reliable.
        Mr. Steil. Your members are the end users to some of these
    credit ratings. Are they advocating for some of these pretty
    drastic changes proposed by some of my colleagues?
        Mr. Bright. No, they are not. And many of them are members
    of the FinTech Commission which looked at this last year as
    well, and did not advocate for this.
        Mr. Steil. I appreciate your feedback.
        Cognizant of my time, Mr. Chairman, I will yield back.
        Chairman Sherman. Thank you.
        I now recognize Mr. Hollingsworth from Indiana.
        Mr. Hollingsworth. Good afternoon. I appreciate everyone
    being here.
        One of my favorite quotes about predicting the future comes
    from a famous economist, Mr. Galbraith, who said, ``There are
    two kinds of forecasters: Those who don't know and those who
    don't know they don't know.''
        I have heard a plethora of comments today characterizing
    credit rating agencies as poor forecasters. Even the most
    notable false and hyperbolic point to CRAs as the, ``primary
    cause'' of the 2008 financial crisis. These assertions
    certainly stop short of offering any meaningful alternatives
    that have proven consistently correct or at least nearer in
    their rectitude than the CRAs.
        To state that CRAs have been wrong is to compare them to
    what? We can't simply compare them against what we now know
    looking back, but instead should look for contemporaneous
    forecasts or forecasters who proved more correct in forecasting
    the future.
        Many of my colleagues across the aisle stop short of this
    because the alternative doesn't exist. So, we have proposed
    here something that has no evidence of being further correct in
    those forecasts. We have mobilized the CRA's, ``lack of
    rectitude,'' a characteristic that can also be attributed to
    Federal Government agencies, banks, economists, consultants,
    academic researchers, et cetera, and then state that lack of
    rectitude must mean that there is a latent bias that needs
    rectifying, needs correcting, a diagnosis that is surely
    incorrect. And not shockingly, we have the wrong cure.
        Specifically, I want to talk about one question that keeps
    coming up. I keep hearing from my friends across the aisle as
    though these credit rating agencies have no incentive
    whatsoever to be right in rating these particular issuances.
        Mr. Linnell and Mr. Nadler, there have been several
    accusations made today about credit rating agencies inflating
    ratings or otherwise providing incorrect credit ratings in an
    attempt to maintain consumers, or alternatively, because
    consumers are paying them more to do so. Can you describe the
    reputational risk to credit rating agencies such as yours and
    the broader market implications of intentionally distorting
    those ratings?
        Mr. Linnell, I will let you go first.
        Mr. Linnell. Again, it is simple to yield back business.
    You won't have a long-term viable future if you just simply
    inflate all of your ratings when you are in business.
        Mr. Hollingsworth. Right.
        Mr. Linnell. And that is why you can say, for us, we have
    low market share in many sectors because we have a different
    credit rating.
        Mr. Hollingsworth. Right. So, in short, it doesn't make
    sense to take a few extra dollars today if it might destroy the
    entirety of your business going forward, should investors fail
    to be able to rely on the ratings that you provide?
        Mr. Linnell. Professional investors are not stupid. They
    can see when there is rating inflation and what is happening.
    Investors want to see credible credit ratings but by a long-
    term record. And that is what we try and compete and that is
    what we try and provide.
        Mr. Hollingsworth. Mr. Nadler, any comments from you?
        Mr. Nadler. I think that is absolutely true. And I think
    using the description that Chairman Sherman started with, of
    the baseball game where the--I can go back to my statement--
    where the umpire is paid $1 million and he calls the game wrong
    and everyone knows it, nobody is going to show up for the next
    game. Nobody is going to watch. And that is the same thing that
    would happen to rating agencies. Investors would very quickly
    lose interest in seeing that rating agency on any of the issues
    that they were willing to buy or pay for.
        Mr. Hollingsworth. Exactly. This is the same incentive
    structure that many other businesses have, and you have all the
    reason in the world to not sacrifice long-term viability for
    business for a few small, short-term gains.
        And, with that, I will yield back.
        Chairman Sherman. I now recognize the very patient
    gentleman from Ohio, Mr. Gonzalez.
        Mr. Gonzalez of Ohio. Thank you, Mr. Chairman, for holding
    this hearing today. And thank you to our witnesses for your
    participation.
        While I certainly have concerns with the legislation
    attached to today's hearing, in particular the Commercial
    Credit Rating Reform Act, I think it is important that this
    committee continues to provide proper oversight of NRSROs. We
    should want a marketplace that has strong competition and
    transparency to help market participants make smarter
    investment decisions.
        I want to start with Mr. Bright. In June 2020, the SEC
    Fixed Income Market Structure Advisory Committee released
    recommendations on how to mitigate conflicts of interest in
    credit rating agencies. And I think that is important. One of
    the recommendations was to enhance issuer disclosures,
    detailing the process issuers use to select an NRSRO.
        Do you have any views on this recommendation and how there
    could be additional disclosures for issuers?
        Mr. Bright. There are a lot of disclosures. If you look at
    a deal, it is hundreds of pages of information. The problem
    with that quantity of information is that sometimes it is not
    exactly what you want. So, I think that an iterative process
    that involves investors, it involves the SEC, it involves the
    credit rating agencies about what they are going to explain to
    investors in terms of how they selected the NRSRO for a deal, I
    think that we have a lot of support from our membership on
    that. I don't have a template, but I think it is a worthy
    conversation piece for sure.
        Mr. Gonzalez of Ohio. Who is on the other side of that?
    Because it seems like an obvious answer. What is the argument
    against something like that?
        Mr. Bright. It is just researchers and time. But I don't
    think it is prohibitive of researchers and time.
        Mr. Gonzalez of Ohio. Okay. That same report discussed
    recommendations for bringing more transparency to NRSRO models
    by requiring NRSROs to disclose more in-depth information about
    their models specifically and how they differ by industry. Do
    you have a perspective on that recommendation, especially in
    the context of how NRSROs already make their methodologies
    freely and publicly available?
        Mr. Bright. Yes. At some point, it can get a little weeded.
    So, it is not a binary thing where I would say absolutely not
    or absolutely so. I do think it is important to know that
    models are not right, ever. By definition, a model is to take a
    universe of infinite variables and distill it down to the 50
    you think matter. You just want to have a conversation about
    what assumptions are going in, what empirical data you have or
    don't have for it, and what criteria you use around that in
    terms of making a decision. That is the important thing.
        Mr. Gonzalez of Ohio. Yes. It reminds me of a professor I
    had, Keith Hennessey, who used to work for President Bush. And
    he said, when people talk about their models, it sounds like
    this wonderful, deeply accurate thing. If you just translate
    that on a spreadsheet, you are starting to actually get more of
    what it is. It is just, at the end of the day, somebody's best
    set of--
        Mr. Bright. Fermilab has some good models, I would say, for
    Congressman--
        Mr. Gonzalez of Ohio. I am not saying all models are bad. I
    am just suggesting that they are made by humans and they are
    always inaccurate, although helpful in making decisions.
        In your testimony, you state that your organization found
    that alternative compensation schemes, such as the investor
    subscription model and an assignment model, presented even
    greater risks and consequences than that of the existing
    system. Can you just sort of double-click on that and go
    through that?
        Mr. Bright. Very quickly, again, the assignment model,
    degradation of quality standards, no incentive for a rating
    agency to have to sell, and explain its models and
    methodologies and criteria to the investor, that kind of goes
    away. It is just that, as I understand it, once you are in,
    that is a rotational thing.
        That said, as I mentioned in my testimony, we will discuss
    it, and we will take it and further analyze that.
        With the investor pay model, there are a lot of conflicts
    there. Right? An investor who owns a bond has a particular
    interest in how it is rated. An investor that doesn't own a
    bond but wants to purchase a bond would have a different
    interest. And so, it presents conflicts of interest that could
    be problematic as well. It is really more about, I think,
    having a robust dialogue between the rating agencies and the
    investors to make sure that the whole things works as well as
    possible.
        Mr. Gonzalez of Ohio. I appreciate that. And I tend to
    agree. And like I said, this is not a perfect system. There is
    no perfect way do this, I think, that anybody has come up with.
    But to some of the earlier points, the legislation, in
    particular the assignment model, I just, frankly, think is
    nuts.
        But, with that, I will yield back.
        Chairman Sherman. Thank you.
        We are honored with the presence of the Chair of the Full
    Committee, Chairwoman Waters, who is recognized for 5 minutes.
        Chairwoman Waters. Thank you very much. And I appreciate
    this so much, Mr. Chairman.
        Mr. Linnell, in 2011, your firm settled with CalPERS for
    providing inflated ratings for structured investment vehicles
    in the years leading up to the financial crisis. These inflated
    ratings led to a $1 billion loss for CalPERS, which managed the
    retirement savings of government employees and their families
    in my home State.
        In the decade since the crisis, does Fitch have any regrets
    about how its ratings harmed my constituents?
        Mr. Linnell?
        Is he still here?
        Mr. Linnell. I'm sorry. Are you sure it was us that rated
    the structured vehicle that you are talking about?
        Chairwoman Waters. Am I sure of what?
        Mr. Linnell. Are you sure it was Fitch?
        Chairwoman Waters. Yes. I am sure that in 2011, your firm
    settled with CalPERS. CalPERS is the California Public
    Employees' Retirement System. And that amounted to--these
    inflated ratings led to a $1 billion loss. That is why you had
    to get involved with a settlement. You don't recall this? You
    don't know anything about this?
        Mr. Linnell. I think the settlement that we made with
    CalPERS was very, very small. But the structured investment
    vehicle sector, which was very large at that moment in time
    leading to the financial crisis, was one of the areas where
    Fitch showed a much more conservative approach than S&P and
    Moody's, which dominated that space.
        Typically, our ratings would not be any higher than, ``A.''
    And the standard for that market was, ``AAA.'' So, we had a
    very small market.
        Our rating was still too high in retrospect for that
    structured vehicle that CalPERS had exposure to. Then,
    obviously, we were not happy that their ratings performed in
    that way. And if your constituents lost money as a result of
    that and then--I am sorry.
        Chairwoman Waters. Okay. I am sorry, too. But let me just
    go ahead and tell you that the Financial Crisis Inquiry
    Commission reported that in the lead-up to the financial crisis
    and the Great Recession, the machine turning out collateral
    debt obligations (CDOs) would not have worked without the stamp
    of approval given to these deals by the three leading rating
    agencies: Moody's; S&P; and Fitch. And as we painfully learned,
    these CDOs were time bombs that brought down our economy.
        So rather than saying you're sorry, which I have an
    appreciation for, what can you say about what you have learned,
    how you can prevent the kind of actions that were taken that
    caused PERS to harm all of those who were depending on
    retirement? What have you learned? And what advice do you have?
    What would you do differently? What have you done to correct
    and not be involved that way anymore?
        Mr. Linnell. I would say that a large amount of our ratings
    portfolio going into the financial crisis, including the CDO
    market, actually held up pretty well. The ratings performed
    pretty decently, given the supreme stress that the markets went
    through in the financial crisis. Our nonperformance of our
    ratings was heavily concentrated in U.S. RMBS transactions, and
    to a small extent, the small CDO portfolio and synthetic CDOs
    that we had.
        But what we learned was that our criteria needed to be more
    conservative, that we needed to make the rating process more
    robust, and we needed to be more transparent about the key
    rating drivers and sensitivities that our ratings represent.
    And we have substantially increased our levels of disclosure to
    address those issues. And if you look at the performance of our
    [inaudible] Those very same asset classes during COVID, the
    default rate of our U.S. CLOs--sorry, not default rate, but the
    downgrade rate of our U.S. CDOs is currently less than half a
    percent, despite the COVID impact being probably the biggest
    macro shock we have seen since the Second World War.
        Chairwoman Waters. Have you in any way shown your
    appreciation for the fact that we bailed you out?
        Mr. Linnell. You bailed us out? How?
        Chairwoman Waters. We bailed you out.
        Mr. Linnell. As an industry or the economy?
        When you say, ``We bailed you out,'' do you mean that you
    bailed out the economy as of--
        Chairwoman Waters. Yes.
        Mr. Linnell. --because of the massive [inaudible] COVID?
        Chairwoman Waters. Yes. That is what I mean.
        Mr. Linnell. Yes. That has been a huge credit positive. I
    wouldn't say you bailed us out, but clearly, the huge amount of
    government intervention around the world has had tremendous
    success in building a bridge between a pre-COVID world and a
    post-COVID economy. And that is a real credit factor that needs
    to be reflected in people's analytics.
        Without that, then, yes, the macroeconomic shock would have
    been much more severe, and rating downgrades and ultimately
    credit losses would have been higher. But our ratings would
    have not predicted a global pandemic.
        Chairwoman Waters. My time has expired. But I think that
    the revelations about your role and how we bailed out the
    economy, as you referred to, is something that we must always
    be aware of, take into consideration, and never get in that
    position again.
        I yield back.
        Chairman Sherman. Thank you.
        I will now recognize Mr. Mooney from Virginia.
        Mr. Mooney. Thank you, Mr. Chairman. But I'm from West
    Virginia. In 1865, we separated--
        Chairman Sherman. Congratulations on that.
        Mr. Mooney. So, bond rating agencies play an essential role
    in our financial markets. They measure the risks that influence
    investment decisions for everyone from a hedge fund to a small-
    dollar retail investor. Our focus on this subcommittee should
    be ensuring that bond rating agencies do their job by properly
    weighing those risks. I think that the general goal of better,
    more accurate credit ratings is one that both sides of the
    aisle can generally agree upon.
        So I was surprised to see the, ``Accurate Climate Risk
    Information Act,'' which was noticed for this hearing. That
    bill would direct the SEC to adopt rules dictating how bond
    rating agencies should measure climate risk.
        Mr. Linnell, if credit ratings were less reliable due to
    political interference, what would that mean for the broader
    financial sector?
        Mr. Linnell. I think any impediment on the independence and
    the integrity of credit ratings would reduce their value and
    their contribution to the financial sector. It's as simple as
    that.
        Mr. Mooney. Okay. Thank you, Mr. Linnell.
        I am very concerned about Democrats' efforts to politicize
    the credit rating process. For Democrats in Congress to make a
    top-down ruling on climate risk would have damaging effects.
    With all due respect to my colleagues across the aisle, they
    are not experts in measuring risk. Leave that to the bond
    rating agencies.
        I am also concerned about how the Democrats' climate rules
    could impact industries in my district, like coal, despite
    continued innovations in energy, like carbon capture, which
    makes using coal environmentally friendly. Democrats
    continually ostracize the coal industry, that is important to
    districts like mine across the country.
        This bill is nothing more than another attempt by Democrats
    to insert their leftist ideology into another aspect of the
    financial market. They pursued the same strategy with public
    disclosures, and now they are going after bond ratings. We
    should leave left-wing politics out of the regulation of bond
    rating agencies. Let them focus on properly weighing risk in
    our economy. Doing otherwise is unfair to investors and unfair
    to important industries in my district, like coal.
        Thank you, Mr. Chairman. And I yield back the balance of my
    time.
        Chairman Sherman. Thank you for yielding back.
        I now recognize the ranking member, Mr. Huizenga, for a 2-
    minute closing statement.
        Mr. Huizenga. Thank you, Mr. Chairman. I am glad that we
    could have this conversation again.
        Some interests my friend from California had talked about,
    how the world has changed, and I would agree. We are certainly
    financially in a different place than we at the end of 2008,
    going into 2009. And appropriately, we have tighter
    regulations. We have closer oversight by the SEC. We have seen
    the SEC and the GAO do a study that looked into various models.
    They concluded that it could create incentives that run
    contrary to the goal of ratings quality. That is why they
    issued these nonenforcement letters.
        I would kind of draw on some of my own personal experience
    from when I graduated from college with my oh-so-employable
    political science degree. Usually, political science majors
    chuckle at that, because they know exactly what I am talking
    about. I went into real estate. My family has been involved in
    construction for 3 generations, and has done real estate
    developing and building, among other things.
        And there are a lot of changes happening in that industry,
    including appraisals and how they ended up putting a rotation
    of appraisals in. It hasn't worked, because you have people who
    don't know the market, they don't know the area, they don't
    know the context and the circumstances, making decisions that
    are affecting those things. I am afraid that is exactly what
    might happen here.
        Here are a couple of things that we know have not changed.
    There are still natural disasters, but materiality still reigns
    supreme. And a rotational assignment model is still a bad idea.
        One last thing, Mr. Chairman, and it is important. I do
    have a couple of articles that I would like to submit for the
    record. But I do want to clarify that Fitch, ``settled''--and I
    use the air quotes around that for you, Mr. Linnell, because
    there was no payment to CalPERS with that settlement. There was
    no admission of guilt. It was just dropped. But that was deemed
    a, ``settlement.''
        So, with that, Mr. Chairman, without objection, I would
    like to submit the following statements for the record: A
    written statement by S&P Global Ratings, and then also a letter
    on behalf of Moody's Investors Service; the report that I had
    talked about in my opening, a report from PPI, which is the
    Progressive Policy Institute, titled, ``Credit rating agencies:
    Sending a Clear Signal''; an opinion article from former
    Democrat SEC Commissioner Roel Campos, titled, ``We Should Not
    Initiate Risky Experiments in the Credit Markets''; and
    finally, a report from the Committee on Capital Markets
    Regulation entitled, ``The Role of Credit Rating Agencies
    During COVID-19.''
        Chairman Sherman. Without objection, it is so ordered.
        And I now recognize myself for a closing statement.
        It is my intention to hold another hearing on this subject,
    just as soon as we can get Moody's and S&P to show up. And by
    show up, I don't mean just send a letter to be included in the
    record.
        I point out that while the Federal Government did not write
    a check to any of the bond rating agencies, both in 2008 and in
    2020, many hundreds of billions of dollars were invested by the
    Federal Government, thus bailing out the credit markets, and
    preventing what would have been a huge rash of downgrades that
    otherwise would have occurred and would have affected the
    reputation of the bond rating agencies.
        I strongly disagree with Mr. Linnell when he says that it
    is just fine if a rating is expressed as big A, small A, three,
    epsilon, omega, or something else equally confusing, on the
    theory that bond ratings should only be read by the
    professionals on Wall Street. If I am in a bond fund, they send
    me a list of all of the bonds they own and the ratings. If I am
    a part of a pension plan, I have a right to know how the money
    is invested and how the bonds are rated. And to say that things
    should be deliberately confusing shows a contempt for ordinary
    Americans.
        I also think that Mr. Linnell was very interesting when he
    pointed out that his rating agency is more conservative than
    his competitors in rating certain classes of dead instruments,
    and so they don't get that portion of the market. Those dead
    instruments go to his competitors. That proves that while
    perhaps the integrity of Fitch is to those particular
    instruments, it shows the bias in the system. You can get the
    liberal rating; you just can't get it from Fitch.
        As to the baseball analogies, I do not think that if the
    umpires were paid and selected by one of the teams, that
    nothing Kershaw threw would be a ball, but there is the risk
    that the strike zone would just be an inch wider. That is why
    professional baseball won't let one of the teams buy a dinner
    for an umpire. Yet we, in our capital allocation system, allow
    for the bond rating agency to be selected and paid by the
    issuer.
        There are two systems to control this. One is liability. If
    we don't need liability, why are accountants held liable or why
    are auditors held liable? They have the same level of personal
    integrity. If personal integrity is enough, then why are we
    subjecting them to lawsuits?
        The other way to do it is through selection and having a
    panel selection process similar to what we do for bankruptcy
    trustees. But to leave this in this circumstance where the
    umpire is incredibly well paid, where the umpire is selected
    and paid by one of the teams, was a disaster for our country in
    2008, and was a primary cause of a financial disaster that is
    still affecting America today in tragic ways.
        So, I look forward to another hearing. And I look forward
    to the CEOs of Moody's and S&P joining us.
        The Chair notes that some Members may have additional
    questions for these witnesses, which they may wish to submit in
    writing. Without objection, the hearing record will remain open
    for 5 legislative days for Members to submit written questions
    to these witnesses and to place their responses in the record.
    Also, without objection, Members will have 5 legislative days
    to submit extraneous materials to the Chair for inclusion in
    the record.
        And this hearing is hereby adjourned.
        [Whereupon, at 5:18 p.m., the hearing was adjourned.]

                                A P P E N D I X

                                 July 21, 2021

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