[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
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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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