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


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

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

                             HYBRID HEARING

                               BEFORE THE

                  SUBCOMMITTEE ON INVESTOR PROTECTION,

                 ENTREPRENEURSHIP, AND CAPITAL MARKETS

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                    ONE HUNDRED SEVENTEENTH CONGRESS

                             FIRST SESSION

                               __________

                             JULY 21, 2021

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 117-42
                           
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]

                              __________

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




                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 MAXINE WATERS, California, Chairwoman

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

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

                   BRAD SHERMAN, California, Chairman

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

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

                               WITNESSES
                        Wednesday, July 21, 2021

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

                                APPENDIX

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

              Additional Material Submitted for the Record

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

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

                              ----------                              


                        Wednesday, July 21, 2021

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

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

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

       STATEMENT OF IAN LINNELL, PRESIDENT, FITCH RATINGS

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

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

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

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

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

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

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

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                             July 21, 2021
                             
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