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Wednesday, April 2, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:02 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.

    Present: Representatives Ose, Shays, Oxley (ex-officio), Ney, Ryun, Capito, Hart, Tiberi, Brown-Waite, Feeney, Kanjorski, Hooley, Sherman, Inslee, Capuano, Hinojosa, Lucas, Clay, McCarthy, Baca, Matheson, Miller, Emanuel and Scott.
    Chairman BAKER. [Presiding.] I would like to call this meeting of the Subcommittee on Capital Markets to order this morning.
    We are here today to celebrate the birthday of my ranking member, Mr. Paul Kanjorski.
    And secondarily, to take up another small matter relating to the performance of our rating agencies, the regulation and oversight of those agencies by the SEC.
    The hearing today actually represents the next logical step in the committee's work and in examining all sectors in the performance of our capital markets.
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    Most recently the committee received comment concerning mutual fund performance and are awaiting the response from the SEC on matters of particular interest before our next hearing. But today, it is the issue of the nationally recognized statistical rating organization known as the NRSROs. And there are only at this moment four such organizations currently recognized in that capacity.
    It is my hope that we can examine in some detail the manner by which these organizations are designated, the adequacy of our current regulatory oversight methodologies and the basis for which such organization is either to be given approval or the methodology for revocation of such authority.
    It is also important, I think, to understand how the system works. As committee members will recall, in our examination of the analyst investment banking world, many were surprised to learn of the relationships and the revenues generated between the various parties in transactions relating to analytical opinions. It appears that the NRSROs do receive a significant amount of revenue from the parties they are assigned for public purposes to rate.
    Then there is the real issue of bottom line performance. NRSROs do have access to more information than any other market participant other than the officials or the corporation which they are examining. Shouldn't we expect as a result their performance to exceed that of any other analyst or observer of corporate conduct?
    These are all questions of great significance and concern. It has been sometime since the Congress has reviewed the NRSRO system in any detail. And it is my expectation that today's hearing will provide us with a broad scope of information, very helpful in understanding whether any further actions may be warranted or not.
    And I certainly welcome all of those who have agreed to participate here this morning.
    Mr. Birthday Boy?
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    Mr. KANJORSKI. Thank you very much, Mr. Chairman.
    Mr. Chairman, for nearly a century, rating agencies like Moody's, Standard & Poor's and Fitch have published their views about the creditworthiness of issuers of debt securities. The importance of these opinions has grown significantly in recent decades as a result of increases in the number of issues and issuers, the globalization of our financial markets, and the introduction of complex financial products like asset-backed securities and credit derivatives.
    I believe that strong regulation helps to protect the interests of American investors, but regulation in itself may fail to accomplish this goal, and the private market may not necessarily be responsible for the burdens. So somewhere in there, we have to ascertain whether there is a responsibility of the SEC and the Congress to reexamine the need for regulatory activity on behalf of or regarding the credit-rating agencies.
    Accordingly, I am pleased we have worked diligently over the last year to augment the resources available to the Securities and Exchange Commission and enacted sweeping reforms of auditing and accounting practices, restored accountability to investment backing and analyst research, and improved the conduct of business executives and corporate boards.
    Although rating agencies received some scrutiny after the recent spate of corporate scandals, we have not yet mandated any substantive change in their practices.
    At hearings before our committee last year, however, one witness noted that rating agencies played a significant role in Enron's failure. Additionally, a recent Senate investigative report found that the monitoring and review of Enron's finances, quote, fell far below the careful efforts one would have expected from organizations whose ratings hold so much importance, unquote.
    I wholeheartedly agree. Outside of Arthur Andersen, the rating agencies probably had the greatest access to comprehensive non-public information about Enron's complicated financial arrangements, and they exhibited a disappointing lack of diligence in their coverage of the company.
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    Furthermore, the rating agencies have missed a number of other large-scale financial debacles over the last several decades. They failed to sound appropriate alarms before New York City's debt crisis in 1975 and the Washington Public Power Supply System's default in 1983. They have also floundered before when First Executive Life collapsed in early 1990s and during Orange County's bankruptcy of 1994. The failure of rating agencies to lower the ratings in these cases ultimately resulted in the loss of billions of dollars of American investors who little understood the true credit risks.
    As a result of the concerns about the role that the rating agencies played in recent downfalls of Enron, WorldCom and other companies, we called upon the Securities and Exchange Commission to study these issues and report back to us. In reviewing this report, it has become clear to me that while our capital markets and the rating agencies have evolved considerably in recent decades, the Commission's oversight and regulations in this area have changed little.
    Moreover, it disturbs me that the Commission has studied these issues for more than a decade without reaching any firm conclusion. In 1992, for example, then SEC Commissioner Richard Roberts first noted that rating agencies, despite their importance and influence, remained the only participants in the securities markets without any real regulation.
    In 1994, the Commission also solicited public comment on the appropriate role of ratings in our federal securities laws and the need to establish formal procedures for recognizing and monitoring the activities of the nationally recognized statistical rating organizations.
    This release led in 1997 to a rule proposal that the Commission never finalized. In releasing its latest rating agency report to the Congress, the Commission stated that it would issue within 60 days a concept paper asking questions about rating agency regulation. Sixty days have now passed.
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    It is therefore my expectation that the SEC will publish its concept release as quickly as possible and that it will move with due diligence to finally resolve this issue and publish regulations regarding agencies.
    As we proceed today, it is also my hope that we will carefully examine the many issues raised in the recent SEC report on rating agencies. We must discern how the Commission should oversee rating agencies in a systematic way. We should also explore the conflicts of interest that rating agencies encounter like their reliance on payment by issuers, and their provision of consulting services to issuers. Last year, accountants came under fire for similar problems. We should additionally discuss the competitiveness of the credit rating industry. In particular, many critics have raised concerns about the ability of participants to enter the market.
    Furthermore, I think that we should evaluate the ability of investors to understand credit ratings. In studying the recommendations of investment analysts two years ago, we heard stories about ''buy'' meaning ''hold'' and ''hold'' meaning ''sell.'' With respect to credit ratings, investors may well understand that triple A is an excellent credit risk with little probability of default and that triple B+ means an acceptable credit risk with some chance of default. But they may not know that B-, a passing grade on their child's report card, signifies junk bond status. Average American investors need help in deciphering this convoluted code.
    In closing, Mr. Chairman, I expect the Commission to take prompt and prudent action on rating-agency regulatory issues. I also look forward to working with you on these matters as we move forward deliberatively.
    Chairman BAKER. I thank the gentleman.

    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 69 in the appendix.]
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    Chairman BAKER. Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman.
    And I want to thank you and commend you and thank you for holding this important hearing to study the role and function of credit rating agencies in the securities markets.
    Over the past two years, this committee has lead the way on investor protection beginning with an examination of Wall Street analysts and continuing with a review of accountants, corporate officers and boards, investment banks, mutual funds and corporate governance practices generally.
    Our inquiries resulted in the Sarbanes-Oxley Act and other regulatory reforms and now we turn to credit rating agencies.
    Sarbanes-Oxley required the SEC to submit to the committee report on rating agencies and that report was issued in January. I am pleased that the SEC's top market regulator is here this morning to discuss its content.
    Ms. Nazareth, welcome to the committee. We are glad to have you back with your valued experience at the SEC.
    I know that members of this committee have questions about the Commission's oversight for this industry. Some commentators have called for greater transparency in the rating process and have raised questions about potential conflicts of interest that arise because agencies collect fees from and sell other services to the companies that they rate.
    We have seen to many instance where greater transparency has led to better functioning markets and more informed investors.
    The similarities between the potential conflicts of interest presented in this area and those that were addressed in the area of accounting firms in Sarbanes-Oxley are impossible to ignore. I look forward to our panel's views on the need for more disclosure and clarity in the rating process. Beyond the potential conflicts and the lack of transparency, some of questioned the real liability of the ratings themselves, particularly in light of the rating agencies failure to warn investors about the impending bankruptcies at Enron, WorldCom, Global Crossing and other major companies.
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    There are also concerns regarding the openness of the industry and whether anti-competitive barriers to entry exist for ratings firms seeking recognition by the SEC. We are all familiar with the accounting scandals which turned the big five into the final four and resulting concerns that have been raised.
    Somehow the fact that until very recently, there were only three SEC-recognized credit ratings agencies does not seem to garner the same level of scrutiny. The Commission has recognized only one new firm in well over a decade.
    I am concerned that the Commission may have allowed an oligopoly to exist. And I hope and expect to hear from the SEC on how they plan to clarify and improve the application for firms striving to qualify as recognized rating agencies.
    Thank you, Chairman Baker, for holding this hearing. Focusing attention on the role of rating agencies and examining the current levels of disclosure, competition, accuracy and regulatory oversight in the industry will surely benefit investors and the market.
    And I yield back.

    [The prepared statement of Hon. Michael G. Oxley can be found on page 64 in the appendix.]

    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Miller? No opening statement?
    Mr. Emanuel?
    Mr. EMANUEL. Thank you very much.
    Obviously a number of questions, Mr. Chairman, that we need to hear have already been raised. So rather than repeat them, I think like every member of this body and of this committee and subcommittee, we have state funds, teachers' funds, police funds, all who lost money in WorldCom and Enron.
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    And although the Sarbanes-Oxley bill correctly started to realign the walls that exist in the accounting industry, the investment banking, commercial banking, the credit agencies to date have been immune from that oversight. And we need to obviously take a look at what those agencies do, whether there is a conflict of interest that exists, whether there is in fact more of the debt market they should cover rather than limit it.
    So I submit my full remarks to the committee. And then look forward to the testimony and the question and answer period.
    Thank you.

    [The prepared statement of Hon. Rahm Emanuel can be found on page 66 in the appendix.]

    Chairman BAKER. Mr. Shays?
    Mr. SHAYS. Thank you, Mr. Chairman.
    I thank you for conducting this hearing. And just to say to you that when we had the hearing on Enron there was not one profession that looked good. The managers did not manage. The directors did not direct. The employees did not speak out, not withstanding Ms. Watkins who spoke out internally. The lawyers were on a gravy train. The accountants did not do their job of auditing. But what to me was most alarming was how the rating agencies just broke down.
    And it seemed very clear to me that they broke down in measure because they also were part of the renumeration this incredible amount of opportunity to make money at the public's, I think, unfortunate expense.
    So delighted we are having this hearing, and I hope that we hear some very convincing information from the regulators as to how we are dealing with this issue.
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    Chairman BAKER. Thank you, sir.
    Other Members wanting opening statements?
    Mr. Scott?
    Mr. SCOTT. Thank you very much, Mr. Chairman. I too want to thank you Chairman Baker and Ranking Member Kanjorski for holding this important hearing today regarding the Securities and Exchange Commission's oversight of the credit rating agencies. I certainly want to thank the distinguished panel of witnesses today for your testimony.
    This is indeed a very, very important hearing. As we know last year the Senate Governmental Affairs Committee held a hearing on Enron's scandal and questioned why Enron's credit rating was high until just before the company filed for bankruptcy.
    Due to the development of complex financial products and the globalization of the financial markets, credit ratings have been given increased importance. The credit ratings effect the security markets in many ways. But the SEC has not performed any significant oversight over rating agencies.
    And perhaps this lack of oversight has led to what the Senate Governmental Affairs Committee in their hearing, to be incredulous that they had that good credit risk until just before the bankruptcy.
    I think there are several areas we certainly need to focus on—information flow, potential conflicts of interest, alleged anti-competitive or unfair practices, reducing potential regulatory barriers to entry and ongoing oversight.
    And there are some questions that I certainly would want to get some answers to. For example, I would like to know whether there is general agreement about whether greater regulatory oversight of credit agencies is indeed warranted.
    The Senate Governmental Affairs Committee staff report recommended that the SEC monitor credit agency compliance with performance and training standards. I mean, is it time for that change?
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    Again, a very important hearing. I look forward to hearing from the panel and the recommendations for the SEC review of the credit agencies.
    Thank you Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Scott.
    Mr. Tiberi? No opening statement?
    Mr. Ryun? Mr. Ryun has excused himself.
    Mr. Matheson?
    Mr. Sherman?
    Mr. SHERMAN. As we explore the financial world, we find a world where the referees are paid by one of the teams. We find this among auditors and around credit creating agencies or bond rating agencies.
    What insulated bond rating agencies from the same pressures that accountants faced was first an absence of competition. The vast majority of bonds being rated by the two major agencies. So even if you call them as you see them, they still have to hire you for the next game.
    But the absence of competition is not an enshrined value of American free enterprise. And it probably is a good thing that we are going to get some more competition in this area.
    If the competition is to serve investors either by reducing the fees charged to corporations or to provide better insight that is good. My fear is that competition will be best expressed in the sense of who will give you a better a grade.
    If you were to—if a rating agency were to cut its fees by half, it would be nothing in terms of value to the corporation as if it were increase its grade by the slightest denomination available.
    I will look forward to learning in these hearings what we are doing to providing a disclosure of all of the relationships between the rating agencies and the issuer in terms of is there consulting services being provided? What services and what cost? And what are the fees being charged for the basic rating services?
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    The thing that would concern me the most as a bond buyer is if I ever saw that a corporation was paying more than the standard fee to the entity providing its grade.
    One advantage we have in bonds is that most of the decisions are being made by highly sophisticated bond purchasers and that the individual investor plays a smaller role. But even there often it is a fund that invests in bonds and then competes for the highest rate of return saying, ''All of our bonds are at least single A or double A.
    And so even bond managers should they fear that a rating agency's results may not be strong, the pressure on them is to buy the highest yield with the best grade whether they like that grade or not.
    So I look forward to seeing what we can do to prevent the increase in competition from being a competition for who will provide the best grade and to provide investors with the best way for them to decide whether it is a grade they can trust.
    Thank you.
    Chairman BAKER. Thank you, Mr. Sherman.
    If there are no members seeking recognition, then at this time I would like to welcome our first panelist this morning, Ms. Annette Nazareth, who appears here in her capacity as the Director of the Division of Market Regulation for the Securities and Exchange Commission.
    Welcome, Ms. Nazareth. And I do not know if your mike is on. Try that little button.
    Ms. NAZARETH. Can you hear me now?
    Chairman BAKER. Very well.

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    Ms. NAZARETH. Thank you, Chairman Baker, Ranking Member Kanjorski and Members of the Subcommittee.
    On behalf of the Securities and Exchange Commission, I appreciate the opportunity to testify today before you regarding credit rating agencies and their role and function in the operation of the securities markets.
    As you know, this past January, the Commission submitted to Congress a detailed report on credit rating agencies in response to the congressional directive contained in the Sarbanes-Oxley Act of 2002.
    In my testimony this morning, I would like to highlight for you some of the key points in the Commission's report and give you a sense of some of the areas we intend to explore in more depth.
    During the past 30 years, regulators, including the Commission, have increasingly used credit ratings to help monitor the risk of investments held by regulated entities and to provide an appropriate disclosure framework for securities of differing risks.
    Since 1975, the Commission has relied on ratings by market-recognized credible rating agencies for distinguishing among grades of creditworthiness in various regulations under the federal securities laws.
    These nationally recognized statistical rating organizations or NRSROs, are recognized as such by Commission staff through a no-action letter process.
    Recently, the Commission has pursued several approaches, both formal and informal to conduct a thorough and meaningful study of the use of credit ratings in the federal securities laws, the process of determining which credit ratings should be used for regulatory purposes, and the level of oversight to apply to recognized rating agencies.
    Commission efforts included informal discussions with credit rating agencies and market participants, formal examinations of each of the NRSROs, and public hearings that offered a broad cross-section of market participants the opportunity to communicate their views on credit rating agencies and their role in the capital markets.
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    These Commission initiatives coincided with the requirement of the Sarbanes-Oxley Act that the Commission conduct a study of credit rating agencies and submit a report of that study to Congress.
    Our report identified a number of important substantive issues relating to credit rating agencies that the Commission would be exploring in more depth. And the Commission plans to issue a concept release that would seek public comment on these matters in the very near future.
    Among other things, the concept release would ask a wide range of questions regarding possible approaches the Commission could develop to address various concerns regarding credit rating agencies.
    I will devote the remainder of my testimony to a synopsis of some of these complex issues.
    One important group of issues the Commission staff has been reviewing relates to the information flow surrounding the credit rating process.
    First, we are exploring the current amount of disclosure that rating agencies provide regarding their ratings decisions. At the Commission's credit rating agency hearings representatives of the users of securities ratings, particularly the buy side firms, stressed the importance of transparency in the rating process.
    In their view the marketplace needs to more fully understand the reasoning behind the ratings decision and the types of information relied upon by the rating agencies in their analysis.
    Better information about ratings decisions they assert would reduce the uncertainty and accompanying market volatility that frequently surrounds a ratings change.
    Second, the Commission staff is reviewing the implications of direct contacts between rating analysts and subscribers. Some have expressed concern regarding the special access subscribers have to rating agency information and personnel. And questions have been raised as to whether this direct access creates the potential for inappropriate selective disclosure of information.
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    Finally, the Commission staff is assessing the extent and quality of disclosure by issuers. At the Commission's credit rating agency hearings several specific areas for improved issuer disclosure were mentioned, including the need for additional detail regarding an issuer's short term credit facilities and, particularly in light of the Enron experience, better disclosure of the existence and nature of ratings triggers in contracts that are material to an issuer.
    Another set of issues the Commission staff has been examining is the potential conflicts of interest faced by credit rating agencies.
    First, the Commission staff is reviewing potential conflicts of interest that could arise when issuers pay for ratings. Arguably, the dependence of rating agencies on revenues from the companies they rate could induce them to rate issues more liberally and temper their diligence in probing for negative information.
    Rating agencies on the other hand assert that their processes, procedures and market competition sufficiently address these concerns.
    Second, the Commission staff is assessing the potential for conflicts of interest to arise when rating agencies develop ancillary fee-based businesses. The large credit rating agencies recently have begun to develop ancillary businesses such as ratings assessment services and risk management and consulting services to compliment their core ratings business.
    Concerns have been expressed, for example, that credit rating decisions might be impacted by whether or not the issuer purchases additional services offered by the credit rating agency.
    The Commission staff also has been exploring the extent to which allegations of anti-competitive or unfair practices by large credit rating agencies have merit.
    In the course of the Commission's study, there were a few allegations that the largest credit rating agencies have abused their dominant position by engaging in certain aggressive competitive practices.
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    Some allege, for example, that rating agencies may have used what critics term strong-arm tactics to induce payment for a rating that an issuer did not request.
    A fourth set of issues under review by the Commission staff is whether the Commission's historical approach to the NRSRO designation has created potential regulatory barriers to entry into the credit rating business.
    For many years, market participants have voiced concerns about the concentration of credit rating agencies in the U.S. securities markets and whether inordinate barriers to entry exist.
    Most agree that significant natural barriers exist, particularly given the long standing dominance of the credit rating business by a few firms, essentially the NRSROs, as well as the fact that the marketplace may not demand ratings from more than two or three rating agencies.
    There also has been substantial debate regarding the extent to which any natural barriers to entry are augmented by the regulatory use of the NRSRO concept and the process of Commission recognition of NRSROs.
    One obvious way to avoid potential regulatory barriers to entry is to eliminate the regulatory use of the NRSRO concept. And the Commission staff is exploring this possibility.
    The Commission staff also is reviewing steps short of eliminating the NRSRO concept that would reduce potential regulatory barriers including possible clarifications of the current process and criteria for regulatory recognition of rating agencies. Instituting timing goals for the evaluation of applications for regulatory recognition, and considering whether rating agencies that cover a limited sector of the debt market or confine their activity to a limited geographical area could be recognized for regulatory purposes.
    Finally, the Commission staff is assessing whether more direct ongoing oversight of rating agencies is warranted and possible and if so, the appropriate means of doing so.
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    This oversight could include, among other things, record keeping requirements designed for the credit rating business and a program of regular Commission inspections and examinations.
    As part of this analysis, we are examining the scope of the Commission's present oversight as well as the potential impact on the credit rating market of any action the Commission may take.
    In addition, I should note that the rating agencies have asserted that their ratings activities are at least to some extent protected by the First Amendment.
    Another aspect of possible ongoing Commission oversight is whether rating agencies should and can be required to incorporate general standards of diligence in performing their rating analysis and develop standards for training and qualification of credit rating analysts.
    In the aftermath of the Enron situation and the recent corporate failures, some have criticized the performance of the credit rating agencies and questioned whether they are conducting sufficiently thorough analysis of issuers, particularly given their special position in the marketplace.
    Concerns have also been raised regarding the training and qualifications of credit rating agency analysts. Whether and how such standards might be incorporated into the Commission's oversight of credit rating agencies likely will be explored more deeply in the forthcoming concept release.
    As you can see, credit rating agencies raise a wide range of complex regulatory and policy issues. I expect you will get a sense of some of the diverse perspectives on these matters from the witnesses who will be testifying later this morning.
    The Commission has made substantial progress in its review of credit rating agencies as I hope is evident from our recent report to Congress. And I expect our analysis to be focused further based on comments received in response to the planned concept release.
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    Thank you for the opportunity to testify.

    [The prepared statement of Annette Nazareth can be found on page 128 in the appendix.]

    Chairman BAKER. Thank you very much. I do appreciate, Ms. Nazareth, not only your work but the apparent openness having read your written testimony, of the SEC to consider a number of alternative directions to take with regard to current market performance.
    Is there at the current time a written set of standards if one complies with, would lead to a designation as an NRSRO that could be printed in a form and handed to someone? And if you meet these guidelines, you can be assured of approval?
    Ms. NAZARETH. The process is not that formal at this time. I believe that in general the standards for national recognition are understood to the extent that the 1997 proposal basically talked about codifying what was the staff's approach to national recognition.
    But certainly what the Commission has been talking about more recently is taking those general standards and were it to decide to continue to use the NRSRO designation to apply more objective criteria and further list criteria to obtain the NRSRO designation.
    Chairman BAKER. In response to the 1997 rule proposal, in which the SEC had a considerable number of suggestions, the response from the NRSRO group was that the SEC concerns were addressed by their existing policies, meaning the SEC's, procedures and competition.
    Now if there are only four of them, and there were three at the time, doesn't it seem that the competitive argument was at best a little disingenuous? How does one allege that a government granted authority to do a public function and you only have three of you in the country, leads one to conclude that that is a competitive environment? But yet they were saying this strong competition is what keeps us on our toes.
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    Ms. NAZARETH. I understand the position that you are taking. You know, there is a question as to whether or not there really is sort of a natural oligopoly in this business. And——
    Chairman BAKER. I think that is a great answer.
    Ms. NAZARETH. Yes, I think our concern is we certainly do not want to be in a position where we are adding to any impediments to entry into the business through the regulatory process.
    Chairman BAKER. Let me jump to the next level because my time is going to expire here. And we do have members with a lot of interest.
    Let's assume for the moment that I have been designated. What is the normal regulatory oversight process that exists today from your perspectives to my conduct? What is it that I could expect? Do I have an SEC audit? Are there analysts coming through and looking at how I perform my day-to-day? Do you have to present a business plan? What is the formal relationship between this public regulatory authority and the SEC?
    Ms. NAZARETH. The SEC's oversight on an ongoing basis is very limited. These entities are registered as investment advisers, but the Adviser's Act does not really specifically contemplate much of this type of business.
    So there is not sort of a regular examination process or——
    Chairman BAKER. Well, let's assume for the moment that tomorrow we read where one of the four is engaging in their inappropriate conduct, there is a capital adequacy question, whatever the reason. But it is a national in scope issue.
    Is there a process by which the designation can be withdrawn?
    Ms. NAZARETH. The designation has never been withdrawn, but certainly it could be withdrawn. I mean, there is not a formal process, but there is a process in general for no action letters that they could be withdrawn.
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    Chairman BAKER. Well, you can hopefully understand that the concern is that we do not have clinical standards by which someone gets approved. There is not a formal set of standards for continual oversight, and there is not a published methodology for withdrawing the designation once granted.
    Would it at least be advisable to consider having this process subject to the Administration Procedures Act where that requires certain printed notices to the public, public hearings where interested parties could come and make comment?
    At least opening it up to that extent where market participants at the very least and the general public on a large scope would have an ability to express the views of the market to the SEC because one of the principles on which the SEC basis its judgment is national recognition and market acceptance of whoever it is that is to be designated.
    It seems to be difficult to obtain without a formally structured process to get that information. Is that something would or would not be advisable?
    Ms. NAZARETH. It is certainly something that is along the lines of what a number of participants at the credit rating agency hearings that we had, had raised as well. Greater transparency with respect to the process as well as solicitation of more data from the public at large about the national recognition. So that is certainly something that the Commission could consider.
    Chairman BAKER. And let me again, I do not want to end on a negative note. I appreciate your appearance and recognize that this is not a circumstance that has occurred in the last six months. This is an environment, which frankly has existed the first designation. And this is just the appropriate for a review of all aspects of market conduct. And I certainly have more questions, but my time has long expired.
    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman.
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    Ms. Nazareth, your testimony raises some questions about the rating agencies. I am more interested in what is your personal valuation or opinion of the rating agencies? Because you know, there is no reason to go along to set standards and an awful lot of paperwork and a lot of hoops and things to jump through just to make us look like we are closing the door after the horse got out of the barn.
    The question really should go: In your opinion, do the agencies open up the door to allow the horse to get out of the barn?
    Ms. NAZARETH. Well, I do not know who much weight my personal opinion should have on this particularly since I am not familiar with all of the factors, you know, surrounding this. But I can say that, in general what makes this area so difficult and the reason that we never seem to come to closure on how to address these issues is that, fundamentally what is occurring here is financial analysis.
    Mr. KANJORSKI. Yes.
    Ms. NAZARETH. Which is why we certainly need to be sure it is being done in a manner that has integrity and that is free to the fullest extent of conflicts——
    Mr. KANJORSKI. Well, are there any questions concerning——
    Ms. NAZARETH. ——but you do not know whether or in general it is an opinion.
    Mr. KANJORSKI. Well, you mean after all of this time of studying it and the requests that we made under the Sarbanes-Oxley Act, the Commission still has not made a judgment?
    I think it is about time somebody steps up to resolve the problem, rather than spending a lot of time studying it. Look, we have had some startling failures—Enron, WorldCom—and all of us are trying to prove that we did not have anything to do with it. Certainly the Congress is not responsible for it.
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    And the Commission probably is saying, ''Well, we are not responsible for it.'' And the rating agencies I would assume are saying, ''Well, we are not responsible for it either.''
    I do not think that we should concentrate necessarily on finding fault. Those are days gone by. But, do you see any way that we are going to improve analysis, limit conflicts of interest, or restore integrity if we do put into effect some regulatory control over these rating agencies?
    Ms. NAZARETH. Well, what the Commission is going to examine in the concept release is whether or not additional regulatory oversight would be appropriate and whether, you know, it might help in this area. I think——
    Mr. KANJORSKI. I thought that was what the concept release that we are waiting to receive would do.
    Ms. NAZARETH. That is right, in the concept release. That is——
    Mr. KANJORSKI. When is that going to happen? I mean, maybe we should have postponed this hearing until we obtain the concept release.
    Ms. NAZARETH. Well, we suggested that. No, the concept release will be coming out shortly. There are drafts circulating internally now.
    Mr. KANJORSKI. Can you give us a peek preview as to what you are talking about?
    Ms. NAZARETH. Well, I think where it currently stands, and again I cannot say where the Commission will come out, but it could potentially be very broad in its scope in raising as Chairman Baker had mentioned, you know, all manner of issues——
    Mr. KANJORSKI. I understand all of that, and you know, I think we do not get to that level unless we find that rating agencies have either failed or scored very poorly.
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    I guess what I am simply asking you is as a teacher, grade them, A, B, C, D, or F.
    Ms. NAZARETH. You know, I think in general the credit rating agencies have done remarkably well. I think the problem is that you have some colossal failures, and we can—and it is interesting what you have——
    Mr. KANJORSKI. Would you attribute any of these failures of Enron, WorldCom or any of these other organizations to either the conflict of interest that the agencies may or may not have been in, or their failure of analysis, or their failure of due diligence?
    Do you see a problem? I mean, there was not any question when we examined the accountants. There was a very definite link between the accountants who were getting involved in carrying out the fraud. I mean that was very clear as far as testimony.
    Are these people directly involved in any of this or is it a failure of one out what 17,000 publicly traded corporations and they have missed three or four of them. Is that all?
    Ms. NAZARETH. You know, I am personally not aware of all of the facts. I can tell you that the rating agencies certainly take the view that they were defrauded in the same manner as the rest of the investing public was.
    Mr. KANJORSKI. Well, then, shouldn't we——
    Ms. NAZARETH. On the other hand, they may have been privy to more information than others were. So I really do not know.
    Mr. KANJORSKI. Well, I am wondering, rather than concentrate a lot of our time on process and particularly new regulations of an existing business that is doing fairly well, I mean, until preparing for this hearing, over the years, I have always had a great deal of respect for the rating agencies. I have always thought that they have done a pretty good job. The failures also are minute when you really look at them over the scheme of how many papers they are rating.
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    Should we have more transparency on the corporate side? Is it that? There was some mention here on Enron—that they could not pierce the veil of some of these off-shore things because they just did not know about it. Should we be up here arguing for total disclosure of everything a corporation does and then put some rule into effect that the agencies have to be an arm of the government in some way directly or indirectly, to examine that?
    Should the SEC be out there even examining that? I mean, it sort of seems unfair for me to suggest that we are all up here trying to burden this system all over again. Boy, as a Democrat I should not be talking this way.
    Democrats are supposed to be for more regulation, but you know, I do not want to be a party to adding expense to the securities market, driving the credit situations into a jeopardized position because of actions we take that are not really going to accomplish the one thing I am interested in.
    Maybe I should say it: How many unsophisticated investors are the ones that are reading these ratings or is it a fact that the people that read these ratings and understand these ratings are because they are expert in the field? And what we are trying to do is prepare something that mom and pop can decide over a kitchen table discussion, but when it in fact they do not decide on bond ratings or other ratings made by these agencies?
    Ms. NAZARETH. Well, the ratings are used primarily by the sophisticated financial users. And the reason that we consider it important is because it does have great influence on the financial markets and people's ability to raise funds and the like. It is important to——
    Mr. KANJORSKI. Let me come to a conclusion——
    Ms. NAZARETH. ——the——
    Mr. KANJORSKI. ——I know my time is almost gone. Can you attribute any of the financial failures that have occurred over the last year in the American economy to a large extent, not a total extent, but to a large extent or as to the extent of the accountant problem that we have to the rating agencies?
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    Do see them as the——
    Ms. NAZARETH. I personally do not see that level of——
    Mr. KANJORSKI. So we are at a much lower position and——
    Ms. NAZARETH. I would assume so.
    Mr. KANJORSKI. ——therefore our regulations or statutory authority for regulations should be more constricted? Is that——
    Ms. NAZARETH. Again, what we have to analyze is what will additional regulation bring to the process? The Commission is not only going to have to decide if it engages in more regulation, but what additional benefits would that regulation bring? And two, are there limits to the Commission's current authority? And would the Commission need——
    Mr. KANJORSKI. Now——
    Ms. NAZARETH. ——additional authority from Congress to do that?
    Mr. KANJORSKI. In some of our opening statements, we referred to this conflict of interest problem. It is potentially an alleged conflict of interest because we do not know whether there is one where payments are coming from the issuers and/or paying to the rating agencies that may cloud their judgment.
    Have you ever seen anything like that happen? I mean, are we dealing here with conflicts of interest that are rampant or even evident in some of these failures? Or is that just a misstatement of fact and we should apologize to the rating companies.
    Ms. NAZARETH. I think there are always potential conflicts of interest——
    Mr. KANJORSKI. Have you seen any? I know there is a potential conflict of interest in every step we take in life.
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    Ms. NAZARETH. That is right.
    Mr. KANJORSKI. But have we seen any conflict problem or do we know of any or have any evidence that they have had any impact on any of these failures?
    Ms. NAZARETH. I am not aware of their being systemic conflict problems.
    Mr. KANJORSKI. Thank you.
    Chairman BAKER. Mr. Oxley?
    Mr. OXLEY. Thank you.
    Mr. Chairman, in the absence of marketplace competition, the SEC really is the only agency that determines the qualifications of a ratings agency in place of the normal checks and balances a marketplace has. And in the case of other oligopoly or monopolies regulated by the SEC, there are regulations, public interest obligations and the like that tend to provide some balance. But in the case of the rates charged by the agencies, the SEC really has no authority over those rates. Is that correct?
    Ms. NAZARETH. That is right.
    Mr. OXLEY. And what would prevent the—any of the agencies from exercising monopoly power or pricing for their services?
    Ms. NAZARETH. Well, there are a few of them obviously, and I would think that market forces have, you know, prevented that from happening because there is some limited competition there. And I would also assume that were there inappropriate tactics being exercised by these agencies, we would have heard about it.
    Mr. OXLEY. So you think there is some marketplace——
    Ms. NAZARETH. I think there is some marketplace competition. Usually the number of ratings required for an issue is one or two ratings. And they do have some choice here.
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    Mr. OXLEY. I know that there are—at least I have been told that there is one agency that is considering tripling its price even though they apparently are adding no value, extra value.
    If that were the case and they were indeed to triple their price, what would be the—what would be the outcome? What would be the view of the SEC in that situation?
    Ms. NAZARETH. Normally we would not exercise authority over the prices that these entities would charge. We do not do that with the broker dealers either.
    Mr. OXLEY. Well, and I am not here to advocate the government regulation of pricing. Far be it for a conservative Republican to advocate that. But obviously our goal is to—our goal is to try to get more competition, more entries into the market. And you have obviously heard from Chairman Baker, Ranking Member Kanjorski and myself, that that clearly is I think what we are aiming at.
    And so to that extent we want to work with the SEC to encourage market entry. It may very well be potential growth industry given the past history of ratings agencies and some of the problems that developed with failure to recognize some of the major business failures that we had over the last several months. And clearly that is what we are aiming at.
    We appreciate your constant efforts in that—and I know you have been at the Commission for a number of years and have always had the best interests of the public at heart. And this is no exception. And we are looking forward to your leadership, working with us to provide a more competitive marketplace in this area.
    And I thank you and I yield back.
    Ms. NAZARETH. Thank you.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Miller, do you have a question?
    Mr. MILLER. I do, a few. They are along the lines of Mr. Sherman's opening statement. We have heard both concerns for conflicts of interest and a lack of competition. And I know that reliability has to be one basis of competition for these agencies, at least sequentially because no issuer is going to want any agent—if every issuer is going to want a rating that is accepted in the marketplace as reliable.
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    But what will be the basis of the competition? Is it going to be price only to the issuer, what the agency would charge if there were more agencies? And are we going to have to worry about the more of what we saw with the accounting firms becoming willing partners in Enron, WorldCom, et cetera?
    Ms. NAZARETH. What our focus has been all along is that the marketplace ultimately would decide through their use of these rating that the issuers of these ratings were credible and were issuing the ratings in an appropriate way without conflict and side agreements with the issuers.
    So basically, we have used that process to try to recognize or mimic how the marketplace viewed what these agencies were doing.
    Mr. MILLER. What we want these agencies to be is detached. We want detachment from the agencies. That is—isn't that right?
    Ms. NAZARETH. Yes.
    Mr. MILLER. Is it—if there is a proliferation of these agencies, and I know that there are natural barriers to entry, there is not going to be 400 agencies. But is—is there not going to be some push for more favorable ratings as Mr. Sherman suggested in his opening remarks? Is that not a concern?
    Ms. NAZARETH. Well, certainly from our limited perspective—you know, originally we started using this national recognition process because we wanted to ensure that our regulated entities that were using these ratings for regulatory purposes were not in fact doing what you are suggesting, which is sort of buying a rating, you know.
    Because the ratings were used to determine things like capital requirements for the broker dealers and the like. And you did not want to have a situation where there was any issue that the credibility of the rating was called into question.
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    And so there is a concern there if we are going to continue to use this designation because we have become somewhat attached to it for regulatory purposes, we really do have to ensure that all of the appropriate procedures are in place so that you do not have what you are suggesting which is a race to the bottom based on people coming in and competing on basis other than the credibility of their ratings.
    Mr. MILLER. The suggestion is that having essentially three firms is oligolistic.
    Ms. NAZARETH. Yes.
    Mr. MILLER. What would be the appropriate size of the market?
    Ms. NAZARETH. I do not know what the perfect size of the market would be but I do note that in Europe where they do not have this designation process, they likewise have a somewhat limited number of major firms that are operating in the marketplace.
    I think we had a staff person from the Financial Services Authority in London testify at our hearing, who said that they generally have I think south of 10. So I do not think we are talking about a situation here where there are hundreds of new entrants trying to come into this marketplace.
    Mr. MILLER. Okay. Has Europe had any of the kind of problems that we have had or that we fear or agencies missing it?
    Ms. NAZARETH. Well, I think that they feel that they have had a very comparable experience. And they are very much looking to what we are doing in this area. There is a lot of interest in Europe as there has been here to looking into further regulation of the credit rating agencies. So they are very much looking to us for the analysis that we undertake in this regard.
    Mr. MILLER. Okay. Thank you.
    Chairman BAKER. I thank the gentleman.
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    Mr. Shays?
    Mr. SHAYS. I would like to ask you what your reaction was when the whole debacle of Enron unfolded. I would like you to tell me what you thought and why you thought what you thought.
    Ms. NAZARETH. I cannot really speak for the agency in that regard. So I am not sure it is appropriate or how helpful it would be to just say what my own personal views are. I do not think in this regard I am necessarily——
    Mr. SHAYS. Well, you were in office at the time, correct?
    Ms. NAZARETH. Yes.
    Mr. SHAYS. Well, then describe——
    Ms. NAZARETH. Well, we——
    Mr. SHAYS. Describe to me what you felt as a Commissioner.
    Ms. NAZARETH. And——
    Mr. SHAYS. And what that, you know, made you think you might need to do.
    Ms. NAZARETH. I think——
    Mr. SHAYS. I do not think it is a difficult question.
    Ms. NAZARETH. We do not oversee the activities of these credit rating agencies. There may be people in other areas of the Commission involved in Enron enforcement action who have be privy to more detailed information.
    But in the Division of Market Regulation, we are not privy to the specific information that the credit rating agencies reviewed with respect to the Enron situation.
    I think—there is no question that looking at the situation, there are two distinct possibilities. One is that, as I said earlier, the fraud that was perpetrated on the public was likewise perpetrated on the credit rating agencies, and that they were given answers that were not truthful with respect to questions that they raised.
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    The other possibility is that because of their unique role there may have been information that had they probed further might have caused them to realize that things basically did not add up.
    What would be my personal question is—on which side of the line did it fall? But I personally am not aware of which was the case.
    Mr. SHAYS. The—you know, all of us when we had to examine that, I do not think that—since I do not believe there was a professional that did their job or looked good, any one of us in any profession would—I would think have instinctively have said, ''My gosh, what role should or could we have played?''
    And so we as legislators had to look at, you know, whether our oversight was proper and whether we needed to take action.
    I do not think it would be surprising for me to expect that your agency ultimately while you do not regulate a rating agency, you are the that has given them authenticity, correct?
    Ms. NAZARETH. Certainly we have some involvement because of this designation process.
    Mr. SHAYS. So if you believe that maybe the rating agencies did not do their job, do not you have the ability to—in other words, de-designate them?
    Ms. NAZARETH. Well, that is one issue. I do not think that we have considered in this instance that they were subject to designation but I think that——
    Mr. SHAYS. Why not, why not?
    Ms. NAZARETH. Because in general, I think, as we said earlier, ultimately—if we believed that there was a systemic issue, clearly that is something that the Commission or the staff should consider. I think if you look—there have been some, there is no question about it, colossal failures.
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    And we have discussed many of them here today, WHOPPS, Orange County, New York City, but you know the track record in general. It is public—they publish it. It is quite admiral in terms of the track record and in terms of predicting the repayments on debt securities. And I think nobody is a guarantor in this area. This is an area of you know, financial analysis and opinion.
    Mr. SHAYS. Do you believe that the rating agencies adequately serve the public in continuing to rate Enron's investment grade four days before bankruptcy rating the California utilities A-2 weeks before it default, in rating WorldCom investment grades three months before bankruptcy and rating Global Crossing investment grade four months before defaulting on loans?
    Ms. NAZARETH. What was your question—did they serve the pubic?
    Mr. SHAYS. Yes.
    Ms. NAZARETH. I do not think it was their finest hour.
    Mr. SHAYS. Would you say that is an understatement?
    Ms. NAZARETH. In this case, I said I am not sure the reasons for their inability to detect the problems, but certainly the result was extremely problematic. And we all know what the affects of that were.
    Mr. SHAYS. I would just say Mr. Chairman, that the challenge I am having is that I think you wrote a very thorough statement of all the things you are reviewing, but I do not feel any passion in your voice. I do not feel any sense of responsibility in your position. And it makes me tremendously concerned.
    I thought I was giving you a softball that you could have knocked out of the park. I thought I was basically giving you the opportunity to say, ''I was horrified. It caused us to look at what we are doing and how we might make a better contribution. It got us thinking of recommendations we might make to the legislative body on ways that we could protect the public interest to make sure things were done better.''
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    I get the feeling that basically you all are pretty much asleep. That is the feeling I get from the way you responded to me.
    Chairman BAKER. Your question is, ''Did you know that all of those things?'' That is your question. I was just framing it for you as a question instead of a statement.
    Mr. SHAYS. I would like you to do it. That is your question.
    Chairman BAKER. Thank you, Mr. Shays.
    If I may, Mr. Scott, you are next.
    Mr. SCOTT. Thank you very much. Ms. Nazareth let me ask you this, could you explain to me why three credit rating agencies are exempt from the SEC rules on corporate disclosure?
    Ms. NAZARETH. I am glad you asked that question, because there is some misunderstanding about how reg FD works. All credit rating agencies that publicly disseminate their views, whether or not they are NRSROs—have an exemption from reg FD.
    At the time that reg FD was promulgated I think the belief was and continues to be that you want credit ratings to be as knowing and be based on as much information as possible. And to the extent that there is some information that issuers might feel free to share with the rating agency, that could be factored into the rating and therefore, have the rating be to some extent more accurate and timely, that that was an appropriate exception, particularly since the rating then is widely disseminated.
    So it was within keeping of the spirit of reg FD whether or not the full basis on which the rating was promulgated was known. The fact of the matter is that there would be wide dissemination of a rating that included this information. And that therefore you would have a better more fulsome rating than you would have had without it.
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    That was the logic.
    Mr. SCOTT. But as you look at it, do not you think that this lack of disclosure has a harmful effect on the decision making process?
    Ms. NAZARETH. It's not a lack of—it is a question of whether or not something is not required to be disclosed at the time. If you recall, reg FD said if the issuer were determined to disclose something you had that was material that you had to widely disseminate to every one. It could not be selective discloser.
    In this case again, if it is something that the issuer is not obligated at that moment in time to publicly disseminate, but feels that it would be important for the credit rating agency to know, reg FD would not be an impediment to sharing that information.
    It does not require that he share it. If he does share it, it is not a violation of the regulation.
    Mr. SCOTT. These credit rating agencies are sort of like an exclusive club. I mean, they cannot get a foothold in the industry, in the business without the SEC's approval. Is that right?
    Ms. NAZARETH. Well, I think credit rating agencies in general, you know, there are many of them and they can—and many of them are quite successful. I think the issue is the designation as a nationally recognized statistical rating organization which is more selective.
    Mr. SCOTT. Can't get that without the SEC approval?
    Ms. NAZARETH. Yes.
    Mr. SCOTT. Well, why have there not been any new rating agencies designed in the last 10 years? Do you see that as a problem?
    Ms. NAZARETH. I guess I have to put it in the context of how many have applied as well.
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    Again, we think there are some natural barriers to entry here. There have not been that many applications. As you may know, at one point we were up to seven and because of consolidation in the industry, those seven who had been designated went down to three.
    And I would say in the last ten years we probably had about four or five additional rating agencies who had applied who did not receive the designation. We have currently three or four that are pending.
    So we are not talking about scores of people who have come in who we have turned down. There has been a limited number, obviously some of them have received the designation and I think we took action in 1999, on Thompson Bank Watch, which had had a limited designation. And so we expanded their NRSRO designation to cover a wider variety or products in 1999. And then as you know, recently we had Dominion approved. So we are now up to four.
    Mr. SCOTT. Are there artificial barriers?
    Ms. NAZARETH. Well, that is what we want to be sure that we are not creating. I think we are trying to ensure that there is some discipline on this process because we use the designation for regulatory purposes. But I think the Commission is very interested in ensuring that they are not creating artificial barriers that exacerbate any competitive issues.
    Mr. SCOTT. So there are barriers, but you would say they are more natural market forces?
    Ms. NAZARETH. Well, there certainly are a lot of natural market barriers.
    The question is, are there things that the Commission could do to ensure that their regulatory process does not make it worse.
    Chairman BAKER. Mr. Scott, your time is winding up. If you could make this your last one, sir.
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    Mr. SCOTT. Well, I just would like to say that I think that there is a challenge here for the SEC to move forthrightly to make for better competitiveness as an—just—is there—is there general agreement on whether greater regulatory oversight of these credit agencies is warranted? Is it pretty much agreed?
    Ms. NAZARETH. No. I think that the Commission has an open mind about it and is seeking comment on that through the concept release—which explains my lack of passion in my testimony. I think that the Commission is truly open minded about what inputs it gets back in the context of the concept release.
    And I think we will also carefully look at the authority issues and determine if additional regulation is warranted, in which case we may also seek further authority from Congress.
    Mr. SCOTT. Thank you Ms. Nazareth.
    Chairman BAKER. Thank you Mr. Scott.
    Mr. Capuano?
    Mr. CAPUANO. Thank you, Mr. Chairman.
    Ms. Nazareth, do not confuse me with Mr. Shays. I have no softballs to throw at you.
    Ms. NAZARETH. Oh, great.
    Mr. CAPUANO. I have to tell you that I came to this hearing today because I wanted to make sure that I was on record as telling the SEC that think you have done a minimal job at best in reaction to this crisis that has been facing us now for almost two years. If it was not for the state attorney general in New York, I think that you would have done even less than you have done.
    So I am not a happy camper. I do not that the investing confidence has come back. I do think that today's situation or today's hearing relative to rating agencies is just another part of it.
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    But it amazes me, absolutely amazes me that average people can see the potential conflict in the private end in what the agencies do. Every single one of them, just like auditors, are afraid that the people they are rating are going to go to another rating agency if they rate them too harshly. How is that not seeable? How is that not clearly understood?
    And when you have that situation, I think there is no answer other than relatively strict regulation or at least oversight from somebody. And the only somebody is the SEC.
    That is who the public looks to. They look to the SEC.
    And for the SEC to sit back and say, ''Well, we are not sure. We have been thinking about this for—well, since 1994. We are going to continue to think about it. We have a lot of questions.''
    To me is, well, why bother. Why bother? Forget your concern or anybody's concerns for the general public's faith in the system. The credit rating agencies, just like the auditors, have a financial push to not anger their clients.
    Very simple. Having been involved with credit rating agencies in the past, their desire to delve deeply into the numbers underwhelmed me every time I ever dealt with them.
    Cookie cutter stuff, did not fit into the cookie cutter, fine if it did, fine. Very little—very few questions. And here is the rating.
    And you know as well as I do that the average investor, that includes the small investor who might just wonder what their mutual fund is doing, they may not read the credit report but they certainly will know that it is an A or double AA or a triple BBB or whatever it is going to be. They know that.
    And the individual companies themselves use those ratings as advertising. You know that. ''Oh, we got an A. We got a B.''
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    That is what it is all about. And to worry about or to take, I do not know, I think I read somewhere since 1994, if you want to certify a group, do it and make it count. If you do not, then do not.''
    These people are walking around and that does not mean that everybody is doing a bad job. I do not mean to imply that. But the ones who do not do their job, clearly there have been many, but the ones who do not do their job are walking around with their CC certification which tells the investing public, ''It is fine.''
    How is it that you do not see a problem with that? How is that there is still debate in the SEC to do something? How is that possible at this point in time after the crisis that we continue to suffer from?
    Ms. NAZARETH. I do not think that there is any question that the Commission considers it a very important issue. I think—you actually stated it quite clearly. I think where we are is that given that we do give this NRSRO designation—we either have to be in or out.
    We either have to stop giving the designation and basically say we have no oversight responsibility over these entities. And clearly the statute does not specifically say that we are supposed to be overseeing credit rating agencies, or if we are going to continue to designate these entities, there has to be certainly more transparency to the process. And it will raise further issues of what additional oversight is necessary.
    I think we are in a difficult position right now because once you designate an entity, I think it does leave the impression that there is more being done on any ongoing basis. And I think that is the challenge that the Commission has and we are hoping that in the next few months once they basically analyze more current feedback that they get from the soon-to-be-released concept release, that they will make a determination.
    Mr. CAPUANO. The last time they asked for feedback and they analyzed it, they basically decided to do nothing. Do I have any faith whatsoever—should I have any faith that something will be done, anything will be done?
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    Ms. NAZARETH. I would think so. I also think that the concept release of the time was probably somewhat more limited than the issues that we are looking at now.
    So, I think there is much more focus on the issue how.
    But suffice it to say, as others have said here, that it is a very complicated issue. But——
    Mr. CAPUANO. I understand that it is a complicated issue. Everything is complicated in life. I understand that, but at the same time for me, I do not care. The SEC gets paid and now hopefully gets paid more than they used to——
    Ms. NAZARETH. We thank you for that.
    Mr. CAPUANO. Well, happy to do that. I think it was worthwhile. But it gets paid to deal with complicated issues.
    Ms. NAZARETH. Uh, huh.
    Mr. CAPUANO. My mother relies on your goodwill and your positive action to do your best within reason obviously, to make sure that her investment is reasonably safe. We need some speed here.
    I need some speed here.
    Ms. NAZARETH. Right.
    Chairman BAKER. Speaking of speed, Mr. Capuano, your time has expired but——
    Mr. CAPUANO. Thank you.
    Chairman BAKER. Thank you, Mr. Capuano.
    I would like to suggest for members, because everybody has a sincere interest in this, as opposed to going to a second round with five minutes for everybody, that everybody who chooses can ask—well, we have members who have not yet—do you have questions?
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    Okay. Mr. Ney?
    Let me recognize Mr. Ney for his five minutes, and then we will go to a second round with each member having the option to ask two more questions just to make sure we have vetted everything.
    Mr. Ney?
    Mr. NEY. Thank you, Mr. Chairman. One question I wanted to ask is about the rating firms. You know, the rating firms are essentially private research firms. They have been granted a government benefit in the form of a monopoly power they enjoy as a result of receiving an NRSRO status from the Commission's staff.
    Why should they also get special access to information that reg full disclosure restricts from the public?
    Ms. NAZARETH. They do not have a unique benefit under regulation FD. All credit rating agencies whether or not they are designed as an NRSRO have an exception under reg FD.
    Mr. NEY. So they do not have special access to information?
    Ms. NAZARETH. They do not. They do not. NRSROs alone do not have special access.
    Mr. NEY. Okay. The other question, Mr. Chairman, I had is Standard & Poor and Moody's control about 80 percent of the credit ratings market. In light of the fact that a rating from two different firms is typically needed for issuing new debt, the two firms do not actually compete against each other.
    Even though S&P and Moody'ss have failed repeatedly to warn investors, their revenues have not suffered because there are few alternatives.
    What do you think could be done to counter what I consider unhealthy conditions?
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    Ms. NAZARETH. Well, I think there is some issue as to whether or not there are natural barriers to entry, but one of the things that the Commission is interested in ensuring is that it is not sort of adding to the competitive problems through its regulations. So that is something that is the subject of great Commission focus right now and will be hopefully addressed through the concept release, the questions.
    Mr. NEY. So this subject is under internal discussion——
    Ms. NAZARETH. It is under internal discussion, yes.
    Mr. NEY. Is there a timeframe or guesstimate or——
    Ms. NAZARETH. Well, we are hoping that the concept release will be issued within the next few weeks and then from there, we will take the data and the Commission will determine what further steps it wishes to take.
    Mr. NEY. Thank you.
    Thank you.
    Chairman BAKER. Thank you, Mr. Ney. And starting our second round now, we would recognize any member for a couple of additional questions. I just want again reiterate my appreciation for your appearance.
    I have two questions that are not troubling, but of interest. S&P for example, is a publicly owned corporation that has its stock traded in the public market.
    Who rates them?
    Ms. NAZARETH. Who rates S&P? I do not know.
    Chairman BAKER. Because it would seem that if—if we have only four them and they are all publicly traded stock——
    Ms. NAZARETH. Right.
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    Chairman BAKER. And you in normal conduct of business, you have to get access to capital, if you are going to get access to capital, you have to have a rating. It has to be by a nationally recognized rating organization.
    Secondly, it is I think generally known that there are officials of the credit rating corporations, to make it clear, there are businesses making business judgments for their own shareholders who serve in either a board or administrative or executive capacity who also serve on the boards of the companies they rate.
    Now that to me is an extraordinary—a difficult matter.
    Has the SEC looked at that relationship or an executive in a rating agency serving on a—as a board member of a company which they are not rating?
    Ms. NAZARETH. No, we have not. If that is the case, I think that is a good area of pursuit. We have more to suggest but we will get to those later.
    That is my two questions.
    Mr. Miller?
    Mr. MILLER. A quick couple of questions. All of our concerns about conflict of interest, about the lack of detachment by these agencies does seem to date from the agencies from being paid principally by investors being paid principally by issuers.
    Is it possible to go back? Can the market work? Can we get that genie back in the bottle?
    Ms. NAZARETH. You know, the rating agencies themselves may be able to speak more directly to that. I think the reason it switched originally was because it is very difficult in a world where information is sort of freely disseminated through technology to be able to make their money through subscriptions because these ratings become widely known, and you know, there is sort of a free-rider effect.
    So this was really their alternative to that problem. And certainly the rating agencies can address, how they think the potential conflicts are mitigated. Largely it is done, I think, both through their view that their franchise value is based substantially on the integrity of their ratings.
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    That is certainly one thing they argue. But also they rate so many issuers that their income is not reliant to any significant extent on any one issuer so that they do not feel that they are unduly influenced by an issuer leaving because there is no concentration.
    Mr. MILLER. Second question. Mr. Shays pointed out the number of times that changes in ratings did not appear until immediately before bankruptcy. That also may be because the change of rating precipitated bankruptcy.
    One of the things that seems to be most troubling about the amount of power that these agencies have and the lack of—and relative lack of regulation either by the marketplace or by government or anybody is those triggers. Do you think that those are a necessary part of the marketplace having accelerated payments on debt because of changes in ratings?
    Ms. NAZARETH. I think that is a great question. I think certainly one of the lessons learned from some of these situations is that we need a greater understanding of the ratings triggers. I think from what I understand the credit rating agencies themselves do a more rigorous job now of understanding where all of the ratings triggers are and what impact the change in rating would have.
    And I also think that it is something the Commission will consider in terms of adding more disclosure information as well, because it obviously has a material effect. There is in some sense a spiraling effect when things go bad if you have these triggers that as you say, precipitates a bigger crisis.
    Chairman BAKER. Thank you, Mr. Miller.
    Mr. Shays?
    Thank you Mr. Chairman.
    Mr. Chairman, I am going to make two observations. One is that when I have an employee, I want an employee who is anticipating problems and looking for solutions.
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    And so Ms. Nazareth, I understand you are not a Commissioner, but this is your area. And I want to go on record as saying that I believe your lack of energy points out that a fire needs to be lit underneath you.
    Tell me why I should take more comfort in the four rating agencies that basically have your ''no action'' stamp of approval than I should on the ones that do not?
    In other words, it strikes me that there are some rating agencies that do not have the status of your stamp of approval that really have done a better job. Why should I be comfortable when I look at what two of these firms have done, they have 80 percent of the business and they do not compete with each other.
    Why should I take comfort in what they have done?
    Ms. NAZARETH. We are not by virtue of designating these entities saying that any of these other ratings services cannot be used. What we are saying is that we had tried very narrowly for purposes of our regulations to determine that we had agencies that were nationally recognized and as Mr. Miller suggested, who were significant enough and whose ratings presumably would not be influenced by other factors, like other competitive factors, to have credible ratings.
    Obviously, you have raised a number of important issues that the Commission will consider. I take issue with your characterization unfortunately of a lack of zeal. I think that you are perhaps misinterpreting a cautiousness on my part because I am in fact representing the views of a number who may not at this moment in time have completly formulated their views on what the Commission is going to do.
    But I can assure you that the Commission is examining this issue with a tremendous passion and that there is a huge amount of effort going on at the Commission to come to the right answer on this.
    And again, if we feel that more is needed to be done, we may in fact be back here asking Congress for additional authority to do more in this area.
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    Mr. SHAYS. Well, the fact that you would ''if I feel more that needs to be done,'' we all know that more needs to be done. It is the question of what needs to be done.
    My second question, living with the format of the question, is to ask why should I draw comfort that there are no formal requirements to have your stamp of approval and it is not transparent?
    Why should I draw any comfort from that at all?
    Ms. NAZARETH. I am not suggesting that you draw comfort from that. It is quite clear that if the Commission continues to use this designation, there will be much greater transparency around that process. I have no doubt about that at all.
    Mr. SHAYS. And so the proposed rule of 97, maybe we will finally be acted on?
    Ms. NAZARETH. Or some other form of it, yes.
    Mr. SHAYS. Interesting that it is a proposed rule in 1997, isn't it?
    Ms. NAZARETH. Yes.
    Chairman BAKER. Thank you, Mr. Shays.
    Mr. Kanjorski?
    Mr. KANJORSKI. Who is going to win the World Series?
    Thank you very much, Mr. Chairman.
    Ms. NAZARETH. Happy birthday.
    Mr. KANJORSKI. Thank you.
    Chairman BAKER. Thank you, Mr. Kanjorski.
    Ms. Capito?
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    Mr. SHAYS. Can I make an observation?
    I like Mr. Kanjorski, when it is not his birthday. He is just too nice today.
    Totally out of character for the record.
    Mr. KANJORSKI. One day here——
    Chairman BAKER. Officially no comment?
    Ms. Capito?
    Mr. Ney?
    Ms. Hart?
    Mr. Scott?
    Mr. SCOTT. Yes, I would like to—let me ask you in terms of regulatory oversight, do you think that the Securities and Exchange Commission should monitor credit agency compliance with performance and training standards?
    Ms. NAZARETH. That is something that is under very serious consideration by the Commission. I know that was something that was recommended in one of the congressional reports. And it is one of the items that is going to be explored in the concept release.
    Mr. SCOTT. What about you? What do you think? Do you think this should be done?
    Ms. NAZARETH. I think if we continue to use this designation we cannot be sort of half in. If we are going to do that, then we are going to have to do more rigorous oversight. Exactly what form that will take I do not know and whether or not we need to come for additional authority is also an open question.
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    Mr. SCOTT. Okay.
    Ms. NAZARETH. But it is for the Commission to decide. I do not have a vote.
    Mr. SCOTT. Let me ask you this question about conflict of interest.
    Chairman BAKER. And that will have to be your last, Mr. Scott so we can wrap up. Thank you Mr. Scott.
    Mr. SCOTT. What do you think should be done about potential conflicts of interest that arise when insurers pay for ratings and when rating agencies develop additional fee based services?
    Ms. NAZARETH. That definitely raises questions for us. As you may know, at this point, the additional fee-based services that the credit rating agencies, that those businesses are involved in, are rather small. But certainly, intellectually, it raises all the same issues that we saw with the accounting industry. So that is another issue that the Commission is looking at very closely.
    Mr. SCOTT. Thank you, Ms. Nazareth.
    Chairman BAKER. Thank you Mr. Scott.
    Let me express my appreciation on behalf of the committee for your willingness to participate at such length. Your appearance here has been a great help to the committee, and we look forward to working with you on the results of the concept study. And appreciate the efforts of the agency .
    Thank you very much.
    Ms. NAZARETH. Thank you.
    Chairman BAKER. At this time I would like to call up our—members of our second panel, please. I want to welcome each of you here this morning to participate in this informational hearing for the subcommittee.
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    To the extent possible, I would ask that each witness try to summarize their testimony. All of your formal statements will be made part of the official record. It is my observation, given the interest of members, that the follow-on discussion between the committee members and each of you will probably be of great interest to us. And given the number of folks we have to hear from this morning, please try to constrain your remarks to no longer than five minutes.
    To that end, I would like to begin by calling on the managing director of Egan-Jones Ratings Company, Mr. Sean J. Egan.
    Welcome, sir.


    Mr. EGAN. Thank you.
    My name is Sean Egan. I am managing director of Egan-Jones Ratings, a credit ratings firm. By way of background, I am the co-founder, and we were established for providing timely, accurate ratings to institutional investors.
    We are dissimilar to the rating firms that are currently recognized by the SEC, the NRSROs, in that we are not paid by the issuers of ratings. We think there is a fundamental conflict of interest, and we do not think that it is surmountable.
    We are paid by approximately 300 institutional investors and broker-dealers. Unlike the current NRSROs, we provided warning to investors on the major debacles, such as Enron, WorldCom, Global Crossing, Genuity.
    We are based in the Philadelphia, Pennsylvania, area, but we have employees that are in other offices.
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    We believe that the rating industry is flawed in a couple of fundamental ways. One is that there is little competition. This is not an oligopoly. People refer to it as an oligopoly; it is not. What it is is a partner monopoly. That is, that you have two firms, S&P and Moody's, having between 80 and 85 percent of the revenues in this business, and neither of them compete against each other because you need two ratings, typically, for a bond underwriting.
    So, if S&P is awarded a designation for rating a particular issue, Moody's is soon to follow. It is not as if they are competing against each other, unlike the accounting firms. In fact, they are side by side.
    The second problem, of course, is that there is a conflict of interest. The major rating firms, S&P and Moody's, used to be paid by the users of credit ratings, but that changed approximately in the mid-1970s, whereby they received the bulk of their rating, their fees, now from the issuers.
    Some people refer to this as a natural oligopoly. We disagree. It is not a natural oligopoly in any other way than, let's say, the financial analysis industry, or the money management industry; you do not have two firms controlling 80 to 85 percent of the industry. Likewise, in the equity research area you do not have two firms controlling 80 to 85 percent. It is simply not a natural oligopoly. There have been barriers that have been set up for getting this NRSRO designation.
    Because of the unhealthy state of the credit rating industry, investors have lost hundreds of billions of dollars, pensioners have lost their pensions, and workers have lost their futures.
    Now, the current NRSROs will put up what we call five defenses for why they should be the only NRSROs recognized, and I will run through these very quickly. I have four in my written testimony, but we added a fifth.
    One is issuer misdeeds. That is that the issuers did not tell us that they had fraudulent financial statements. Our feeling is that any decent credit rating firm should be able to figure it out. There is always fraud. It always happens. When Bernie Ebbers has a $400 million loan from the company, that should be a fairly good signal that something is wrong.
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    The second defense that the S&P and Moody's put up for why they missed it is that they have little incentive. We call that the Jack Grubman defense, and you heard a little bit about that this morning from Annette.
    Our feeling is that, just like Jack Grubman and Henry Blodget of Merrill Lynch constitute a small part of their respective firms' revenue base, they still misled investors, to their benefit. So we do not believe that the little incentive argument holds much water.
    A third comment you will hear for the defense of the current situation is that ''our reputation is key.'' We refer to this as the Arthur Andersen defense, that, ''There is no way we would let a rating company be misrated''—this is what they will say—''because our reputation is too important.'' Well, we think that is trumped by the compensation issue.
    This fourth defense that they will use is the committee approach. That is, that, ''We rate things via committee and that way no one particular person can affect things.'' We refer to this as the lemming defense, that it is very clear that there is just one analyst that is looking at the company, it is very clear what the hierarchy is, and it is very difficult to buck that.
    The last defense that will be used for not changing this industry is what we call the ''great, great grandfather defense,'' and that is that a firm needs to be established around World War I, which is when S&P and Moody's were established, to have any sort of presence in this industry. We disagree with this.
    We have a number of recommendations. I do not want to get into them now. What we would encourage the SEC to do is to broaden their definition of what is appropriate for an NRSRO. They list national recognition in the United States as being the primary criterion for recognition.
    We commissioned a survey. We contacted the SEC before that survey, during that survey and afterwards, and that survey basically indicated that we had more than four times the recognition of any other non-NRSRO firm. We provided that to the SEC, we asked for a meeting, they refused to have a meeting with us.
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    We were somewhat surprised when DBRS was given the designation. We had more than four times the recognition of them. We asked the SEC what exactly we needed to get this designation and they said they simply could not tell us and they are still studying it.
    So if you have any additional questions, I will be happy to answer them later.

    [The prepared statement of Sean J. Egan can be found on page 75 in the appendix.]

    Chairman BAKER. Thank you very much, Mr. Egan.
    Our next witness is the Senior Vice President of Federated Investors, Ms. Deborah A. Cunningham.
    Welcome, Ms. Cunningham.


    Ms. CUNNINGHAM. Thank you, Chairman Baker.
    I am in charge of the taxable money market group at Federated investors, which is a mutual fund company based in Pennsylvania, and it is in that context that I offer my remarks to you here today.
    The group that I am in charge of at Federated is required from a regulatory standard to utilize the ratings from the various NRSROs, and this is set forth by Rule 297 from the Investment Company Act of 1940, which requires money market funds to utilize NRSROs as information in the minimal credit risk determination that we make. It is one piece of the puzzle that is used in the determination of creditworthiness that our analysts use, but we are required to do so.
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    The securities that the funds that I manage purchase are generally corporate notes from either financial-or industrial-type corporations, as well as asset-backed securities. The asset-backed securities that I purchase are required, again from a regulatory standpoint, to have NRSRO ratings, while that requirement is not mandatory for the corporate securities that we purchase. On average, however, though, 99 percent of the securities that I purchase in the funds that I manage are indeed rated by at least one NRSRO.
    On the positive side, I think that the content of the NRSRO writeups that have been disseminated has improved drastically over the last several years. The qualitative information, as well the timeliness of those writeups is very good.
    On the negative side, there have been instances in recent times when I have reviewed information that shows data that is more than 18 months out of date. So it is obviously not a perfect scenario yet in this context.
    The NRSRO reports are helpful from my analysts standpoint because they are concise, they offer peer-group information, show industry averages, industry comparisons. They also show a large array of historical information, so you are able to look at some trend analysis from this information that is disseminated by the rating agencies.
    In general, then, they have a summary that has positives and negatives that effectively is the justification for the rating that in fact that rating agency is giving to that particular company.
    The NRSROs are also providing clues for future financial health of the particular entities that we are using by way of their outlook and by way of their watch lists. The watch list companies are basically those who are closer to having their ratings change, either upward or downward, in the near future.
    Occasionally, however, an issuer will be downgraded without first having a negative outlook or first being listed on a watch list as a potential downgrade, and this causes a lot of havoc in the marketplace. It is a very disruptive procedure.
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    The reason for those sort of sudden surprise changes can be necessarily a sudden surprise change in the information that is being disseminated by the company or it can be misrepresentation or a misunderstanding of the information that had been previously disseminated.
    Whichever the case is, I think an improvement that we would like to see would be for any type of sudden, unexpected changes by the NRSROs to be accompanied by a more detailed, transparent statement as to why those changes occurred and what the future outlook will be for other such changes.
    Switching to asset-backed securities for a second, these issuers are special purpose entities, they are not publicly traded, publicly held companies, so the information that is available in the marketplace for them is much, much lower than it is for publicly traded corporates and financials.
    The NRSROs do require a great amount of information to be submitted in order for them to rate these special purpose entity, asset-backed securities and they require that information on a regular basis to monitor and upkeep that rating.
    Another suggestion that I would have for the NRSROs for improvement would be to better disseminate a lot of this information to the investing community so that we are not always at odds trying to get that information directly from the issuers.
    Now let me address for a second the issue of fees. The fees that are paid by fund companies, such as Federated Investors, who manage money market funds and other types of bond funds, are a substantial portion of the advisory fees that we charge our customers for those funds.
    Although these fees may indeed pale to what the issuers are actually paying those NRSROs, I guess I believe that it is incremental enough that the rating agencies are in fact looked upon by us as being unbiased third-party experts.
    In order to ensure this unbiased quality, I think all of the contract negotiations that take place for fees from the issuers to the rating agencies should be done away from the analysts and the committee members that are actually responsible for designating ratings for that particular company. And I am not sure if that is the case today or not.
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    With regard to additional fee-based businesses, I guess I take a different tack, and it is one that we are familiar with, in that I have many of the funds that I manage rated by the rating agencies themselves.
    And in those instances some of the rating agencies dictate that the securities that are held within those funds are also rated by that same NRSRO. So this seems to be a little bit of a bad business practice that I think could be amended in that, as long as there is any rating on those securities within those rated funds, this should suffice.
    Let me recap by looking at the current NRSRO status. The SEC most recently designated Dominion Bond Ratings as the fourth NRSRO. At one point there was a high of seven NRSROs and through consolidation that shrunk down to three.
    I think this recognition of DBRS as the fourth agency is one that is welcome. Investors are always looking for additional information and additional opinions, and we are in the process right now of negotiating with DBRS as to how we are going to utilize their information.
    I think that the addition, though, of these NRSROs should be deliberate and it should be detailed by the Commission. However, more transparency in that process is probably a good idea.

    [The prepared statement of Deborah A. Cunningham can be found on page 71 in the appendix.]

    Chairman BAKER. Thank you very much, Ms. Cunningham.
    Out next witness is the Executive Vice President of Dominion Bond Rating Service, Mr. Greg Root.
    Welcome, sir.
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    Mr. ROOT. Thank you very much. I would like to thank you and the subcommittee for giving us the opportunity to address such an important issue today.
    As we all know, ratings have become a key, integral part of the financial markets, and therefore I think it is imperative that there be a clear understanding of the role of rating agencies, how they operate and how they compete.
    Let me begin with just a brief overview of Dominion Bond Rating. We are based in Toronto, founded in 1976 by Walter Schroeder, who remains the company's president. And DBRS is employee owned. We do not have public shareholders, we are not affiliated with any other organization and we limit our business to providing credit ratings and research.
    DBRS is what we call a general rating agency in that we analyze and rate a wide variety of institutions and provide credit research on these as well.
    We currently rate about 700 different entities, and we have about another 250 companies, most of which are based here in the U.S., that we are providing credit research on without ratings.
    DBRS has 65 employees and we have 45 analysts at this time.
    Since our inception, DBRS has been widely recognized as a provider of timely, in-depth, impartial credit analysis. Our opinions are conveyed to the marketplace using a familiar, easy-to-use letter grade rating scale. These ratings are supported by extensive research, which include detailed reports on individual companies, as well as comprehensive industry studies.
    This information is disseminated through various means, including a proprietary subscription service, which is used by more than 300 institutional investors, financial institutions and government bodies.
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    DBRS credit ratings reflect the company's opinion as to the likelihood of timely payment in full of principal and interest. In arriving at these decisions, our team of analysts consider a wide range of quantitative and qualitative factors that could affect the future creditworthiness of the issuer or specific instrument in question.
    As part of the process, we maintain an ongoing dialogue with the managements of the companies we rate. All ratings are processed through a committee system and are reviewed constantly. Ratings are changed whenever we are of the opinion the relative creditworthiness has changed positively or negatively.
    Next I would like to say a few words about the role of rating agencies in the capital markets. Again, over the past 30 years the SEC, other federal and state regulators and even Congress have increasingly relied on credit ratings as a way to monitor the risk of investments held by regulated entities. In addition to these legislative and regulatory uses, NRSRO credit ratings are widely used extensively in debt covenants and other financial instruments between private parties.
    I am pleased to say that the confidence the regulators and the markets have shown in the rating agencies is not misplaced. While ratings are certainly not guarantees of future performance, studies show that there is a strong positive correlation between ratings and default rates.
    However, although DBRS is proud of the role rating agencies play in the global securities markets, we are aware that there are certain concerns that have been raised regarding our industry, and I would like to touch on a few of these at this time.
    First is transparency. At the SEC's rating agency hearings last fall we heard institutional investors express a desire for a clear understanding of the reasoning behind rating decisions. DBRS makes every effort to satisfy this desire by issuing full detailed reports on the companies we rate. These reports openly convey our views on both current ratings and on the direction of ratings. We believe everyones' interests are best served when the reasons behind ratings are widely known.
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    The second involves conflict of interest. DBRS has worked diligently to minimize the potential for conflicts of interest in the rating process. My written testimony goes into this topic in my detail, but let me just say here that the success of our business is primarily based on one key factor: our reputation. If at any point investors doubted the independence of our judgment, the demand for our services would decline. We have no intention of letting that happen.
    And the third is the competition and barriers to entry. As the rating that has been most recently granted the NRSRO designation, DBRS has somewhat of a unique perspective on this issue. Because credit ratings play such an important role in the capital markets, we believe that barriers to entry in this field should be high.
    That said, the real concern, as we see it, is not so much that the barriers make it difficult for new competitors to enter the field, but rather that there is no well-defined process for designating NRSROs.
    The no action letter process that the SEC currently use is, in our opinion, ill suited for this task because the criteria for designation are not sufficiently defined, the application process is not standardized and adverse decisions on requests for designation are not subject to appeal.
    Based on our recent experience, DBRS believes that there should be a clear definition of what constitutes an NRSRO and a transparent process to enable qualified companies to apply for this designation.
    In conclusion, I believe that the credit rating system as it exists today works quite well and has helped foster the growth of the financial markets globally. In light of recent events, it is appropriate that the issues being raised by the subcommittee be thoroughly reviewed, and we very much appreciate having the opportunity to be part of this process.
    Thank you.
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    [The prepared statement of Greg Root can be found on page 137 in the appendix.]

    Chairman BAKER. Thank you, Mr. Root.
    It would be my intent, we have announcement of two votes on the floor that are now pending, we have about 10, 12 minutes left before the first vote closes, so we could proceed with Dr. White's testimony. The committee would then stay in recess for 15 minutes to go over and come back for the two votes and hopefully not inconvenience you too greatly.
    Dr. White is a Professor of Economies at Stern School of Business, New York University.
    Welcome, Doctor.


    Mr. WHITE. Thank you, Mr. Chairman. I am very pleased to be here and to have this opportunity to testify before the subcommittee. My written testimony states my position in greater depth.
    The problem of the regulation of the NRSROs is what I have described as ''the SEC's other problem.'' Of course the SEC's efforts with respect to corporate governance and public accounting is at center stage, but the NRSRO issues could well be as important for the efficient operation of the U.S. capital markets.
    The SEC's current regulatory barriers to entry into the NRSRO category are highly unsatisfactory, and the two potential paths out of these difficulties are clear. Unfortunately, the SEC's recent report was a great disappointment. It simply raised the same old questions instead of pointing toward the solutions.
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    The basic problem is as follows: Since 1931, financial regulators have required their regulated institutions to pay attention to the credit ratings of the bonds and obligations that they hold. That regulation has grown greatly, especially in the past three decades.
    The issue of whose ratings should be paid attention to was addressed only in 1975, when the SEC created the NRSRO category. It immediately grandfathered into the category the three major incumbents, and it then allowed only four additional entrants over the next 17 years. But mergers and consolidation among those entrants and between those entrants and Fitch then reduced the total number back to the original three by the end of the year 2000.
    From 1992 until the end of February of this year, the SEC allowed no new entrants. Only at the end of February, as we have just heard, did DBRS enter this category.
    So that is where we are: greatly expanded regulatory demand that financial institutions use ratings, and limited supply of SEC-designated approved rating firms, the NRSROs. It is no wonder that we are here today discussing the problems of this industry.
    Now, it is important to remember: So long as regulators delegate their safety judgments to ratings firms, there is going to be a need to designate whose ratings should be heeded by the regulated financial institutions. So long as we have that process set up, this designation is unavoidable. But that process forces the capital markets to pay attention primarily to the designated entities, and there are unfortunate consequences to this whole limitation process. One has to worry whether new ideas, new innovations are going to enter the marketplace in this kind of framework.
    There are two basic paths that could be followed to get us out of these difficulties. The first and best is to have the financial regulators withdraw those safety delegations and to make the safety judgments themselves. I say this as a former bank regulator myself. For almost three years I served on the Federal Home Loan Bank Board. I had a number of sessions in just this hearing room, Mr. Chairman, some of them enjoyable, some of them less so, but I know what it is like. And those delegations can be withdrawn, those judgments can be made by the financial regulators themselves.
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    Once that is done, the SEC could eliminate the NRSRO category, and the capital markets would then be free to make up their own minds: ''Whose judgments do we follow? Whose predictions of default do we pay attention to? What new ideas should we be paying attention to?''
    Indeed, they might even ask, ''Do we even need rating firms in the 2003, 94 years after John Moody's first started issuing ratings?''
    This is the best, the clearest, the cleanest and the most market-oriented approach to dealing with these problems.
    But if this route is considered infeasible, then there is Plan B: The SEC must cease being a barrier to entry, it must actively certify qualified firms as NRSROs and inevitably it must periodically assess the suitability of incumbents to continue to be NRSROs.
    The SEC in this process must focus on performance: How well does the firm, entrant or incumbent, predict defaults?
    In this light, the criteria that the SEC proposed in 1997 must be scrapped. Those criteria focused on inputs, not on performance. An innovative firm that could predict defaults well could nevertheless fail the input criteria. Also, the criteria create a Catch-22 that could exclude entrants.
    If this expanded regulatory task is considered to be beyond the capabilities of the SEC, then there is always Plan A: Withdraw those regulatory delegations, then eliminate the NRSRO category and let the markets make their own choices and decisions.
    The paths are clear, and I disagree with Ms. Nazareth's comment this morning. This is not a complicated issue. The time for action is now.
    Thank you very much, Mr. Chairman.

    [The prepared statement of Lawrence J. White can be found on page 144 in the appendix.]
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    Chairman BAKER. Thank you very much.
    Time for action has also occurred for me. I have to go vote and I will be right back. We stand in recess.
    Chairman BAKER. If I may ask folks to resume the seats at table, we will reconvene. Members will be on their way back as they conclude the vote.
    At this time I would like to call on the President and Chief Executive Officer of Fitch, Inc., Mr. Stephen W. Joynt.
    Welcome, sir.


    Mr. JOYNT. Thank you, Mr. Chairman. Thank you for inviting me to come participate today.
    My name is Steve Joynt, and I am President and CEO of Fitch Ratings.
    Ratings are used by a broad mix of investors as a common benchmark to grade the credit risk of various securities. In addition to their ease of use, efficiency and widespread availability, credit ratings are most useful to investors because they allow for reliable comparisons across many diverse investment opportunities.
    Credit ratings assess credit accurately in the overwhelming majority of cases. Credit ratings have proven to be a reliable indicator for assessing the likelihood of a securities default possibilities.
    I think it is important to note that while the current inquiry into the role of rating agencies has been focused on issues surrounding the ratings of corporate issuers, corporate ratings only represent approximately 10 percent of the total rated universe. Fifty percent or more of Fitch's activities and revenues and ratings come from mortgage-backed and asset-backed securities analysis. New criteria development, original analysis, published research and follow-up surveillance information have support transparency in development of these markets.
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    Fitch is also very active in rating other markets, such as global financial institutions and the 1.8 trillion U.S. municipal market. Any changes for the rating industry need to consider the impact on these markets as well.
    We believe the SEC's review of the rating agencies is a constructive process. As a result of this review, the SEC has already recommended some improvements to our policies and procedures and we are voluntarily implementing them.
    Today's hearings may probe several areas regarding the business of rating agencies: regulatory barriers to entry, potential conflicts of interest with issuers and information disclosure. And I would like to briefly comment on each of these.
    At Fitch we firmly believe in the power of competition. Fitch's emergence as a global, full-service rating agency capable of competing against Moody's and S&P across all products and market segments has created meaningful competition in the ratings market for the first time in a decade.
    Fitch's challenge to the Moody's-S&P monopoly has enhanced innovation, forced transparency in the ratings process, improved service to investors and created much needed price competition.
    We also believe that there is a demand for insightful, independent credit research. The NRSRO system is designed appropriately, in our view, to assure that recognized organizations possess the competence to develop accurate and reliable ratings. Without a system to recognize rating organizations for their competence, many important capital adequacy and eligibility investment rules used in financial institutions regulations would be ineffective.
    To address concerns regarding potential conflicts of interest and issuer fees, Fitch goes to great efforts to assure that our receipt of fees from issuers does not affect or impair the objectivity of our ratings. Fitch culture emphasizes the importance of integrity and independence as critical foundations of our most important asset, our reputation. Fitch has separate sales and marketing teams that work independently of the analysts that cover the issuers.
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    Our analyst compensation philosophy reflects quality of effort and individual accomplishment in research and ratings. Individual company fees, revenue production and individual department profitability do not factor in analyst compensation.
    Analysts may not own securities in companies that they rate. Fitch does not have an advisory relationships with companies it rates.
    Another issue that merits discussion is better disclosure of information. We believe for the most part the credit rating agencies have adequate access to the information they need to form an independent and objective opinion about the creditworthiness of an issuer. Non-public information is provided to the rating agencies as part of the rating process. The nature and level of that information varies widely, by company, industry and even country.
    Typically, it is not the value of any particular piece of non-public information that is important to the rating process, but that access to such information and senior management can assist us in forming a qualitative judgment about a company's management and its prospects.
    At Fitch, we are working to encourage transparency throughout all sectors of the capital markets. As we found in our recently published study on credit derivatives in the global market, financial reporting and disclosure with respect to areas such as credit derivatives. off-balance-sheet financing and other forms of contingencies varies greatly by sector. Comparability is further obscured by differences in international reporting and accounting standards.
    If this type of information is difficult for us to obtain, it is almost impossible for the typical investor. Better disclosure not only leads to more accurate ratings, it creates a more informed investor.
    Fitch is an independent global rating agency valued by the credit markets, and we are here today open to all suggestions on how to improve our industry's performance and our performance.
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    Thank you.

    [The prepared statement of Stephen W. Joynt can be found on page 87 in the appendix.]

    Chairman BAKER. Thank you, sir.
    Our next witness is Mr. James A. Kaitz, President and Chief Executive Officer, Association for Financial Professionals.
    Welcome, sir.


    Mr. KAITZ. Thank you, Mr. Chairman.
    I am Jim Kaitz, President and CEO of the Association for Financial Professionals, and we thank you for the invitation today.
    Chairman BAKER. And I took my best guess on the name. I am sorry. Mr. Kaitz.
    Mr. KAITZ. You did a great job. Thank you.
    AFP represents 14,000 finance and treasury professionals from over 5,000 organizations throughout the United States. Our members are drawn generally from the Fortune 1000 and the largest of the middle market companies in a wide variety of industries.
    Our members are responsible for issuing short-term and long-term debt and investing corporate cash and pension funds for their organizations. They rely on the rating agencies when their companies issue debt and when they make investment decisions. As such, their experience with the rating agencies provides them with an opportunity to form opinions on both the strengths and weaknesses of the agencies.
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    AFP's members recognize the important role that the SEC and the rating agencies play in ensuring the efficient operation of the capital markets.
    In September 2002, we surveyed senior-level corporate practitioners, such as chief financial officers, vice presidents of finance and corporate treasurers, regarding the accuracy and timeliness of credit ratings, the role the SEC should take in regulating the rating agencies, and the impact additional competition may have on the marketplace for ratings information.
    In summary, survey respondents expressed concerns about the accuracy and timeliness of credit ratings. Twenty-nine percent of corporate treasury and finance professionals who work for companies with rated debt indicate that their companies' ratings are inaccurate. This is true for companies that have recently been upgraded, as well as for those that have been downgraded.
    Respondents from companies that have seen their debt upgraded indicate that the change took place more than six months after the improvement in the company's financials.
    Additionally, some respondents from companies that were downgraded report that it took more than six months for their ratings to reflect a deterioration in the company's financial condition.
    The survey also found that rating agencies are primarily serving the interests of parties other than investors. Less than one-quarter of treasury and finance professionals believe that ratings most favored the interests of investors. Rather, they believe ratings favored debt issuers, investment banks and commercial banks.
    Our members believe that the SEC plays an important role in overseeing the rating agencies. The overwhelming majority of respondents indicate that the SEC should take additional steps in the oversight of the rating agencies.
    Currently, there is no clearly defined process for credit agencies to achieve nationally recognized statistical rating organization status. Most respondents believed that the SEC should clarify the procedures it follows to determine whether it will recognize a rating agency as an NRSRO. Granting NRSRO status to other credit-rating agencies would provide additional competition that could result in improved accuracy and timeliness of ratings. Respondents believed that additional competition could increase both the accuracy and timeliness of credit ratings and lead to greater certainty in the assessment of corporate credit risk.
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    Once the SEC recognizes a rating agency as an NRSRO, there is currently no ongoing process to ensure that the agency's methodologies and procedures continued to be appropriate. Our survey respondents believe that periodic review of the rating agencies is necessary.
    In conclusion, AFP believes that our survey results clearly show that the time has come to reexamine the role, function and regulation of credit-rating agencies. We are encouraged by the SEC report delivered to Congress in January and the issues it identified for further examination. Many of those issues are consistent with the findings of our survey. We look forward to reviewing and commenting on the SEC's concept release when it is published.
    We are also encouraged by the SEC's recognition of Dominion Bond Rating Service as a fourth nationally recognized statistical rating organization. As I mentioned, our members expect additional competition to improve the accuracy and timeliness of the information provided by rating agencies, providing them with a greater certainty in assessing corporate credit risk.
    AFP believes that the credit-rating agencies are vital to the efficient operation of capital markets and is pleased that you have taken the lead in examining these issues. We hope that this hearing will bring to light opportunities to increase competition in the market for credit ratings and improve the quality of the information provided by credit-rating agencies for the benefit of issuers and investors in the securities markets.
    Thank you, Mr. Chairman, and I would be pleased to answer any questions you might have.

    [The prepared statement of James A. Kaitz can be found on page 95 in the appendix.]

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    Chairman BAKER. Thank you, Mr. Kaitz.
    Our final witness is Mr. Raymond W. McDaniel, President, Moody's Investors Service, Inc.
    Welcome, sir.


    Mr. MCDANIEL. Thank you, Chairman Baker.
    My name is Ray McDaniel. I am the President of Moody's Investors Service. On behalf of my colleagues, I appreciate the opportunity to be here today.
    As you know, a large number of companies over the past two years have experienced serious financial difficulties, causing suffering for their employees and sometimes significant losses for the investors in their stocks and bonds.
    Attempting to understand, and where appropriate redress the underlying reasons associated with these failings, has been both necessary and beneficial.
    Yet it is also important to keep in mind that the economy and financial markets of the United States remain the envy of most of the world.
    Moody's is proud of our role as a supporting participant in these markets. Credit ratings help level the playing field for information between borrowers and investors. Ratings improve both transparency and efficiency in debt markets by promoting investor confidence, which in turn allows creditworthy borrowers greater access to capital.
    With that perspective in mind, I would like to offer a few comments about our industry and Moody's in particular.
    Founded at the beginning of the last century, Moody's is the oldest credit-rating agency in the world. From the start, Moody's has focused on rating debt instruments.
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    Our long-term debt rating system for public bonds is the heart of our business. We have 21 long-term debt rating categories which provide a relative measure of risk. The probability of default increases with each step down our ratings scale.
    Our ratings are reliable predictors of relative creditworthiness. Their predictive content has been demonstrated and consistently confirmed through Moody's publication of annual corporate bond default studies and by third-party academic analysis.
    What this means is that, as forward-looking opinions, our ratings have effectively distinguished bonds with higher credit risk from bonds with lower credit risk.
    At Moody's, we are committed to providing the highest quality credit assessments available in the global markets. We are committed to continuous learning, both from our successes and our mistakes.
    In this spirit, we have undertaken substantial internal initiatives to learn from recent difficulties in the credit markets, as well as in response to potential shortcomings in our own analytical approach and in the broader system of market checks and balances.
    Our business model is based primarily on receipt of fees from debt issuers. Issuers are the natural source of rating agency fees for several related reasons, but most importantly for one key attribute demanded of our ratings: that they be freely and widely disseminated to the investing public.
    Ratings are critical because they condense and transmit a great deal of credit information about issuers and because they do so for the equal benefit of all investors, publicly and promptly.
    We recognize that being paid by issuers creates potential conflict of interest. Moody's has taken strict measures to avoid conflicts. As a corporation, for example, Moody's does not offer investment products, nor do we buy, sell or recommend securities. Within our ratings practice, committees, rather than individual analysts, assign Moody's ratings. Analysts are neither compensated based upon the revenues associated with the companies that they analyze, nor are they permitted to hold or trade the securities in their areas of primary analytical responsibility.
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    Over time, the use of our ratings has been adopted by numerous capital market participants for multiple and sometimes conflicting objectives. For example, issuers use our ratings because many investors demand ratings on debt issues.
    Not surprisingly, issuers would like the highest possible plausible ratings and greater control over the rating process. Large institutional investors often use our ratings in their portfolio composition and governance guidelines. Generally, these investors prefer stability in the ratings on securities that they own.
    Finally, global governmental authorities have incorporated ratings into banking, insurance, securities and other regulations to limit risk in financial institutions for the dual purposes of promoting investor protection and improving financial market stability.
    Because each group has different objectives in using ratings, the performance or quality of ratings has been subjected to multiple assessment processes. In some cases, those assessments are incompatible with Moody's goal of leveling the information playing field.
    Let me briefly turn to the degree of competition within the industry. We are confident of our ability to compete in diverse competitive environments, if competing successfully is driven by who offers the most reliably predictive credit opinions.
    That form of competition requires diverse, independent opinions. As such, we urge that any new framework not inadvertently encourage competition based on forced harmonization or reduced standards.
    Lastly, we believe that in examining ratings quality and rating-agency performance, two essential principles must be kept in mind.
    First, ratings at their core must be independently formed opinions. They must capably predict bond issuers' future creditworthiness, which means that the rating agencies must be motivated to act independently of each other, of governments and of issuers and their agents to reach the highest standards, not the most popular or most convenient standards.
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    And second, rating agencies must disseminate ratings broadly and promptly to all of the investing public. Without this attribute, ratings would cease to be a public good. They would become a tool for the few and would further tilt the playing field for information.
    Only by preserving these principles can ratings continue to fulfill the larger public values of transparency and investment protection that the marketplace, regulatory authorities and lawmakers expect of us.
    Moody's greatly appreciates the subcommittee's invitation to participate in this important panel discussion, and I look forward to answering any questions that you might have.
    Thank you.

    [The prepared statement of Raymond W. McDaniel can be found on page 123 in the appendix.]

    Chairman BAKER. Thank you, Mr. McDaniel.
    To Moody's, especially, Mr. McDaniel, I want to express the view that the committee's work is not about any particular company's performance in light of the past 36 months of market disappointments. But rather an obligation to examine the structure and question on periodic basis, whether there are alterations that are warranted or significant structures that would be justified in light of the past pass performance.
    There have been issues raised, for example, not with Moody's, that a rating agency might perform for as much as a $150,000 fee, a corporate governance examination to tell the corporate management how they can better improve their methods of operations in order to presumably enhance their ratings. It would be difficult to see someone pay such a fee, and then not have a subsequent enhancement in the rating result, otherwise the recommendations seem to be without merit. Just that one is an example.
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    We could go to other issues where a rating agency executive could serve on a broad of a company which they might be rating.
    When we went through the Sarbanes-Oxley debate, much was made to do about the relationship of analysts with investment bankers with clients and that there needed to be more separation or at least disclosure where separation was not deemed advisable of those relationships; transparency.
    It may be okay to do business with someone for a fee outside your principle public responsibility, as long as the individuals who rely on that information are made aware of the relationship and make their own judgments about the quality of that review. I think that is fine.
    And I am not suggesting that we need to have dramatic new regulatory structures, but given where we are today, in light of some of the comments made by those here on the panel and other information brought to the committee's attention, it would seem some modifications.
    For example, a clear-cut guideline by the SEC as what constitutes the approval process within a fixed period of time in which you would either get approval or not get approval as a designated rating organization.
    A clear-cut set of standards for the SEC in oversight of your activities to ensure that Moody's high standards of conduct are being attained by all others. Finally, a clear-cut process by which, if one fails to perform to that standard, one could be de-designated or undesignated. Would those kinds of principle constructs present any operational concern to an organization, such as Moody's?
    Mr. MCDANIEL. With respect to the general nature of your question and transparency and disclosure, Moody's could not agree more strongly that disclosure and transparency of information is critical to the sound operation of our financial markets.
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    We are a consumer of good information, as much as we are a provider of good information. And in that respect, we absolutely would support any efforts to improve transparency not only in the markets, but in our own industry. That is something that is very easy for us as a firm to get behind.
    With respect to two of your specific comments, I should just say that Moody's does not offer any corporate governance fee-based service, nor do we have any of our executives sit on the boards of any rated companies.
    Chairman BAKER. To that end, let's assume for the moment that members of the committee would find some generalized package not to be necessarily advisable, in light of the rating agency's performance over past years, what about the flip side? What would be the negative to a company with the stature and market share of Moody's in simply not having an SEC impromptu on the front bumper of the corporate automobile.
    I do not believe neither S&P nor Moody's needs that designation to maintain its market position and may, then, obviate the need for all these standards relative to entry, oversight and decommissioning because the market would do that between the two. Or is there a third position that you proffer as being more appropriate?
    Mr. MCDANIEL. Moody's had a very strong position in the market prior to 1975 and prior to the introduction of what was the more rapid acceleration of the use of the NRSRO designation in regulations and legislation. And we would certainly expect that we would be able to compete effectively if that designation were removed. In fact, we have a similar position elsewhere around the world where the NRSRO designation does not play a role in——
    Chairman BAKER. In your opinion, would such a determination be to the public's disinterest in any way?
    Mr. MCDANIEL. For a number of years, Moody's observed that there were risks of incorporating ratings and regulation. More recently, however, I think we have taken a pragmatic view that the concept of or the interaction of regulation with the rating agency industry as a practical matter, has become very broad and deep and it would be difficult to reverse that process. We feel that we can perform a valuable public service and compete effectively regardless of the existence or nonexistence of this designation.
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    Chairman BAKER. Thank you.
    My time has expired.
    Mr. Kanjorski?
    Mr. KANJORSKI. I just want to correct something. Mr. Alexander is the Chairman of Moody's?
    Mr. MCDANIEL. Mr. Alexander, Cliff Alexander is the Chairman of the Board of Moody's Corporation currently, that is Moody's Investors Service parent company, yes.
    Mr. KANJORSKI. Well, didn't he serve as a director of MCI from 1981 to 1998 and on WorldCom from 1998 until June of 2001?
    Mr. MCDANIEL. I do not know the dates specifically, but he did serve on the board of MCI, and then of WorldCom.
    Mr. KANJORSKI. Well, didn't you rate those two corporations?
    Mr. MCDANIEL. Yes, we did.
    Mr. KANJORSKI. Well, isn't that in conflict to what you just testified that your officials and officers are not allowed to serve on boards?
    Mr. MCDANIEL. He is nonexecutive Chairman of our Board——
    Mr. KANJORSKI. So Board of Directors Chairman——
    Mr. MCDANIEL. Yes. I am sorry. If I either misspoke or——
    Mr. KANJORSKI. Well, he has sort of an interest, so——
    Mr. MCDANIEL. He is the nonexecutive Chairman of——
    Mr. KANJORSKI. Chairman?
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    Mr. MCDANIEL. ——Moody's corporation. Yes. Absolutely.
    Mr. KANJORSKI. I would imagine that he is a major stockholder of Moody's.
    Mr. MCDANIEL. I do not know that.
    Mr. KANJORSKI. Okay. So you are giving a very limited qualification. Those in direct line authority are not allowed to serve on boards of corporations that are rated.
    Mr. MCDANIEL. The management and executives of Moody's Investor Service and Moody's Corporation did not serve on the boards of any rated companies. We do have members of the board of——
    Mr. KANJORSKI. But Directors and Chairman of the Board of Directors are allowed to.
    Mr. MCDANIEL. Yes.
    Mr. KANJORSKI. And you make a distinction.
    Mr. MCDANIEL. Yes.
    Mr. KANJORSKI. Okay.
    Mr. Egan, did you rate Enron or WorldCom or any of the failed corporations in your organization?
    Mr. EGAN. Yes, we did.
    Mr. KANJORSKI. Okay. Do you think that some of the questions should have been asked by Moody's and other rating organizations of these corporations? Should they have known the answers that would have indicated that they should not have had the ratings that they had immediately prior to bankruptcy? What did your organization rate Enron and WorldCom, et cetera? At what time did you change your ratings relative to when Moody's changed their ratings?
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    Mr. EGAN. It is a part of the written testimony that I provided. Let me just refer to it.
    We started downgrading Enron in January 27th of 2001. Okay?
    Mr. KANJORSKI. About six months before bankruptcy.
    Mr. EGAN. That is correct, yes.
    And then, you can see in the testimony our other negative actions on Enron.
    Mr. KANJORSKI. Okay.
    Mr. EGAN. WorldCom is the same sort of thing.
    Mr. KANJORSKI. Was that based on the fact that your examiners or raters asked certain questions that indicated there were offshore transactions that you felt were risky toward the viability of the organization?
    Mr. EGAN. We rely on information in the public domain. In fact, we encourage companies not to give us any information that is not public.
    Mr. KANJORSKI. You mean without asking the questions of the company you came to this conclusion?
    Mr. EGAN. That is correct. There is enough information out there to perform the analysis.
    Mr. KANJORSKI. Because Mr. Egan did not attack Moody's directly because you are on the same panel, let me throw out the question: Why did you operate only within a week of bankruptcy to find out what they found out six months before?
    Mr. MCDANIEL. The actions that Moody's took with respect to Enron were based on all the information that we were able to gather both publicly and privately on Enron.
    Mr. KANJORSKI. So you had the information of the offshore transaction?
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    Mr. MCDANIEL. I am sorry?
    Mr. KANJORSKI. You knew about all the offshore transactions, the off-balance sheet transactions?
    Mr. MCDANIEL. No, absolutely not. We did not know about all of those. We knew about a very small handful of them.
    Mr. KANJORSKI. So Mr. Egan's people, assuming they only knew what you knew, made a six-month perception that there was a problem here, six months ahead of when you were able to do it.
    But the question that we are faced with is we are trying to protect investors. How is he did not ask these questions. You were not aware that they were offshore transactions? Some of them were actually disclosed, if I recall, in the statements' footnotes.
    Mr. MCDANIEL. Yes, we did have information on a handful of offshore transactions, that is correct.
    Mr. KANJORSKI. Well, didn't you follow through what they were, what was the nature of them, how large were they, why were they there? Didn't that send up any signal that they were putting debt off the books?
    Mr. MCDANIEL. The scope of fraud with Enron was unprecedented. And we asked many questions over the course of the rating relationship with Enron to try and have the best possible understanding of that company's credit worthiness.
    However, there were multi-billion dollars worth of transactions and assets off the balance sheet which were not revealed.
    Mr. KANJORSKI. I understand all that. But what we are trying to find is a mechanism here of how to find out, get transparency of those things, so that the information is related to the investor.
    It seems to me you are telling us that, under the existing ways of what rating agencies are doing, they are not going to find this fraud, and they are not going to find this misinformation that is being given to the investor and the public and everyone else in the marketplace. So then you seem to be telling me that we have a very serious problem here that we do not have a functioning credit-rating system.
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    Mr. MCDANIEL. In hindsight, Congressman, we could have done a better job——
    Mr. KANJORSKI. I know, but that is what the accountants said. What do we have to fix?
    You heard my opening statement. I do not want to clutter up the marketplace with anymore regulations that are absolutely necessary to get to positive ends. I mean, we can have the SEC come in here with books of regulations that by the time—as a matter of fact—that will limit the business because nobody will be able to compete cause they will not be able to spend the money to conform to the regulations, and then we will really have a monopoly.
    Forgetting all of that—and we do not want to do that—how do we advise the public and the marketplace of scurrilous activity like this? For example, let's forget Enron for a moment. Did you rate HealthSouth?
    Mr. MCDANIEL. Yes, we did.
    Mr. KANJORSKI. What was it rated at?
    Mr. MCDANIEL. It has been a junk bond rated credit for three years.
    Mr. KANJORSKI. Okay. Now why was it rated that way?
    Mr. MCDANIEL. Because our analysis of the fundamentals of that company indicated that it was a relatively weak company.
    Mr. KANJORSKI. Right. And one of the things would have been, maybe, the CEO's income and residence and yachts and airplanes may exceed what he should be getting, and then maybe the board is not really a board.
    All of these things are what analysts should be looking at in making the ratings. Obviously, you got the bell to ring over there. You saw something was wrong and you notified the investor. It would be interesting to see how many people listen to your rating and got out in time to save their money.
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    Chairman BAKER. Will the gentleman yield on that point?
    Mr. KANJORSKI. Sure.
    Chairman BAKER. I would just help in the cause here.
    What troubles me is that we were very upset with the conduct of the analysts who were supposed to be advising the broader market. But in this case, rating agencies have a level of access to data which even the analysts do not have. From my uninformed position, it would appear that the rating agencies should be out ahead of the professional analysts. Did the gentleman know that?
    Mr. MCDANIEL. Yes.
    Mr. KANJORSKI. You are in the same position, as I see it, as the auditor. You can ask any question. They must have the fear of God of you, and the CEO is not going to give you misinformation that is going to kick his bond ratings and other ratings down significantly. So it would seem to me he is going to respond or else the response is going to indicate that there is some fraud going on, something is being misstated here. It should become apparent.
    All I would like to correct is to fill that vacuum. I probably would like the industry to make a self-analysis. What happened? Why? Where did the vacuums occur? What responsible actions should the Congress or the SEC also take to make sure it does not happen again in the future so that we have a better market?
    I say that because, quite frankly, I am so impressed with the fact that we are making so much out of 10 or 15 major failures. A lot of money was lost. But, there are the thousands and thousands of good companies, good executives, and good people that are out there. I cannot over emphasize that point.
    We are just talking about problems in the margins, more than two standard deviations from the norm. We are way out here. But still we cannot allow hundreds of billions of dollars to be lost fraudulently or by misrepresentation that either the accountants, the rating agencies, the analysts, or somebody else has to be out there picking up.
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    I come to the question Dr. White proposed. He said that we had two alternatives: We can do it in-house or we can enlarge the number of recognized entities that can perform this function and try and agitate some competition out in the field. Are you suggesting a government-sponsored enterprise to perform ratings?
    Mr. WHITE. Absolutely not, Congressman. The basic choices I laid out were essentially the position that Moody's held until a few years ago. If you look at their comments to the SEC back at the 1997——
    Mr. KANJORSKI. What did they do a few years ago that changed them? In your estimation, what made them lose the right——
    Mr. WHITE. I do not know. And I must confess, I was distressed to hear Mr. McDaniel's statement. I fear that this is a bargain with the devil and that you [Mr. McDaniel] are going to regret it when you find SEC regulations coming down on top of you. I think that this is a mistake.
    I think the clean market-oriented result is to get the regulators out of delegating, have them do their jobs, make their own judgments about the safety of, for example, corporate bonds in bank portfolios——
    Mr. KANJORSKI. But when you were talking about the regulators——
    Mr. WHITE. ——and then the capital markets can make their own decisions.
    Mr. KANJORSKI. But when you were talking about the regulators, Dr. White, you are talking about the SEC as being one major regulator?
    Mr. WHITE. That is right.
    Mr. KANJORSKI. And this Congress refused to appropriate sufficient funds for them to hire the personnel to do the job. I say in the last three years since the peak of the bubble, thank God we had the private market to self regulate. I mean, those people at the SEC were inundated. What were they doing, one audit every five years of major corporations?
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    When we have the political swings and the philosophical swings in this country there is a tendency if you want to avoid regulations you can repeal them. But if it is not politically acceptable or if you do not want to do it, just starve the agency that has the responsibility and you have accomplished the same thing. And we did starve the SEC.
    Mr. WHITE. Congressman, I could not agree with you more and I think that was a big mistake. Where regulation is needed, the regulators should have the funds and the resources to do the job.
    Here is one area, though, where I think we could pull back and let the financial markets make their own decisions. We would get more innovation, more new ideas, and we would not have to worry about, ''Is the SEC doing the right thing or the wrong thing with respect to the NRSRO.''
    Mr. KANJORSKI. Accomplishing that by taken a designation away as a nationally recognized statistical rating organization.
    Mr. WHITE. That is right, get rid of the category. But it does mean you have to get the other regulators, including the SEC to make their own judgments——
    Mr. KANJORSKI. But then we would have to back up and change a lot of prior legislation that used that standard.
    Mr. WHITE. It is really worth doing. You would not be holding this hearing today in that kind of world.
    Mr. KANJORSKI. How about if we have a Texas cowboy—and I hate to use that expression——
    But what if we have a Texas cowboy rating agency that comes along and says, you know, ''You hire us for $1 million, and you just may get the best rating you have ever heard of.''
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    Mr. WHITE. And very quickly the markets—if you do not have that regulatory overlay, the markets will figure out, ''This guy's ratings ain't worth the paper they are written on. We will pay no attention to this guy's ratings.'' And very quickly other companies will realize they do not get anything by paying this guy whatever he is asking.
    Mr. KANJORSKI. After several years. But up until that time, what would happen?
    Mr. WHITE. Oh, I think it will be quicker than that.
    Chairman BAKER. If I can, recognize Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman.
    Mr. Joynt, in your prepared testimony you talk about addressing concerns raised about conflicts of interest posed when rating agencies offer ratings advisory services. And according to your testimony, I understand that you have already decided to stop providing this service to some issuers and are contemplating doing away with it altogether. Is that correct?
    Mr. JOYNT. It is. But it is sort of an easy concession because we just started doing rating assessments last June, and we had only completed three. So we did not have an extensive practice at all. And so what we have decided to do for now, while it is being looked into, is not accept any new proposals in the U.S., at least for any rating assessment services, and consider whether they should be done by separate analysts, nothing to do with our rating analysts.
    Mr. OXLEY. And after three examples, what changed your mind?
    Mr. JOYNT. Only the outside spotlight on that practice coming from the SEC's review and thinking about it; not a concern of our own internally.
    Mr. OXLEY. I see.
    Mr. Root and Mr. McDaniel, what is the status in that particular issue with Dominion and Moody's? Do you offer similar services, and have you determined whether you wish to continue those?
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    Mr. ROOT. At Dominion, we do not offer those services. Our revenue stream is strictly from the rating of institutions and the research that we provide.
    Mr. MCDANIEL. We do offer the service called the rating assessment service. It constitutes less than 1 percent of our annual revenues. I would expect, even if we continue it, that it would continue to represent 1 percent or less of our total revenues. And we do it as an accommodation for companies that are contemplating major transactions, acquisitions or mergers or something of that sort. And are looking for some idea of what the consequences of those activities might be on the credit rating.
    We frankly would prefer to provide informal feedback. It is less time consuming. It is a process that does not carry some of the issues that, I think, concern the SEC and other authorities that have looked into the business, and we do encourage that.
    Mr. OXLEY. Informal meaning, noncompensated?
    Mr. MCDANIEL. Yes, exactly, noncompensated.
    Mr. OXLEY. Do other members of the panel have any opinions on the conflict of potential conflict of interest in this particular service.
    Mr. WHITE. Congressman, it cannot be a completely black box. Suppose a company needs to know, ''Now, if I do X, what are the consequences going to be?'' The answer just cannot be, ''Well, we cannot tell you, just go ahead and do it, and then we will tell you.'' That is just not a feasible way to proceed. I am very sympathetic to this process. But you know, I am not sympathetic to the whole, larger structure.
    Mr. OXLEY. So you like what Mr. McDaniel's said in terms of the informal aspect to it?
    Mr. WHITE. Whether it is formal or informal is not important. It cannot be a black box.
    Mr. OXLEY. Now, Mr. Chairman, I could raise a question, and I apologize for this because Ms. Nazareth, our first panelist, in her testimony this morning talked about some issues regarding the potential changes in regulation and how this whole concept is treated at the SEC. And she made the comment—and I made a note at the time, and then we had to go vote and I did not get a chance to ask her.
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    I am kind of paraphrasing this, but she indicated that there were some First Amendment issues raised by the ratings agencies—and I see the professor shaking his head—could you help me on that? What First Amendment issues are out there and how are they raised.
    Mr. WHITE. Sorry, I am not a lawyer. I do not practice law without a license, especially in this August body——
    Mr. OXLEY. We give you a dispensation here.
    Mr. WHITE. Well, thank you.
    I think the representatives of the agencies would be in a better position to be able to explain.
    My understanding is that they have described themselves as publishers. They are publishing opinions and are thereby covered by the First Amendment, in terms of commercial speech.
    Mr. MCDANIEL. Chairman Oxley, I would be happy to add. I agree with Professor White. The basis for the First Amendment comments that Ms. Nazareth made, I believe relate to the fact that we are publishers of opinions, and our opinions are released to the general public in the form of ratings and press releases explaining the ratings. And it is not just simply an assertion on our part, there is case law history that supports that.
    Mr. OXLEY. Yes?
    Mr. EGAN. In our view, the First Amendment has provided an ideal cover for the major rating firms to take anti-competitive behavior. They were sued by two municipal issuers in the early 1990s when in Moody's case, they were not retained by the issuer and they issued a punishment rating. The issuers sued Moody's. And Moody's said: ''This is our opinion. I am sorry we did not have enough information, we had to issue a very low rating.'' The fact is, they were protecting the monopoly.
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    Mr. OXLEY. And that defense was a First Amendment defense?
    Mr. EGAN. Exactly.
    Mr. OXLEY. And that was the case that you referred to.
    Mr. EGAN. That is what I was referring to, yes.
    Mr. OXLEY. Was that the case—I am sorry—Mr.—was that the case you referred to?
    Mr. MCDANIEL. Well, I am not sure if I am talking about the same case as Mr. Egan. We have never issued a punishment rating. We would never put anything into market other than our best possible opinion. It may be right, it may be wrong, but it is our best possible opinion.
    And we have had cases where issuers have not wanted us to publish opinions. And in a particular case, one in Colorado is one I would be referring to, an issuer did sue us for assigning a rating on an unsolicited basis. And we had a successful First Amendment defense to that suit.
    Mr. OXLEY. Mr. Egan, is it your understanding that that case is a controlling authority in that area?
    Mr. EGAN. I think it was—well, I do not know.
    Mr. OXLEY. Mr. Chairman, I would ask unanimous consent, perhaps, that Mr. Egan could supply us with some of that information in writing.
    Mr. EGAN. Yes. There are some articles in Wall Street Journal in the mid-90s about the two municipal issuers that did sue Moody's for the punishment ratings——
    Mr. OXLEY. And for balance in if I may suggest we ask Mr. McDaniel for the same information to have their—that would be helpful, I think, for staff and the members to better understand that whole First Amendment issue.
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    Mr. EGAN. Yes.
    Mr. OXLEY. Thank you, Mr. Chairman.
    Chairman BAKER. Mr. Shays?
    Mr. SHAYS. Thank you, Mr. Chairman, again, for holding this hearing.
    And thank you to the witnesses.
    When bad things happen it is easy to, with hindsight, obviously to cast dispersions, and I do not want to do that, but I am interested, with hindsight, how people reacted. And I found Ms. Nazareth's response is frankly, you know, not alarming, but very disappointing.
    And I also want to say, you know, since I have been in college, Moody's and Standards & Poors, you know, I just put them way up there, but I have to say, I also put Enron up pretty high, too. And for me, what happened in Enron, was a wake-up call. I want to know if we are waking up.
    So let me ask you, first, Mr. McDaniel, what was your reaction when you learned about what happened at Enron?
    Mr. MCDANIEL. The Enron situation was, I would agree, indeed a wake-up call not just for Moody's, but for the market generally. And we took a number of steps in response to the collapse of Enron, as well as some of the other corporate collapses that have followed over the last 18 months or so.
    We began publishing liquidity risks assessments which focused on the short-term liquidity position of the firms that we rate. We conducted a comprehensive rating trigger survey, both in the United States and in Europe asking companies specifically whether they had elements in financial contracts that would cause posting of collateral or cash calls in the event that rating fell below a certain level. And we found that there were a large number of those and a large number of those that were not otherwise disclosed.
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    We created two regional chief credit officer positions for our corporate ratings; one in the United States and one in Europe. Most importantly, though, we began what we call a specialist initiative or an enhanced analysis initiative where we have been hiring accountants, off-balance sheet risk transfer specialists and corporate governance specialists to both broaden and deepen the scope of our rating analysis.
    Mr. SHAYS. Let me ask you, though, in terms of your own state of mind, was this a shock to you?
    Mr. MCDANIEL. Yes.
    Mr. SHAYS. Were you embarrassed that Moody's was so high on this company for, you know, until death do us part?
    Mr. MCDANIEL. I want to be careful in answering because we were not high on the company. We had rated it in our lowest investment grade category.
    Mr. SHAYS. Yes, but your lowest investment rating is still—I mean, was it that in the standard of one to 20-something, it is still pretty high up there, right?
    Mr. MCDANIEL. Yes. Well, it is in the middle.
    Mr. SHAYS. But it clearly—you mean it is like a 10 or is it more like a four? I mean, in terms of your rating scale.
    Mr. MCDANIEL. It is in the middle. A BAA rating is—there are three rating categories above it and three rating categories below it. So it is a rating indicating that we do believe it is investment grade and, as we publish in our definitions, contains——
    Mr. SHAYS. Do you have people that are totally focused on Enron or is your business so big that you just—I mean, do you have people dedicated to just looking at Enron?
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    Mr. MCDANIEL. We never had a single individual dedicated to Enron.
    Mr. SHAYS. When VIVA, a Germany company, wanted to unite with Enron, and another accounting firm was called in, like two years before Enron took a nose dive, I think, the U.S. accounting firm said there is $2 billion of undisclosed liability. Why didn't that impact Moody's determination of this company?
    Mr. MCDANIEL. I apologize, Congressman, but I do not have those specific facts at hand. I would be happy to, you know, provide them for you afterward.
    Mr. SHAYS. Help me out, Mr. White. I would also say I do not often get someone from the Stern's school, where I graduated in economics, but never had you, sir, only cause I was there 30 years ago.
    I am intrigued by the fact that evidently there are no standards, no formal requirements in which to joint this select group of nationally recognized statistical rating organizations—and it is done in private—how someone—to know how they qualify.
    Mr. WHITE. Congressman, I think that is an excellent question. I do not have a good answer for you, and I was not happy with Ms. Nazareth's answers either. Basically it is body language. If you look at the 1997 proposed criteria, the SEC said, ''We have been sort of using this criteria for our no-action letters. We might as well put them out and see what the reaction is.'' So——
    Mr. SHAYS. But it strikes me, how are you able to determine if you do not have—I mean, it is almost like what you would be taught in ninth grade or earlier that you got to have some kind of standards and people have to meet these standards and then you know. I mean, it is like I have an impression that the business community is pretty smart. And that when people criticize politicians, you know, we sometimes take hits. But I am begging to think the business community almost makes politicians look brilliant.
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    Because, seriously, I mean—I am almost sounding very self-righteous here—but someone on this panel tell me why you do not need, first, if you disagree and you think there are standards, and then tell me why we do not need standards. One person here tell me why.
    Mr. WHITE. Again, Congressman, if we are going to have the NRSRO category, then we need standards. They need to be transparent. And they need to be applied equally to incumbents, as well as to entrants. They should be performance standards, not input standards the way the 1997 criteria were stated.
    Mr. SHAYS. Does anyone on this panel disagree with that, with what Mr. White said? Anybody? I am going to infer that all of you agree with that.
    Chairman BAKER. Mr. Shays, if I can seize upon that moment? We are going to come back for another round. And Mr. Inslee's arrived, and since he has not had an opportunity to ask, I would like—Mr. Inslee do you have questions at this time?
    Well, that makes it easy. Well, we will start a second round here. Just briefly; following on Mr. Shays' point, I may suggest in writing, to each of you, just to respond to us on some points that were raised during the course of the hearing today, one of which will be the Shays' observation about no objection to the generalized points he made.
    Mr. Kanjorski had a few points he wanted to get on that record that, I think, we would include in that document.
    And I want to find out, basically, two generalized approaches. If we maintain the current system, from each of you, what do you see as the minimal steps necessary to have a functioning system treating all participants equally that is transparent and understood by the market without getting into day-to-day regulation of your business, whether you engage in rating and consulting with the same client or not? I am not prejudging any activity. But if you do it, how do you disclose that?
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    Whether officers and officials of the rating agency serve in a board capacity of a rate enterprise? Fine. But if you do it, how do you disclose that in a broad context, not as narrowly defined today?
    And further, the comment as to whether or not you deem it advisable to maintain the current system, meaning the bumper sticker on the front of the corporate vehicle, as a necessity for the flow of information to the capital markets and to the public? And it will be cleaned up where it makes more sense than that.
    But just indicate to you that I hope we have several members of the committee sign on and we may very well send the same letter to the appropriate SEC officials for comments, which will enable us to kind of get to closure on this. I do not want to have this hearing raise a bunch of issues, and then not subsequently take some steps to bring us to resolution. So I think Mr. Shays' question is a good starting point. And Mr. Kanjorski and others who are interested will engage in that activity and get it out forthwith.
    Mr. Kanjorski, I believe you had some more questions.
    Mr. KANJORSKI. Yes. I am going to take advantage of my position and the quality of our panel. I direct this question to everybody on the panel, but primarily the representatives of the major rating agencies, including Mr. Egan.
    A number of months ago, probably less than six, probably more than three—I cannot quite yet place it in, I had an extensive meeting with a very highly appointed official of the present Administration who has a great deal to do with economics, financial markets, et cetera. I will leave it at that.
    In the course of that meeting, in analyzing the macroeconomic condition of the United States and the world, he indicated to me that he had great worries that there were perhaps more than 200 corporations that had difficulties yet undisclosed and unknown that he saw coming down the road. Most recently, HealthSouth fell into that category.
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    Now, those of you who are in the rating agencies, are you giving the investors a macroeconomic picture of that possible future? Are you giving the public any awareness that could help us out? Do we have to go through every company that is on all the exchanges to try and come up with the identification of who those companies may be?
    The thing that worries me, since I do not either have the time nor the inclination to examine every publicly traded corporation to try and identify those 200, is would they, the problem companies clearly, in your ratings, show up so that a simpleton, such as myself, could look at those ratings and say, ''Here are the 200 of them that are in trouble, and that we can anticipate problems that will have a definite impact on the economy.''
    Mr. EGAN. Yes. We maintain a list where we compare our ratings against Standard & Poors ratings, and there are a number of companies where we are significantly lower. And by the way, we are in the business of protecting investors, period. So we want to get to the truth quickly.
    We measure ourselves on what is called hits and misses. That is, if there is convergence where S&P or Moody's move toward our ratings, that is considered a hit. If they move away, it is a miss. Last year, there were 440 hits and about 19 misses; year before, about the same. So we constantly keep track of it.
    And we do see a number of huge problems out there. Probably the biggest one that has not been dealt with is the pension fund and health care liabilities. A lot of corporations are not treating it as real liabilities. They are hoping that the market is going to zip up 100 percent over the next two years. We tell our clients or identify where there are huge problems. Many times we get into difficulty because our ratings are so far apart from the majors. And the Enron, the WorldCom, the Global Crossing has given us the leeway with our clients to maintain that huge discrepancy.
    Chairman BAKER. Would the gentleman yield?
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    How many companies do you rate?
    Mr. EGAN. Approximately 800.
    Chairman BAKER. And how many does S&P rate?
    Mr. EGAN. In the corporate area, significantly more——
    Chairman BAKER. Including bond market and everything. The scope of their full authority, what do they do in an annual period of time?
    Or if I can, I will jump Mr. McDaniel. What is your rating responsibility? I am trying to get some sense of scale here.
    Mr. MCDANIEL. Almost 6,000 corporate and structured finance—corporate entities and structured financed vehicles, about 16,000 public finance issuers.
    Chairman BAKER. So a total of 22,000 obligations versus——
    Mr. EGAN. Eight hundred, maybe 900. But we focus on the corporate.
    Chairman BAKER. I understand.
    I thank the gentleman for yielding.
    Mr. KANJORSKI. Mr. McDaniel, do you have any macro picture that you could make available? In other words, I am trying to determine whether this remark was off the top of his head or is this really a serious matter where we have 200 major corporations that may be in significant difficulty out there that the public is not aware of?
    Mr. MCDANIEL. Well, we rate slightly over 1,000 corporations in the junk category, speculative grade, below investment grade. I think your question is going more to, ''Are we providing a macroeconomic framing around that?'' And we do do that through our economics department, and that is published both on our Web site and through major media outlets, and that includes economic analysis and default probability analysis and forecasting.
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    Mr. KANJORSKI. Is this information readily made available? It was rather shocking to me when he told me that statement, but maybe it just means I am under read.
    Mr. MCDANIEL. It is available on our Web site. Our economists would speak to the major news outlets. I do not know how broadly it might be consumed. I have not looked at the Web sites hits on that in some time.
    Mr. KANJORSKI. Mr. Joynt, do you have a comment on that?
    Mr. JOYNT. I have a couple of comments. One, I think, also Fitch does industry surveys describing whole industries and how they would be affected by economic development. So if we expect in the next several years deteriorating economic conditions globally or in the U.S., then you could first look at those industry pieces to try to identify companies that might be problematic; the airlines industry today. So I could not have maybe told you the amount of problems they would have had a year ago, but in light of what has happened in the world today and with the war, then they are having significant problems and they are quickly deteriorating.
    Also, by looking at industry studies you can look at groups of companies that are competing against each and how they are leveraged. And so there are a significant number of companies, as Mr. McDaniel has pointed out, that Moody's rates 1,000 that are non-investment grade, many of which would be highly leveraged, and so those would be candidates for a more rapid deterioration.
    Is that helpful?
    Mr. KANJORSKI. Yes, it is helpful.
    I am sitting back here and listening to a lot of analysis coming out of government, coming out of industry, coming out of academia, and it does not seem to me that there are many people out there discussing real potential economic risks.
    Some people call it meltdown, others have termed it something else. Everybody can use their own imagination to describe it. But it is something that we must explore. For example, about two or three months ago, the Japanese Government went to the bond market and they wanted to sell Japanese bonds and there were no buyers. Is that correct?
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    And I do not know how they were rated.
    Now, just around two weeks ago, the Deutsche Bank formally notified the German government that under present conditions, if they continue as they might, the German banking system might become insolvent.
    So now we have the second-largest economy in the world unable to sell its bonds; we have the third-largest economy in the world talking about bank insolvency; and we are the first economy in the world and I do not know whether we are in the stage of prosperity or recession. We do not know. I would say, however, we are probably in stagnation, and in the midst of a war.
    Additionally, I am hearing hue and cry out there indicating that not only the United States but the world may have some very, very, very serious economic situations. We seem to be only talking about the economic situation of the United States vis-a-vis the 2004 presidential and congressional elections at this point. You know, as long as we can do anything to not address this issue between now and then, we do not want to shake the population up.
    And yet, let me go further with this analysis, this discussion, because it did disturb me and does continue to disturb me. It is something I want to take up with my chairman in the not too distant future. The unnamed official then indicated that the problematic period would be 12 to 18 months. We subsequently did talk about an economic meltdown.
    We did not just talk about an industry meltdown, such as the airlines, but a global meltdown. I said I was always worried about that problem and I had always wanted to look at that problem. I also estimated at best there would be maybe a one-in-ten chance of that meltdown happening, but he shook his head knowingly. He then said that he thought it was more like a one-in-three chance of that meltdown happening.
    Is there any reasonable truth to that analysis?
    Mr. EGAN. We would not disagree with that. The problem that we face is when we sound the alarm, and we did on some of the auto companies recently, that we have run into a lot of difficulty. We have sounded the alarm on some major government-sponsored entities and some major bond insurers who have Triple A ratings by our competitors; we think they are far from it.
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    There are a number of things that can happen that can trigger it and we are very concerned. So we are balancing that high level of concern with protecting investors and really trying to steer them to the safe harbors.
    Mr. MCDANIEL. The issues that you are identifying that are macroeconomic level, Congressman, particularly in the situation of Japan and Germany, I think might be more fairly characterized as longer term, chronic problems, rather than acute problems that are likely to have significant deterioration over the next 12 to 18 months. We have a Single A rating on Japanese government bonds, those are the Yen denominated bonds——
    Mr. KANJORSKI. Those are the ones they could not sell?
    Mr. MCDANIEL. The ones that they sold several months ago, yes, we rate them A-2.
    Mr. KANJORSKI. But there were some that they had no buyers?
    Mr. MCDANIEL. And the Bank of Japan and governmental authorities may step in and buy the paper.
    Mr. KANJORSKI. The real market did not buy those bonds, though you had an ''A'' rating?
    Mr. MCDANIEL. I read the papers, in terms of what the market appetite was for those bonds. You know, we did not have conversations with the Japanese government about what the appetite was for those bonds. But we do hold a Single A rating on the government of Japan for the yen-denominated bonds. That is down from a number of years ago, from Triple A. So we have been moving down on the rating scale for the yen-denominated securities. And, in fact, they are substantially below their dollar-denominated securities.
    Chairman BAKER. If I can, Mr. Kanjorski, can I jump to Mr. Shays.
    Mr. Shays?
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    Mr. SHAYS. Mr. Chairman, I want to say, this is an excellent panel. We have just kind of scratched at the surface, though. For instance, Ms. Cummingham, I would like to ask you, the rating agencies are important to you because of law, but do they provide a valuable service to you if the law was not requiring that you use them?
    Ms. CUNNINGHAM. They are one of many inputs that go into our decision-making process for the securities that we purchase in the institutional marketplace with funds that we manage. I think that by and large the fixed income marketplace is an institutional marketplace; it is really not a retail marketplace.
    If you are going to buy bonds as a retail investor, you would probably buy Treasury securities. So it is not necessarily something you would be utilizing rating agencies for.
    On the assessment of the other types of fixed-income securities that are in the marketplace, I think by and large the retail investor is looking to independent adviser services, such as Federated, that utilize the rating agencies as one of the inputs, but certainly not entirety.
    Mr. SHAYS. Do you have to use the nationally recognized statistical rating organizations or can you use Mr. Egan's organization?
    Ms. CUNNINGHAM. We can use any input that we would like. We are required by law to recognize if a rating is designated from one of the NRSROs.
    Mr. SHAYS. So it becomes pretty important that it be from one of the four?
    Ms. CUNNINGHAM. It is a hurdle level that is mandated on a regulatory basis if it exists. If it does not exists, we do not have to use them.
    Mr. SHAYS. Mr. Egan, would you explain to me why you have worked so hard to be one of these four, now five. What difference does it make to you? You have how many employees?
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    Mr. EGAN. I think we are up to about 13 right now. We have about 300 institutional clients, mostly institutional investors, some broker dealers. A number of institutions simply will not look at our ratings since we are not an NRSRO. The thought is that if you are any good, you would have the designation.
    It is interesting, but I just heard yesterday from a client when they heard about this hearing, they said, ''Please, please, do not become an NRSRO because their ratings are no good.'' In other words, they did not want us to be compensated by the issuers, who—they think that is a fundamental conflict, and we said, ''We could not agree with you more.'' And we are not going to change our business practice. We are going to continue to refuse compensation from the issuers, and just get it from the investors.
    So to answer your question, it will broaden our voice in the market.
    Chairman BAKER. If the gentleman will yield on a point you asked Ms. Cummingham about, just to make sure that I got it correct. In your earlier testimony you did indicate that the Investment Company Act does require you by law to utilize the NRSROs with regard to money market funds and asset-backed securities.
    Is that correct?
    Ms. CUNNINGHAM. That is correct.
    Chairman BAKER. Okay, thanks. I thank the gentleman for——
    Mr. SHAYS. So you only have, basically, four companies to turn to?
    Ms. CUNNINGHAM. That is correct, if those ratings exist. If those ratings do not exist for those particular issuers that we are purchasing we can buy non-rated securities.
    Mr. SHAYS. Mr. Kaitz observes in his testimony that 29 percent of corporate treasury and finance professionals who work for companies with rated debt, indicated that their companies ratings are inaccurate.
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    He also states that only 65 percent of the corporate respondents that use credit ratings to make investment decisions believe that the ratings of the companies in which they invest are accurate.
    Doesn't this lack of confidence in the accuracy of firms ratings raise concerns about their ability to perform their jobs. And, Mr. Kaitz, would you start and then I want to ask each of you to answer.
    Mr. KAITZ. The premise of the survey really was a result of, to your point earlier, Mr. Shays, the debacle with Enron. So this was an outgrowth of our membership, which is a professional organization.
    And I think that it was expressed in some of our membership that this was a broader issue, which is why we did this survey. Obviously, the results speak for themselves in terms of the accuracy and the timeliness of those ratings. And interestingly enough, as I pointed out, members revealed that not only with upgrades, but also with downgrades that there was a significant time lag.
    So I think the survey speaks for itself that our membership does believe that there are some issues, both in accuracy and timeliness of the rating agencies.
    Mr. SHAYS. Before I go to the other panelists, to answer who rates the rating agencies?
    Mr. KAITZ. From a——
    Mr. SHAYS. From a standpoint of how accurate they are in comparing them? Does Fortune Magazine look at the others?
    Mr. KAITZ. To my knowledge there is no one that currently does that.
    Mr. SHAYS. I would think that would be a great business to go into.
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    Mr. EGAN. In fact, the——
    Mr. SHAYS. No, I am serious, it would seem to me that if you could start to develop a standard on how accurate these folks are, that you would basically provide a tremendous public service.
    I would think an entrepreneur like you, Mr. Egan, would jump on that.
    Mr. EGAN. In fact, the Federal Reserve Board of Kansas City just came out with a study, it was published yesterday, and it indicated that there is a lot of stickiness in the investment grade ratings of S&P and Moody's——
    Mr. SHAYS. There are a lot of what?
    Mr. EGAN. What they call stickiness. In other words, like the Enron case, where the rating was kept too high for too long—same with WorldCom.
    And that the other rating agencies, S&P and Moody's moved in, down to our ratings afterwards, an average of about three months or something like that.
    But, yes, you are absolutely right. And they went through all of our ratings from when we started in December of 1995. I think I sent to your staff, it just became available yesterday, a copy of that survey.
    Mr. SHAYS. I guess that I could kind of change the design of the question that I asked Mr. Kaitz and ask, the four rating agencies, three that have the designation, how are you held accountable?
    Mr. MCDANIEL. At Moody's we publish annual default studies——
    Mr. SHAYS. Annual what?
    Mr. MCDANIEL. Annual default studies. It looks at all of the ratings that we have out in the corporate bond market, and it looks at the defaults that have occurred over the previous year.
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    I think we have just published our 16th annual default study. That shows whether or not our ratings are predictive. It shows whether or not companies that receive higher ratings default less frequently that companies that receive lower ratings.
    Mr. SHAYS. Would that be the standard or should there be some levels in between? A default means bankruptcy, basically?
    Mr. MCDANIEL. A failure to pay on an obligation.
    Mr. SHAYS. But what, would there be anything that would be in between that that you could also—I mean, I think that is good that you do that, obviously.
    So, but that is the extreme, correct?
    Mr. MCDANIEL. Well, it is an aggregate measure of whether as you move down the rating scale defaults become more frequent or whether there is not a relationship between a lower rating, in increasing degrees, with higher default probability.
    Mr. SHAYS. How about, I am sorry, thank you.
    Mr. JOYNT. I might just add to that, actually, to address your question, there is also transition studies that are published by Moody's, Standard & Poor's and Fitch, of the movement of ratings among categories, A to A minus, so in addition to the ultimate default probability there is the movements that are studied.
    Mr. SHAYS. Okay.
    Mr. JOYNT. And Fitch also——
    Mr. SHAYS. And the study of the movement suggests what? That you are describing the movement or you are saying we could have called it better here or here?
    Mr. JOYNT. No, it is actually looked at in the many ways one would want to look. Does it look like the ratings are moving too quickly—overreactions? Are they moving too slowly? Have they jumped categories? Do they move by one notch at a time?
    So, and to come back to your more basic question, which is, who rates the rating agencies? Investors do, all the time.
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    I think the effectiveness of rating agencies comes from investor scrutiny and the improvements in rating agencies come from investor demands for more research and more background information, not just the published rating alone.
    And I think that is who is rating the rating agencies. And I think that is a separate matter from just the NRSRO designation, which I would acknowledge has some bearing and merit on people's usage of ratings, as well.
    But not the sole——
    Mr. SHAYS. Just to put it on the record.
    Mr. ROOT. Yes, I am going to add, you know, our core business is in Canada, and there is no such thing as NRSRO; so, you know, kind of following up on what Steve just said that, you know, who is rating us, who is grading us? It is the marketplace.
    Because there is no regulatory designation that gives us the similar type of status, if you will, as we have here. So to the extent——
    Mr. SHAYS. So you would argue that you do not need that status?
    Mr. ROOT. As long as everybody else did not have it, correct.
    Mr. SHAYS. Right.
    No, but that is interesting. I think that is a summation for me. I mean, if the others do not have it then let the marketplace—I mean, S&P and Moody's would be way up there, it is just, they are both great companies, they are big, they are large, and it is not like the ratings are enabling the new folks with just 13 employees to jump in and be given that status.
    Would you agree with Mr. Egan that maybe you just get rid of it all?
    Mr. EGAN. I believe so. What has happened to this point is that there has become a whole infrastructure that has supported the two majors. For example, if an issuer decided not to hire S&P and Moody's, and they hired somebody else, the investment bankers could very well make it difficult for that issuer and discourage the issuer from using those other sources.
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    It is very—the system has already been set up, it does not work and there are a lot of parties supporting the current system. So maybe—it probably would be better than what is currently, but I do not know if that is the ultimate answer.
    Mr. SHAYS. Okay, Mr. White, I am going to just let you finish, I am sorry.
    Mr. WHITE. Thank you. I want to give you my reaction to what you have just heard.
    Mr. SHAYS. Okay.
    Mr. WHITE. First, I did not before and I was derelict as a professor at the NYU Stern School of Business in not commending you for having made a good choice of institutions.
    Mr. SHAYS. Yes, you made a good choice in the past.
    Mr. WHITE. I have been there for 27 years, so I think we just——
    Mr. SHAYS. 1974 is when I graduated.
    Mr. WHITE. And I arrived in 1976. But I will make sure our alumni office has you——
    Mr. SHAYS. Trust me, they do.
    Mr. WHITE. Okay.
    As I stated earlier, I believe in a markets-oriented approach; I think that this is the best way to ensure that we get new ideas, innovations, in the whole assessment of corporate health and viability. That is the direction we need to go. But if we going to go in that direction, then we have to realize that this does require a number of financial regulators to cease delegating their judgments to the rating companies. They must make those judgments themselves.
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    For example, since 1931, bank regulators have been telling banks that the banks must pay attention to the ratings on the bonds that the banks hold in their portfolios. Since 1936, banks have not been permitted to hold bonds that were below investment grade in their portfolios.
    The immediate question is: Whose judgment——
    Mr. SHAYS. Right.
    Mr. WHITE. ——as to investment grade? And that was in limbo until 1975 when the SEC stepped up, to its credit, and said, NRSRO, that will be the category whose judgments should be adhered to.
    If you are going to get rid of the NRSRO category, then you have to somehow deal with this issue of what is to prevent the XYZ rating company from coming along, giving out AAA ratings to anybody——
    Mr. SHAYS. Very good point.
    Mr. WHITE. ——willing to line their pockets?
    And the bank regulators can do it. They need to deal with bonds the way they deal with loans: Bonds are just another form of loans. When the bank regulators sent their examiners into a bank, on day one the examiner says, ''tell me about your loans.'' And on day two the examiner should say, ''tell me about your bonds.''
    Moody's, back in 1997, offered similar types of suggestions to the SEC as to how the SEC could substitute its own judgments for its use of NRSRO status. That could be done across the board.
    Mr. SHAYS. You took about four minutes to give me a one-second answer, but I got it.
    Well, I get the point. In other words, you made your point.
    Mr. WHITE. Okay. Thank you, Congressman.
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    Mr. EGAN. I question whether bank regulators would be able to catch Enron or Worldcom or Genuity. I do not think they have the training, the incentive, the tools to do it. I think to reform the system you need rating firms not to be paid by the issuers, get rid of some of these basic conflicts of interest, that is the first step to reforming it.
    Encourage young firms, like ourselves, to have a vibrant, healthy credit analysis industry, as opposed to what we have—this basic partner monopoly, with people sitting on boards and all the other unhealthy aspects.
    Chairman BAKER. Okay. Thank you, Mr. Shays.
    Mr. SHAYS. Thank you.
    Chairman BAKER. I want to thank all of you for your participation in a what was not expected—if anybody had told me that a hearing on transparency in credit reporting agencies would last until 1:30 in the afternoon, I would have had them—well, in any event, I am surprised by the events of the day.
    And I do find it very helpful to the committee's work. We will followup with our letter of inquiry. And we look forward to your responses, as timely as possible. We thank you for your participation. And this meeting is adjourned.
    [Whereupon, at 1:32 p.m., the subcommittee was adjourned.]