[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE RATINGS GAME: IMPROVING
TRANSPARENCY AND COMPETITION
AMONG THE CREDIT RATING AGENCIES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 14, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-110
U.S. GOVERNMENT PRINTING OFFICE
97-016 WASHINGTON : 2004
_________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866)512-1800;
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Washington, DC 20402-0001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana PAUL E. KANJORSKI, Pennsylvania
SPENCER BACHUS, Alabama MAXINE WATERS, California
MICHAEL N. CASTLE, Delaware CAROLYN B. MALONEY, New York
PETER T. KING, New York LUIS V. GUTIERREZ, Illinois
EDWARD R. ROYCE, California NYDIA M. VELAZQUEZ, New York
FRANK D. LUCAS, Oklahoma MELVIN L. WATT, North Carolina
ROBERT W. NEY, Ohio GARY L. ACKERMAN, New York
SUE W. KELLY, New York, Vice Chair DARLENE HOOLEY, Oregon
RON PAUL, Texas JULIA CARSON, Indiana
PAUL E. GILLMOR, Ohio BRAD SHERMAN, California
JIM RYUN, Kansas GREGORY W. MEEKS, New York
STEVEN C. LaTOURETTE, Ohio BARBARA LEE, California
DONALD A. MANZULLO, Illinois JAY INSLEE, Washington
WALTER B. JONES, Jr., North DENNIS MOORE, Kansas
Carolina MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona STEVE ISRAEL, New York
VITO FOSSELLA, New York MIKE ROSS, Arkansas
GARY G. MILLER, California CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota BRAD MILLER, North Carolina
TOM FEENEY, Florida RAHM EMANUEL, Illinois
JEB HENSARLING, Texas DAVID SCOTT, Georgia
SCOTT GARRETT, New Jersey ARTUR DAVIS, Alabama
TIM MURPHY, Pennsylvania CHRIS BELL, Texas
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina BERNARD SANDERS, Vermont
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
----------
Page
Hearing held on:
September 14, 2004........................................... 1
Appendix:
September 14, 2004........................................... 23
WITNESSES
Tuesday, September 14, 2004
Egan, Sean, Managing Director, Egan-Jones Ratings Co............. 10
Kaitz, James A., President and CEO, Association for Financial
Professionals.................................................. 4
Pollock, Alex J., Resident Fellow, American Enterprise Institute. 9
Putnam, Barron H., President and Chief Economist, LACE Financial
Corporation.................................................... 6
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 24
Gillmor, Hon. Paul E......................................... 26
Kanjorski, Hon. Paul E....................................... 27
Egan, Sean................................................... 29
Kaitz, James A............................................... 31
Pollock, Alex J.............................................. 52
Putnam, Barron H............................................. 55
THE RATINGS GAME: IMPROVING
TRANSPARENCY AND COMPETITION
AMONG THE CREDIT RATING AGENCIES
----------
Tuesday, September 14, 2004
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 10:04 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Gillmor, Biggert, Capito,
Brown-Waite, Kanjorski, Moore, Ford, Lucas of Kentucky,
McCarthy, and Scott.
Chairman Baker. [Presiding.] I would like to call this
meeting of the Capital Markets Subcommittee to order.
The purpose of this morning's hearing is to again review
the performance and regulatory authority for the conduct of
what are commonly known as the credit rating agencies. On April
2, 2003, this committee convened a hearing in the course of its
normal review of market sector performance to hear from a
representative of the SEC and others concerning the status of
and performance of the rating agency community.
To date, there is not clearly established a methodology by
which a corporate entity may become recognized as a rating
agency. There is no ongoing supervision as to the methodologies
utilized in performing their duty, and there is not a method to
formally decommission an agency once having been designated.
The purpose of today's hearing is to receive additional
comment as to the advisability of either SEC rule or
legislative action to provide additional transparency, to
provide sufficient disclosure as to methodologies, and to
evaluate the very manner by which these agencies engage in
their rating practices.
The Investment Company Act requires the maintenance of at
least two rating agency analyses before issuance of public
debt, and therefore there is a statutory requirement that
public corporations utilize the services of these rating
agencies. That makes it all the more important for us to make
sure that market participants fully understand their function
and the methodologies by which these ratings are issued. It is
clear, at least to me, that we are a long way from that type of
functioning system.
Secondarily, it is extraordinarily important that the
agencies engage in and conduct arms-length evaluations to
ensure the ratings which are used by many in the market for
various purposes are reliable and professional. It is troubling
to realize the superficial nature by which many of the ratings
have been issued and the reliance that many have placed upon
that data. We only have to return to the bursting bubble a few
months back and painfully look at the ratings issue just prior
to many prominent corporations' announced bankruptcies.
How is it that these events came to pass? What is it that
needs to be changed to ensure that it does not occur again in
the future? And are there other options available to us to
obtain the necessary financial data without perhaps mandatory
reliance on the rating agency system as it is structured today?
For all these reasons, the committee meets. We will be
pleased to hear the comments of those who have agreed to
testify, and would point out that Standard & Poor's, which was
invited to participate, notified the committee as of yesterday
they would be unable to attend here today. We look forward to
hearing from them on another occasion.
With that, I yield to the gentleman from Pennsylvania.
Mr. Kanjorski. Mr. Chairman, we meet for the second time in
the 108th Congress to examine the issue of credit rating
agencies.
Entities like Moody's, Standard & Poor's and Fitch have
long published their views on the creditworthiness of the
issuers of debt securities. The importance of these opinions
has grown significantly in recent years as a result of the
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.
As you know, Mr. Chairman, I have made investor protection
one of my top priorities. I believe that strong regulation
helps to protect the interests of America's investors.
Accordingly, I am pleased that we have worked diligently
during the last several years to augment the resources
available to the Securities and Exchange Commission, enacted
sweeping reforms of auditing and accounting practices, restored
accountability to investment banking and analyst research, and
improved the conduct of business executives and corporate
boards. Although credit rating agencies received some scrutiny
after the recent tidal wave of corporate scandals, we have not
yet mandated any substantive changes in their practices.
Nevertheless, this issue is ripe for examination and
action. At hearings before our committee last year, the
commission's Director of Market Regulation noted that while
credit rating agencies have generally performed their work well
for nearly a century, they have also missed some colossal
failures in recent years. A Senate investigative report also
found that the monitoring and review of Enron's finances ``fell
far below the careful efforts one would have expected from
organizations whose ratings hold so much importance.''
After last year's hearing, I was hopeful that the
commission would take swift action regarding these matters. It
did belatedly issue a concept release to examine the issues
surrounding rating organizations in June of 2003. Since that
time, the commission has continued to study these matters
without reaching any conclusion. The commission, I should note,
has been examining these matters for more than a decade.
Although a formal proposal for improved oversight of credit
rating agencies has yet to emerge, a top official at the
commission did suggest in a recent speech that additional
legislative authority may be needed I this area.
I have previously urged the commission to act promptly and
prudently in these matters. It is therefore my expectation that
it will move expeditiously in the coming months to finalize its
opinions on credit rating agencies and advise us about the most
appropriate steps to take in these matters during the 109th
Congress.
When we revisit these matters next year, it is also my hope
that we will be able to put together a more inclusive and
comprehensive hearing. We are fortunate today to have with us
two rating professionals. We will also hear from the
Association for Financial Professionals, which has taken a
leading role in examining the need and identifying ways to
improve the oversight of credit rating agencies.
Rather than rushing to hold a hearing, our proceedings
would have greatly benefited if we had waited and been able to
receive the testimony of the commission, major credit rating
agencies, and other interested parties.
In closing, Mr. Chairman, we are at a crucial moment in the
evolution of our capital markets. We must act to ensure the
continued integrity of the rating agencies and the credit
rating process. I also look forward to continuing to work with
you as we move forward deliberately on these important matters.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 27 in the appendix.]
Chairman Baker. I thank the gentleman.
Mr. Scott?
Mr. Scott. Thank you, Mr. Chairman.
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 affect the
securities markets in many ways, but the Securities and
Exchange Commission has not performed any significant oversight
over rating agencies. Several of the large corporate scandals
at Enron, WorldCom and other companies were not brought to the
attention of regulators by the rating agencies.
Since 1994, the SEC has developed proposed rulemaking to
provide better oversight of rating agencies. I believe that it
is time for the SEC to try to provide a better standard for
oversight of rating agencies. In that regard, Mr. Chairman, I
look forward to hearing from our distinguished panel about
recommendations for the SEC review of the credit agencies.
Chairman Baker. Thank you, Mr. Scott.
Ms. McCarthy, did you have a statement?
Mrs. McCarthy. Thank you, Mr. Chairman. I will hand in my
opening statement. I would rather hear the testimony.
Chairman Baker. Thank you, Ms. McCarthy.
If we could please have our witnesses come forward, we
would like to recognize you at this time. This morning, we are
pleased to have Mr. Sean Egan, managing director of Egan-Jones
Rating Company; Mr. James A. Kaitz, President and CEO,
Association for Financial Professionals; Dr. Barron H. Putnam,
President and chief economist, LACE Financial Corporation; and
Mr. Alex J. Pollock, resident fellow, American Enterprise
Institute.
Since Mr. Egan is a little behind this morning, we are
going to start first with Mr. Kaitz.
Welcome, sir.
STATEMENT OF JAMES A. KAITZ, PRESIDENT AND CEO, ASSOCIATION FOR
FINANCIAL PROFESSIONALS
Mr. Kaitz. Thank you, Congressman.
Good morning, Chairman Baker, Ranking Member Kanjorski, and
members of the committee. I am Jim Kaitz, President and CEO of
the Association for Financial Professionals.
AFP welcomes the opportunity to participate in today's
hearing on improving competition and transparency among the
credit rating agencies. As we have continually noted, AFP
believes that the credit rating agencies and investor
confidence in the ratings they issue are vital to the efficient
operation of global capital markets.
AFP represents more than 14,000 finance and treasury
professionals representing more than 5,000 organizations.
Organizations represented by our members are drawn generally
from the Fortune 1000 and the largest of the middle-market
companies from a very wide variety of industries. Many of our
members are responsible for issuing short-and long-term debt
and managing corporate cash and pension assets for their
organizations.
In these capacities, our members are significant users of
the information provided by credit rating agencies. Acting as
both issuers of debt and investors, our members have a balanced
view of the credit rating process and a significant stake in
the outcome of the examination of rating agency practices and
their regulation.
When I appeared before this committee more than 17 months
ago, I shared the results of a survey conducted by AFP in
September 2002. In summary, that survey found that many of our
members believe that the information provided by credit rating
agencies is neither timely nor accurate and that the Securities
and Exchange Commission should take steps to foster greater
competition in the market for credit ratings and improve its
oversight of rating agencies.
AFP is currently conducting an update to the 2002 survey
and preliminary results indicate that confidence in the credit
rating agencies has not improved. We will be releasing the
results of the updated survey later in the fall.
In June of 2003, the SEC issued a concept release on rating
agencies and the use of credit ratings under the federal
securities laws. That concept release asked 56 questions about
the nationally recognized statistical rating organization,
designation, recognition criteria, the examination and
oversight of NRSROs, conflicts of interest, and
anticompetitive, unfair and abusive practices.
The concept release asked market participants to provide
answers in less than 60 days. Yet more than 15 months after
this concept release and more than a decade after a similar
concept release in 1994, the SEC has yet to provide a single
answer of its own.
To address many of the questions raised by the SEC and
market participants, the Association for Financial
Professionals in April of this year, along with treasury
associations from the United Kingdom and France, took the
initiative and developed an exposure draft of a Code of
Standard Practices for Participants in the Credit Rating
Process.
We are currently reviewing comments we received on the
exposure draft and intend to release our final recommendations
later this year. We developed the draft code in an effort to
improve investor and issuer confidence in the credit rating
agencies and the ratings they promulgate. This is particularly
important in light of the SEC's continued inaction.
I have submitted a copy of the code, along with my
testimony. However, I would like to take a minute to summarize
the key themes. The code contains recommendations for
regulators, as well as rating agencies and issuers. To be
clear, the code is a private-sector response intended to
complement rather than replace regulation.
Regulatory recommendations in the code of standard
practices focus on establishing transparent recognition
criteria based on whether a credit rating agency can
consistently produce credible and reliable ratings over the
long term. Establishing clearly defined recognition criteria is
a crucial step to removing barriers to entry and enhancing
competition in the credit ratings market.
The regulatory recommendations also include improving
ongoing oversight of approved rating agencies to ensure that
NRSROs continue to meet the recognition criteria. The code also
urges regulators to require that rating agencies document
internal controls that protect against conflicts of interest
and anticompetitive and abusive practices that may arise from
ancillary services such as corporate governance reviews and
ratings advisory services.
For rating agencies, the code includes suggestions to
improve the transparency of the rating process, protect non-
public information provided by issuers, protect against
conflicts of interest, address the issue of unsolicited
ratings, and improve communication with issuers and other
market participants.
Finally, recognizing that the credibility and reliability
of credit ratings is heavily dependent on issuers' providing
accurate and adequate information to the rating agencies, the
code of standard practice outlines issuer obligations in the
credit rating process. These obligations are intended to
improve the quality of the information available to the rating
agencies during the initial rating process and on an ongoing
basis, and to ensure that issuers respond appropriately to
communications received from rating agencies.
Other organizations have also taken steps to address this
critical issue. The International Organization of Securities
Commissions, IOSCO, in September 2003 issued a statement of
principles regarding the manner in which rating agency
activities are conducted. In February of this year, IOSCO also
announced the formation of a special task force chaired by SEC
Commissioner Campos to develop a code of conduct for credit
rating agencies. We expect IOSCO to issue that code shortly.
In July, the Committee of European Securities Regulators,
at the request of the European Commission, issued a call for
evidence on possible measures concerning credit rating
agencies. The committee intends to review comments, develop a
consultation paper, hold an open hearing, and approve and
publish its final advice to the European Commission in March
2005, I would note, less than 8 months after the commencement
of its activities.
Despite all this activity, the SEC remains silent on the
appropriate regulation of credit rating agencies. At hearings
before the Bond Market Association in January, a senior SEC
official admitted that the commission needs to come up with an
approach or ``cede the area'' to other rulemakers. By its
continuing inaction on this issue, the SEC is abdicating its
responsibility to capital market participants and potentially
subjecting issuers, investors and rating agencies to a
fragmented, duplicative and overly prescriptive regulatory
regime.
A reasonable regulatory framework that minimizes barriers
to entry and is flexible enough to allow innovation and
creativity will foster competition among existing NRSROs and
those that may later be recognized and restore investor
confidence in the rating agencies and global capital markets.
Rather than excessively prescriptive regulatory regimes,
innovation and private-sector solutions, such as AFP's Code of
Standard Practices, are the appropriate responses to many of
the questions that have been raised about credit ratings.
Restoring issuer and investor confidence in the credit
ratings process is critical to global capital markets. We
commend you, Mr. Chairman and the committee, for recognizing
the importance of this issue and its impact on all
institutional and individual participants in global capital
markets. We hope this hearing will motivate the SEC to action.
In addition, regulators should require rating agencies to
develop policies to insure against the inappropriate use of
nonpublic information to which the rating industries are privy
because of their exemption from regulation FD. Recently, the
SEC took action against a former credit rating agency employee
who used nonpublic information regarding pending mergers for
personal enrichment. While we cannot comment on the specifics
of this case, this again highlights the need for the SEC to
take an active role in the oversight of credit rating agencies.
Thank you.
[The prepared statement of James A. Kaitz can be found on
page 31 in the appendix.]
Chairman Baker. Thank you very much, sir. We appreciate
your comments.
Dr. Putnam, please proceed.
STATEMENT OF BARRON H. PUTNAM, PRESIDENT AND CHIEF ECONOMIST,
LACE FINANCIAL CORPORATION
Mr. Putnam. Thank you, Mr. Chairman and other distinguished
members of the committee. My name is Barron Putnam and I am
President of LACE Financial Corporation. I am a former staff
member of the Federal Reserve Board here in Washington. While I
was at the Fed, I chaired the committees that put together--
this is a three-interagency bank committee that put together
the off-site rating system for the Fed. I also set up the Bank
Holding Company Analysis Program for the Fed and I directed for
the Fed the surveillance of all banks and bank holding
companies for a period of 10 years.
I left the Fed in 1984 and established LACE Financial
Corporation. LACE Financial rates approximately 20,000
institutions. We have issued over a period of 20 years about
1.2 million credit ratings. We have never received a complaint
from a regulator, be it state or federal or any regulator, nor
have we ever had a serious threat of a lawsuit. We have
actually rated banks and other financial institutions prior to
Moody's and Standard & Poor's entering the market.
I have been in the banking business for more than 25 years.
I would like to say that it is an honor for me to sit here
today before your committee.
I would like to address two areas of concern to your
committee, the NRSRO designation process and the
anticompetitive effects that the SEC net capital rules and the
NRSRO designation have on a rating company like ours.
First, we submitted our application for NRSRO status back
in 1992. Eight years later, we received a phone call from a
lawyer at the SEC stating that our application was denied. I
asked him what the reason was, and he could not give that to me
over the phone. So I said, well, would you put it in writing.
He was a little surprised that I asked for that, but they sent
it to me and the denial was based on the fact that we only had
three financial analysts. I wrote back to them saying this was
an error; that in fact we had 10 financial analysts and that
eight were involved in the ratings process.
We received another letter, which stated the NRSRO
criteria, which I am sure most of you are familiar with. It is
very detailed and lengthy. And then they stated at the bottom
of the letter that our application had been denied because you
did not meet the criteria above. They did not say what part of
the criteria. When we saw that Congress was interested in this
issue as well as the press we appealed our application. We sent
our appeal in and it has been now 2 years and 3 months and we
have not heard anything from the SEC.
To me, this is deja vu. I think that given what we have
gone through, I do not feel that any person or corporation
should go through something in this manner. It is just that an
agency of the government should not act in this way. Obviously,
there needs to be transparency in this process and the
application process needs to be expedited.
I also would like to say that I feel that the SEC staff,
and I think it is the policies, not necessarily the staff
members, have more of an adversary view towards companies like
ours. It should be the other way around. They should be
proactive. If a company does not meet the criteria, they should
state why and let the company come back and show that in fact
what it is that they need so that they can go on and eventually
become an NRSRO company.
Now, the other point I would like to speak to the committee
on is the effects of both the net capital rules and the NRSRO
designation on the ability of a company like ours, a small
company, to effectively compete with other NRSRO companies.
First, Moody's, Standard & Poor's and Fitch have tremendous
name recognition and market share. That is a tough act to
compete against. However, from the very beginning, all we
wanted was to be on a level playing field with these companies.
The problem is, and people at this table know this well, that
we are prohibited by law, federal law, the SEC regulations, to
compete with these existing NRSRO companies.
The designation and the use in the bylaws of large
corporations prohibit companies like ourselves from being able
to use these companies as clients. To put it in other words, if
the company does not have an investment-grade rating from an
NRSRO company, those are the only ratings they can use, either
credit ratings or buy securities of those companies. That keeps
us, we cannot compete with a very large portion of the AFP
members. Although we do have several clients in that
organization, many of them are prohibited from using us. I used
to get, and finally the gentleman gave up, from GE Capital, an
e-mail asking me when we were going to get that status because
they want to use us. Finally, he just gave up because I sent
him back I was not sure.
But it is a very tough problem. In 1992, about the time we
submitted our application, Thompson Bank Watch received NRSRO
status. Our revenues prior to that time were growing about 25
or 30 percent a year. For 10 years, they just stopped growing.
They stagnated. Only until recently have our revenues starting
picking up and growing about 20 percent because we have entered
into new security issues. We have kind of broken into that
market, but it has taken us 20 years to do so. It is a very
tough game for a non-NRSRO company to basically stay in this
business.
If you want to bring competition into this industry, you
not only have to recognize companies like ours, Sean's company,
also there are several others out there that are very credible
companies, but they have to aid these companies in becoming
larger and better competitors. The NRSRO status is a double-
edged sword. It keeps you from competing, but if you receive
the designation it will help you a great deal in growing
because clients will come your way if you are good and
credible. Companies like ourselves have to grow about 40
percent a year to become effective competitors to the NRSRO
companies.
Moody's and Standard & Poor's, I do not know exactly, but
they are growing about 20 percent a year, about what we are,
but our size is so small relative to theirs that we will not
become effective competitors unless we grow faster. We cannot
do it unless we have the NRSRO status.
Thank you, sir.
[The prepared statement of Barron H. Putnam can be found on
page 55 in the appendix.]
Chairman Baker. Thank you very much.
Welcome back, Mr. Pollock. I think this is your first
appearance in your new capacity.
STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Pollock. It is, Mr. Chairman, and thank you very much.
Mr. Chairman, Ranking Member Kanjorski, and members of the
committee. It is a pleasure to be here to present my views,
which focus on the unintended cartel-like effects of the SEC's
regulation of rating agencies through its NRSRO designation.
I must say I find Dr. Putnam's comments very convincing. He
expresses in a specific case many of the same things I am going
to say in a somewhat more abstract way. I then want to talk
about what steps might be taken to reduce these barriers to
competition.
The theme of my work at the American Enterprise Institute
is to examine ways to inject greater economic efficiency and
market choice into situations in which the government in one
way or another has created noncompetitive structures.
What do we find in the rating agency sector? As Professor
Larry White of New York University has written, ``The problem
concerns the SEC's regulation of the bond rating industry.
Incumbent bond rating firms are protected; potential entrants
are excluded, and new ideas and technologies for assessing the
riskiness of debt, and therefore the allocation of capital, may
well be stifled. This entry regulation is a perfect example of
good intentions gone awry.''
The fundamental source of the problem is that the
designation ``nationally recognized statistical rating
organization'' or NRSRO has become embedded in numerous rules
of numerous regulators. The only way to get to be an NRSRO is
to be designated as one by the SEC, and this involves, as many
commentators have pointed out, a practically insuperable Catch-
22.
The SEC's own concept release, which was referred to
earlier by the ranking member, on the subject states that in
order to become a recognized NRSRO, ``The single most important
criterion is that the rating agency is widely accepted in the
U.S. as an issuer of credible and reliable ratings by the
predominant users of securities ratings.''
To summarize their position, you cannot be widely accepted
by the predominant users unless you are an NRSRO, but you
cannot become an NRSRO unless you are already widely accepted.
That is the Catch-22. The same SEC release says, ``Some
commenters believe that the NRSRO designation acts as a barrier
to entry into the credit rating business.'' There seems to be
no doubt that these commenters, which include the Department to
Justice, are correct.
It seems to me that we should simply consider that when
John Moody published his first ratings in 1909, or when Poor's
Publishing Company published its first ratings in 1916, or the
Fitch Publishing Company published its first ratings in 1924,
they were not yet ``widely accepted by the predominant users.''
They all had to discover a market need, and compete their way
into becoming nationally recognized in time.
Dr. Putnam also touched on the natural barriers to entry in
the credit rating business, which seem to be pretty
substantial, including the need to establish reputation,
reliability and integrity; a definite prestige factor involved
in the purchase of opinions and judgments; and natural
conservatism of the users of ratings. To add to this a
``distortionary entry restriction regime,'' to use Professor
White's phrase, ensures a noncompetitive outcome.
What could be done to make this business more competitive?
I suggest four possible actions. First, it is clear that what
NSRSO really means is ``SEC approved rating agency.'' The term
``NRSRO'' with its implication that is represents some sort of
a market test, which 30 or 40 years ago it did, but it no
longer does, should be dropped altogether. If the SEC continues
to require its own approval of raging agencies for regulatory
purposes, at least we could get the designation accurate and
just make it ``SEC approved.''
Second, if the SEC continues to require its approval of
rating agencies, the Catch-22 criterion of having to be
``nationally recognized'' in advance should be simply
eliminated.
Third, the approval of rating agencies for specialized
purposes, as the SEC has sometimes done in the past, should be
encouraged. Such specialization might be an industry, for
example, financial institutions; a country, for example, Japan;
or any other logical domain defined by competence and
knowledge. This would allow new entrants to create competition
based on their skills and where they are best able to compete,
to demonstrate in those specialized domains their value, and if
they succeed, then to grow organically.
Fourth, in my opinion, in the best case, not only the term
``NRSRO'' but also the requirement of designation by the SEC
would be dropped. Instead, the responsibility to choose among
rating agency alternatives should belong to investors,
financial firms, securities issuers and other users, in short,
the market. Every firm should have among its financial and risk
management policies its approved policies for how it uses
credit ratings and whose ratings can be used for what.
These policies should be appropriately disclosed, and could
be examined by any relevant regulators. Under these
circumstances, which rating agencies turn out to be nationally
recognized would reflect a true competitive market test, and
that competition would provide its normal benefits of
innovation, improved services, lower cost, choice and
efficiency.
Thank you very much for the opportunity to testify, Mr.
Chairman.
[The prepared statement of Alex J. Pollock can be found on
page 52 in the appendix.]
Chairman Baker. Thank you, Mr. Pollock.
I wish to welcome Mr. Sean Egan, managing director, Egan-
Jones Rating Company.
Welcome.
STATEMENT OF SEAN EGAN, MANAGING DIRECTOR, EGAN-JONES RATINGS
CO.
Mr. Egan. Thank you. I apologize for being late.
Chairman Baker, members of the subcommittee, good morning.
I am Sean Egan, managing director of Egan-Jones Ratings
Company, a credit ratings firm. By way of background, I am a
co-founder of Egan-Jones Ratings, which was established to
provide timely, accurate credit ratings to institutional
investors.
Our firm differs significantly from other rating agencies
in that we have distinguished ourselves by providing timely,
accurate ratings and we are not paid by issuers of debt, which
we view as a fundamental conflict of interest. Instead, we are
paid by approximately 400 firms consisting mainly of
institutional investors and broker-dealers. We are based in a
suburb of Philadelphia, although we do have employees that
operate from other offices.
The rating industry currently is suffering from a severe
lack of competition. S&P and Moody's dominate the industry,
which has caused the following problems. One, issuers pay too
much for capital because they are underrated; and two,
investors are not provided with sufficient warning about
failing firms such as Enron, WorldCom, and Parmalat.
By way of interest, we receive a lot of publicity for our
identifying problem companies. That is because reporters like
to report on that. But in reality, we have pointed out many
more cases where companies are underrated, that is they are
paying too much for capital.
There are few industries where the two major firms do not
directly compete, and yet control over 90 percent of the
revenues. Since two ratings are needed to issue debt, the two
major firms do not compete and therefore are not subjected to
the normal checks and balances. Even after the recent credit
rating debacles, S&P and Moody's revenues have continued to
grow because of their lock on the market.
To put the industry structure in perspective, it is as
though there are only two major broker-dealers for corporate
securities and the approval of both were required before any
transactions could be completed. Some other manifestations of
the limited competition include abuses in the use of
unsolicited ratings and heavy-handed marketing of related
corporate services such as issuer governance ratings.
Regarding Egan-Jones, we have provided warning for the
Enron, Genuity, Global Crossing and WorldCom failures. We did
not rate Parmalat. Furthermore, we regularly identify improving
credits. Most of our ratings have been above S&P's and Moody's
over the past 2 years, thereby providing issuers with more
competitive capital. Our success has been recognized by the
Federal Reserve Bank of Kansas City, which compared all our
ratings since inception in December 1995 to those of S&P and
Moody's. You can read the quote from that study. It is
available online.
Stanford University and the University of Michigan drew
similar conclusions. That also is available online. In August
1998, we applied for recognition by the SEC as a ratings firm,
i.e. NRSRO status. We continue to provide information to the
SEC and hope to eventually be recognized.
To reform the ratings industry, we recommend the following
changes. One, recognize some rating firms which have succeeded
in providing timely, accurate ratings. Two, wean rating firms
from issuer compensation. We think that is a fundamental
conflict, just like the equity analyst problem. Three, adopt a
code of standard practices for participants in the credit
rating process issued by the ACT, AFP, and AFTE. And four,
encourage SEC action. This area has been under review since the
early 1990s and is in dire need of reform. The costs of
delaying the recognition of additional rating firms is far
greater than the benefit of additional study.
There are two additional points that I would like to make.
That is, one of my colleagues brought up the issue of national
recognition criteria being dropped. We disagree with that. We
believe that the successful firms can achieve national
recognition. We have national recognition. A recent firm that
was admitted by the SEC, DBRS, according to outside studies did
not have that recognition in the United States. We take issue
with the application of those criteria.
The second problem is that it may be worth finding out why
it is that there has been such a delay in taking action. We
tend to believe that it is because the SEC has bought into the
notion offered by S&P and Moody's that more competition in this
area would lead to problems. That is, there would be rate
shopping. We think in those cases where the rating firm is not
paid by the issuers, that is not a problem. But there has to be
some fundamental cause for the huge delay in action in this
area, and this may be one of them.
Thank you very much.
[The prepared statement of Sean Egan can be found on page
29 in the appendix.]
Chairman Baker. Thank you very much, Mr. Egan.
I appreciate each of your perspectives on this important
issue. It is clear to me there is not an objective standard by
which a corporation may comply and be assured it will achieve a
NRSRO status. There really is no oversight of an entity once it
has received a designation, and there is not an official
decommissioning process by which such an award may be removed.
Secondly, it is not very clear as to what standards of
review the rating agencies utilize in determining a public
corporation's rating; that prior to the rating being made
public, the agency can meet with a subscriber and go over the
information or release it previously prior to public
disclosure; that an agency can send a bill to a public company
without having solicited the rating, which creates an
interesting problem for the company, I am sure; and that at the
end of the day the rating agency performance in the midst of
the corporate crisis we faced was frankly marginally, if better
at all, than the broader market controls that seem to have
failed us generally.
It leads me to the question or the observation, this may be
one area where the Congress can actually act and not make
matters worse. There is no room for us to go downhill from
here. In light of that, we have had a concept release as early
as 1994 by the SEC, subsequent concept release, and to date
still no recommendation for action either for the SEC or for
the Congress.
I am very troubled by this because of the Public Company
Investment Act requires the maintenance of at least two ratings
prior to issuance of public debt, and there appears to be great
reliance on these ratings by many stakeholders without
understanding fully the mechanisms by which these ratings are
issued.
I even have read of late where Basel is considering
utilizing the rating agency determinations for determination of
capital adequacy for financial institutions, which is a
shocking turn of events given what I think I know about the
agency's performance to date.
I know that each of you has suggested that enhanced
competition may be the ultimate reform that is most beneficial.
But I am very concerned that that potential could have been
exercised over the last decade, where resources could have been
brought to bear, and as Dr. Putnam's case indicates, the
languishing in response from the SEC to be told no for 2 years
is not the most professional standard of conduct.
Is there anything short of incentivizing additional
competitors? For example, some have suggested that utilization
of credit spreads might be more beneficial in getting real
critical examination of financials than looking with a
retrospective view that apparently the rating agencies use.
What other rating alternatives might there be available to
us? Are there any? And is the only hope SEC action and
competition? I just make that observation and question to the
panel.
Mr. Egan. Regarding credit spreads, we have a variety of
clients including a number of hedge funds. I think if there is
a turning to credit spreads as being the rating proxy, it would
be fairly easy for sophisticated traders to manipulate it.
Basically what they would do is buy up the company's
securities and sometimes the float is not that great so it does
not take much time to control the float; move down the spread,
which would imply a higher rating; let other institutions get
into that security and then move out. You can do that multiple
times. It is very, very easy to manipulate a system like that.
Also, there is some suggestion for pure quantitative
systems. We started out, probably about 12 or 13 years ago when
the firm was founded, as purely a quantitative shop. We found
that it did not get us where our clients wanted to go. That is,
we were maintaining 95 percent-plus accuracy. With a pure
quantitative system, it would be between 85 and 90 percent.
Typically, these quantitative systems rely on equity prices,
and again you have mixed signals. For example, if a company
announces a share buy-back, its share price will go up, but
that would be a negative for credit quality.
Chairman Baker. But in the current circumstance, though,
the rating agency to a great extent relies on representations
made by management. They do not appear at least to rely on
audit or underlying financial examination to a great degree.
How assured can we be that the manipulative effects you are
concerned about are not already in the market?
Mr. Egan. Sometimes they are and sometimes they are not. I
think that the best safeguard is to have a viable competitive
market, which we do not have.
Chairman Baker. My time has just about expired, and I do
have other members, but just one other question that concerns
me about the way these markets function. Wouldn't it seem
likely, given the way in which the review is now done, that the
bigger the corporation the less scrutiny one might receive, and
the further down the food chain you go the more likely the
rating agency is to actually get involved into the real
financials to make their determination?
Mr. Egan. Sometimes there is greater scrutiny of the larger
companies, but they are given the benefit of the doubt.
Chairman Baker. Thank you.
Mr. Kanjorski?
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Egan, you have been here so often you are starting to
get the demeanor of a member of Congress.
Mr. Egan. My wife is wondering about my multiple trips to
Washington.
[Laughter.]
Mr. Kanjorski. Welcome.
I do not know, if I were sitting at the table I sense a
great deal of frustration. Am I correct?
Mr. Egan. Yes.
Mr. Kaitz. Yes.
Mr. Putnam. Yes.
Mr. Pollock. Yes.
Mr. Kanjorski. We obviously can give the authority for the
SEC to regulate a particular industry or activity, but after
that it is in their hands.
Dr. Putnam, you indicated 8 years your application was
pending?
Mr. Putnam. Yes, sir.
Mr. Kanjorski. And, Mr. Egan, yours is 6 years?
Mr. Egan. Ours is since 1998, so yes.
Mr. Kanjorski. Six years.
Do you think it is time that we throw up our hands and say
that obviously the SEC does not want to be the regulatory body
and we take the proposals of the professionals and craft
authorization and assign it to the Federal Reserve and see if
we have a better activity there and maybe you can create
competition between the regulators.
If a regulator does not seem to want to assert its
authority in a field, let us find another regulator. What is
your thought to that?
Mr. Putnam. I am from the Fed, so I would look in that
direction. But no, I think that the SEC should do it right.
Mr. Kanjorski. What if we cannot make them? Obviously, 10
years, Doctor.
Mr. Putnam. Then it is time for change. There are obviously
very serious problems, but it seems so simple, to be able to
expedite an application and be more positive.
Mr. Kanjorski. What do you think the underlying proposition
for the delay is?
Mr. Putnam. I think it is to maintain the status quo.
Mr. Kanjorski. I mean, is there restriction of competition?
Do they just want the majors in the field and nobody else?
Mr. Egan. Our feeling is that if the area is not cleaned
up; if the SEC cannot take action in the near future, that they
should step away from regulating the area. Our relationship
with the SEC has gone through different stages. At one point,
they would not return our phone calls and simply ignored our
requests. At this point, it appears as though we are making
progress, but it is very easy to sidetrack that progress.
It is very easy for them to compare us to S&P and Moody's
and say you are significantly smaller, and therefore even
though you have all these ratings correct, you warned investors
about Enron, WorldCom and Global Crossing and Genuity, you
still do not look big enough compared to them. At which point,
we think that we would be fairly upset, because neither the
investors nor the corporations are being served by the current
arrangement.
Mr. Kanjorski. What do you want? To hang in for another 6
years?
Mr. Egan. No, I do not have that patience.
Mr. Kanjorski. What do you want us to do? Myself, I am
convinced after the second year of hearings that we will be
back next year in the 109th, and we will just have to have
larger handkerchiefs.
[Laughter.]
Mr. Egan. If there is not significant progress in the next
6 months, consider withdrawing their ability to regulate this
area.
Mr. Kanjorski. As I say, why don't we prepare a model
statute with the criteria set out of what the regulation should
be and what the standards should be, and give them a year to
promulgate rules and regulations and act to regulate, or
automatic action that the authority transfers to the Federal
Reserve.
Mr. Egan. There are some other changes that are needed,
too. The issue of compensation is something that is going to
continue to cause problems. There are some issuers that pay
multimillion-dollar fees and they are given the benefit of the
doubt. If there is a collapse, and there are some problem
companies out there right now, it will cause huge problems for
investors.
The flip side is that there are some corporations that are
being basically shaken down by the major rating agencies for
their governance ratings, which is wrong. Also, some issuers
are not given the opportunity to respond to ratings.
Mr. Kanjorski. You have convinced me. You made your
argument and you convinced me. Now I am just trying to find a
remedy.
Mr. Pollock. Congressman, if I could comment from this end.
I support your idea that you ought to go ahead and try to take
some action, and that more competition on the regulatory front
is not a bad idea either.
As I read the history of the NRSRO designation, it was
something of an accident. It started off as part of the haircut
capital rules for securities firms and which ratings you held
in inventory determined how big a capital haircut the position
got. It grew into this preferred designation of firms. This
looks to me something by historical accident, as other
regulators then picked up the theme of whose ratings could
count for various regulations.
So I think your notion to do something to move it along is
correct.
Mr. Kanjorski. Mr. Kaitz?
Mr. Kaitz. I would also support that at AFP.
Also the code of standard practice, as we have proposed, as
you have suggested, lays out regulatory recommendations for
both the issuer as well as the credit rating agencies; talks
about transparency in the process; talks about all the issues
that have come up here today that need to be addressed by some
regulatory body.
But we would very much support Congress pushing the SEC
into some action based upon the code of standard practice, with
a limited regulatory framework.
Mr. Kanjorski. Do you sense that if we took such action
like that it may reflect on what happened with FASB and the
stock options question? That at that point the regulatory
agencies would run up here to the Congress and at least
disclose themselves that they want to maintain a monopoly?
Mr. Kaitz. I think you can draw a lot of comparisons to the
accounting profession, as well, as has been noted by Sean and
the equity analysts on the research side. These are all the
same issues of separation of responsibility. They are as
critical to global capital markets and U.S. capital markets as
those two professions. So I do not know what the SEC would do.
Are you referring to the credit rating agencies coming up here?
The other thing you could speculate is that the SEC does
not want to address this issue because they realize they do
have regulatory authority here and they would have to enforce
that authority to more firms. So I do not know what kind of
resources that would take, but it seems to me that there has
been a compelling case made for the SEC to take action here
today.
Mr. Kanjorski. I am particularly impressed with the fact
that you make the point that there is a greater cost for
capital because of the failure to have competition in a broader
rating agency marketplace. I think that is a very compelling
argument. We tend to think that five, 10, 15 basis points do
not make a difference.
Mr. Egan. It is far greater than that.
A typical company would be Nextel. Nextel is a vibrant,
exciting company that is changing the telecommunications
industry. It is still not rated investment-grade even though,
from the traditional measures, just taking them out 6 or 12
months, it is very clear that this is a strong, vibrant company
that has a high chance of being bought out by some of the other
highly rated companies in the industry.
So the bottom line is that it is not just five or 10 basis
points. It is closer to about 50 or 100 or 150 basis points,
and you are talking about $5 billion to $10 billion worth of
debt.
That is significant, and it is hurting young, growing
companies. Sometimes there are older companies that have
improved, but it is hurting companies like that, where they do
not get a fair chance in the capital markets.
Mr. Kaitz. Also, to the extent that the European countries
implement their own regulations, which is likely to happen, you
are going to have a fragmented process here, and that is
definitely going to raise the cost of capital because a U.S.
multinational company that wants to raise debt in other
countries is then going to have to comply with multiple rules
and multiple companies, and you know who is going to be paying
for that.
Mr. Kanjorski. So you think if we concluded, if the
Chairman and I get together and put a piece of legislation
together to set up your criteria for a regulation and offer
certification of these agencies, that we will either get them
to move or appropriately improve the industry.
Is there anyone here at the table that thinks that this
would be injurious to the rating agencies?
Very good, thank you.
Chairman Baker. I thank the gentleman.
Ms. Brown-Waite?
Ms. Brown-Waite. Thank you very much, Mr. Chairman.
I would like to ask Mr. Pollock a few questions, and if any
of the other gentlemen would like to jump in.
First of all, I am what is called a freshman, a little old
to be a freshman, but I moved to this committee. Has the SEC
ever revoked NRSRO designations? And what would you anticipate
if you could wave a magic wand? What should be the criteria for
such revocation?
And also, if I understand this correctly, each of the four
SEC-approved rating agencies derives the bulk of its revenues
actually from fees charged to the companies they rate. Isn't
this a blatant conflict of interest? Am I missing something
here? Should we be concerned, as we have been about the
conflicts created by equity analysts being compensated based on
the investment banking business that they bring in?
I think if the average investor out there had any clue,
they would really use the term, a fox watching over the chicken
coop. I would just like to hear your views on this.
Mr. Egan. No rating agency has had its NRSRO designation
withdrawn. What has happened in the industry is that the firms
have consolidated. As of about 5 years ago, there were about
seven NRSROs. Three of them merged into Fitch. That was
Thompson Bank Watch, Duff & Phelps and a London firm called
IBCA. So there has been no withdrawal of the NRSRO designation
or threat of withdrawal.
We tend to think that there should be some basis for
threatening that designation. In the case of Enron, it was
rated investment-grade 4 days before it went bankrupt. So
basically, it just took the time for the bankruptcy attorneys
to put together the papers and then it was in bankruptcy. That
is outrageous.
What should have happened, in our opinion, is that their
license, if you will, in the investment-grade area or else in
the energy or utilities area, should have been on probation for
6-, 12-or a 24-month period. There has to be some threat.
There are other horror stories in the manufactured housing
area, the securitization whereby AAA ratings had been
downgraded to junk in the period of just an hour or so. In that
case, it shows clear negligence on the part of the ratings
firm. There should be some process where the license is
suspended or in some kind of penalty box-type area for a period
of time when things like that happen.
Lastly, you mentioned the conflict of interest. That is a
problem. It is a huge problem. This industry is basically
accepted because of the lack of competition. People throw up
their hands and say, well, it is S&P and Moody's; they really
designate the ratings; we strongly disagree with that, but they
have become the currency, if you will, in this area.
First of all, that should be disallowed. It might take some
time. Maybe they have to do it over a 5-year period, but that
should not happen. You are waiting for another huge accident.
The incentives are in the wrong place.
Secondly, they should not be allowed to use the term
``independent.'' They are not independent. Take it away. You
are misleading the people who need the protection the most.
They think that these terms are independent and they are being
paid huge fees by selected issuers.
So that is our response to those three issues.
Mr. Pollock. Congresswoman, I would only add, it would be
better to have a competitive market instead of having a cliff-
type decision that a regular would have to make. ``I am now
taking away your license,'' is a very hard decision for people
to make.
The market, if there is poor performance, like the examples
just cited, can little by little take the business away if
there are in fact alternatives. From an investor point of view,
if investors like better the idea of having ratings that the
rated entity did not pay for, that they paid for themselves,
why then would they gravitate to those ratings. If they thought
it was okay to have the issuing company pay for ratings, they
could purchase them. But none of that can happen if you do not
have alternatives in the market available to the users of
ratings, investors and others, to choose from.
Mr. Baker. Thank you, Ms. Brown-Waite.
Ms. McCarthy?
Mrs. McCarthy. Thank you, Mr. Chairman.
I am just curious, Mr. Chairman, are we going to have
another hearing with the SEC and find out why this is
happening? Or have you had it and I did not see it. I was not
here.
Chairman Baker. We had one about 18 months ago which was
particularly painful for the SEC at that time.
Mrs. McCarthy. Okay.
Chairman Baker. I do not see how we can avoid revisiting
this subject at some appropriate time. I need to visit further
with my chairman and Mr. Kanjorski on any initiatives that
might be contemplated. But be assured, this is the beginning,
not the end of our process.
Mrs. McCarthy. Because again, even though we both came on
the committee 18 months ago, I probably had no idea what I was
hearing. I am sorry. It takes a while to learn this stuff.
The questions that I was going to ask actually have been
answered in a number of give and take back, so I am not going
to bother with that. But it has been a real eye-opener for me
on a number of things. Let us face it, the majority of people
do not understand it. I did not know there was anything else
out there, but the two competitions are there. I thought that
was just the way it was, so this has been fascinating for me.
I thank you for the testimony and I thank you for bringing
this hearing forward.
Chairman Baker. Thank you, Ms. McCarthy.
Ms. Biggert?
Mrs. Biggert. Thank you, Mr. Chairman.
I, too, think that the really basic questions have been
asked, so I will just have a couple of questions. The Northern
Trust Company submitted a comment in response to the SEC's
concept release in which it stated that the major rating
agencies have requested payment for unsolicited ratings, and in
some instances paid the invoices in order to preserve the
goodwill with the rating agency.
So my question from that is, how would enhanced competition
in the rating industry prevent this type of abuse? That would
probably be for anyone who would like to answer.
Mr. Putnam. I would like to answer that question. First,
Northern Trust is a very financially sound organization. It has
one of our highest ratings. However, we are not an NRSRO
company, so they cannot divert to that. That competition will
help in that area.
I would like, if I can grab the microphone, to make a point
that it is not just that some people are paying a very high
price for capital. Some of them do not have access to capital
markets. The fees charged by Moody's and Standard & Poor's and
Fitch are so high for a rating that it may be 5 percent of the
issue. Small companies cannot afford to raise capital in that
arena. We are providing information to the committee showing
that we have rated some companies as small as $23 million in
asset size. This is a very serious problem.
Another very serious problem that I do not believe has
really been addressed by the SEC is that there are billions of
dollars of excessive, and I feel the fees are very excessive,
fees that are being paid by municipalities and by corporations
for these ratings. Competition can bring these prices down
considerably if in fact it can be generated. That I think is a
very tough thing to do.
The expertise in a rating agency is very hard to develop.
It takes time to do this, and usually these companies, like
Sean and myself, we specialize in a certain area. Once you get
the NRSRO status, then you can branch out and then hopefully
you can bring somebody in that helps you build your company and
the SEC or the new regulator allows that to happen. You have to
be very proactive in this arena.
Mr. Egan. The reason why I think Northern Trust paid those
fees is because they are afraid of alienating the two, in their
mind, only two firms in this industry. It is another
manifestation of the lock that they have on this industry. An
example might be if your utility in the dead of winter
overcharged you $50 or $100 or $200. You are far more likely to
pay that additional amount than be faced with the threat of
having the utility cut off.
That is the case here. These companies, issuers cannot
afford to be cut off. This industry has deteriorated to the
point where there are only two firms in many participants'
minds, and it is highly unhealthy and it is going to cause some
additional Enrons in the future. It is going to cause some
other companies to continue to pay much more for capital, so it
has to be cleaned up.
Mrs. Biggert. Do you think that not only are these firms
afraid not to go to these companies, but also do you think that
the rating fees then affect the ability of some of the largest
rating firms to provide objective rating analysis?
Mr. Egan. There is no question that they do. There is
another problem that comes up with the issuer compensation, and
that is, it was about 8 years ago in the municipal area whereby
two municipalities refused to pay Moody's. It is in the Wall
Street Journal, and I can send the reference in later. It was
in the Wall Street Journal where these issuers refused to pay
the rating fees that were being charged by Moody's. And Moody's
just said, well, you should participate in our process.
The issuer said, no, we are not going to. Moody's said, we
have enough information in the public domain and we are going
to give you a rating, period. And they gave them what I call a
punishment rating, which significantly increased the cost of
floating that issue. The municipalities subsequently sued and
they were unsuccessful. They were unsuccessful because Moody's
said the ratings are opinions and we are entitled to the
freedom of speech. So it is just another indication of this
unhealthy industry.
Mrs. Biggert. I know that you would like to get into this.
Mr. Egan. We already are issuing ratings. There are a
number of clients that want to use our ratings for regulatory
purposes and we told them they cannot until we get the
designation.
Mrs. Biggert. Okay. But the current NRSROs have already
absorbed three companies.
Mr. Egan. Yes.
Mrs. Biggert. So how are you going to do this?
Mr. Egan. There are two things that distinguish us. One is
our success, and no one can match that in flagging Enron,
WorldCom and these others, number one. And number two, we do
not charge the issuers. We think we can continue our success
and do very nicely.
Mrs. Biggert. Thank you.
Thank you, Mr. Chairman. I yield back.
Chairman Baker. Thank you, Ms. Biggert.
I want to just go back for a few brief points. I know other
members may have follow-up questions.
As to the elements that possibly should be considered in
our construction of some remedy, it would appear to me that
requiring an enhanced standard of disclosure for material
facts, that it would seem that the agencies today rely to a
great extent on representations made by management, without the
benefit of a true audit.
To have a requirement on management to disclose to a rating
agency in the course of its inquiry any material fact that a
reasonable man would assume would have some positive or
negative or any impact on shareholder value would be sort of a
minimum opening requirement; that in the course of developing
whatever standards of review the rating agency determines is
appropriate, that the elements that go into a rating
determination be made public; the process by which you get from
beginning to end.
I also think it is important to disclose whether or not
nonpublic information is utilized. Not that you disclose it,
but simply the statement that we are using only publicly
available information would tell any outside observer, they are
only feeding us back what is readily available in the market,
or we have insight to information you do not have, therefore
this rating is based on that information. I think those are
very helpful tools.
And then finally, before reaching the ultimate rating
determination, that that decision not be made available to the
subscriber before it is being made available to the public.
This goes back to our old analyst-investment banker problems
where we had people able to get access to important information
even hours, much less days ahead of time, seems to be an
obvious, well, I hate to say impropriety, but certainly
something that needs to be addressed.
Then the rating outlooks that are made available by the
agencies are troubling. Now, we are making a determination
about current value based on representations of management
without an audit. So at best, you can say the critical analysis
of present-day value ought to be carefully examined, but we are
going to permit a national rating agency to do a forecast for
the next 18 months?
There seems to be a little problem here in my mind with
just sending someone an invoice for services you did not ask
for, and the ability to forecast what you are going to look
like 18 months from now. Now, I do not know if that bothers
you, but I am from Louisiana and I can see that one coming.
And then lastly, it was an issue in Sarbanes-Oxley,
consulting services. It seems to me to be highly questionable
as to whether or not you ought to be able to consult with
someone for whom you are being asked to issue a public rating
on which others may make their investment decisions, which
certainly speaks directly to the issue of fees and the
appropriateness of fees being paid to great extent for someone
who is going to give you your report card.
Any adverse comments about those observations or
problematic observations, anyone?
Mr. Kaitz. I would just say that almost all the issues that
you addressed, Mr. Chairman, have been included in the code of
standard practices, both for the credit rating agencies, as
well as the issuers. So we would be very supportive of your
framework.
Mr. Putnam. I think a very serious problem with the
existing NRSRO companies, if they issue ratings, they do not
show the date necessarily that the rating was issued, nor do
they show the data from which the rating was derived. I think
that is very, very important, because if you do that and you
show that for many other companies as well, and one rating does
not adjust to that data, you can see that something is wrong.
In our comments to your committee, we had made a suggestion
that one way, I do not think the fee problem is going to be
resolved right away. We do not charge for our credit ratings.
We do charge for new issue ratings. You cannot help but do it.
The financial analyst involved in this and the discussions with
management are just so important.
But one point that you made, I do not think a rating agency
worth its salt should ever take what management says they are
going to and base a rating on that. You have to judge the
financial condition of an institution based on its financial
soundness. LACE comes from liquidity, asset quality, capital
and earnings. Those are the major determinants of financial
soundness.
If you take those and you show these determinants, along
with the rating, that helps. Plus, these rating agencies,
existing NRSROs should rate more frequently. They charge so
much money. The balance sheets and income statements of these
companies are put out quarterly. They are generally audited,
and you can take that information and you can confirm or deny a
rating, rather than just change that rating somewhere in the
timeframe of a company. But if you show that information, you
are going to bring more credibility to the rating process.
Chairman Baker. What is it that is gained from a rating
company analysis that is not already available from the
quarterly statement?
Mr. Putnam. Interpretation, analyst interpretation.
Chairman Baker. So if we went back and looked at the
outlook forecast for S&P and compared it to say the analyst
community, we ought to be astounded by how well S&P is able to
forecast.
Okay, thank you. I think I have exercised all the time I
should take.
Any further questions? Ms. McCarthy?
Mrs. McCarthy. Thank you.
I think part of the question was answered, because when you
said earlier conflict of interest on the pay, and then you came
back, because I was sitting here wondering how do you guys make
any money.
Mr. Egan. We get paid by institutional investors.
Mrs. McCarthy. Okay.
Mr. Putnam. We get paid by subscribers primarily, but about
20 percent of our revenues are derived on new issue ratings,
and we do charge for that. But we do, as I have said, show
those ratings every quarter. I provided to the committee, on
some of the pools that we rate for structured preferred stocks,
for community banks.
We will actually follow that pool each quarter, re-rate the
pool each quarter, and re-rate every member of the pool each
quarter. We have a follow-up rating report that does that. It
is the most advanced report in the industry that exists. That
has been supplied to the committee. That is what should be
done.
Mrs. McCarthy. Okay. Thank you.
Chairman Baker. There being no further questions, I want to
express my appreciation to each of you for your participation.
You have been most helpful. As I have indicated earlier, this
is just another step in our review of this sector. We do have a
lot of additional work ahead of us, and we appreciate your
contribution.
The meeting is adjourned.
[Whereupon, at 11:20 p.m., the subcommittee was adjourned.]
A P P E N D I X
September 14, 2004
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