[Senate Hearing 109-997] [From the U.S. Government Publishing Office] S. Hrg. 109-997 ASSESSING THE CURRENT OVERSIGHT AND OPERATIONS OF CREDIT RATING AGENCIES ======================================================================= HEARING before the COMMITTEE ON BANKING,HOUSING,AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED NINTH CONGRESS SECOND SESSION ON THE CURRENT OVERSIGHT AND OPERATION OF CREDIT RATING AGENCIES __________ MARCH 7, 2006 __________ Printed for the use of the Committee on Banking, Housing, and Urban Affairs Available at: http: //www.access.gpo.gov /congress /senate/ senate05sh.html ______ U.S. GOVERNMENT PRINTING OFFICE 39-602 WASHINGTON : 2007 _____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800 Fax: (202) 512�092104 Mail: Stop IDCC, Washington, DC 20402�090001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS RICHARD C. SHELBY, Alabama, Chairman ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota CHUCK HAGEL, Nebraska JACK REED, Rhode Island RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky EVAN BAYH, Indiana MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida Kathleen L. Casey, Staff Director and Counsel Steven B. Harris, Democratic Staff Director and Chief Counsel Mark Oesterle, Counsel Justin Daly, Counsel Dean V. Shahinian, Democratic Counsel Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator George E. Whittle, Editor (ii) ? C O N T E N T S ---------- TUESDAY, MARCH 7, 2006 Page Opening statement of Chairman Shelby............................. 1 Opening statements, comments, or prepared statements of: Senator Sarbanes............................................. 3 Senator Hagel................................................ 4 Senator Carper............................................... 4 Senator Sununu............................................... 4 Senator Menendez............................................. 5 WITNESSES Paul Schott Stevens, President, Investment Company Institute..... 5 Prepared statement........................................... 28 Glenn L. Reynolds, Chief Executive Officer, CreditSights, Inc.... 8 Prepared statement........................................... 31 Vickie A. Tillman, Executive Vice President, Credit Market Services, Standard & Poor's.................................... 10 Prepared statement........................................... 41 Frank Partnoy, Professor of Law, University of San Diego School of Law......................................................... 11 Prepared statement........................................... 48 Colleen S. Cunningham, President and Chief Executive Officer, Financial Executives International............................. 13 Prepared statement........................................... 50 Damon A. Silvers, Associate General Counsel, American Federation of Labor and Congress of Industrial Organizations.............. 15 Prepared statement........................................... 53 Jeffrey J. Diermeier, CFA, President and Chief Executive Officer, CFA Institute.................................................. 17 Prepared statement........................................... 55 Alex J. Pollock, Resident Fellow, American Enterprise Institute.. 21 Prepared statement........................................... 58 (iii) ASSESSING THE CURRENT OVERSIGHT AND OPERATIONS OF CREDIT RATING AGENCIES ---------- TUESDAY, MARCH 7, 2006 U.S. Senate, Committee on Banking, Housing, and Urban Affairs, Washington, DC. The Committee met at 10:03 a.m., in room SD-538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY Chairman Shelby. The hearing will come to order. Good morning to everyone. Today, the Banking Committee continues its review of credit rating agencies. These entities wield extraordinary power in their role as gatekeepers to the bond markets. Although the rating business has existed for almost a century, recently there has been a renewed interest in how the industry operates and how it is regulated due to its increased importance in today's markets and because of the well-publicized failures to warn investors about the bankruptcies at Enron, WorldCom, and other companies. The modern rating industry was established in 1975 when staff of the Securities and Exchange Commission first issued no-action letters, essentially regulatory license to a select number of rating firms. With the addition of only a few more firms, these nationally recognized statistical rating organizations, or NRSRO's, have since provided almost all of the ratings used in the markets. While their market share has remained steady at 99 percent, the industry has grown considerably as regulatory changes have consistently increased the need for ratings issued by firms with the NRSRO designation. It is almost impossible for a rating firm to compete in this industry without the designation. I believe it is important for us to consider the manner in which the designation is awarded. The single most important factor in the SEC staff 's NRSRO process is the national recognition requirement. As many commentators have noted, this presents an obvious dilemma for firms seeking to do business in this industry. To receive the license, a firm must be nationally recognized, but it cannot become nationally recognized without first having the license. There are other key questions with respect to the NRSRO regime. For example, what is the SEC staff 's definition of the term ``NRSRO''? There are no objective standards. What constitutes the application process? What is the time frame involved for a decision? Once a firm is approved, is there any way for the investors to know an NRSRO continues to meet the requirements necessary for the designation? What amount of ongoing oversight by the SEC occurs? There is no transparency, I believe, in the process. The Commission has studied ways to improve and to clarify the NRSRO system for more than a decade, but has failed to act in spite of two concept releases. Two proposed rules--a comprehensive report mandated by the Sarbanes-Oxley Act, 2 days of public hearings, and an investigation of the NRSRO's triggered by the Enron scandal that revealed numerous problems at the then-three NRSRO's, including potential illegal activity. Considering the artificial barriers erected by the NRSRO system, it is not surprising that the rating system is highly concentrated. It is even more concentrated than the accounting profession, which is controlled by four firms. Here, only two companies dominate the business. The Big Two--Standard & Poor's and Moody's--generate unusual high operating profits for their publicly traded parent corporations. The profit margins are among the highest in the corporate world. Some describe the market penetration of these companies as remarkable, even astonishing. Both S&P and Moody's rate more than 99 percent of the debt obligations and preferred stock issues publicly traded in the United States. Given their profit margins and market penetration, it is understandable why the Big Two have been called a shared monopoly, a partner monopoly, and a duopoly. Their 99-percent market share suggests that they do not actually compete with each other, particularly in the corporate bond market. These conditions raise questions regarding the impact of the NRSRO system on investors and the markets. Has the absence of competition affected the quality of ratings, as some have suggested? Were NRSRO failures to downgrade Enron, WorldCom, and others in a timely manner a result of the current system's fundamental weaknesses? The existing regime also raises critical questions regarding the treatment of conflicts of interest. In addition to the inherent conflict of debt issuers paying rating agencies for ratings, there have been suggestions that the NRSRO's are marketing ancillary, fee-based consulting services to their issuer clients. This practice, if true, raises questions about the independence and objectivity of the rating agencies. Of course, it is difficult to assess some of these criticisms of NRSRO's because they are so lightly regulated and they conduct a great deal of their activities with minimal scrutiny. For example, information with respect to rating fees is limited. We do not know whether and to what extent NRSRO's are marketing additional services, such as consulting, to their issuer clients or engaging in anticompetitive practices, such as notching. We do not know whether the firms are complying with their procedures and ethics codes. We do not know any of these things because the SEC does not conduct periodic inspections of the NRSRO's. Three decades after granting a few firms privileged status with protection from competition, senior SEC staff recently questioned whether the Commission even has the statutory authority to oversee NRSRO's. It is quite clear that the U.S. Congress has a decision to make regarding this essentially self-regulated yet noncompetitive industry with duopoly profits. This morning, the Committee welcomes the distinguished panel of witnesses. From left to right, we will hear from Mr. Paul Schott Stevens, President, Investment Company Institute; Mr. Glenn Reynolds, Chief Executive Officer, CreditSights, Inc.; Ms. Vickie Tillman, Executive Vice President for Credit Market Services, Standard & Poor's; Mr. Frank Partnoy, Professor of Law, University of San Diego School of Law; Ms. Colleen Cunningham, President and Chief Executive Officer, Financial Executives International; Mr. Damon Silvers, Associate General Counsel, AFL-CIO; Mr. Jeffrey Diermeier, President and Chief Executive Officer, CFA Institute; and Mr. Alex Pollock, Resident Fellow, American Enterprise Institute. We welcome all of you to the Committee. Senator Sarbanes. STATEMENT OF SENATOR PAUL S. SARBANES Senator Sarbanes. Mr. Chairman, thank you very much for holding this hearing on assessing the current oversight and operations of the credit rating agencies. Credit rating agencies play a very important role in the capital markets by providing opinions to investors on the ability and the willingness of issuers to make timely payments on debt instruments. These ratings issued by the agencies can have very significant impacts. The Washington Post, in an article in November 2004, wrote, ``They can, with the stroke of a pen, effectively add or subtract millions from a company's bottom line, rattle a city budget, shock the stock and bond markets, and reroute international investment.'' Investors rely upon the agencies' impartiality, and they rely upon their ratings. The SEC created the designation of nationally recognized statistical rating organization, NRSRO, which is currently applies to five agencies, and many institutional investors buy debt only if it has been rated by an NRSRO. A Reuters article last month, February 2006, stated, ``The SEC designation gives these firms a major advantage in competing for business against other firms.'' In recent years, concerns have been raised about the industry. In late 2001, the largest credit rating agencies maintained an investment grade rating on Enron debt after its major financial restatements and until 4 days before Enron declared bankruptcy. As a result, as BusinessWeek reported, there was a barrage of criticism that raters should have uncovered the problem sooner at Enron, WorldCom, and other corporate disasters. Today's hearing will provide us with the opportunity to hear testimony on issues that have been raised about the credit rating industry, issues such as: Competition in the credit rating industry and barriers to entry; the regulatory process for recognizing NRSRO's; the SEC's legislative authority to regulate, exam, or impose requirements on rating agencies; conflicts of interest that may arise under several circumstances, such as when rating agencies are paid by the issuers they rate; sell consulting services or have affiliates that sell services or products to issuers which they rate; or have a director who also holds an executive position for an issuer that is rated--alleged anticompetitive processes such as those former SEC Chairman Bill Donaldson identified, ``tying arrangements, solicitation of payments for unsolicited ratings, and threats to modify ratings based on payment for related services.'' The testimony today will add to the Committee's record from the hearings in February of last year when witnesses representing rating agencies, the bond market, and financial professionals testified on the role of credit rating agencies in the capital markets, and in March of last year when then-SEC Chairman Bill Donaldson testified on the Commission's rule proposal to define the term ``NRSRO,'' and on staff discussion with the NRSRO's about a possible voluntary oversight framework. Mr. Chairman, I commend your ongoing interest in this area. I look forward to working with you on addressing the many issues involved. I join you in welcoming the distinguished panel of witnesses, and I look forward to hearing their testimony. Chairman Shelby. Thank you, Senator Sarbanes. Senator Hagel. COMMENTS OF SENATOR CHUCK HAGEL Senator Hagel. Mr. Chairman, thank you. I, too, appreciate very much your attention to this issue and look forward to our witnesses' testimony this morning. Chairman Shelby. Thank you. Senator Carper. STATEMENT OF SENATOR THOMAS R. CARPER Senator Carper. Thanks, Mr. Chairman. I want to welcome our witnesses. I used to be a Governor, and I used to meet with rating agencies on a fairly regular basis. Before that, I was State Treasurer and a bond issuing officer, so I have a special appreciation for the work that you do and just a great appreciation. One of the happiest days of my life as 8 years as Governor was the 3 days that we got upgrades to AAA from Moody's, S&P, and Fitch. I will always remember those days. And whenever I am having a bad day, I just get out those press clips and read them all over again. [Laughter.] I am going to be in and out today. I look forward to your testimony. We are just delighted that you are here. This is an important hearing. Thank you for being with us. Chairman Shelby. Senator Sununu. STATEMENT OF SENATOR JOHN E. SUNUNU Senator Sununu. Thank you, Mr. Chairman. I think you covered most of the critical points in your opening statement. I do not have any formal remarks, but I do think this is an area that deserves our attention. My concern and I think my caution is that we make sure whatever solution we proposes, it addresses the problem. And I do not see the problem as being one of a lack of regulation or need for additional regulation in the area of particular business practices as much as it is a question of a lack of competition. And I think that competition is lacking in part because there are a number of barriers to entry, and one of the most significant barriers to entry are regulations, and they are the barriers that have been created by--unintended, but have been created by some of the existing regulations, and we need to look carefully at those. We have sophisticated financial markets. We want to make sure we have good disclosure, good standards for certification, but at the same time, if you look just at the market share data, which I think the Chairman quoted in his opening testimony, you see one of the most concentrated markets in the entire country, one of the most concentrated market share profiles in the entire country, and it is an industry that currently acts as an oligopoly, and that can create a lot of bad behavior and a lot of pricing problems. And that is not necessarily the case or the fault of the participants. Again, we get back to the question of whether we have a regulatory structure that is actually discouraging competition. No one wants that to happen, but it could well be the effect of some of the existing rules. So this is a critical issue. We have the ability to make, I think, modest changes that will result in greater competition, greater pricing, greater range of choices for both investors and companies that seek to get rated by one of these important firms. Thank you, Mr. Chairman. Chairman Shelby. Senator Menendez. STATEMENT OF SENATOR ROBERT MENENDEZ Senator Menendez. Thank you, Mr. Chairman. I look forward to the witnesses' testimony, and I hope that we will hear part of the concerns that many of us have expressed about the timeliness of the essence of the ratings and the nature of, particularly at State and local governments, timely basis of financial troubles that may exist. And while I have been on the other side of this equation, as Senator Carper has, in receiving ratings, as a former mayor and being in the State legislature as well, I am increasingly concerned about finding out too late in the process and what that means both for the public when it is a public entity and what it means for employees when it is a private entity. So, I look forward to the testimony. Chairman Shelby. Thank you, Senator. All of your written testimony will be made part of the hearing record, if you will--it is a large panel--briefly sum up your remarks. Mr. Stevens, we will start with you. STATEMENT OF PAUL SCHOTT STEVENS PRESIDENT, INVESTMENT COMPANY INSTITUTE Mr. Stevens. Thank you, Mr. Chairman. Good morning. As you have noted, I am President of the Investment Company Institute, the national association of U.S. investment companies. Our members include mutual funds, closed-end funds, exchange-traded funds, and sponsors of unit investment trusts. ICI members manage a total of approximately $9.6 trillion. This is my first opportunity as President of the ICI to testify before the Committee, so ably led by you, Chairman Shelby. Under your leadership and that of Ranking Member Sarbanes, the Committee has been very active on critically important issues affecting all aspects of our capital markets. I do commend you for holding this hearing to examine the current oversight and operation of credit rating agencies. The institute welcomes the opportunity to provide its views on these issues and others before the Committee. Credit rating agencies play a significant role in the U.S. securities markets generally and vis-a-vis mutual funds in particular. Mutual funds employ credit ratings in a variety of ways: To help make investment decisions, to define investment strategies, to communicate with their shareholders about credit risk, and to inform the process for valuing securities. The most significant influence of credit ratings on the fund industry is on the $2 trillion invested in money market mutual funds. Money market funds are a remarkable chapter in U.S. financial history. For many years, retail and institutional investors alike have relied on money market funds as an indispensable tool for cash management because of the high degree of liquidity, stability in principal value, and current yield that they offer. ICI estimates that between 1980 and 2004, roughly $100 trillion flowed into, and the same amount out of, money market funds. If money market funds are an industry success story, they also most certainly are an SEC success story. Since 1983, money market funds have been governed very effectively by Rule 2a-7 under the Investment Company Act of 1940. Rule 2a-7 limits the types of securities in which money market funds can invest in order to help them achieve the objective of maintaining a stable net asset value of $1 per share. Credit ratings form an integral part of these limitations. Chairman Shelby. Explain further what you mean there, their limit on what you can invest. Mr. Stevens. Money market funds may invest only in securities that are rated by an NRSRO in one of its two highest short-term rating categories, or if the securities are unrated, they have to be determined by the fund's board to be of a comparable quality. So it is a restriction on the way that we can invest our assets. It is written into the regulations, yes, Mr. Chairman. Now, it is important to note that no governmental entity ensures money market funds. Nevertheless, despite this estimated $200 trillion flowing into and out of these funds over the past 25 years, through some of the most volatile markets in our history, only once has such a fund failed to repay the full principal amount of its shareholders' investments. In that case, a very small institutional money fund ``broke the buck''--the $1 per share value--due to extensive derivatives-related holdings. Now, we believe the record of success achieved under Rule 2a-7 must continue for the benefit of money market fund investors. And this, in turn, depends on the ratings issued by NRSRO's providing credible indications of the risk characteristics of those instruments in which money market funds invest. To promote the integrity and quality of the credit ratings process and, in turn, serve the interests of investors who utilize credit ratings, we believe it is timely and appropriate for Congress to consider legislation to advance several objectives. First, the NRSRO designation process should be reformed to facilitate the recognition of more rating agencies and thereby introduce much needed competition in the credit rating industry. The mutual fund sector is one in which intense competition has brought unparalleled benefits to investors. I firmly believe that robust competition can do the same for the credit ratings industry and is the best way to promote the continued integrity and reliability of credit ratings. Unfortunately, the current SEC process for designation credit rating agencies does not promote but, in fact, retards competition. That process involving the issuance of no-action letters utilizing a vague ``national recognition standard'' has not worked effectively. In place of the process, the institute recommends the implementation of a mandatory, expedited NRSRO registration process with the Commission. Second, there should be appropriate regulatory oversight by the SEC over NRSRO's to ensure the credibility and reliability of their ratings. We believe this can be achieved through a combination of: One, periodic filings with the SEC; and, two, appropriate inspection authority for the SEC, coupled with adequate enforcement powers. Specifically, credit rating agencies should be required to provide key information to the SEC upon registration, including information relating to conflicts of interest, the procedures used in determining ratings, ratings performance measurement statistics, and procedures to prevent the misuse of nonpublic information. NRSRO's should be required to the report to the SEC on an annual basis that no material changes have occurred in these areas. Similarly, they should be required to report any material changes that do occur on a timely basis, and this information should be made available promptly to investors who rely on their ratings. Such disclosures should be accompanied by an appropriate SEC inspection process, tailored to the nature of credit rating agencies' specific business activities. Third, investors should have regular and timely access to information about NRSRO's to provide them a continuing opportunity to evaluate the ratings that they produce. It is important to our members as investors that they have access to information about an NRSRO's policies, procedures, and other practices relating to credit rating decisions. In particular, it would be helpful for credit rating agencies to disclose to their investors their policies and procedures addressing conflicts of interest, as well as the conflicts themselves, and periodically to disclose information sufficient for investors to evaluate whether they have the necessary staffing, resources, structure, internal procedures, and issuer contacts to serve as NRSRO's. Finally, they should have some accountability for their ratings in order to provide them with incentive to analyze information critically and to challenge an issuer's representations. Any reforms to the credit rating process should, at a minimum, make the agencies accountable for ratings issued in contravention of their own disclosed procedures and standards. Surely, the First Amendment does not prevent Congress from requiring credit rating agencies to make truthful disclosures to the SEC and to the investing public. Increased competition, appropriate SEC oversight, greater transparency, and heightened accountability--these are the right objectives for reform of the credit rating industry from the perspective of mutual funds, other investment companies, other investors, and the securities markets as a whole. I very much appreciate the opportunity to share the institute's views with you today. I look forward to working with the Committee on these and other issues and would be delighted to take your questions. Chairman Shelby. Thank you. Mr. Reynolds. STATEMENT OF GLENN L. REYNOLDS CHIEF EXECUTIVE OFFICER, CREDITSIGHTS, INC. Mr. Reynolds. Thank you, Mr. Chairman and Members of the Committee. I am happy to have this opportunity to express our views on this very important subject. I would just like to clarify that we are an independent research firm. We have never applied to be an NRSRO and have no plans to in the immediate future. What we would like to say up front is that the timing could not be better for productive change in the credit ratings industry, especially given the trends in the global markets, how information and research is delivered, and who will be delivering it in coming years. The incumbent NRSRO's will look to represent this current process as being about burdensome regulation and oversight. It is really about lowering barriers and removing structural impediments to competition. The agencies will wave the flag of letting the markets work when, in fact, they are promoting the exact opposite. Lowering barriers will still mean raising the bar for product quality and innovation, and that point often gets lost in all the angling in the reform process. New market entrants will need to deliver high-quality products to generate a meaningful revenue stream. The market will get very competitive among the new entrants looking to establish a foothold, and that is not a bad thing at all for quality. It will take more time for Moody's and S&P to feel any meaningful competitive pressure, but we need to start somewhere. Moody's and S&P have done a good job pushing back the start date of all of this, but the inevitable is on the way. In our discussions on this topic, we always remind people that business reality, the need to develop quality products, build brand power, and develop distribution capabilities all entails a lot of costs and takes literally many millions of dollars even for small firms. Individuals do not invest in or work at firms where the product cannot generate cash to grow. Analysts cost money, websites cost money, and opening offices costs money. As Moody's and S&P probably can attest, lawyers and lobbyists most likely also cost a lot of money. The business reality has always been a very compelling gatekeeper, and always will be. That will be the case with market entrants into the credit ratings industry. Innovation in the credit markets has always been heavily due to growing competition in the banking and brokerage industry. There were predictions of doom by the securities industry well over a decade ago when the commercial banks started their concerted moves into the traditional underwriting businesses. The investment banks were playing an old but transparent game of hyping the fear of the unknown. The incumbent securities firms were looking to stave off competition and thought predictions of chaos and trouble might strike a nerve. The opposite effect came true. Now investors and issuers have much more choice of who they want to deal with, pricing is more competitive, the markets are more efficient, and despite some bumps, the system is stronger and better capitalized. Innovation in such areas as securitization and risk management have served the U.S. corporate sector well. It is in no small part due to the evolution of the banking and underwriting industry from a small group of a half-dozen bulge bracket investment banks to a global bulge bracket of a few dozen major integrated financial services operations. The evolution of the credit markets was about letting competitors compete and seeing the market benefit from innovation and choice. Along the way, Moody's and S&P have been able to hitch a ride to the sweeping benefits that came with this intensified competition. Unfortunately for the market, new ratings firms were essentially blocked by a regulatory system that kept market entrants out, while banking sector innovation fed the rating agencies a steady diet of new business. All in all, it was a very sweet deal. Wall Street, the investment banks, and the securities firms invent it and engage in brutal competition to market it. Then Moody's and S&P come in and rate it and reap the benefits of inelastic pricing and no choice. Now Moody's and S&P wave the same red flags around market disruptions. Their take is that hidden risks lurk around the corner that will create problems in the markets. It sounds a lot like what the investment banks were crying about with the commercial banks and non-U.S. banks came into their space. It is an old ploy. In the case of the banks and brokerage houses, the system in the end benefited, and innovation was everywhere. Not coincidentally, Moody's and S&P cashed in on the value of someone else's competitive excellence. There is a reason that Moody's pretax profit margins significantly outdistance those of Microsoft and dwarf Exxon Mobil. That is all well and good. Now it is time to let more high- quality institutions in to compete and push the incumbents to do a better job rather than reap profits tied in part to the market being a price taker by regulatory dictate. Competition makes an analyst want to know it better than the next guy, write it up faster than the next guy, and look to establish himself and his firm in the market. Quality only benefits from that. Plus if you want to take on these behemoths, you better have a good product, if not some major backing. We are all in favor of profit maximization, but we also favor fair play and truly competitive markets. New competition will not be disruptive or undermine quality. That is a ruse. The rating agencies' performance during the scandal years with their Reg FD exemptions and absolute market power does not leave room for them to hype quality fears. After all, we have already seen the downside of quality problems that come with no competition. We address some of the quality worries we have heard in our formally filed testimony, but do not buy the lie that quality will suffer and information flows will not improve. In the end, Moody's and S&P may just have to settle for enormously profitable, high-margin growth under the rules of fair competition and open markets that the rest of the underwriting chain has to adhere to. They will somehow bear up under the strain. In the meantime, issuers will have choices as will investors. Thank you for your time and this opportunity. Senator Sununu. [Presiding.] Thank you, Mr. Reynolds. Ms. Tillman. STATEMENT OF VICKIE A. TILLMAN EXECUTIVE VICE PRESIDENT, CREDIT MARKET SERVICES, STANDARD & POOR'S Ms. Tillman. Mr. Chairman, Members of the Committee, good morning. I am Vickie Tillman. I am the head of ratings at Standard & Poor's, and I have been in the business for about 30 years. Let me start by saying that S&P strongly supports the lowering of barriers to entry in our industry and the resulting designation of additional NRSRO's. Over the years, Congress and other regulators have used their NRSRO recognition as a means to provide a quality check for investors. By way of example, the Federal Deposit Insurance Act includes a provision that generally prohibits savings and loans associations from holding securities unless they are deemed investment grade by an NRSRO. To abandon the NRSRO system would be to abandon this quality check. The result would be a regulatory vacuum that could expose to unwarranted risk the very investors Congress and these regulators have determined to protect. In our view and in the view of the market, as reflected in an SEC study, a more effective and significantly less disruptive approach is to improve on the existing system. The groundwork for this approach is already in place. The SEC has drafted, published, and received extensive comments on a proposed rule that should lead to a streamlined NRSRO designation process, and more NRSRO's, all of which would promoted competition. Unfortunately, despite receiving broad support for the proposed rule, the SEC has taken no step, since the close of comments last June, toward finalizing it. We urge Congress to press the SEC to move forward on the proposed rule. The financial markets have accepted the longstanding global practice of S&P and other rating agencies of charging fees to rated issuers. Despite this broad acceptance, concerns have been raised about potential conflicts of interest arising from this practice. These concerns are unfounded. There is no evidence that the ``issuer pays'' model compromises the independence and objectivity of ratings. Quite the contrary. Studies have found that any potential conflicts of interest have either not materialized or have been effectively managed. On the other hand, ``issuer pays'' models have benefits not available under other models. For example, it allows rating agencies to make their ratings available to the entire market without cost. S&P does this by, among other things, posting our rating actions on our free website. In this way our ratings are subject to constant market scrutiny. The ``issuer pays'' approach also allows for the ongoing monitoring of ratings and the rated issuers. Put simply, effective ways exist to increase competition and manage potential conflicts of interest in our industry without drastically overhauling a system that has worked for decades. We believe that legislation, therefore, is unnecessary at this time. It could also be harmful to the quality of ratings. Ratings are opinions, and analysts must be free to form their opinions without fears of being second guessed or subjected to sanctions for ratings others might feel are too high or too low. Substantive SEC oversight or legislation of the analytical process would necessarily involve such second guessing, and we believe, cause analysts to be unduly tentative or conservative in their analysis so as to avoid later criticism. In our view, a better approach is one that was recently adopted by the European Commission following an intensive stud of the issues. The EC determined that oversight of rating agencies is more appropriately accomplished through the establishment of codes of conduct, such as the S&P code of conduct that I have attached to my testimony. To that end, we have been working diligently with the SEC and the other NRSRO's toward the adoption of an oversight framework. Each NRSRO would adopt, as S&P already has, a code of conduct, and would establish an independent internal audit mechanism by which to test annually compliance with that code. The audit results would be shared and discussed with members of the SEC staff. We have met with the SEC on many occasions, and are now close to final agreement on the framework. Not only would such an approach avoid the public policy pitfalls of more intrusive Government oversight, but it would also avoid infringing the well-established First Amendment rights of S&P and other rating agencies. Thank you, I would be happy to answer any of your questions. Chairman Shelby. Thank you. Professor Partnoy. STATEMENT OF FRANK PARTNOY, PROFESSOR OF LAW, UNIVERSITY OF SAN DIEGO SCHOOL OF LAW Mr. Partnoy. Thank you, Chairman Shelby, Ranking Members Sarbanes, and Members of this Committee, for the opportunity to testify today. I am a Law Professor at the University of San Diego, where I have spent much of the past 9 years studying the credit ratings industry. First, a bit of historical perspective. When I wrote my first academic article on credit rating agencies, Moody's was not a public company, and S&P was a relatively small line item at McGraw-Hill. I argued that the companies had an unfair oligopoly because of legal rules that required the use of NRSRO ratings. I also set forth evidence showing that ratings often are ``too little, too late,'' because they generate little information and lag the market by months. I did not expect much of a response--academic articles rarely receive much of a response. But the NRSRO's sent representatives to meet with me in San Diego and to discuss my findings at an academic conference. They also began a lobbying effort aimed at influencing opinion in the area. Moody's funded an academic research and advisory committee, and even hired academics who had been examining NRSRO's. Not much changed until Enron collapsed in late 2001. As evidence emerged that the NRSRO's had played an important role, the U.S. Senate decided to examine the NRSRO process. When Senator Joseph Lieberman's staff invited me to testify before the Senate Committee on Governmental Affairs in January 2002, more than 4 years ago, Senators from both parties asked detailed questions about the serious problems and dangers in the credit rating industry. Shortly thereafter, Moody's went public, with shares worth just about $4 billion, about one-seventh of the value of General Motors, and less than half the value of major financial firms such as Bear Stearns. Congress ultimately included, as part of the Sarbanes-Oxley legislation, a provision requiring that the SEC reexamine the NRSRO designation, and I thank the Members of this body, particularly Ranking Member Sarbanes, for doing so. Today, we have the results of that investigation and the evidence against credit rating agencies is damning. The problems I addressed in 1999 have multiplied exponentially. Moody's and S&P are more powerful and profitable than ever, and the dangers associated with the NRSRO system are much greater than they were in 2002. Moody's shares are now worth $20 billion more than those of either General Motors or Bear Stearns. Moody's shares have increased in value by more than 500 percent since they were issued, when the rest of the market was down. Moody's and S&P say they are merely publishing companies, and that they distribute their ratings to the public for free. But if that is right, why have they become so much more profitable? Even a simple financial analysis shows that the NRSRO's are not in the publishing business. For example, Moody's shares are worth more than the combined value of Dow Jones, publisher of The Wall Street Journal, The New York Times, The Washington Post and Knight-Ridder, which owns dozens of publications. But Moody's has only a fraction of those firms' employees, and provides far less information. And credit ratings certainly are not free. The cost of ratings are passed to investors who buy rated securities, which are more expensive than they otherwise would be, by billions of dollars, because issuers are effectively required to pay for ratings. The NRSRO's increasing oligopoly profits are a dangerous sign, a symptom of an infection spreading through the financial markets. Because regulators make NRSRO ratings so important, investors have incentives to engage in dysfunctional behavior to try to obtain high ratings, and they pay very high fees to do so. The rating agencies are conflicted, not only because issuers pay for ratings, but they also provide consulting services and threaten unsolicited ratings. The multitrillion dollar credit derivatives industry, which is driven by NRSRO ratings, and generates a large share of NRSRO profits, is opaque, volatile, and downright frightening. Overall, the NRSRO regime poses a serious threat to the financial system. It is no coincidence that NRSRO ratings played a central role in the bankruptcy of Orange County, the collapse of Enron, and numerous other scandals. In my view, the ideal solution would be to replace the entire NRSRO regime with one based on market measures. Every day, every hour, even every second, the markets provide information about the risks of particular securities. Indeed, the NRSRO's use these very measures, albeit not very well, in determining ratings. Congress might simply replace NRSRO ratings with reasonable market ranges. Alternatively, I believe, H.R. 2990 is a fair compromise. It would increase competition and create incentives for rating companies to use market-based measures and/or receive fees from investors rather than issuers, and pressure from competition will vastly improve quality in the credit rating industry. To the extent there are market-based constraints, they should eliminate any ``race to the bottom.'' I have not see evidence that opening markets to competition would be disruptive or lead to rate shopping. Instead, it is the conflicts of interest and perverse incentives associated with the current NRSRO system that pose the greatest concerns. Indeed, it is possible that S&P and Moody's will continue to dominate the industry after reform, but if they do so, it will be because of high-quality ratings and not because of a regulatory oligopoly. Let me conclude just very briefly by mentioning three issues related to NRSRO accountability, which I believe should be part of the discussion. First, Federal law currently exempts NRSRO's for Federal securities fraud. It should not. Second, Moody's and S&P have claimed that their ratings are merely opinions that are protected as free speech. In my opinion, that argument is laughable. H.R. 2990 is not unconstitutional. If it were, much of the Federal securities law system would be subject to challenges based on the First Amendment. And third, the NRSRO's have argued they can take care of any industry problems on a voluntary basis, perhaps with the help of the SEC, but both the NRSRO's and the SEC have demonstrated during the past three decades that they cannot be trusted to reform the credit rating business. Our financial markets are the strongest in the world, in large part because Congress has intervened at critical moments to reshape the financial landscape. When the stock market collapsed in 1929, Congress responded with important legislation, not just once, but several times over a period of years. In 2002, Congress offered its first response to the wave of corporate scandals with the Sarbanes-Oxley legislation. In my view, now is the time for Congress to continue that response by acting on this crucially important issue of credit ratings. Thank you again for the opportunity to give you my thoughts. Chairman Shelby. Thank you. Ms. Cunningham. STATEMENT OF COLLEEN S. CUNNINGHAM PRESIDENT AND CHIEF EXECUTIVE OFFICER, FINANCIAL EXECUTIVES INTERNATIONAL Ms. Cunningham. Thank you, Chairman Shelby, and Members of the Committee, for this opportunity to appear before you today. I am the President and Chief Executive Officer of Financial Executives International. FEI is a leading advocate for the views of senior financial executives representing 15,000 CFO's, treasurers, controllers in the United States and Canada. I am pleased to have the opportunity to share our views with you today on the important issue of credit agency operations and oversight. There are more than 100 CRA's operation worldwide, but only five are designated as nationally recognized statistical rating organizations by the Securities and Exchange Commission. These five enjoy a competitive advantage over their peers because the guidelines for many government, mutual fund, and other institutional investment portfolios not only specify minimum credit ratings for their securities, but also require that the ratings come from NRSRO's. The absence of competition and the ambiguity surrounding the designation criteria have left these incumbent NRSRO's with a distinct competitive advantage. The most effective way to increase competition in the credit agency market would be to eliminate the no-action process the SEC uses to recognize NRSRO's, and to replace it with transparent registration requirements, which any CRA can understand and aim for. Additionally, there is no mechanism in place in the current system to ensure that NRSRO's continue to satisfy the criteria necessary to maintain their designation. Once a rating agency has been designated, it is only required to notify the SEC when it experiences material changes that may affect its ability to meet these criteria. Given the enormous financial impact that a loss of designation would have on a rating agency, I believe it is unrealistic to expect them to police themselves. For this reason, I urge Congress to increase accountability through regular performance audits to ensure that registered CRA's continue to satisfy this criteria. I also believe the CRA's should be required to disclose additional information about their operations as part of their registration application with the SEC. These disclosures could address such items as the CRA's policies and procedures for protecting nonpublic information, and for handling conflicts of interest. The training and experience of those individuals tasked with developing the ratings, and the extent to which the CRA staff met with an issuer's management prior to developing its rating. This information would help investors differentiate between or among registered CRA's and might help issuers decide which rating agency to retain for rating purposes. Yet another flaw in the current system is that it fails to address the important issue of conflicts of interest. For example, some have sold fee-based advisory services to their rated-A clients in areas such as risk management, corporate governance, shareholder disputes, and data analysis. The NRSRO's offering these services have assured policymakers that they have erected adequate firewalls between their rating service and advisory service operation. While this may be true, issuers may, nevertheless, feel pressure to purchase advisory services to enhance the likelihood of receiving a good rating. I believe that a simple rule, similar to the restrictions included in Title II of the Sarbanes-Oxley legislation, as the Members of this Committee know well, would solve this problem. Title II of the Sarbanes-Oxley Act addressed the issue of auditor independence, and listed specific activities which registered audit firms could no longer perform for their audit clients. I believe a similar line should be drawn here. Rating agencies should not be permitted to provide both fee-based advisory services and rating services to the same issuer. This bifurcation of rating services and advisory services would help ensure that credit ratings are developed based solely on the company's creditworthiness, and not on any unrelated matters. In closing, I would like to urge Congress to introduce legislation that addresses the three concerns I have raised, the need to increase competition in the marketplace, the need to increase accountability and credit agency operations, and the need to eliminate conflicts of interest. That concludes my remarks. I want to thank the Chairman and the Members of the Committee for inviting FEI to participate in today's hearings, and I would be pleased to answer any questions. Chairman Shelby. Thank you. Mr. Silvers. STATEMENT OF DAMON A. SILVERS ASSOCIATE GENERAL COUNSEL, AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL ORGANIZATIONS Mr. Silvers. Thank you, Chairman Shelby and Member. I appreciate Senator Sarbanes' leadership in this as well. The AFL-CIO appreciates the opportunity to discuss the credit rating agencies and the role they play in the debt markets from the perspective of America's working families, who look to the credit markets to finance their employers, support their communities, and to fund their retirement and their children's education. Union-sponsored benefit funds have over $400 billion in assets, and union members participate in benefit funds with over $5 trillion in assets. Most defined benefit funds have between 40 and 60 percent of their assets invested in fixed- income investments. Our funds rely on credit rating agencies to help price these assets, and when the agencies get it wrong, as they did in Enron, our funds paid the price. The AFL-CIO called, in 2001, 1 week after the bankruptcy of Enron, for the SEC and Congress to address conflicts of interest and quality issues at the rating agencies, and we are very pleased to see, Mr. Chairman, you are taking up that task at this time, as you have for some time. Credit rating agencies are a vital part of the functioning of our capital markets. As one Moody's spokesperson has said, ``Our ratings are essentially a public good.'' The public good here is the provision of reliable, easily analyzed credit quality data to all credit market investors that enable investors to quickly and efficiently make investment decisions without each investor having to determine for themselves the degree of risk involved in a given financial instrument. However, this system is vulnerable to structural problems in particular, because the credit rating business is an effective duopoly, as the Chairman noted, with the Congressional Research Service estimating that Moody's and S&P together have 80 percent of the market. Many have expressed concern about the level of concentration and the business of auditing public companies. Obviously, the degree of concentration in the credit rating business is substantially greater, with two dominant firms and one subordinate firm, compared to four comparably sized major public audit firms and a substantial number of minor ones. While there are benefits to having a limited number of well-regarded credit rating firms, information, economics benefits to investors and other market participants, the current degree of concentration appears to us to be excessive. However, greater competition by itself is unlikely to be a sufficient solution to the structural problems with the credit rating business. There are two reasons for this. First, the scale and prominence of the existing firms are going to be a formidable barrier to entry, regardless of the regulatory changes that have been discussed here this morning. Second, and I believe more critically, there is a structural principal agent problem here that is unlikely to go away because the real customers are not doing the buying. It is hard to see how the real customers, the investors, and other people making investment credit quality decisions, are going to be able to do the buying without substantially detracting from the liquidity of the credit markets and the general availability of information. In this respect, as in many others, the credit rating business has similarities to the business of public company auditing, and for this reason, this business is not--there are risks in this business in looking to competition to be the sole solution because there is an interest on the part of both the rating agencies and the purchasers of their services to collude, and in particular to collude in areas, such as a previous witness mentioned, where the public interest is very much at stake, like in the area of what securities, S&L's, and other regulated entities buy. We have seen in both the Washington Post coverage of the rating agencies and in the SEC's examination of the same allegations, evidence of exactly the abuse one would expect to see in an unregulated monopoly providing a public good: Alleged differential treatment of firms, depending on whether they paid rating agency fees, agencies engaging in consulting businesses that parallel their core rating businesses, and extracting essentially concessions from the companies they rate, and lax treatment of major issuers like Enron with devastating consequences. We believe that there must be, as a result, public oversight of the rating agencies. I think you will find that my views on this parallel those of the FEI, and of the ICI, which is a new experience for me in certain instances. [Laughter.] This oversight must focus on three areas: Monitoring the seriousness of agency reviews of issuers, preventing abuse of business practices like coercing payments through bad ratings, and putting an end to conflicts of interest that lead rating agencies to become too cozy with the companies they rate. Again, this is analogous to the bar and most auditor-consulting services contained within the Sarbanes-Oxley Act and expanded on by the PCAOB. We find the need for regulation particularly compelling in light of the--extensively discussed here today--existence of the NRSRO concept in our securities laws. The NRSRO concept though is helpful in dealing with information cost to investors, Government agencies, and a wide variety of financial market actors. Replacing it with a mere registration process without substantive oversight, in light of the principal agent problem I discussed a moment ago, as some have suggested and is embodied in legislation introduced in the House, will be harmful to investors and ultimately to the functioning of our credit markets. However, the NRSRO system today should be more transparent and open so that firms that wish to become NRSRO's know what that entails, and so that existing NRSRO's can be held accountable to clear standards. Obviously, it also should be possible for firms that are not NRSRO's to become one, and that the process ought not to be Catch-22. For these reasons, we would favor the regulation of the rating agencies either by the SEC directly or by a PCAOB-like body with the powers to set specific criteria for being recognized as an NRSRO, powers to oversee agency practices, set positive standards, and prescribe abusive practices. This direction was embodied in the recommendations of the Senate Governmental Affairs Committee's October 2002 report following the collapse of Enron, and was raised and addressed extensively by the SEC in its June 2003 concept release, but as has been noted by prior witnesses, the Commission has not taken final action on any of these items, even the rather modest reforms in the NRSRO application process from the June rulemaking. This Committee can be very proud of its work in crafting the Sarbanes-Oxley Act of 2002. That Act contains within the principles that should be applied to the credit rating agencies, real independent oversight and an end to conflicts of interest. Credit rating agency regulation is part of the unfinished agenda of corporate reform, like the reform of executive compensation that the SEC is now attempting, and the continuing need to reform public company board elections that remains today unaddressed. The AFL-CIO commends this Committee for taking up this issue, and hopes that this unfinished agenda item can be finished. We appreciate very much the opportunity to appear before the Committee. Mr. Chairman, we appreciate your leadership in this area, and we look forward to working with you as you move forward. Chairman Shelby. Thank you. Mr. Diermeier. STATEMENT OF JEFFREY J. DIERMEIER PRESIDENT AND CHIEF EXECUTIVE OFFICER, CFA INSTITUTE Mr. Diermeier. Good morning. I am Jeff Diermeier, and I am President and Chief Executive Officer of CFA Institute. Up until about 14 months ago, I was a 29-year veteran of the institutional investment management wars, most recently as Global Chief Investment Officer of UBS Global Asset Management. I would certainly like to thank Senator Shelby, Senator Sarbanes, and other Members of the Committee for the opportunity to speak to you this morning on this important topic. First, some background about CFA Institute. CFA Institute is a nonprofit membership organization made up of individuals, investment professionals with a lofty mission of leading the investment profession globally by setting the highest standards of ethics, education, and professional excellence. CFA Institute is most widely recognized as the organization that administers the CFA examination and awards the CFA designation, a designation that I share with nearly 68,000 investment professionals worldwide. We also fund and support the CFA Center for Financial Markets Integrity, which promotes high standards of ethics and integrity. A common denominator for anyone involved with our organization is adherence to a code of ethics that I am comfortable calling the highest ethical standard that exists for investment professionals. CFA Institute is also a staunch proponent of self-regulation. This approach is embodied not just in our own code of ethics, but also in a number of additional guidelines and standards we have established in areas such as issuer-paid research and objectivity of analyst research. A necessary prerequisite to self-regulation is that it must be embraced by the market participants whose activities it attempts to standardize. Such appears not to be the case with credit rating agencies that have been reluctant to embrace any type of regulation over the services they provide to the investment community. This, despite the fact, from our viewpoint, that their business model appears to have significant conflicts. In a business that relies upon public trust for its existence, credit rating agencies should be held to the highest standards of transparency, disclosure, and professional conduct. Instead, there are no standards, there is no oversight. We are pleased to see that the Committee has listed, as a priority for the second session of Congress, the need to address conflict of interest and competition concerns that have been raised about credit rating agencies, as Senator Shelby announced on January 31. Were credit rating agencies operating within an environment of openness and transparency of business practices, free from substantial conflicts of interest, your Committee might have been advised to leave them alone. Such is not the case. Their problems notwithstanding, if credit rating agencies were willing to engage with regulators to address a variety of serious issues facing their businesses, it would have been reasonable for your Committee to let those discussions run their course. Such is not the case. Or if credit rating agencies were eager to avoid regulation, but began serious dialogue about a self-regulatory system, there would be no need for this Committee to focus its attention on these issues. Such is not the case. What we hear from rating agencies, when prompted, on the idea of reform does not help matters. They state that theirs is not a product intended for use by investors and that their work should be protected under the First Amendment as journalist product. These viewpoints, I understand, may perform well in a court of law, but they are not in alignment with the reality that investors do indeed rely on their services as an important tool in verifying the legitimacy of debt securities. Chief among the issues are conflicts of interest that appear to exist, notably that rating agencies rely on revenues provided from the issuers that they rate. These conflicts are exacerbated by rating agencies pitching ancillary services to issuers, such as prerating assessments and corporate consulting. In these relationships, the rated companies hold the cards, meaning they have the power to end the contract if and when the rating agency offers anything other than glowing review. Rating agencies are under constant pressure to issue favorable reviews in order to retain a particular book of business. Further, agencies are under no obligation whatsoever to publish their findings. Negative reviews, therefore, never make their way to the investing public. Under ordinary circumstances, competitive market forces might be capable of solving this problem. Those with reputations of full disclosure and investor focus could be expected to rise to the top. But, ironically, the one bit of authority the SEC does have is to require issuers of publicly trade debt securities to receive credit ratings from NRSRO's. This has the unintended consequence of reducing competition, since the threshold for a new entrant in the marketplace to achieve nationally recognized status is practically insurmountable. As a result, only five agencies hold this coveted status. In other words, even though rating agencies are not beholden to regulators, they nonetheless are beneficiaries of the rules that are in place for issuers. It is our belief that the standoff between rating agencies and the SEC is likely to remain unless Congress decides either to expand the SEC's oversight powers and/or to mandate rating agencies to submit to either involuntary regulation or voluntary self-regulation. Given the impasse that appears to exist between the SEC and rating agencies, we have a number of suggestions that we believe your Committee should consider as it determines how to address the current situation. First, the NRSRO definition is antiquated and must be revised. The initial hurdle to become nationally recognized is high and has had the unintended consequence of reducing the ability of new entrants into the marketplace, placing an emphasis on recognition versus an emphasis on competence. Second, regulatory oversight for credit rating agencies should be assigned to the SEC and rating agencies should be subject to periodic SEC review. Without adequate authority assigned to the SEC, any changes that the agencies make, either voluntary or by regulation, cannot be quantified or verified. Third, I believe the situation we are talking about here with credit rating agencies is materially similar to a situation we have dealt with in the area of issuer-paid research. In this case, small companies that are not covered by Wall Street analysts pay firms to provide equity research. To address these conflicts, the CFA Institute and the National Investor Relations Institute partnered to develop best practice guidelines for managing the relationship between corporations and financial analysts. I believe these guidelines, entitled ``Best Practice Guidelines Governing Analyst-Corporate Issuer Relations,'' could serve as a model if and when standards for better managing the relationships between corporations and credit rating agencies are developed. We will provide a copy of the guidelines with my written remarks. Another relevant situation of the recent past is the well- documented conflict that has existed between the investment banking and research departments at brokerage firms. This, of course, has had a multitude of consequences, most notably that analysts received pressure from both inside and outside their firms to issue favorable recommendations on the stock of current and potential investment banking clients. In this case, CFA Institute developed research objectivity standards to address the conflicts in the research process which are not limited to equity research, but extend to fixed- income research as well. The same disclosures and restrictions should be required of credit rating agencies. Fourth, an industry-wide standard of professional conduct should be developed that clearly defines standards of independence, appropriate relations between agencies and issuers, and duties to the investing public. Analysts and supervisors should be required to attest annually of their adherence to the standard. In many cases, simply identifying the areas of conflict and processes to eliminate or manage those conflicts would be a big step forward, but annual attestation of adherence moves us to a higher standard. This code of conduct should require rating agencies to explain in their written reports what analyses were performed in arriving at a particular rating and what factors were considered in preparing the rating. The current lack of transparency that is endemic among rating agencies must be address. No NRSRO standards currently exist for defining what minimal analysis should be performed. This code of conduct should also require NRSRO's to adhere to standards that govern the analysis performed. One of the simplest approaches would be to require that policies and procedures be established and verified to ensure compliance. These could include requiring documentation in support of the analyses, as well as a periodic supervisory view of the documentation and ratings. Last, the code of conduct should establish minimum competency requirements within rating agencies for those who analyze securities and assign their ratings. As I stated earlier, CFA Institute is a proponent whenever possible for self-regulation over government-mandated regulation. Nonetheless, we recognize that self-regulation has its limitations and there comes a time when a full-fledged regulation may be the only course of action. Of all the directions this Committee has at its disposal, we believe the one direction it absolutely should avoid is the status quo. The code of ethics I mentioned earlier which all of our 80,000 members must abide by requires them above all else to place the interests of investors first. And we believe that this Committee, the SEC, and rating agencies, if they are to follow that same basic principle, will ultimately find the right solution. CFA Institute is committed to providing our perspective and any type of assistance we may give the Committee. Thank you very much. Senator Bennett. [Presiding] Thank you. Mr. Pollock. STATEMENT OF ALEX J. POLLOCK RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE Mr. Pollock. Thank you, Senator, and I would like to thank the Chairman, Ranking Member Sarbanes, and Members of the Committee for the opportunity to be here today. These are my personal views on the need to reform the credit rating agency sector. I think it is both important and also quite timely for Congress to address this issue now, since the actual result of the SEC's actions, and in recent years its notable inaction, as various other panelists have pointed out, has been to create and sustain a Government-sponsored cartel, or the term you used, Mr. Chairman, a Government-sponsored shared monopoly. A few weeks ago, Barron's magazine had this to say, ``Moody's and Standard and Poor's are among the world's great businesses. The firms amount to a duopoly and they have enjoyed huge growth in revenue and profits. Moody's has a lush operating profit margin of 55 percent, S&P of 42 percent.'' And I have to say if I were a manager of such a firm, I would try very hard to maintain the status quo. One securities analyst recommending purchase of Moody's shares wrote, ``Thanks to the fact that the credit ratings market is heavily regulated by the Federal Government,'' rating agencies enjoy what he called ``a wide economic moat''; in other words, protection. It is my recommendation that Congress should remove this Government-created protection or economic moat and instead promote a truly competitive credit rating agency sector, and that will bring all the advantages of competition to the customers of ratings. It is my view that the time has come for legislation to achieve this. Instead of allowing the SEC to protect the dominant firms, which it does, in fact, although I do not believe it does so on purpose, it is my view that Congress should mandate an approach in legislation to end the Government-sponsored cartel and credit ratings. As part of this, you obviously have to think about this NRSRO issue, as many others have discussed and you have covered quite well in your opening comments, Mr. Chairman. I think the nub of the matter is that a competitive market test, not a bureaucratic process, should determine which credit rating agencies end up earning the market's view that they are the worthwhile, recognized agencies, so competition can provide its normal benefits of higher quality and lower costs. I will note this is completely different from the approach taken in proposals by the SEC staff on the NRSRO issue, and these proposals, in my opinion, are unsatisfactory. On the other hand, I believe that very much in the right direction is the bill which has been mentioned before introduced into the House by Congressman Fitzpatrick, H.R. 2990. What this bill does is directly address a really big, practical problem with the NRSRO issue, which is that this NRSRO designation over the three decades of its life has become enshrined in a very large and complex web of regulations and statutes which all interlock and interact with each other and pose a serious question of how could you ever untangle this web which affects thousands of financial actors, basically all of the regulated parts of the financial system, which is most of the financial system. H.R. 2990 does this in what I believe is an elegant fashion by keeping the abbreviation ``NRSRO,'' but completely changing what it means. As you know, it does that by changing the first ``R'' from ``Recognized'' to ``Registered,'' so you have nationally registered credit ratings organizations. This change would move us from an anticompetitive designation regime, which is what we have now, to a procompetitive disclosure regime. Many of the other members of the panel have mentioned the need for operating on a disclosure basis. I believe that registration in such a system should be voluntary, and if any rating agency, such as apparently Mr. Reynolds' firm, does not want to be an NRSRO, it should not have to be. But if it wants to be an NRSRO, the way is plain and clear what you do to get there. If you do not want to be an NRSRO, then your ratings cannot be used for regulatory purposes. And if you are happy with that, we should be happy with you, but if you want entry into this regulated part of the system, then you should have to register as a nationally registered rating agency. This voluntary approach, in my view, entirely removes any First Amendment objections which can be made. A very important advantage of a voluntary registration system is it would allow multiple pricing models for the credit rating agency business. As has been discussed, the model of the dominant agencies is that securities issuers pay for credit ratings, which arguably creates a conflict of interest which needs to be closely managed. The alternative is, of course, having investors purchase the credit ratings directly, and this seems to create a superior incentive structure. If the investors pay, it obviously removes any potential conflict. I am not suggesting that regulation should require one or the other, just that both should be available in the market. This contrasts to the SEC staff proposal which would enshrine the issuer-paying model in the regulation. I do not believe we should have actual regulation of credit ratings by the SEC or the process of forming credit ratings. I think that would be a worse regime that we have now, but we do need a competitive system. I do not think there is any doubt that a fully competitive rating agency market would perform better, but it will not happen all at once. This would be an evolutionary process and the desirable transition, given the natural conservatism of risk policies and financial actors, will be gradual. In my view, any concern about disrupting the fixed-income markets is entirely misplaced. Having worked in banking and dealt with bond and derivatives markets for a good long time, I see no chance of any market disruption from these changes, no chance at all. Also, having dealt with numerous financial regulators over many years, I see no chance of what one panelist called a regulatory vacuum. I do not think that will happen at all. A final thought on timing. The NRSRO issue has been a regulatory issue and discussion for a decade in what seems to me a quite dilatory fashion, and I think the time would be very appropriate for Congress now to settle this issue of competition versus cartel in this key financial sector. In my view, this will bring, as the evolution proceeds, better customer service, more innovation, more customer alternatives, and reduce duopoly profits. Also, it will bring higher-quality credit ratings. I think there is a certain analogy to publishing and the press in rating agencies, and we all know the more reporters you have working, the more likely the story is to come out. In the same way, in my view, the more credit rating agencies we have working on risk assessments, ideas, analysis, and looking at firms, out of this vibrant competition we are going to get better risk assessments. Thanks again, Mr. Chairman, for the chance to be here. Chairman Shelby. I thank all of you. The regulation of rating agencies begins and ends when the SEC staff issues the NRSRO license. Was the Department of Justice's Antitrust Division correct when it asserted that the NRSRO regime established, ``a nearly insurmountable barrier to competition for new entrants?'' Mr. Pollock. Mr. Pollock. I think the Department of Justice, Mr. Chairman, was absolutely correct in that opinion. Chairman Shelby. Mr. Partnoy. Mr. Partnoy. I agree. I think we have seen evidence of insurmountable barriers, and we will continue to see that unless we have action. Chairman Shelby. Mr. Stevens. Mr. Stevens. I think the circumstances speak for themselves. If it did not, there would be presumably many more NRSRO's than there are today. Chairman Shelby. Once the SEC staff issues the NRSRO license, what is the level of Commission oversight? Ms. Cunningham. Ms. Cunningham. None; very little. Chairman Shelby. Mr. Stevens. Mr. Stevens. You mean currently, Mr. Chairman? Chairman Shelby. Yes, sir. Mr. Stevens. I think it is slim to none. Chairman Shelby. Slim to none? Mr. Stevens. Probably more to the ``none'' side. Chairman Shelby. Mr. Pollock, do you agree with that? Mr. Pollock. That is my understanding, as well, Mr. Chairman. Chairman Shelby. Would SEC oversight benefit investors and the markets? Mr. Silvers. Mr. Silvers. Oh, I think undoubtedly. I think that is the main problem here. We have granted an unregulated monopoly in something where such harm can be done that to have substantive SEC oversight would be of huge benefit to working people in the markets. Chairman Shelby. Given that S&P and Moody's both have 99 percent, from what we have been told, of the corporate bond market and profit margins that exceed 40 and even 50 percent, how would you assess the level of competition in the rating industry? Do the Big Two actually compete with each other or is it a duopoly or partner monopoly, as some economists have asserted? Mr. Partnoy. Mr. Partnoy. I think you have heard consensus today, and the literature suggests that we have a duopoly, that this is not a market that is working well. It would be hard to find a market that is working worse where you had higher operating margins and greater oligopoly profit. Ms. Tillman. If I may, Mr. Chairman? Chairman Shelby. Go ahead, Ms. Tillman. Ms. Tillman. Being that I seem to be in the minority here, I would like to mention a couple of things that we believe need to be said. First of all, we believe that the NRSRO framework that was put in place did, in fact, have unintended consequences. Certainly, all you have to do is figure out how many years it has been in place and say that there are only five NRSRO's and that, in fact, it has limited the designation. However, what we do believe is that there is a system in place or there are a number of actions that can be taken that would simply and effectively increase the level of competition, and for that matter allow the NRSRO's and any additional NRSRO's to review their processes and procedures on an annual basis, reporting back to the SEC and allowing the SEC to have discussions with them. Chairman Shelby. Mr. Reynolds, are investors in the markets disadvantaged by the absence of any real competition among the Big Two? In other words, what is the impact of all of this? Do they have unlimited pricing power? Mr. Reynolds. Well, there are multiple levels. The first immediate one is when you have two firms dominating a market, it creates severe market disruptions. Market access, cost of capital, the ability to expand--it all wags on basically what I would argue would be one opinion rather than two, given the fact that the two very often operate in lock-step. A comparable situation would be having only two investment banks can make over-the-counter markets in debt securities. If one changes their mind and the other one has a history of following, there is no second and third opinion, and people need a second and third opinion. And because they are issuer- based models, not investor-based, at the end of the day you do not get paid for having the best opinion by the investor. You get paid by the issuer for just providing those ratings, or I should say for not withholding ratings. Chairman Shelby. Senator Sarbanes. Senator Sarbanes. Thank you, Mr. Chairman. I know we have a vote on. I am going to put just a couple of questions because I am not going to be able to return if you continue the hearing. I want to address something that may appear tangential, but I mean I think the basic arrangement needs to be examined carefully along the lines of the Chairman's questioning. Last year, The Economist wrote, ``There are unsettling parallels to the disgraced auditing industry. The rating agencies are started up consulting businesses which advise on matters that might affect an issuer's ratings.'' The Washington Post, in an editorial entitled ``Rating and Raters,'' said ``It is also troubling that the rating agencies are starting to sell consulting services. To secure contracts, the raters may be tempted to inflate grades for consulting clients. An acute version of this conflict of interest used to bedevil accounting firms.'' Why should the rating agencies engage in these consulting services? Shouldn't an appropriate arrangement be that they are a rating agency, pure and simple? And you avoid the conflicts of interest that are associated with going into the consulting business for people that they are then going to rate? Mr. Diermeier. Senator Sarbanes, I would definitely agree. It is not just a competition issue. This conflict in terms of consulting and ancillary services does create pressure. And since businesses and people that work in businesses understand how those pressures can manifest themselves, unless you have a clear, cut-and-dry rating process that is free from those conflicts, we are going to continue to have these kinds of problems. So, I think that the parallel is an excellent one. Senator Sarbanes. Ms. Cunningham, and then, Ms. Tillman, we will certainly give you an opportunity. Ms. Cunningham. I could not agree with you more, and I think we have seen that the audit example is a perfect example of where even the self-policing just did not work. It is a bit like putting the fox in the hen house. Senator Sarbanes. Ms. Tillman. Ms. Tillman. I would just like to state that Standard and Poor's rating services does not offer any consulting business, nor are any of its analysts involved in any consulting business. Senator Sarbanes. And you do that in order to avoid this charge of a conflict of interest? Ms. Tillman. Well, not just because of that. It is because they are separate businesses and our code of conduct that we have in place does not permit analysts to be involved in any consulting business. And as I said earlier, the ratings services do not offer any consulting business. Mr. Partnoy. Senator, could I just point out---- Senator Sarbanes. We have a lot of takers here. Real quick, because we have a vote. Mr. Partnoy. It might not be called consulting, but Standard and Poor's and Moody's offer services to issuers. For example, if an issuer wants to come to the agency to find out how a particular transaction might affect their rating, they can do so. So there certainly are these kinds of services being offered. They might not be called consulting, but they are consulting by any other name. Ms. Tillman. If I could reply to Mr.---- Senator Sarbanes. I will come back to you in a minute. Ms. Tillman. Thank you. Chairman Shelby. Mr. Silvers. Mr. Silvers. Thank you, Senator Sarbanes. Two quick points. First, there is not a lot of data, at least not that I could find, that really gets at the question of how much consulting is going on not just by the silo that the firms will tell you about, but by all of their affiliates and all the things that are not called consulting, but might be consulting. Second, I think it is really worth the Committee's attention to the fact that these issues of conflicts and the quality of ratings dwarf the issues around pricing. The collapse of Enron literally wiped out in debt more value than the entire market has placed on Moody's, which is the market's value of essentially all of the bad pricing that other witnesses have been talking about. But one catastrophe bred by conflicts is of greater consequence than all of that, which is frankly why my testimony focused on managing those. Senator Sarbanes. Mr. Stevens. Mr. Stevens. Senator, it seems to me we need more participants in the market and we need to know a lot more about all of those participants so that people who use these ratings can judge them. And if we have conflict of interest disclosure that is detailed enough and that is current enough, then the users of ratings can determine whether the rating is worth it or not. Senator Sarbanes. Ms. Tillman, you wanted to add something? Ms. Tillman. Yes, just a couple of points. Senator Sarbanes. The last word, I think. Ms. Tillman. One, we agree that Enron was a tragic situation and certainly hurt and was harmful to many people. But we were also victimized. As was stated in a plea agreement, the rating agencies were purposefully deceived. Literally, the executives of Enron sat down and put a plan in place to deceive the rating agencies so that they would not lower the ratings. On conflicts of interest, the weight of opinion by market participants is that the issuer-paid model does not compromise the objectivity of the rating. In numerous surveys, responses, and comments to regulators both here and abroad, they have found no occurrence of conflicts of ratings, or if there is, they have been well-managed. Therefore, you know, I believe that the issuer-paid model also offers something that we do not talk about, and that is the benefits of disseminating information for free, disseminating media analysis, disseminating the reasons and rationale for those ratings. One other clarification. We are paid to do analysis. We are not paid to publish it, and we freely publish it so that the investing public is aware of what the creditworthiness is of the issuers and the securities in the market. Senator Sarbanes. Let me ask one quick question. What is the view of panelists on whether the director of a rating agency--let me put it the other way--that the chief executive officer or director of a company that is being rated should also be the director of the rating agency? Is that a problem? It seems to me if it is, it is pretty easy to fix. Mr. Silvers. Senator, I think that the ideal governance of a rating agency would be that the board would be composed of individuals who did not have an economic interest in any way in the ratings that were being done. That being said, it is fairly easy to wall off that particular conflict, but the real question, I think, is why is that conflict necessary? There does not seem to me to be a good reason why you have to have that conflict in the first place. Senator Sarbanes. Thank you. Chairman Shelby. We appreciate you coming. We are controlled by the floor, as you know, and we have a big vote on the floor now. I have a number of questions to ask all of you and I would like to do that for the record. It will be part of this hearing record. We will follow up with all of you and go from there. We appreciate your participation here today. I would just like to sum up with one thought. What is wrong with competition? What is wrong with transparency, competition, and healthy oversight? Mr. Pollock, you have been here many times. Mr. Pollock. Absolutely nothing, Mr. Chairman. Chairman Shelby. We preach competition, do we not? Mr. Pollock. You have just said it all. Chairman Shelby. Thank you so much. The hearing is adjourned. [Whereupon, at 11:26 a.m., the hearing was adjourned.] [Prepared statements supplied for the record follow:]