1   UNITED STATES SECURITIES AND EXCHANGE COMMISSION

             2                                       (REVISED 01-15-03)

             3   HEARINGS ON THE CURRENT ROLE AND FUNCTION OF THE

             4   CREDIT RATING AGENCIES IN THE OPERATION OF THE

             5   SECURITIES MARKETS

             6

             7

             8   PAGES:  1 through 244

             9

            10        The above-entitled hearing commenced, pursuant to

            11   notice, at 9:00 a.m.

            12

            13

            14

            15              U.S. Securities and Exchange Commission

            16                          Washington, D.C.

            17

            18

            19                     Friday, November 15, 2002

            20

            21

            22

            23

            24                Diversified Reporting Services, Inc.

            25                           (202) 467-9200






             1   COMMISSIONERS:

             2   Chairman Harvey Pitt

             3   Commissioner Roel Campos

             4   Commissioner Cynthia Glassman

             5   Commissioner Harvey Goldschmid

             6   Commissioner Paul Atkins

             7

             8   OTHERS PRESENT:

             9   John McCarthy

            10   Michael A. Macchiaroli

            11   Larry Harris

            12   Annette Nazareth

            13   Bob Colby

            14

            15   PRESENTERS:    

            16   H. Kent Baker, Ph.D.

            17   University Professor of Finance

            18   Kogod School of Business

            19   American University

            20

            21   Deborah A. Cunningham

            22   Senior Vice President and Senior Portfolio Manager

            23   Federated Investors, Inc.

            24

            25






             1   PRESENTERS:  (Continued)

             2

             3   Sean J. Egan

             4   President

             5   Egan-Jones Ratings Company

             6

             7   Gay Huey Evans

             8   Director, Markets and Exchanges Division

             9   The Financial Services Authority

            10

            11   Frank A. Fernandez

            12   Senior Vice President, Chief Economist and 

            13   Director of Research

            14   The Securities Industry Association

            15

            16   Malcolm S. Macdonald

            17   Vice President - Finance and Treasurer

            18   Ford Motor Company

            19

            20   Leo C. O'Neill

            21   President

            22   Standard & Poor's, a division of the McGraw Hill Companies,

            23   Inc.

            24

            25






             1   PRESENTERS:  (Continued)

             2

             3   Glenn L. Reynolds

             4   Chief Executive Officer

             5   CreditSights, Inc.

             6

             7   Greg Root

             8   Executive Vice President

             9   Dominion Bond Rating Service Limited

            10

            11   Cynthia L. Strauss

            12   Director of Taxable Bond Research

            13   Fidelity Investments Money Management, Inc.

            14

            15

            16

            17

            18

            19

            20

            21

            22

            23

            24

            25






             1                          C O N T E N T S

             2                                                            PAGE

             3   Session I:  The Current Role and Function of

             4        Credit Rating Agencies                                8

             5

             6   Session II:  Information Flow in the Credit

             7        Rating Process                                       71

             8

             9   Session III:  Potential Concerns Regarding the

            10        Role of Credit Rating Agencies (Conflicts

            11        of Interest/Abusive Practices)                      127

            12

            13   Session IV  Potential Barriers to 

            14        Entry/Regulatory Treatment                          184

            15

            16

            17

            18

            19

            20

            21

            22

            23

            24

            25






             1                       P R O C E E D I N G S

             2             CHAIRMAN PITT:  As I think everybody knows, for

             3   about a century, credit rating agencies have been providing

             4   opinions on the creditworthiness of issues of securities and

             5   other financial obligations.

             6             These opinions are, obviously, of great importance

             7   to investors and other market participants, and they have an

             8   enormous influence on the securities markets, all of which

             9   has increased significantly, particularly with the increase

            10   in the number of issuers in the advent of new and complex

            11   financial instruments, such as asset backed securities and

            12   credit derivatives.

            13             I think the globalization of our financial markets

            14   also has served to expand the role of credit ratings to

            15   jurisdictions beyond the United States, where the reliance on

            16   credit ratings largely was confined for the first half of the

            17   Twentieth Century.

            18             Today, credit ratings affect securities markets in

            19   a number of important and critical ways.

            20             During the past 30 years, regulators, such as the

            21   Securities and Exchange Commission, have increasingly used

            22   credit ratings as a convenient surrogate for the measurement

            23   of risk in assessing investments held by regulated entities,

            24   because of the quasi public responsibilities in assessing

            25   investments held by regulated entities.






             1             Because of the quasi public responsibilities of

             2   rating agencies, the importance given to ratings by investors

             3   and other market participants and the influence of ratings on

             4   the securities markets, we announced last March that we would

             5   engage in a thorough examination of rating agencies to

             6   ascertain facts, conditions, practices, and other matters

             7   related to the role of rating agencies in the U.S. securities

             8   markets.

             9             Since that time, the Sarbanes-Oxley Act has been

            10   enacted and it directs us to conduct a study of rating

            11   agencies and their impact, as well.

            12             The hearing today and the one scheduled for next

            13   week represent the culmination of months of effort by the

            14   staff and the Divisions of Market Regulation and Investment

            15   Management, as well as in the Office of Compliance,

            16   Inspections, and Examination.

            17             I want to thank the staff for their tremendous

            18   efforts that they have expended over the past few months.  I

            19   would also like to thank the members of our panel for taking

            20   the time to appear before us today.

            21             With that, I will turn it over to Annette Nazareth,

            22   the Director of our Division of Market Regulation.

            23             MS. NAZARETH:  Thank you, Chairman Pitt.  We have

            24   assembled this broad section of distinguished and experienced

            25   panelists not only to discuss the increasing importance of






             1   credit ratings in today's financial markets, but, also, to

             2   facilitate a number of initiatives currently underway at the

             3   Commission.  

             4             First, the Commission has been directed by

             5   Congress, as Chairman Pitt said, to conduct a study of the

             6   role and function of credit rating agencies in the operation

             7   of the securities markets.

             8             This directive was issued in Section 702 of the

             9   recently enacted Sarbanes-Oxley Act of 2002, which also

            10   directs the Commission to submit a report on the study to the

            11   President and Congress by January 26, 2003.

            12             It is our goal and expectation that these will

            13   enable us to parse in a more meaningful way the areas of

            14   consideration set forth in Section 702. 

            15             Specifically, these areas include the role of

            16   credit rating agencies in the evaluation of issuers of

            17   securities; the importance of that role to investors and the

            18   functioning of the securities markets; any impediments to the

            19   accurate appraisal by credit rating agencies of the financial

            20   resources and risks of issuers of securities; any measures

            21   which may be required to improve the dissemination of

            22   information concerning such resources and risks when credit

            23   rating agencies announce credit ratings; any barriers to

            24   entry in the business of acting as a credit rating agency and

            25   any measures to remove such barriers; and, finally, any






             1   conflicts of interest in the operation of credit ratings and

             2   measures to prevent such conflicts or ameliorate the

             3   consequences of such conflicts.

             4             Another goal of these hearings is to assist the

             5   Commission in determining how the Commission's regulatory

             6   framework should best be applied to credit rating agencies.

             7             For over 25 years, the Commission has been using

             8   credit ratings from nationally recognized statistical rating

             9   organizations, known as NRSROs, in Commission rules and

            10   regulations.  

            11             During this time, the Commission has considered a

            12   number of issues related to credit rating agencies, including

            13   the need for direct oversight authority over credit rating

            14   agencies and the appropriate role of ratings in the federal

            15   securities laws.

            16             Nonetheless, there remain a number of difficult

            17   issues, many of which are reflected in Section 702 of the

            18   Sarbanes-Oxley Act, that the Commission would like to review

            19   before formally considering possible changes to the rules and

            20   regulations regarding rating agencies.

            21             Our agenda today reflects these issues.

            22             Before I introduce today's participants, I will

            23   briefly mention some details concerning our schedule today. 

            24   This morning there will be two sessions.  We will begin our

            25   opening session with brief introductory remarks from each of






             1   the hearing participants. 

             2             We will then discuss in some detail the current

             3   role and functioning of credit rating agencies.  This session

             4   will last approximately 90 minutes, and will be followed by a

             5   15-minute break.

             6             The second session this morning will explore the

             7   information flow of the credit rating process; that is, how

             8   rating agencies obtain and use information in the rating

             9   process and how and what type of information is communicated

            10   publicly and privately to issuers of credit ratings.

            11             At approximately 12:15, we will break for lunch for

            12   one hour and 15 minutes and we will resume our program at

            13   1:30 this afternoon.

            14             The first afternoon panel, which will last an hour

            15   and a half, will focus on concerns regarding the role of

            16   credit rating agencies, such as the potential conflicts of

            17   interest and abusive practices, and our final panel, which

            18   will run from 3:15 to 4:45, will address potential barriers

            19   to entry in the rating business and the appropriate degree

            20   and manner of regulatory oversight of rating agencies.

            21             As you can see, we have a very ambitious agenda to

            22   cover in a relatively short time.  

            23             Now, with that out of the way, I would like to

            24   introduce each of the participants and then circle back for

            25   any opening remarks that they would like to make.






             1             First, I would like to introduce the Commission

             2   today.  Of course, Chairman Pitt, who we would very much like

             3   to thank for calling for these hearings.

             4             We also have Commissioner Atkins, Commissioner

             5   Goldschmid, Commissioner Glassman, and Commissioner Campos.

             6             We also have staff here today, as well, and while

             7   we do have one moderator for each session, we fully expect,

             8   since there is such a tremendous collective knowledge on the

             9   part of the staff on this issue, that there will be a lot of

            10   give and take and weighing in by the staff members who will

            11   be participating, as well.

            12             We have Bob Colby, Larry Harris, and Mike

            13   Macchiaroli.  We will be joined by John McCarthy, as well.  

            14             Let me introduce our panelists, as well, and we do

            15   very much appreciate people taking the time to be with us

            16   today.

            17             We have Sean Egan, from Egan-Jones Ratings.  We

            18   have Malcolm Macdonald, from Ford.  We will be joined, I

            19   think her flight is delayed, by Deborah Cunningham, from

            20   Federated Investors.  

            21             We have Gay Huey Evans, who very graciously came

            22   all the way from London to be with us today.  She is with the

            23   FSA.  We have Frank Fernandez, who is with the SIA and Leo

            24   O'Neill, from S&P.  

            25             We have Greg Root, from Dominion Bond Ratings; 






             1   Glenn Reynolds, from CreditSights; and H. Kent Baker, from

             2   American University.  And that's our panel.

             3             So I'd like -- oh, I'm sorry.  What did I do.

             4   Cynthia Strauss, from Fidelity.  You know, I got tricked.  I

             5   said that was going to be a problem.  They put two Cynthias

             6   next to each other.  So I've merged you into one Cynthia.

             7             That's very bad, since I have a sister named

             8   Cynthia.  I will never live that down.  

             9             So I would like to give each of you an opportunity

            10   to make a brief opening statement.  Please be mindful that we

            11   have a comprehensive and ambitious agenda, so I would ask

            12   that, if you could, that you limit your statements to

            13   approximately three minutes.

            14             Shall we start with you, Sean?

            15             MR. EGAN:  Thank you.  I have passed out and,

            16   hopefully, everybody has a letter that we prepared.  If you

            17   don't have it, feel free.  We have additional ones.

            18             But it explains our position on the whole rating

            19   field.  In the first paragraph, the SEC portrays itself as an

            20   investor advocate.  That's their number one mission, investor

            21   advocate.  However, in that process, it extends that mission

            22   to the rating agencies that it's recognized.  Unfortunately,

            23   the rating agencies that are currently recognized by the SEC

            24   have had some major failures.  It includes Enron, the

            25   California utilities, Worldcom, Global Crossing, AT&T, AB&B. 






             1   There's probably a number more that we could list, but these

             2   are the big ones.

             3             Paragraph three, there is a study that was done by

             4   Professor Baker that refers to only 29 percent of investors

             5   thought that rating agencies issue timely, accurate ratings.

             6             We think there are two problems associated with

             7   this.  One is that there's a conflict of interest, and I will

             8   elaborate on that more this morning.

             9             Two is the lack of competition.  

            10             Let me just, first, touch on the conflict of

            11   interest.  Moody's, and that's the only one where we can get

            12   public information, Moody's obtains 87 percent of their

            13   revenue base from issuers.  

            14             You have a similar problem, and that is the problem

            15   with the equity analysts.  They are serving the issuers'

            16   interests.

            17             Now, they can claim that any one issuer is

            18   relatively a small portion of their overall revenue base.

            19   However, the same argument could be made for the equity

            20   analysts, Blodget -- and who is the other big one that is in

            21   the news?  Grubman, Jack Grubman, the equity analyst.  So we

            22   don't think that argument that they are a relatively small

            23   portion of the revenue base holds much water.

            24             The second fact, and that is a lack of competition,

            25   is really picked up by the Justice Department's phrase,






             1   "partner monopoly." 

             2             Now, this is not an oligopoly.  If you remember

             3   from your economics, oligopoly is when you have a couple

             4   firms competing for the same revenues.  Here, if Moody's

             5   gains some revenues, it's not going to take away from S&P's

             6   revenues.

             7             You need two ratings to have an issue and some

             8   people refer to this as a two and a half firm industry. 

             9   Fitch shows up in less than ten percent of the corporate

            10   ratings that we look at.

            11             I'm on to page two.  In the package, you have a

            12   letter and it's rare to get letters like this, but it's a

            13   letter from First Albany.  Basically, a First Albany broker

            14   had clients that had some securities.  Those securities were

            15   ultimately -- the company was acquired by Allied Signal.

            16             Allied Signal asked the rating agencies not to

            17   issue a rating, to withdraw their ratings, so that Allied

            18   Signal could buy back those securities at a lower price.

            19             And the rating agencies said, "I'm sorry.  That's

            20   what the issuer requested."  And they came to us asking for a

            21   rating.  

            22             We thought this was inappropriate, and you have

            23   some material.  It's very rare to get something in writing

            24   with that and it's a couple years old, but it's still there.

            25             We have a couple recommendations and they're at the






             1   bottom of page two.  One is to recognize some non-conflicted

             2   rating firms that have succeeded in warning investors.  I

             3   mean, that's why we're all here is because of these huge

             4   losses.

             5             Two is to prohibit issuer compensation.  If there

             6   are problems in the equity analyst field, there are also

             7   problems in the ratings field.  You're dealing with basically

             8   the flip-side of the same coin.

             9             Three is prohibit involvement with rated firms and

            10   dealers.  Moody's Chairman, Clifford Alexander, was on the

            11   board of Worldcom up until last year.  The biggest bankruptcy

            12   in U.S. history and the Chairman of Moody's was on the board.

            13             This is crazy.  There's no way that should happen. 

            14   You should also shoot down the board of the National

            15   Association of Security Dealers.  They're supposed to be

            16   independent.

            17             Four is remove the exclusion from Regulation FD. 

            18   Why in the world should these private firms be given an

            19   exclusion from Regulation FD, when all their competitors

            20   aren't given that?  It doesn't make any sense.  They're

            21   private firms.  Why not let them compete on the same business

            22   as everybody else.

            23             Five is separate ratings from consulting.  The same

            24   issue with the accounting firms.

            25             Six, prohibit the use of rating triggers.  One of






             1   the problems with Enron is that S&P and Moody's didn't want

             2   to downgrade them because these rating triggers would have

             3   thrown them into bankruptcy.  

             4             Get rid of your triggers.  Just say forget it, you

             5   can't use it in any security documents.  

             6             Seven is don't hold yourself out as independent if

             7   you're not independent.  They list in their web site, they

             8   describe themselves as independent.  They're not.

             9             Eight is police monopolistic practices.  There are

            10   two aspects to it.  One is right now in the structured

            11   finance area, there are a number of press releases that Fitch

            12   has made whereby Moody's is cutting their ratings by up to

            13   six notches in the structured finance, which basically makes

            14   it very difficult for Fitch to compete.

            15             Moody's has no basis for doing that.  They haven't

            16   done a study.  In fact, you could probably argue that in some

            17   cases, Moody's ratings should be cut much more, especially

            18   right before offering.

            19             Nine is prohibit a collar to investors as basically

            20   inside information. 

            21             Ten, if this is too much, get rid of this whole

            22   NRSRO designation.  If the SEC doesn't feel comfortable in

            23   making adjustments to protect investors' interests, and that

            24   has to be the guiding light, we think, in this whole process,

            25   we agree with the SEC's mission, get rid of it.  Get rid of






             1   the whole NRSRO designation.  The market will sort it out and

             2   they will be much better off.

             3             We have, afterwards, some additional charts. 

             4             MS. NAZARETH:  Sean, could I cut you a little short

             5   now.

             6             MR. EGAN:  Yes.  Thank you.

             7             MS. NAZARETH:  We have lots of additional time. 

             8   Thank you.  Mr. Macdonald?

             9             MR. MACDONALD:  Thank you.  I'm delighted to be

            10   here on behalf of Ford Motor Company.  Certainly, we hope to

            11   provide our insights into a very important subject to our

            12   company and to many other companies in the United States.

            13             In our view, the rating agencies provide a very

            14   valuable service to the capital markets.  At best, they have

            15   a very difficult job, with multiple objectives and serving

            16   multiple constituencies.

            17             Ford has extensive experience with the rating

            18   agencies.  For many years, we lived in the rarified air of

            19   AAA.  Unfortunately, that's a thing of the past and, in more

            20   recent times, our ratings have varied quite considerably with

            21   the economy and the health of the domestic auto industry.

            22             The principal issues that we would hope will be

            23   raised today include these significant concentration of power

            24   in a shrinking number of rating agencies.

            25             The potential for conflict with differing forms of






             1   communication to differing constituencies which they serve.

             2             Finally, the potential lack of transparency in the

             3   rating process and the seeming inconsistencies in the rating

             4   process over time.  

             5             Thank you.

             6             MS. NAZARETH:  Thank you.  Gay Huey Evans?

             7             MS. EVANS:  Thank you.  On behalf of the Financial

             8   Services Authority, we thank the Commission for inviting us

             9   here today.  So thanks.

            10             Clearly, much can be said about rating agencies,

            11   and I know this is to be brief comment, but from the UK, we

            12   do believe there is information asymmetry in the securities

            13   markets.

            14             Issuers do know more about their own

            15   creditworthiness than do investors.  It may be both feasible

            16   and cost-effective for major investors to undertake their own

            17   credit analysis, but this is not the case for small

            18   investors.  So there is a demand for information and to meet

            19   this demand, we need a supply of information, reliability,

            20   and, firstly comes along the supply of information in the

            21   form of rating agencies.

            22             So we have demand and supply in the market for

            23   information, just as in the markets for any other commodity.

            24             Second, investors cannot easily monitor credit

            25   rating agencies for the same reasons they cannot easily






             1   monitor issuers.

             2             Thirdly, the final trick is to find a way of

             3   charging for the information provided by credit rating

             4   agencies, since, once this information is revealed publicly,

             5   it is no longer of value to the credit rating agency.

             6             Over time, we have seen, which has been good, a

             7   general switch from charging for subscriptions to charging

             8   the issuer for a rating.  The issuer is prepared to pay

             9   because the impact on its cost of funding, access to a

            10   broader pool of investors, and by signal of relative quality.

            11             So credit rating agencies appear to have solved the

            12   equivalent public good problem of how to pay for the what

            13   lighthouse.  In fact, they spread the costs across investors.

            14             Now, the paradox is, is this for the best, in the

            15   best of all possible worlds.  There has been explosive growth

            16   in the use of credit ratings since the 1970s, but at the same

            17   time, the informational value of credit ratings appears to

            18   have declined.

            19             Maybe a lot has been published on the web, but the

            20   length and complexity of methodologies is probably not so

            21   comprehensible to many, particularly the retail.

            22             There also remains a broad correlation between

            23   ratings and default experience, but there has also been a

            24   lack of predicted power in individual cases that were

            25   mentioned earlier.  






             1             And how much of the broad correlation is due to

             2   changes in ratings immediately ahead of defaults?

             3             Almost no empirical studies find no added value of

             4   credit ratings over and above other indicators of default,

             5   and particularly what we watch are credit spreads, despite

             6   the access of credit ratings agencies to non-public

             7   information.  

             8             Indeed, some studies find that credit spreads are

             9   superior to credit ratings in predicting defaults, although,

            10   equally, it must be recognized that credit spreads perform

            11   just as badly as credit ratings in the individual cases that

            12   we've already mentioned earlier.

            13             Now, on the regulatory side, why have credit rating

            14   agencies prospered in recent decades?  Now, some have

            15   attributed this to regulation.  

            16             Now, this is not the place for a UK regulator, even

            17   though I have a non-English accent, to explain the history of

            18   this regulation, and I think Chairman Pitt did a little bit

            19   of this earlier.

            20             But it is substantial and it is noteworthy. 

            21   However, these regulatory licenses should not be portrayed in

            22   black and white.  First, investors also impose rating caps

            23   for purely market related reasons; for example, to resolve

            24   the principal agent problem in monitoring fund managers,

            25   insurance companies, et cetera.  






             1             Second, the use of ratings by the market is much

             2   more refined than the use by regulators who tend simply, in

             3   Europe, to divide securities into investment grade and sub-

             4   investment grade.

             5             Third, part of the explanation for the growth in

             6   the use of ratings since the '70s must be because of the

             7   growth of tradings in securities and, indeed, credit.

             8             Nevertheless, we must remain alert to the

             9   possibility that the use of credit ratings by regulators may

            10   distort the market for ratings information.  

            11             A new area that has come out, if anybody is

            12   watching, as a banking regulator, the new Basel Accord.  It

            13   is designed to include a reasonably simple standardized

            14   approach, but nevertheless, for this term risk sensitive, to

            15   including what we call risk buckets, than currently exists

            16   today, and credit ratings are to provide a reasonably simple

            17   and straightforward means of populating these risk buckets.

            18             The use of credit ratings reflects the universal

            19   availability and because, as a more risk sensitive approach

            20   demands, the ratings are reasonably well correlated with

            21   probabilities of default.

            22             So, for example, in the standardized approach that

            23   the banks have today for putting capital aside and if they

            24   used any of the ratings, let's say S&P, sorry, but whereby

            25   all corporate exposures are currently included with the 100






             1   percent risk bucket, in the Basel II new approach, a AAA to a

             2   AA-minus rated corporate can be included at 20 percent, an A-

             3   plus to an A-minus at 50 percent, and a BBB-plus to BB-minus

             4   at a 100 percent, and then below the BB-minus, at a 150

             5   percent.

             6             So the ratings are extremely important, at least

             7   for the future, if Basel II goes forward, and, similarly, for

             8   collateral and guarantees, and it goes on.

             9             But the recognition in the Basel Accord II has to

            10   be a public processes, and basing off six criteria.  

            11             The first criteria is objective, objectivity, and

            12   the other five are independence, international access and

            13   transparency, disclosure of methods, actual default rates,

            14   and a likelihood of ratings transitions, sufficient resources

            15   and credibility.

            16             The least of the eligible rating agencies is made

            17   available by national regulators under Basel II.  Banks are

            18   not allowed to cherry-pick across credit rating agencies and

            19   they must use agencies consistently and disclose which ones

            20   they use.

            21             Banks also have to disclose the amount of exposures

            22   they have in each risk rated basket.

            23             So Basel II, designed to be more risk sensitive

            24   than Basel I, will actually depend on rating agencies more

            25   than they do so today.






             1             So in conclusion, we can say a whole lot more, but

             2   much can be said with regard to the usage of credit ratings

             3   for other market purposes, either whether it's rated

             4   structures, finance, SPVs and synthetics, and other aspects

             5   of rating agencies which we are bound to discuss.

             6             But I would like to close on a major problem with

             7   ratings, that adjustment is delayed for far too long before

             8   the ratings fall to the trigger level, again, the problem of

             9   too much reliance being placed on ratings, and I hope that

            10   gets covered today.

            11             MS. NAZARETH:  Thank you, Gay.  Frank?

            12             MR. FERNANDEZ:  Thank you, Annette.  I promise to

            13   be brief and respect the two minute rule.  

            14             Since you have my written introductory remarks, I

            15   would just like to say my thanks to the staff and the

            16   Commission for this opportunity to appear here at these

            17   hearings.

            18             I applaud you for both the timeliness of this issue

            19   and bringing it forward and recognizing the critical role

            20   played by the credit rating agencies in providing valuations

            21   and risk assessments to financial markets, and for providing

            22   this forum to evaluate and assess these functions which are

            23   key to securities markets operations, as well as the

            24   performance of the credit rating agencies who provide them.

            25             Given the breadth and depth of the market expertise






             1   around this panel, I'm going to try and confine myself to

             2   something I do disproportionately, which is assessing the

             3   costs and benefits of supervision and regulation, and looking

             4   at the business model that is being applied here.

             5             I think it is important to consider some of the

             6   broader issues of the provision and the business of

             7   information, particularly economic and financial assessments

             8   of that business, particularly and specifically looking at

             9   them both in the whole and for the segments of both the

            10   provision of data analysis and valuation, because I think

            11   they are distinct functions with distinct implications.

            12             Beyond that, I will address them when we get to

            13   specific points.

            14             MS. NAZARETH:  Thank you.  Leo?

            15             MR. O'NEILL:  Thank you.  Well, on behalf of

            16   Standard & Poor's, I would like to thank the SEC for the

            17   invitation to discuss the role of rating agencies in the

            18   United States capital markets.

            19             Standard & Poor's has been rating debt securities

            20   since 1916 and in view of this long history in the capital

            21   markets, we fully recognize the importance that our ratings

            22   have played and will continue to play in the assessment of

            23   credit risk in this country and abroad.

            24             I believe the fundamental reason that Standard &

            25   Poor's and other ratings have grown in importance in our






             1   capital markets is our long track record of providing

             2   independent, objective, and reliable opinions on

             3   creditworthiness.  

             4             Indeed, ratings have found their way into various

             5   regulations far back as 1931, when the Comptroller of the

             6   Currency sanctioned ratings as a tool for banks to haircut

             7   their capital for bonds held in inventory.  We are heartened

             8   that Basel II, they're seeing the same need.

             9             In 1975, when the SEC coined the phrase "nationally

            10   recognized statistical rating organization," and in 1976,

            11   when the SEC designated Standard & Poor's as an NRSRO, I

            12   believe they were simply stating a market reality that

            13   Standard & Poor's had earned over 60 years and they were not

            14   conferring a newly won status on us.

            15             Now, more than 25 years later, the U.S. capital

            16   markets, which have experienced enormous growth, continue to

            17   be extremely well served by Standard & Poor's ratings.

            18             Our ratings are subject to intense market scrutiny

            19   every day, but they remain globally accepted benchmarks that

            20   are respected for their independence and their integrity.

            21             In continuing our important role and extending the

            22   benefits of independent, credible rating services, both here

            23   and abroad, depends on a framework that continues to preserve

            24   the independence of credit rating agencies and recognizes the 

            25   market, the market is the best judge of a credit rating






             1   agency's quality, objectivity, and independence.

             2             Standard & Poor's also has a long history of

             3   constructive dialogue with the SEC and other government

             4   agencies about important issues affecting the capital

             5   markets.  We are frequently asked our views on key analytical

             6   issues and we openly share our rating methodologies and

             7   practices with the SEC and other government entities.

             8             Today will be no exception.

             9             Let me close by stating the obvious.  We fully

            10   recognize the value that we add to the markets and we

            11   understand that it rests on a platform of integrity,

            12   objectivity, and independence.

            13             We also recognize that in the absence of such

            14   qualities, our value in the marketplace diminishes, if not

            15   disappears entirely.  Hence, all of our processes, all of our

            16   standards, all of our methodologies are geared to meeting the

            17   objectives of integrity, quality, independence, and the

            18   record will show, as it has in the past, that the valued

            19   reputation that Standard & Poor's has earned is well-deserved

            20   because of that deep commitment and our every intention is to

            21   keep it.

            22             Thank you.

            23             MS. NAZARETH:  Thank you.  Greg?

            24             MR. ROOT:  I want to thank the Commission very much

            25   for giving us this opportunity to address such an important






             1   issue that affects the capital markets.

             2             I'd just like to give you a little bit of

             3   background about Dominion Bond Rating and summarize what we

             4   think is the most critical issue that the rating industry

             5   faces at this point in time or that the Commission faces

             6   regarding rating agencies.

             7             Dominion Bond Rating is a Canadian-based rating

             8   agency.  We have been in business now for 26 years, so we

             9   don't have quite the longevity of Standard & Poor's, but we

            10   are one of the early participants in the rating agency

            11   business.  So we have quite a long experience level in that

            12   respect.

            13             We are a privately held company.  We have no other

            14   activity.  So we are totally independent in our activities.

            15             Just by way of background, the Canadian market,

            16   there are no actual formal rules and regulations as there may

            17   be here, that exist here in the states in terms of mandating

            18   that issuers be rated.

            19             So the success of DBRS and our activities are very

            20   much driven by market acceptance, and that's the acceptance

            21   of the issuers, as well as the investors, as we think that's

            22   a very important aspect that drives the rating business

            23   overall, not just in Canada, but here as well.

            24             DBRS rates and tracks about a thousand different

            25   issuers, but because of the nature of the Canadian market,






             1   with all the cross-border activity between the U.S. and

             2   Canada, a substantial amount of our activity is here in the

             3   United States.

             4             So, obviously, what affects the rating business

             5   here in the U.S. is very much important to Dominion Bond

             6   Rating.

             7             Overall, having been in the industry for quite some

             8   time, I would concur with Leo.  I think the rating business

             9   has been very effective and has been very supportive of the

            10   development of the capital markets overall.

            11             I wouldn't say it's been totally flawless.  But if

            12   you look at the overall track record, I think it stands on

            13   its own. 

            14             The key issue that we see that we think needs to be

            15   addressed is with the NRSRO being such an important part of

            16   many of the activities in the capital markets, we feel NRSRO

            17   should be clearly defined.  I think that is the most

            18   important issue, is to define what an NRSRO is, have very

            19   clear rules and regulations and guidelines for what it takes

            20   to become an NRSRO, with an appropriate time frame, and, that

            21   way, let the market judge very much who is the NRSRO and who

            22   can be and who should not be.

            23             So I think if that were to be accomplished,

            24   overall, I very much believe that the system works well and I

            25   think that today's session is important to continue to






             1   discuss it, see if there are areas that could benefit from

             2   some adjustment or improvement, but I think we will hopefully

             3   find that it's not broken.

             4             Thank you very much.

             5             MS. NAZARETH:  Thank you.  Glenn?

             6             MR. REYNOLDS:  Thank you for inviting me to be part

             7   of this very important hearing.  

             8             I come to this topic from the angle of an

             9   independent credit research firm.  We are not a rating agency

            10   and we are not looking to become a rating agency.  

            11             Our primary product is market-based research on

            12   issuers, industries, and segments of the marketplace.  We are

            13   not involved with managing assets or with underwriting

            14   activity.

            15             But like many analysts, I have been spending a fair

            16   share of my 20-year career trying to predict the rating

            17   agency behavior patterns.  It's a significant input into the

            18   performance of securities in the market and is a critical

            19   portfolio management variable that we all need to watch

            20   closely.

            21             The last year has been as challenging as any in my

            22   career and it's easier to sympathize with the demands placed

            23   on the rating agency.  That said, they have one of the most

            24   important roles in the capital markets.

            25             In my prepared written comments, which will be






             1   posted to the SEC website, I focused on three areas that I

             2   find most pressing and look forward to discussing today.

             3             First, the quality of information flows and the

             4   transparency of the ratings process has proven very uneven

             5   over the past year and the post-Enron response has left many

             6   institutional investors alarmed that there is an attempt to

             7   over-compensate.

             8             Together with some other dislocations in the

             9   market, coming off a year of record investment grade

            10   issuance, in particular, in 2001, it has inflamed market

            11   volatility and created a serious crisis of confidence among

            12   bond-holders.

            13             If there is anything that is the case, it's that

            14   there has never been a time where clarity and specific

            15   descriptions and details of the ratings parameters have been

            16   more important than they are today and the process has left

            17   much to be desired.

            18             Investors are intermediaries in the business of

            19   taking risks, but they do need to understand fully the rules

            20   of engagement.

            21        Second, we believe that changes in the market over the

            22   past year could bring some new competition to the NRSRO peer

            23   group.  We don't believe it is appropriate to attempt to burn

            24   the NRSRO framework to the ground.  We just think it needs to

            25   be upgraded and the bar raised.  






             1             Third, we believe there are some working conflicts

             2   of interest that are at least worth exploring, which we will

             3   discuss later.

             4             I will repeat one point that we made in our written

             5   comments, and that is I think it would be worthwhile to more

             6   intensively survey the institutional investor base and the

             7   processionals in the brokerage and banking sector on the

             8   performance of the agencies and the pros and cons of the

             9   approaches.

            10             We suspect that the power of the agencies and what

            11   they wield in the marketplace and the relationships that need

            12   to be maintained with the rating agencies may discourage a

            13   full public airing and confidentiality could encourage more

            14   candor.  

            15             I look forward to the proceedings.  Thank you.  

            16             MS. NAZARETH:  Thank you.  Kent?

            17             MR. BAKER:  Thank you very much.  I appreciate the

            18   opportunity of being asked to participate in the panel.

            19             The role that I perceive for myself is really that

            20   on the academic role, because that's my environment.  One of

            21   the things that I hope to be able to contribute to these

            22   hearings involves some empirical research that a colleague

            23   Sattar Mansi, and myself have conducted involving credit

            24   rating agencies.

            25             These publications, one appeared earlier in the






             1   year in the Journal of Investing, and the second publication

             2   Mr. Egan referred to earlier, at least one of the comments or

             3   findings from that particular study will appear in the next

             4   issue of the Journal of the Business Finance Accounting, and

             5   the title of that paper is "Assessing Credit Rating Agencies

             6   by Bond Issuers and Institutional Investors."

             7             In those studies, we took, hopefully, a

             8   dispassionate view of credit agencies and trying to get input

             9   from users of those particular services, specifically looking

            10   at the bond issuers, focusing upon industrial issuers, and,

            11   also, from institutional investors, primarily looking at the

            12   segment relating to mutual fund investors, which, of course,

            13   are large purchasers of these bonds.

            14             There were four key issues or key research

            15   questions that we focused upon in these studies, and I just

            16   want to mention those topics, without going into the findings

            17   at this particular time, which I can share, where that is

            18   appropriate, during these hearings.

            19             The first research question focused upon does the

            20   number of rating agencies hired by issuers to rate bonds

            21   differ from the number that are required by institutional

            22   investors of these corporate bonds, given the different

            23   perspectives.

            24             We'll talk about the importance of having that type

            25   of competition within the industry.






             1             The second issue involved do the issuers and

             2   institutional investors perceive any differences in the

             3   accuracy among the various key rating agencies within the

             4   U.S., and I'm sure our folks at S&P would like the results of

             5   that, since they tend to be more favorable for S&P than the

             6   other agencies.  But I'd just make that as a quick comment.

             7             The last two questions, I think, perhaps are more

             8   germane to these hearings.  The third question basically

             9   focuses upon do issuers and institutional investors believe

            10   that agencies maintain corporate bond ratings on a timely

            11   basis, and Mr. Egan referred to part of the results that we

            12   had, and being able to maintain timely ratings certainly is 

            13   critical in the marketplace today as opposed to having

            14   excessive lags or at least lags that may be viewed as

            15   excessive by market participants.

            16             The final issue that we investigated involved do

            17   issuers and institutional investors believe published ratings

            18   of corporate bonds accurately reflect their issuers'

            19   creditworthiness, and, of course, that is the key purpose

            20   underlying bond ratings in the first place.

            21             So we'll try to share some of those results during

            22   the course of the hearings today.

            23             Thank you very much.

            24             MS. NAZARETH:  Thank you.  Cynthia?

            25             MS. STRAUSS:  I'm Cynthia Strauss, from Fidelity






             1   Investments.  I thought in these few minutes I would just

             2   give a little background on who we are and how the rating

             3   agencies really affect us, as well as a general comment on

             4   our views.

             5             At Fidelity, we manage about $360 billion of

             6   investment grade U.S. dollar fixed income funds, and that's

             7   spread about $240 billion in money market funds and about 

             8   $120 billion in bond funds.  

             9             We play a fiduciary role for millions of

            10   shareholders.  Our funds are principally distributed through

            11   retail investors and they are in mutual funds, and Fidelity's

            12   role is one of a fiduciary.

            13             We do our own research for these funds.

            14             The rating agencies are incredibly important to us

            15   because they have tremendous influence on the markets in

            16   which we participate.  They are supportive tools, as we've

            17   all said, for individual investors in the marketplace, small

            18   and large.

            19             They are the very structure of the marketplace,

            20   just I said, investment grade references their ratings.  They

            21   are the risk language that we all speak and rely on.

            22             They are important, too, because they are embedded,

            23   appropriate to the SEC, in many of our regulations, very

            24   important to money markets.  Again, the cash for many, many

            25   individuals in the marketplace.






             1             They are also embedded in various state and federal

             2   regulations that really we pay a tremendous amount of

             3   attention to as fiduciaries.  

             4             And last, but not least, I think often goes

             5   unnoticed is that the rating agencies drive industry

             6   standards.  They, in essence, are the voice for the

             7   marketplace.  They may set, for example, the level of

             8   liquidity that a corporation should have to be a strong

             9   issuer.

            10             They actually are at the front line in designing

            11   the structure of the ever-growing asset backed market.

            12             So with that background, we have tremendous respect

            13   for the agencies.  We think, in many ways, they do an

            14   excellent job with an ever increasing challenge.

            15             When you think about it, there are only three. 

            16   Their business model is a for profit model, and yet they

            17   serve a public, a greater public interest, and things really

            18   haven't gone too wrong.

            19             However, all is not well.  I do think I agree it's

            20   very timely that we're here.  The examples that brought us

            21   here were Worldcom and Enron, but as I hope to be able to get

            22   into later today, there are many other examples, perhaps more

            23   subtle today, of problems that could be facing this model

            24   with only few rating agencies in the future.

            25             That being the case, I think Fidelity's view is






             1   that the NRSROs do need greater oversight to make them more

             2   directly accountable to the markets that they serve.

             3             Our specific issues are going to be more in the

             4   area of the inconsistency and lack of transparency, which you

             5   have already heard from a few, as well as their role as

             6   driving industry standards, as I already mentioned, and I

             7   look forward to getting into those in the examples later on.

             8             Thank you.

             9             MS. NAZARETH:  Thank you.  I want to welcome

            10   Deborah Cunningham, who has had an arduous trip to get here. 

            11   We haven't given you time to sort of get settled in.  

            12             We can offer you a chance to make a statement now

            13   or give you a little time to get your bearings and speak up

            14   later.

            15             MS. CUNNINGHAM:  I'm fine.  

            16             MS. NAZARETH:  Great.  Wonderful.

            17             MS. CUNNINGHAM:  I'm Debbie Cunningham.  I'm Senior

            18   Portfolio Manager and Senior Vice President with Federated

            19   Investors.  Federators is an asset management firm that is

            20   based in Pittsburgh, Pennsylvania.

            21             Currently, we have about 200 billion in assets

            22   under management.

            23             My particular group that I'm in charge of at

            24   Federated deals with our stable net value asset taxable

            25   funds, and that includes about a $130 billion of those $200






             1   billion in assets.

             2             It includes our government money market funds and

             3   our stable net asset value GIC products.  

             4             So my intention today is to address the group more

             5   as a buy side, particularly with emphasis with regard to

             6   money market funds and Rule 2a-7, as a Rule 2a-7 buy side

             7   investor.

             8             My use of the rating agencies and the NRSROs is

             9   basically through the portion of our assets that we invest in

            10   what we call our prime money market funds, and those are the

            11   ones that can take credit risks.

            12             Rule 2a-7, which is part of the Investment Company

            13   Act of 1940, is the precedent that we use and that is the

            14   NRSROs are required to be utilized within management of funds

            15   that are holding themselves out as being 2a-7 funds.

            16             Currently, about $70 billion of the assets that we

            17   manage are subject to this particular regulation requiring

            18   the use of NRSROs.  So we've been using them since they've

            19   been in business, since we've been in business, and,

            20   essentially, when the NRSRO information was added into Rule

            21   2a-7, there were seven different rating agencies at that

            22   time.

            23             We are now down to, through consolidation, through

            24   the consolidation process, to three of them.  

            25             And although I don't really have a problem with the






             1   three that exist, our preference is definitely to have more

             2   rather than fewer, and this is basically because we like the

             3   input that is available from the reputable sources.

             4             This would assume that these would be qualified

             5   NRSROs and that they would meet some minimum standard that

             6   was set in the marketplace.

             7             On the other hand, if there were any type of

             8   legislative changes that would require us to always follow

             9   all NRSROs and always purchase all NRSRO ratings, we would

            10   have problems with more than the three or four or five or six

            11   that have been in place in the marketplace on a recent

            12   historical basis.

            13             Currently, Rule 2a-7 is such that it requires

            14   what's called a second opinion rule and the ratings

            15   information is derived from a second opinion rule.

            16             If there is only one rating on the particular

            17   issuer that we're looking at, then that rating is the one

            18   that counts.

            19             If there is more than one rating, then,

            20   effectively, you need two, a second opinion, in order for an

            21   issuer to be considered first here, topped here.  

            22             So even if you had seven different rating agencies,

            23   really the two that you need, there are two that you would

            24   need as confirmation that this issuer would be first tier.

            25             This is all utilized within our analytical basis at






             1   Federated from an independent credit analysis standpoint of

             2   taking inputs directly from the research that's done by the

             3   rating agencies and utilizing that in determining minimal

             4   credit risk for the securities that we purchase within the

             5   portfolios that we use.

             6             We would definitely advocate more NRSROs, as I had

             7   indicated, and we would absolutely hope that any additional,

             8   as well as the current NRSROs would be subject to oversight

             9   and accountability, some of which exists today, but a lot of

            10   which does not exist today.

            11             And we know that the assessment of financial health

            12   is not an easy thing to predict going into the future,

            13   whether it's short-term or long-term, and our analysts are

            14   faced with that on a day-to-day basis.  

            15             We know there is never going to be a 100 percent

            16   certainty in that type of a business, but we feel that with

            17   additional oversight, with additional accountability, and

            18   with additional competition in that marketplace, definitely

            19   the usefulness of these assessments, I think, will be better

            20   served and would be better used by the investor base.

            21             We also think that if you merge the due diligence

            22   process that is typical by analysts to assess analysis or to

            23   assess the financial health of a company with what is

            24   currently the rating agencies' credit assessment, we, again,

            25   think that with more oversight, you could produce better






             1   results for investors.  

             2             Lastly, the last thing I would like to encourage

             3   rating agencies to do is really to recognize each others'

             4   ratings.  There are published sources of information that

             5   detail what makes up a AAA rating or what makes up an A1-plus

             6   or a P1 or an F1-plus rating across the three NRSROs that

             7   exist today, yet, in many instances, the rating agencies will

             8   only look to their own internal ratings when viewing

             9   information and trying to rate it.

            10             So I would promote some sort of an acknowledgment

            11   and recognition across the NRSRO base so that we would be

            12   able to more fully enjoy the ratings benefits of the three

            13   that exist today and hopefully more that exist in the near

            14   future.

            15             I think that's about it.  I can address other

            16   things as the questions come forth.

            17             MS. NAZARETH:  I was going to start with a question

            18   that I think Cynthia actually touched on quite directly in 

            19   her opening statement, which was the relative importance of

            20   credit ratings for use for credit analysis.

            21             So I thought I would turn to the other two

            22   participants who may have some interesting insights into

            23   this, which would be Glenn and Deborah.  

            24             You spoke, Deborah, about how you make use of these

            25   credit ratings, partly because they are regulatorily






             1   mandated.  But could you speak a little bit more about how

             2   much they are actually used, even on the buy side, in a

             3   sophisticated shop like your own in terms of how you

             4   determine what you are going to purchase for various

             5   portfolios and how much you do rely on the ratings?

             6             MS. CUNNINGHAM:  Certainly.  We utilize the ratings

             7   as an input to our own internal credit assessment.  We, in

             8   many ways, attempt to duplicate the process that the rating

             9   agencies provide for investors that don't have the means of

            10   duplicating that internal mechanism themselves, and we

            11   essentially utilize, in that process, the rating agencies'

            12   information. 

            13             We utilize other sources of information, as well,

            14   from various street firms research, to information from the

            15   companies themselves, to basically public information that is

            16   available via internet type sources.

            17             But the rating agencies' input is absolutely of

            18   importance and it's also important, I think, from a

            19   regulatory standpoint, that before we can start the process

            20   with our own internal analysis, we have to meet the hurdles

            21   of having the NRSRO ratings that we're looking for from a

            22   regulatory standpoint.  

            23             MS. NAZARETH:  Okay.  Glenn?

            24             MR. REYNOLDS:  If people want to get a sense of how

            25   all pervasive the NRSRO designation is, just go to Google and






             1   type in those letters and you'll read page one of one

             2   thousand pages.  So you get the idea, it's everywhere out

             3   there.

             4             The first line of using the ratings designation is

             5   just the explicit parameters that many mutual funds, pension

             6   funds, and insurance companies may have put some of its

             7   discretionary and in-house and some of its shareholder-driven

             8   based on a prospectus which has been delivered to investors.

             9             So very often it's hard and fast, but then as you

            10   drove down a little bit more, it can very dramatically impact

            11   the price behavior of securities, which is a performance

            12   issue for these portfolios, which directly affects policy-

            13   holders, mom-and-pop retail investors, mutual funds, savings

            14   plans, pensions.  

            15             One of the things in the past that has been a real

            16   problem is the minimum rating threshold in some portfolios

            17   creates what we used to call a forced seller. 

            18             Once it drops below a ratings tier, they have to

            19   kick the security out.  Wall Street traders are in the

            20   business of looking to chop trading for those opportunities,

            21   because they immediately drop the bid down because they smell

            22   a forced seller in the market.

            23             That inflames the volatility and heightens the

            24   loss.  After some difficult experiences with that, people

            25   have eased those types of restrictions, where they're even






             1   more discretionary in the timing of the sale, but a ratings

             2   move goes far beyond just a lower average quality.  It can

             3   inflame the magnitude of a loss for a given institutional

             4   investor.

             5             And when we talk about institutional investors,

             6   behind every institutional investor is a whole array of

             7   retail investors.

             8             But then it keeps going from there, as we'll talk

             9   about later, ratings triggers in other areas.  That security

            10   that you may own, whether it be a BB or a BBB rated security,

            11   will have follow-on effects from that ratings change that

            12   effects the quality of the credit collateral posting

            13   requirements on OTC derivative trades, bank line repricing;

            14   in some cases, explicit puts, ratings indexed.

            15             So it gets very complicated, and we'll spare you

            16   all the arcane credit mumbo jumbo, but it goes well beyond

            17   the fact that the spread widens.  It can have follow-on

            18   effects that are concentrated on some investors and some

            19   types of portfolios more than others.

            20             MS. NAZARETH:  Did you have something to say?  

            21             MR. BAKER:  I just had an observation on the uses

            22   of those ratings.  Part of our study did focus on, from the

            23   issuer's perspective, on the number of ratings that they

            24   generally used and we found that, from our study, again,

            25   relating to the industrial sector, that approximately 20






             1   percent of those companies did use a third credit rating

             2   agency, and the primary reason that that was done was because

             3   there were essential conflicts that existed, that is, a split

             4   rating between basically S&P and Moody's.

             5             In order to try to clarify that, they went for a

             6   third rating, in many respects, to try to provide additional

             7   information to the marketplace with that third rating.

             8             MS. NAZARETH:  Thank you.  

             9             MR. COLBY:  Could I just follow-up?  Glenn, I

            10   understood you to say that you have to watch the rating

            11   because of the impact of the rating itself on the market

            12   price.  But could I just go back and follow up with Cynthia

            13   and Debbie?

            14             To what extent are you using the rating because of

            15   the clarity of the insights and the analysis of the rating

            16   agency itself as opposed to the effect it might have on

            17   price?

            18             MS. STRAUSS:  As Debbie said, as well, we use it in

            19   two ways.  One is the rating agencies are some of the best,

            20   we consider, peer analysts out there, in many cases.  So we

            21   use their research as an input to our research.

            22             But since we do independent research, it's a

            23   compliment.  It's input.

            24             But what really is critical, I think, in some of

            25   the issues looking forward is the point that Glenn made, that






             1   the direction of the ratings can really impact many things

             2   about that company, and I'm sure Mac will have comments about

             3   that, as well, and it can really impact that company's access

             4   to capital markets, what's going to happen in the

             5   marketplace, which is something that we, as market

             6   participants, look at.

             7             And we'll talk about later that we argue greatly

             8   that the rating agencies are trying to figure out how their

             9   ratings impact market prices, and we'll get back to that

            10   later.  It's a very worrisome area.

            11             We're looking at market prices, what could happen

            12   if the rating goes down, what could happen to that company's

            13   fundamental liquidity if they are shut out of the investment

            14   grade market.

            15             MS. CUNNINGHAM:  I echo all the things that Cynthia

            16   said.  I would just add that we have found, in the past, that

            17   the written input that we get on the rating agencies, what is

            18   available in written form or what is available in printed

            19   form on their web sites, is oftentimes not as useful as the

            20   global input that we get from talking to their analysts.

            21             It's oftentimes less timely, from a date specific

            22   standpoint.  So the printed material may be dated, to some

            23   degree.  It's hard to keep exactly with current times on

            24   that, in that regard, yet we are able to, from a verbal

            25   standpoint, get very good input, typically, up-to-date input






             1   by speaking with their analysts.

             2             So I would note that it's not just on a written

             3   basis that we utilize their information, but even more

             4   important, probably on a speaking basis.

             5             MS. NAZARETH:  Thank you.  Mac?

             6             MR. MACDONALD:  While I recognize that from an

             7   investor perspective, the input, other than the written input

             8   from the agencies may be important.

             9             It does, I think, give me a great deal of cause for

            10   concern that that data, which, in many cases, is data that is

            11   being released free of the oversight of Reg FD, is being

            12   potentially used to provide information to one individual

            13   alone.

            14             I have to say up front that the agencies with whom

            15   we deal have been absolutely superb in their handling of

            16   confidential information.  In the 20 or so years that I've

            17   had personal experience, we have never come across a

            18   situation where confidences have been abused.

            19             But having said that, we do find that we receive

            20   reports that personnel from the rating agencies have made

            21   comments to analysts, investors, and others that they will

            22   not make publicly and they will not make to us, and I believe

            23   and I am concerned that that can lead to serious distortions

            24   in the markets.  

            25             MS. STRAUSS:  Can I just make one comment on that? 






             1   We may get a chance to -- I know we have FD later on, but I

             2   just want to make the linkage, which is very worrisome to

             3   Fidelity and I think others in the marketplace.

             4             We just mentioned the power of a moving of a rating

             5   in impacting market prices, and yet the fact that the rating

             6   agencies have access to information that investors can't have

             7   creates great concern for us.

             8             Our position has always been that we encourage

             9   greater disclosure to the marketplace and to investors,

            10   because this creates a difficult situation for all parties.

            11             MS. NAZARETH:  I think this does raise a very

            12   interesting issue for the Commission.  It is something that

            13   has come up in other discussions that we have had with market

            14   participants and has been high on Chairman Pitt's list of

            15   issues.

            16             If the key information that is so important for the

            17   buy side is information that, in fact, is not in the public

            18   domain, then perhaps there is something with what we are

            19   requiring to be in the public domain, and I certainly think

            20   that is a significant point that is being made there.  

            21             MR. O'NEILL:  Ms. Nazareth, I feel like -- I'm

            22   trying to behave myself here.  I can respond to all of these

            23   here at one time or another, but I will take your lead on

            24   that.  

            25             On the information that we get, the confidential






             1   information we get, we've actually -- this is not something

             2   that came out of Reg FD, as you know.  Rating agencies, for

             3   many, many, many years prior to Reg FD, were the recipients

             4   of information that issuers provided to us on the condition

             5   that we would not make that public and, also, on the

             6   condition, and what we are, is we do not trade securities, we

             7   do not buy, hold, sell securities in that regard.

             8             That information is there solely for the purpose of

             9   providing a credit rating.

            10             The disclosure obligation, obviously, is not on the

            11   rating agencies.  The disclosure obligation is on the

            12   corporations that file with the Securities and Exchange

            13   Commission.  

            14             MR. COLBY:  Mr. O'Neill, could you address the

            15   issue that has been raised about verbal contacts with the

            16   analysts at the rating agencies and what sort of information

            17   is made available in that context?

            18             MR. O'NEILL:  Sure.  I'll take Deborah and Cynthia,

            19   who have direct contact with our analysts and they hear what

            20   they hear. 

            21             I suspect, like I believe, that what we put out on

            22   our web site, what we put in our publications is intended to

            23   provide a broad audience with the reasons for maintaining our

            24   rating or changing our rating or what have you.

            25             Certainly, an analyst from outside our organization






             1   calls up with a specific question or specific concern,

             2   assuming it does not breach, it cannot breach the

             3   confidentiality seal that we have put on this information, we

             4   will, obviously, respond to those analysts with specifics.

             5             I think that's important that we do that and, in

             6   fact, we pride ourselves on being available to the analytical

             7   community that way.

             8             I would encourage our people to continue to do that

             9   and I think it would be a bad practice for the rating

            10   agencies to put a cloak or a seal over their rating opinions

            11   in any way.

            12             So, again, we will respect the confidentiality.  We

            13   will not disclose the confidentiality of that information. 

            14             MS. NAZARETH:  Could I ask the other two rating

            15   agency representatives to address the issue, as well?  

            16             MR. ROOT:  First of all, I very much agree with

            17   Leo.  I think the important thing is transparency and I think

            18   if you take a look at the type of information that Dominion

            19   Bond Rating publishes and puts out there, we are very clear

            20   and open in terms of what is incorporated into our ratings,

            21   what the key issues are, and we think that's important.  I

            22   think that is one of the issues here, is to what extent the

            23   rating agencies are communicating, what is behind the

            24   ratings, basically.

            25             I'm not going to speak for our competitors, but,






             1   certainly, if you look at Dominion Bond Rating, this is

             2   something that we put very much as a top priority, is making

             3   sure that -- the rating itself is one thing.

             4             It's what is behind the rating, what you are

             5   assuming, because, again, we can sit down and discuss ratings

             6   between us and we're going to agree to disagree.

             7             So I think what's important for us is that you know

             8   what's behind our thinking and you may say that we may be too

             9   optimistic about the economy or whatever it is and,

            10   therefore, you can adjust our ratings accordingly, but it's

            11   important, as long as we are quite open in terms of what

            12   we're looking at, then we think that is as important as the

            13   rating itself, and that is something that we very much

            14   emphasize at Dominion Bond Rating.  

            15             COMMISSIONER GOLDSCHMID:  Just to pin that down a

            16   drop.  But do you have a confidentiality policy on material

            17   information you have been given?

            18             MR. ROOT:  Absolutely.  Again, I'll go back to Leo. 

            19   Prior to joining Dominion Bond Rating, I was with one of the

            20   NRSROs, Thomson BankWatch.  I have never come across a

            21   situation where having confidential information has been

            22   breached, certainly by any of the organizations currently or

            23   prior, and I assume Leo will support that at Standard &

            24   Poor's and I suspect the other agency.

            25             So while it's something that needs to be continued






             1   to be looked at and considered, I think if you look at the

             2   history, it has never been an issue that has been violated

             3   and I think that is very important to communicate in this

             4   forum.  

             5             CHAIRMAN PITT:  Mr. Macdonald, do you find that you

             6   are asked for the same information from each credit rating

             7   agency?  

             8             MR. MACDONALD:  To a great extent, Mr. Chairman, we

             9   are.  But the nuances and the depth to which the questioning

            10   is subjected can be quite different over time.

            11             I would give you a current example.  The issue of

            12   under-funded pensions is of great concern to one rating

            13   agency, far less a concern to others.

            14             All three have asked about it, but in one case, in

            15   great depth, in the other cases, a few questions, an

            16   understanding, and move on.

            17             MS. NAZARETH:  Sean?

            18             MR. EGAN:  Thank you.  Our position at Egan-Jones

            19   is that the exclusion of NRSROs from Regulation FD provides

            20   the opportunity for abuse, and those opportunities haven't

            21   fully been explored

            22             In fact, if it is not corrected, we think, over the

            23   next couple years, you will see some huge abuses.

            24             There is no reason why these private firms should

            25   be given information ahead of other participants in the






             1   market.  If it's relevant, produce a press release to

             2   everybody.

             3             Gathering information such as on the rating

             4   triggers which is done by the two rating firms and then

             5   providing that to private clients is inappropriate.  It

             6   should be sent out to everybody at the same time to even the

             7   playing field.  

             8             CHAIRMAN PITT:  There is a general exclusion,

             9   though, in FD, if you have a confidentiality agreement, which

            10   would seem to me to achieve exactly the same purpose.  How

            11   would you differentiate that?

            12             MR. EGAN:  The other market participants aren't

            13   going to get that confidentiality.  In fact, as a practical

            14   matter, what would happen is that if the name S&P or Moody's

            15   is on the letterhead, they will be given that confidential

            16   information.  If it's not, they won't be given it.

            17             CHAIRMAN PITT:  Maybe I haven't made myself clear. 

            18   Let's assume you got your wish and there were no specific

            19   exemption for NRSROs in the process.  There is still an

            20   exemption for anybody who receives information based on

            21   giving a confidentiality agreement.

            22             So what is the difference?  

            23             MR. EGAN:  Our position is exclude that.  If it's

            24   part of an underwriting, that's fine, but if it's part of an

            25   ongoing rating assessment process, why hold these other firms






             1   in some superior position?  

             2             COMMISSIONER GOLDSCHMID:  But one thing ought to be

             3   clear to everybody.  If you've signed a confidentiality

             4   agreement or you have such a policy that is understood, if

             5   there is then misuse of that information, there are far more

             6   serious consequences than FD.  That becomes insider trading,

             7   with all of that criminal and civil and treble damage

             8   penalties potentially available.

             9             So this would be a very serious violation, if it

            10   occurred.  

            11             CHAIRMAN PITT:  But there is also a shifting of

            12   responsibility.  It shifts the information away from the

            13   originator of the information, the issuer, to the recipient

            14   of the information, where it would belong once you've gotten

            15   a confidentiality agreement. 

            16             I don't want to belabor the point, I just don't

            17   understand how getting rid of the specific exemption would

            18   necessarily change anything if companies complied with the

            19   policy of FD to require a confidentiality agreement from any

            20   rating agency to whom they gave information. 

            21             MR. MACDONALD:  Following up on the Chairman's

            22   point.  I would merely say that in terms of if we were

            23   required to observe FD with the ratings, the quality of the

            24   rating for the investors would undoubtedly go down, because

            25   there is no way that we would release confidential product






             1   plans for future years and data of that type, which could be

             2   used by our competitors.  

             3             So applying the exemption from FD, I think,

             4   improves the rating process.

             5             Now, let me change subjects a little bit.  One of

             6   my concerns about this, shall we call it, informal contact

             7   between people from the agencies and individual investors is

             8   that the general form of rating comes out of a committee, as

             9   I understand it, at most of the agencies. 

            10             That committee is made up of a group of

            11   individuals, clearly, not all of whom share the same opinion

            12   on an individual company.

            13             To the extent that one individual perhaps has a

            14   more positive or a more negative outlook and that individual

            15   is talking with an investor, the nuances and phrasing of his

            16   or her comments may not necessarily reflect the opinion of

            17   the rating committee.

            18             For that reason, I would strongly support the data

            19   from the rating agencies only be published and, therefore,

            20   subject to full oversight of the internal committees.  

            21             COMMISSIONER GLASSMAN:  Can I just ask a follow-up

            22   question?  I just want to make sure I understand.

            23             Are you saying that the exemption from FD does

            24   improve the quality of the ratings?

            25             MR. MACDONALD:  Absolutely.  






             1             COMMISSIONER GLASSMAN:  So for the non-designated,

             2   the rating agencies that are not designated NRSROs, who are

             3   not exempt from Reg FD, are missing whatever it is that is

             4   improving the ratings by this exemption.  

             5             Is that a correct interpretation?  

             6             MR. MACDONALD:  Basically, I was taking the point

             7   that to require us to observe FD with respect to the rating

             8   agencies that we choose to use, we do have a choice, gives us

             9   the ability to give them better information, which, in turn,

            10   benefits investors.

            11             CHAIRMAN PITT:  The question that I was originally

            12   getting at when I posed it to you, which relates to FD, is if

            13   you see different rating agencies focusing on different

            14   information, do you assume any responsibility to make sure

            15   that every rating agency that comes in to talk to you winds

            16   up receiving effectively the same information irrespective of

            17   how they may use it in their rating?

            18             MR. MACDONALD:  I think the answer to that is

            19   certainly with respect to written information, for example,

            20   in the past month, we have met with the three nationally

            21   recognized agencies and each one of them received an

            22   identical 76 page book of data.

            23             Now, the questions that followed from meetings,

            24   that were extensive, clearly provided more follow-up and, in

            25   fact, subsequent telephone conversations would probably mean






             1   that in certain areas, one agency asked more questions and

             2   received more information than others.  

             3             CHAIRMAN PITT:  That's what I would assume, simply

             4   because different people are going to be focused on different

             5   issues.

             6             But if you apply what the underlying philosophy of

             7   FD is, so the company gives out information that may be

             8   significant, it is supposed to provide it to everyone.

             9             Now, in the rating agency context, where there is

            10   no application of FD, the question still remains if, in the

            11   course of doing this, you discover that information that has

            12   been ferreted out by questioning may be relevant to a rating

            13   or may take on more significance than you would have thought,

            14   the question is should there be some obligation to provide

            15   the same information to every rating agency that might be

            16   interested in covering Ford, for example?

            17             MR. O'NEILL:  Having done this sort of thing, I

            18   think that puts a burden on the issuers to get into the minds

            19   of the analysts and try to determine what it is that's truly

            20   important to the analysts.

            21             I don't think our analysts come in and say to

            22   Malcolm, "Malcolm, here's a real big one, you got to get this

            23   one right."  No.  They would ask dozens and dozens and dozens

            24   of questions, I'm sure, over periods of days, many times.

            25             CHAIRMAN PITT:  Thousands and thousands.






             1             MR. O'NEILL:  It would be wonderful if that could

             2   happen.  I think, in reality, it's difficult.  

             3             CHAIRMAN PITT:  That is the way FD operates outside

             4   that context.  If a corporate official says something to an

             5   analyst who happens to ask the right question, putting aside

             6   the rating agency context, there is an obligation on that

             7   official to then consider whether that information is

             8   material and should be disclosed to the marketplace as a

             9   whole.

            10             MR. MACDONALD:  I would have -- in fact, it would

            11   be a major efficiency if I could see all three rating

            12   agencies in the same room on the same day for four hours.

            13             I do not believe the agencies necessarily, and I

            14   look to Leo as to whether they would support that.

            15             MR. O'NEILL:  No.  No.  We think that the value

            16   inherent in our ratings is the key value, is the independence

            17   of our process from the other rating agencies.  So we would

            18   definitely not want to participate in a process which

            19   creates, in the final analysis, a homogenized singular view

            20   to the marketplace.

            21             Some comments have been made about rating agencies

            22   and transparency and understanding why our ratings are what

            23   they are.  I think part of the issue is that we all have our

            24   own criteria, our own emphasis.  Yes, there is a strong

            25   correlation between the rating agencies, but there are






             1   nuances to our approaches, changes in our approaches,

             2   differences in our approaches.

             3             It sometimes makes it difficult to understand what

             4   the total picture is.  You may understand exactly what DBRS

             5   does or even Egan Ratings and S&P, but then when you put it

             6   all together in one situation, it becomes difficult to

             7   understand what is driving the total mix.

             8             I think that's appropriate.  This is a market that

             9   is based upon the independence of opinion and investors'

            10   ability to ferret that out and make it ultimately their own

            11   decision.  

            12             MS. STRAUSS:  I'd like to just have another voice

            13   in this, which is, again, we are here talking about advocacy

            14   for the marketplace.

            15             Two points.  One, Mr. Macdonald, you may feel that

            16   the confidential conversations you're allowed to have with

            17   the rating agencies makes a better rating process, but we

            18   would disagree.  From the rating process to the marketplace

            19   is really what is important here.

            20             Again, I'm not sure that that is always the case. 

            21   It may feel better that you don't have to give information in

            22   a more public forum and, therefore, you think that the

            23   outcome of the rating is better, but I don't know that that

            24   is the case.

            25             I can see many situations where that is not






             1   necessarily the case.  What makes the rating good is how well

             2   the agency analyzes the company, makes an assessment, and

             3   clearly articulates that to the marketplace, so the

             4   marketplace can make its best assessment of that.

             5             I also want to remind you that many investors, such

             6   as ourselves and Federated, we're fiduciaries, and the SEC

             7   specifically asks us to make independent assessments of these

             8   companies.  

             9             In addition, with just very specifically saying you

            10   should not rely on the ratings, with your regulations

            11   requiring us to do this, and yet you are also saying the

            12   agencies can have access to things that we don't, it puts us

            13   in a very -- we think that is where the conflict is. 

            14             We like the process the rating agencies do.  We

            15   think they have vigorous discussions that are healthy.  But

            16   we also, in the marketplace, have responsibilities that are

            17   separate from that, which are fiduciary duties, which we take

            18   very seriously and we think are appropriately put into Rule

            19   2a-7.

            20             Different perspective.  

            21             CHAIRMAN PITT:  Mr. Egan, could I just ask you one

            22   question?  Do you find that there are circumstances where you

            23   do not get information you request?  

            24             MR. EGAN:  Yes.  In fact, it's rather frustrating

            25   that the information is provided to the other NRSROs and it






             1   is not disclosed to the market shortly after it is provided

             2   to them.

             3             So, yes, but we manage.  In fact, we tend to think

             4   that this whole Regulation FD issue is outweighed by the lack

             5   of competition and the conflict of interest.

             6             We have been getting ratings right and by measuring

             7   of whether or not the other agencies come in to our ratings.

             8             So it's very important.  We think that Regulation

             9   FD should address this issue.  Obviously, some other people

            10   share our opinion.

            11             But it ties into some other things, too, that have

            12   -- that are more important.  Otherwise, we wouldn't be able

            13   to -- we wouldn't be in business.  We wouldn't be able to get

            14   the ratings early and right.  

            15             COMMISSIONER CAMPOS:  I have a question, Cynthia. 

            16   We have two perspectives.  Mr. Macdonald says he needs

            17   confidentiality.  You're saying, yes, but from the buy side,

            18   I don't get information that the ratings agencies get.

            19             How would you square that?  What, in your mind,

            20   creates the right balance to satisfy the marketplace and

            21   satisfy the need of companies to keep things confidential, if

            22   you acknowledge that there is such a need?

            23             MS. STRAUSS:  I guess it's pretty simple.  I think

            24   we would encourage companies to disclose, if it's that

            25   important to a rating, that it should be disclosed publicly.






             1             There are finer points to things.

             2             COMMISSIONER CAMPOS:  What about the future

             3   products and if that's going to mess up my competition with

             4   GM or something, what would you do about that?

             5             MS. STRAUSS:  Quite frankly, I personally, and

             6   others in our group have been long-time analysts of the auto

             7   companies and I don't think the ability for the debt holders 

             8   -- we're talking about the debt markets here, which are

             9   looking at future earnings streams with a particular weight

            10   on liquidity, cash flow, sustainability.

            11             I don't think you need to know what the latest new

            12   design on the auto -- for a new auto is to assess their

            13   financial capabilities.

            14             Again, I don't know whether all that is released to

            15   the ratings agencies, but I haven't felt that we -- with the

            16   auto companies, to be fair, I don't think that we feel like

            17   we're going without important information.  We get, I think,

            18   pretty good disclosure.

            19             We always want it to be better, but -- so the idea,

            20   what is worrisome is that there -- I just don't think it's a

            21   good area to be in where there is this confidential

            22   information.

            23             We don't have it and then we're reliant, we the

            24   marketplace, on the rating agencies doing the right thing

            25   with it.  I just think it creates an uncomfortable imbalance,






             1   which can also add volatility.

             2             One of the issues I'm very concerned about now is

             3   the increased volatility in the debt markets, and there are

             4   many factors for that.  But one of them is if a rating agency

             5   moves its rating in a way that we can't understand, because

             6   it may not be transparent and clear, the marketplace right

             7   now, one of the things they wonder is why are they doing

             8   that, what is it that they know that is not disclosed to us,

             9   and I don't think that favors companies.

            10             It certainly adds to volatility and I just don't

            11   see the benefit for investors or issuers.  

            12             MR. O'NEILL:  I think we try to.  We try to go to

            13   great, great lengths to explain why we lower our ratings.

            14             I think we're in kind of a unique period.  I mean,

            15   hopefully, it's unique, and the sensitivity about

            16   creditworthiness I think is probably at a pretty all time

            17   high, maybe going back to the mid '70s or early '70s, when

            18   people woke up to credit risk.

            19             So, obviously, there is great sensitivity.  Credit

            20   spreads are very, very wide here.  A lot of uncertainty,

            21   trust, we've all heard all of these things in the

            22   marketplace.

            23             There have been periods of time, and not too long

            24   ago, when rating agencies lowered ratings and did those sorts

            25   of things and the market didn't -- you know, it made






             1   absolutely no difference whatsoever in any respect.

             2             So our view is stay level, stay consistent, and

             3   make sure that we are responsive to the information

             4   requirements of the markets, and also stay independent.  We

             5   can't be adjusting our ratings because other rating agencies

             6   do certain things.

             7             So that's our mantra.  

             8             MR. HARRIS:  I wanted to follow up on a question

             9   for Ms. Strauss, because you all are in the same position,

            10   theoretically, as any other stockholder out there.  In fact,

            11   Reg FD was pretty much aimed at you all, because in the past,

            12   companies would share information on road shows with

            13   institutional investors rather than with individual

            14   investors.

            15             So it seems to me that if there is a

            16   confidentiality agreement with a credit agency, that that

            17   acts as sort of a safety valve, a pressure valve to get

            18   information out into the marketplace in more of a rational

            19   way.

            20             So I was wondering if you all had any opinion about

            21   that.

            22             MS. STRAUSS:  I would just like to -- we did,

            23   actually, both Debbie Cunningham and ourselves actually

            24   addressed this issue at the time of Reg FD.  Reg FD was

            25   addressing concerns about companies, I think, in large part,






             1   companies giving equity investors information that wasn't

             2   broadly available, a concern, a serious concern for all of

             3   us.

             4             But particularly in this market, we're talking

             5   about the debt holders and so we don't particularly have

             6   people running to us trying to give us a lot of extra

             7   information about their future earnings or try to influence

             8   us in that part.

             9             MR. HARRIS:  But it did in road shows.  I mean,

            10   that was what FD was aimed at.

            11             MS. STRAUSS:  I understand that, but I can't --

            12   Fidelity did not feel that they were abusing that, getting

            13   tips on that.

            14             But let me just get over to the debt markets.  One

            15   of our concerns at that time, and is always the case, is,

            16   again, the position of us.  We are fiduciaries and under Rule

            17   2a-7, we are specifically required to make an independent

            18   assessment of a company's debt metrics, which includes

            19   liquidity.

            20             Disclosure does not focus on the debt markets.  It

            21   typically focuses on the equity markets.  So we, for years,

            22   relied on conversations with companies about their backstop

            23   facilities, their liquidity profiles, how they are planning,

            24   if the markets throw them -- if they're throwing out of the

            25   markets, to manage their short-term debt positions and so






             1   forth, and our great concern about Reg FD is that it is not

             2   typically disclosed in financial statements because they tend

             3   to aim at the stock market, which isn't typically -- maybe a

             4   little more recently, but is not typically interested in the

             5   liquidity.  They are interested in earnings growth.  

             6             I don't know if that really answers it, but we're

             7   not looking -- we don't want non-public information.  We're

             8   not seeking to get extra information people are not -- our

             9   business is taking what information is available and making

            10   the best possible decision with it.

            11             So that's why I say this whole issue of the rating

            12   agencies, potential or theoretical, I mean, I don't know how

            13   much they get, just seems to me to create an imbalance.

            14             It's not a big thing we worry about, but I think it

            15   does add concern in the marketplace when an agency may act in

            16   a way that we don't understand.

            17             We sit there and one of the first things we wonder

            18   is what is it that they know, and I think that that adds

            19   unnecessary volatility and uncertainty to the marketplace.

            20             That's it.  

            21             MR. O'NEILL:  We would strongly advocate that there

            22   be more disclosure, more communication between debt issuers

            23   and buy side or sell side analysts.  We think there is a

            24   great need for it.

            25             The debt markets have grown huge in the last 25






             1   years and have a huge impact on the future of how retirees

             2   are going to finance their future.

             3             We need a robust, independent buy side fixed income

             4   community.  They need to have the right information.  They

             5   need to have good ratings and good transparency.

             6             The debt markets have gotten very complex with

             7   securitization and how do you figure all of this out.

             8             So clearly there is a need for more open

             9   communication between the buy side and the issuer community,

            10   and we would advocate that.  We encourage that.

            11             I don't know what it creates for Malcolm in his

            12   work day, but maybe a lot more.  

            13             MS. NAZARETH:  Frank has been very patiently

            14   sitting here.  He's ready to make a point.

            15             MR. FERNANDEZ:  First, Cynthia, I'm not

            16   unsympathetic.  It sounds like you're arguing a lot of points

            17   that I argued from our standpoint when it was an equity issue

            18   on Reg FD, and I think it would probably be a shock to

            19   anybody at the staff of the Commission to find I would agree

            20   with you on a Reg FD issue, particularly Commissioner

            21   Goldschmid.  But I do have to agree with you on this.

            22             COMMISSIONER GOLDSCHMID:  Goldschmid will note that

            23   one basic distinction between the rating agencies and

            24   everyone else in terms of analysts is they're not doing it

            25   for selfish interest.






             1             Everyone else can trade and trade ahead to the

             2   public and tip clients, and that is a very serious market

             3   problem.  

             4             MS. NAZARETH:  Could I interject, also?  I think

             5   there has been some confusion on what the exception is for

             6   FD, and you know it far better than I do.

             7             But it's not limited to NRSROs.  It's for people

             8   involved in the credit rating business.  So whether a firm

             9   has that designation or not is not, at least by the words of

            10   the exception -- 

            11             MR. EGAN:  The reality in the marketplace, the

            12   reality is that companies will only give that confidential

            13   information to the currently recognized NRSROs.

            14             I think it is quite ironic that Fidelity, one of

            15   the biggest investors, is arguing that Regulation FD be

            16   adjusted for the rating agencies.  What about the middle tier

            17   firms or the small firms?

            18             There is no reason why a couple of private firms

            19   should be given market information ahead of everybody else. 

            20   It's crazy.  I mean, how is the investor being benefitted by

            21   that?  They're not.  

            22             MR. FERNANDEZ:  I think this is the point -- if I

            23   could finish.

            24             MS. NAZARETH:  Go ahead, Frank.

            25             MR. FERNANDEZ:  You hit on one of the points here. 






             1   I think you have to distinguish between the exemption

             2   provided for someone who is providing a quasi public function

             3   here.

             4             You are not trading in the market if you are an

             5   NRSRO.  You are not acting on this for portfolio adjustments

             6   or any other purpose.  We hope.  

             7             But I think that's a point that we should address,

             8   because I don't believe that this is a Reg FD issue and I

             9   think there are more important issues that need to be

            10   considered today than this one.

            11             But there is another flaw, I think, in here, is the

            12   failure to distinguish, and you alluded to it, between

            13   information and analysis.  At a certain point, you have to

            14   draw the line there in terms of what is disclosed and then

            15   the mosaic that may be created by the analysts with that

            16   information or conclusions he may draw or his competitive

            17   ability to ferret and drive from a piece of information that

            18   he is provided.

            19             That's different than the disclosure of a piece of

            20   material information.  So I think that distinction has to be

            21   drawn, as well.

            22             The second is the inference that is being made here

            23   that there is some evidence that there has been misuse of

            24   this privilege, this safe harbor, this exemption that has

            25   been provided, and I would like to hear what that is, because






             1   I've looked at this and we not only look at the application

             2   of this for just the NRSROs, but let's remember there's like

             3   37 different credit rating agencies, CRAs, globally.

             4             Then there is, in addition to the surveys we do of

             5   our own risk management functions, the particularly the very

             6   sophisticated large institutions and their risk management

             7   systems that also have some regulatory obligations in terms

             8   of providing oversight.

             9             I hear and see nothing either on an anecdotal or a

            10   secondhand nature that there has been any abuse of this at

            11   all.  So I think in conclusion on this generalized point, I

            12   hate to agree on a Reg FD issue with you, but I think that

            13   this is not the issue that we are treating here.

            14             You can argue a lot that there are impediments to

            15   accurate appraisal, and if there is a problem, if you have a

            16   problem, do what we have had to do.  If you think they know

            17   something you don't, go to the person who has the obligation

            18   to disclose what that material piece of information is and

            19   ask the company themselves for an explanation.

            20             MS. STRAUSS:  We actually have not had a specific

            21   concern -- I don't have a specific example with the rating

            22   agencies on this.  So I was just clarifying the various

            23   points here.  

            24             Also, as you can see by the fact that I don't know

            25   what they get that we don't, if they do, they're keeping it






             1   very confidentially.  We don't get tipped, we don't get -- 

             2             MR. FERNANDEZ:  Quite honestly, on the sell side,

             3   when you're doing this, you discreetly or explicitly

             4   incorporate all the publicly available credit rating

             5   assessments out there as part of a reflection of market

             6   sentiment, and that tends to be actually a numerical input

             7   into your evaluation process.

             8             And it's a two-way flow, in a lot of senses.  So

             9   when there is a deviation even between your assessment and

            10   those of the three rating agencies, you do want to know what

            11   the basis of that deviation is.

            12             I'm not a lawyer, but if I understand FD correctly,

            13   the obligation then for that disclosure is on the part of the

            14   issuer and you have a right to certainly go ask the issuer is

            15   there something that I am missing here.  

            16             MS. NAZARETH:  Right.  Commissioner Goldschmid?

            17             COMMISSIONER GOLDSCHMID:  How good are these

            18   ratings?  How good are they over time in terms of correcting?

            19             MS. NAZARETH:  I think that's a very important

            20   question.  I think we should start with that.  Why don't we

            21   take a 15-minute break and come back with that very important

            22   question.  

            23             Thank you.

            24             (A brief recess was taken.)  

            25             MR. HARRIS:  Welcome to this session on information






             1   flow in the credit rating process.  

             2             Access to current reliable information is an

             3   essential ingredient in making a timely and credible credit

             4   assessment.  This holds true for credit rating agencies,

             5   which need a continuous flow of accurate information to

             6   assess the creditworthiness of a specific issuer or issue.

             7             It also holds true for many issuers of credit

             8   ratings who need explanatory information to understand the

             9   rationale upon which a credit rating is based.

            10             During the past few years, a rapidly changing

            11   credit environment and a number of high profile bankruptcies

            12   have highlighted the need for the communication of reliable

            13   and timely credit information to credit rating agencies and

            14   to the users of credit ratings.

            15             To better understand how information flows in the

            16   credit rating process to and from credit rating agencies, we

            17   will focus this session on issues related to the flow of

            18   information in the credit rating process.

            19             We will begin the session by discussing a number of

            20   issues concerning the flow of information from issuers to

            21   rating agencies.  We will consider the types of information

            22   made available by issuers and deemed significant by rating

            23   agencies when issuing credit ratings, the access credit

            24   rating analysts have to senior level management of an issuer,

            25   the extent to which rating agencies independently verify






             1   information obtained from issuers, and steps taken by rating

             2   agencies when they are unable to obtain complete or reliable

             3   information.

             4             Of course, you recognize I am reading from set text

             5   here.  We have already done much of this and we will adjust

             6   ourselves a little bit accordingly.

             7              We will then focus on the flow of information from

             8   rating agencies to the users of ratings.  We will consider

             9   the method by which credit agencies disseminate their ratings

            10   and notices that ratings are under review to subscribers and

            11   the public; whether sufficient information is publicly

            12   available regarding credit ratings, the rating process, and

            13   the information on which a rating is based; and the extent to

            14   which information concerning the rating is available to

            15   subscribers that is not available or not publicly as readily

            16   or as soon to the public.  

            17             Two specific areas that we would like to discuss,

            18   actually, we have already discussed one of these, are the so-

            19   called rating triggers and Regulation FD.  I suspect we'll

            20   skip much of FD, since we've done a good job of it already.

            21             Rating triggers are provisions in financing or

            22   operating agreements that require a company to retire its

            23   financing or post new collateral with counterparts in the

            24   event of creating a credit rating for the firm or if its

            25   outstanding obligations decline below a certain level.






             1             We would like to discuss the extent to which rating

             2   agencies are aware of credit triggers and whether rating

             3   agencies are hesitant to issue a downgrade that would

             4   activate a credit trigger.

             5             We can talk a little further about Regulation FD,

             6   but I suspect we've done a pretty good job.

             7             There are also, in addition, a few topics that we

             8   didn't have a chance to get to from the last session that I

             9   would also like to address, and I'm going to start with a

            10   very fundamental issue that I think we need to explore

            11   further as we consider the flow of information in the credit

            12   rating process.

            13             What exactly is a credit rating?  All of us are

            14   familiar with it, but we need to understand exactly what a

            15   credit rating is to understand many of the issues that we are

            16   discussing today.

            17             So let me start by asking Leo, with a blank piece

            18   of paper, what is a credit rating?  What purpose does it

            19   serve?

            20             MR. O'NEILL:  Actually, I hope I can answer this.

            21             COMMISSIONER GOLDSCHMID:  And, Leo, I'm going to

            22   push you to go on and say how good are they and how good are

            23   they over time.

            24             MR. O'NEILL:  The credit rating is a relative sense

            25   of the creditworthiness of an obligor, what is the






             1   likelihood, relative likelihood that the obligor will be able

             2   to make its debt repayments in a timely fashion over a period

             3   of time.  

             4             A rating is assigned at a point in time. 

             5   Consequently, if events change or circumstances change,

             6   ratings will change accordingly, and that's why we maintain

             7   surveillance and that's such an important part of what we do

             8   on ratings.

             9             In terms of the quality of ratings, how well do

            10   they work, clearly, as I think was pointed out and all the

            11   statistical evidence will show, there is a very, very strong

            12   correlation between the ratings and ultimate default.  And

            13   I'm proud to say it's a positive correlation.  The higher the

            14   rating, the less likely that an issuer will default.

            15             A rating is not predicted in the sense that I can

            16   tell you today which issuers are going to default at some

            17   point in the future.

            18             What I can tell you is that AAAs, for example, one-

            19   half of one percent, roughly, of AAA will, in all likelihood,

            20   default sometime over the next 15 years.  I can also tell you

            21   that if you are rated single B, that likelihood of default

            22   rises to about 50 percent over that period of time.

            23             Interestingly enough, and I think this supports the

            24   earlier discussion, obviously, there is great need for

            25   investors to have their own analytical expertise to identify






             1   which of those 50 percent don't default and they may disagree

             2   about percentages, even.

             3             So I think that sometimes people believe because we

             4   rate something single A, that that guarantees that this issue

             5   is not going to default.  No, it doesn't.  It just creates a

             6   relative likelihood.

             7             Finally, the whole quality issue of ratings, I

             8   think that you cannot accept the rating just solely on its

             9   symbol.  That symbol is usually accompanied with something

            10   that's called an outlook or credit watch or a rationale that

            11   decrease the dependency, the dependency of that rating on

            12   certain conditions that might take place in the future.

            13             So to just take the number, the letter grade and

            14   say that's it, no.  You have to look at it in the total

            15   context of the opinion that we give.

            16             The final comment I will make, the quality of that

            17   rating ultimately depends upon the accuracy and the

            18   timeliness, and the disclosure that is provided to the rating

            19   agencies.  

            20             I would clearly say that when that disclosure is

            21   flawed, as it was in many of the situations we have

            22   unfortunately had in the last couple of years, I'm sorry to

            23   say that the basic premise of that rating is suspect, because

            24   it cannot accurately reflect credit conditions at a point in

            25   time without that accurate disclosure.






             1             COMMISSIONER GLASSMAN:  Can I ask a question on

             2   those statistics?  What is the time frame that you're talking

             3   about in terms of if you have a AAA?

             4             MR. O'NEILL:  Generally, what we've said, we

             5   generally like to take a view that goes out two to three

             6   years in terms of what we think we can understand today about

             7   current conditions in the future.  

             8             I think what we've seen in the past several years,

             9   and other periods in history, is that the volatility tends to

            10   accelerate in periods of economic decline and economic

            11   recession.

            12             So what happens is the events change.  They change

            13   quickly.  Conditions worsen much more so than what we

            14   foresaw, perhaps others foresaw, and hence the ratings tend

            15   to change with more volatility during periods of high

            16   economic stress.  

            17             MR. HARRIS:  Can you describe more completely the

            18   process by which ratings are reissued?

            19             MR. O'NEILL:  A rating is -- first of all, the

            20   process, very simply stated, is we assign two analysts to

            21   every rating that we do, a senior analyst or a lead analyst

            22   and a junior analyst.

            23             We will meet with issuers.  We will gather all the

            24   information.  We will then do all the analysis and assign a

            25   rating.  We then begin a continuous review process on that






             1   rating.  We don't just put it on the shelf and bring it out a

             2   year later, dust it off, and take a look at it.  It's a

             3   continuous review process.

             4             To the extent, from the earlier discussion on

             5   conversations with third party institutional analysts and

             6   everything, we control that very, very precisely.

             7             The only people that are allowed to speak to the

             8   media or to others, including investors, are the analysts who

             9   follow the company, and they are clearly instructed that

            10   their position is the institutional position of Standard &

            11   Poor's.  We do not have a Star system.  We don't have a

            12   Grubman or Blodget or anything like that.

            13             This is an institutional process.  The rating is

            14   assigned by a committee.  The committee is responsible for

            15   the assignment of that rating.  The analysts are responsible

            16   for surveilling, monitoring the credit conditions and

            17   bringing those changes to the attention of the committee. 

            18             This -- sorry to go on here, I apologize here, but,

            19   obviously, it means a lot to me.

            20             The problem that we have is -- and I don't know if

            21   it's a problem.  It's an operating stance we have. 

            22   Conditions begin to change, especially in an environment like

            23   this.  We will put the rating on a credit watch.  We think

            24   that issuers in some of this environment have a right to

            25   address our credit quality concerns, and we have a need to






             1   make sure that we fully understand that rating or what those

             2   conditions are.

             3             So sometimes when you hear, well, S&P didn't rate

             4   something to here and to there, actually, we put it on credit

             5   watch and sent that very negative signal, in most cases, to

             6   the marketplace that this rating is under intense review.

             7             So I come back to my earlier point, when looking at

             8   the performance of ratings, it's really critically important

             9   to understand the context that surrounds and the rationale

            10   that surrounds that rating.  

            11             Now I'll be quiet.  

            12             MR. HARRIS:  Are the procedures at Dominion

            13   similar?

            14             MR. ROOT:  Overall, I'd say definitely.  Just a

            15   couple other points, again, that Leo made.  First of all,

            16   again, all our ratings are done on a committee basis.  

            17             So this way, any one analyst may be biased

            18   positively or negatively, which could influence the rating. 

            19   By doing it on a committee basis, we feel that it avoids that

            20   kind of an issue.

            21             Another, I think, important aspect is that before

            22   we finalize the rating, initial rating or rating change or

            23   whatever, we communicate that with the company, so that we're

            24   not just blind siding them at all, that they have an

            25   opportunity -- and we explain to the company what our






             1   concerns are and why and give them a chance to respond, which

             2   I think is a very important aspect.

             3             The other thing is kind of what Leo is alluding to,

             4   is that we have the rating, but in addition to the rating

             5   itself, we use trends, so that if there's -- if we try and

             6   project, and, again, we don't have the crystal ball, but as

             7   we look forward, to the extent we think the next rating

             8   change will be downward, we'll have a negative trend.

             9             Then to the extent that we have more concerns or

            10   there is an event, we'll put it on credit watch, and then the

            11   next step.

            12             So it's not -- again, there will be circumstances

            13   potentially that surprise us and you have to respond quickly,

            14   but beyond that, what we try to do is have a communication to

            15   the investors and to the issues about where we see things

            16   going and have an orderly process, so that rating changes

            17   hopefully don't tend to be disruptive, and I think that's

            18   very important.

            19             Again, the research and the information that we

            20   publish with that, I think, is an important aspect of this

            21   whole process.  

            22             MR. HARRIS:  What does it mean to have a disruptive

            23   rating change?

            24             MR. ROOT:  I guess I should let the investors speak

            25   to that.  But I think to the extent that you can at least






             1   communicate effectively where your concerns are and people

             2   can adjust so that when a rating change happens, they're not

             3   surprised, I think the one thing -- noone likes surprises. 

             4   Rating agencies don't like surprises. 

             5             Investors don't like surprises, and the issuers

             6   don't like surprises.  The issuers don't want to come in and

             7   meet with you and the next day they see a press release

             8   saying you've just downgraded them, which would never happen

             9   at DBRS, by the way.

            10             So I think, again, to the extent that you can be

            11   open and communicative to the marketplace, I think that is

            12   what is critical.

            13             MR. HARRIS:  Just a couple more questions on the

            14   issuing of ratings in an attempt to understand exactly what

            15   ratings are.

            16             I presume that when you reissue a rating, that the

            17   analysis is based upon all available information, including,

            18   of course, all information that has been revealed since you

            19   last did the analysis, is that correct? 

            20             MR. ROOT:  That is correct. 

            21             MR. HARRIS:  And that would be the same for you,

            22   too.  Which is to say that when an issue is re-rated, any

            23   change in the rating must be based on something that was not

            24   available at the time you last did it, is that correct? 

            25             MR. ROOT:  Let me, again, give you my view on this. 






             1   To me, ratings are reviewed every day, in essence.  There is

             2   a formal review process that would be triggered off of a

             3   quarterly earnings statement or a meeting with management or

             4   some other event that would maybe trigger a review process so

             5   that it's done on a regular basis, but, again, essentially,

             6   our view is that we are watching ratings every single day.

             7             So to the extent that ratings change, there could

             8   be a variety of factors that cause us to change our rating. 

             9   Again, it could be component specific.  It could be an

            10   external factor that we think would have an impact on the

            11   creditworthiness, positive or negative, on that institution.

            12             So there is a whole variety of reasons why a rating

            13   may change, but, again, you have to keep in mind this is a

            14   collective, educated, and professional opinion.  

            15             MR. HARRIS:  I understand that, but my point is

            16   this:  if the rating is changed from the last time, if,

            17   indeed, the last time it reflected all of the information

            18   available to you, the rating change must result from

            19   information that was newly revealed in some sense.

            20             MR. REYNOLDS:  Not necessarily.  

            21             MR. HARRIS:  Or that became more significant in

            22   some way.

            23             MR. ROOT:  Again, I think -- 

            24             MR. HARRIS:  Would that be safe to day?

            25             MR. O'NEILL:  I think from a classical efficient






             1   market theory, that if a market encapsulates all available

             2   information and prices it accordingly at a point in time,

             3   and, therefore, if, at some point in time, the price changes,

             4   there must be new information.

             5             I guess a rating is analogous to that model, and so

             6   I don't disagree.  

             7             MR. HARRIS:  This is very important.  

             8             MR. O'NEILL:  Now I probably will.

             9             MR. HARRIS:  Yes, you will.  This is a very

            10   important point, because as we are trying to understand what

            11   ratings are, what you have described, I believe, is

            12   inconsistent with the pattern of rating revisions that we

            13   see.

            14             In particular, we know that rating revisions don't

            15   follow random walk.  That is to say that a revision is not

            16   equally likely to be up as it is down, but rather they tend

            17   to have far more continuations.

            18             And so the question is what are ratings, you

            19   would expect them to follow a random walk if indeed they are

            20   fully aggregating information, because all changes then would

            21   be based only on things that are fully unanticipated, and

            22   unanticipated stuff could be either good or bad.

            23             So the question is why are the ratings not

            24   reversing, say, 50 percent of the time?  I understand the

            25   continuation rate when there's a change more on the order of






             1   92 or something like that percent of the time.

             2             MR. O'NEILL:  I'm not sure that there is a cause

             3   and effect of what you're saying and what ratings are, but I

             4   think the reality is that when we lower a rating, it is in

             5   response to a set of conditions that exist and to the extent

             6   that those conditions worsen, the rating will be worse.  So

             7   maybe there is new information in the marketplace.

             8             The fact that they tend to continue to go down

             9   probably is a reflection of the fact that the situation is

            10   getting worse, and then we're adjusting accordingly.

            11             I don't think that the role of ratings, though, is

            12   to try to guess, when we do a rating and lower it from BB to

            13   BB-minus and say, well, I guess it's going to go into

            14   default.  We're assessing what the current information is in

            15   the marketplace at that time.

            16             MR. HARRIS:  This is a question to everybody,

            17   though I can direct it to some, is there a particular problem

            18   with ratings that reverse too frequently?

            19             MR. REYNOLDS:  Can I jump in on that?

            20             MR. HARRIS:  Sure.

            21             MR. REYNOLDS:  That has been one of the problems we

            22   have had in the market this past year.  Because the market

            23   has been under pressure, it is easy to justify, but at the

            24   same time, there has been a pronounced acceleration in fallen

            25   angels, high grade credits moving to speculative grade.






             1             To add to your point, it's not just -- 

             2             MR. HARRIS:  I'm confused.  Is it a problem that

             3   ratings are changing?

             4             MR. REYNOLDS:  Changing very quickly on the

             5   downside in the immediately aftermath of them having printed

             6   bond deals.

             7             So to your point about new information, it's not

             8   just new information.  It's new information versus

             9   expectations and the problem in the marketplace is it's not

            10   clearly laid out exactly what those expectations are.

            11             MR. HARRIS:  I'm still unclear.  Is the problem

            12   that they changed or that they didn't change earlier?  

            13             MR. REYNOLDS:  The problem is that they didn't

            14   change when the bond deal was priced, leading investors to

            15   believe that there's some time horizon where they will get to

            16   prove out the variables.

            17             So what happens is the rating agencies get a fee. 

            18   The brokerage houses get a fee.  The banks lay off their risk

            19   and the one holding the bag at the end of the day is the

            20   investor, who has stepped in with a set of assumptions about

            21   how the rating agencies rated it in the first place, whether

            22   it be a bond deal in October that's downgraded in November or

            23   an eight billion dollar debt deal done by two telecom

            24   companies in March which are downgraded or watch listed in

            25   June.






             1             We just need to understand the variables so we can

             2   assess accordingly and price risk.  

             3             So it's not the action itself.  It's the sense that

             4   you really, on the prior ratings action, didn't have the full

             5   picture to understand how the ratings would respond going

             6   forward.

             7             So in terms of the random walk and all that, it's

             8   not a case of people getting new information.  It's really

             9   not understanding firmly the criteria.

            10             MR. HARRIS:  Sean?  

            11             MR. EGAN:  What we see in the market is a lot of

            12   frustration with some of the actions of the NRSROs.  For

            13   example, investors just can't swallow that Enron was an

            14   investment grade credit four days before bankruptcy or the

            15   California utilities were rated A-minus about two weeks

            16   before they defaulted, or they have ingenuity, you have a six

            17   notch downgrade in the period of two months.

            18             It's just -- 

            19             MR. HARRIS:  Sean, how would you explain why the

            20   market itself didn't anticipate those effects?

            21             MR. EGAN:  The market doesn't have the information

            22   is the reason why, because the market, historically, has

            23   looked to the rating agencies for that information and they

            24   haven't fulfilled that role very well.

            25             We, fortunately, have stepped in and caught most of






             1   these, but I think there is an evolution in the market's

             2   perception of what a rating is.

             3             I'll give you the story of a person in Colorado.  I

             4   think they headed up the Colorado state pension fund.  They

             5   said they couldn't believe that they weren't going to get all

             6   their money back on Enron.  They said this thing was rated

             7   investment grade, how in the world can something that was

             8   rated investment grade, how can we get less than ten cents

             9   back.

            10             Our response is believe it, because the company

            11   isn't worth it, and then they got also caught in Worldcom,

            12   and then they got caught in Global Crossing.  

            13             It just is a huge eye opener that some of these

            14   ratings aren't as good as they had thought they were.  We

            15   explained that our business is protecting investors.  We're

            16   not looking to help companies at all.  In fact, we regularly

            17   alienate companies, but we have to assign timely, accurate

            18   ratings, and we do look to the future, too.

            19             We believe that our ratings should reflect what the

            20   credit quality is going to be within six months, between six

            21   and 12 months out.

            22             We also don't buy into this fraud, the company

            23   isn't giving us accurate information, therefore, we can't

            24   assess credit quality accurately.

            25             We don't believe the information that typically






             1   comes out from the company.  We didn't believe that Bernie

             2   Evers had the backing for his $400 million loan from the

             3   company.

             4             We didn't believe that the capital expenditures

             5   that they listed were truly capital expenditures.  We treated

             6   them as expenses.  It's like the fast food business, where

             7   you have to put in the capital expenditures to keep up.  You

             8   have to put in the new lines.  You have to upgrade the

             9   software.

            10             So we made the adjustment.  We saw that the

            11   coverage was being cut in half.  So, basically, we're putting

            12   ourselves in the investor's shoes and trying to get to the

            13   truth quickly.

            14             MR. O'NEILL:  I think I really need to -- this is a

            15   public record and I think we need to correct the public

            16   record.

            17             On Enron, on November 9, I believe it was the

            18   eighth or ninth, Standard & Poor's put its BBB-minus rating

            19   on credit watch with a very strong statement stating that

            20   that rating was dependent upon the pending merger agreement

            21   with Dynergy and the failure of that agreement would cause us

            22   to lower our rating to BB or B.  

            23             I think Sean would even agree, I think the

            24   following day you raised your rating, as a matter of fact,

            25   from BB-minus to BB in the middle of November.  So you,






             1   obviously, were depending upon the disclosure the

             2   organization was making.

             3             At one point, you had an A-minus when we all had

             4   BBB-plus.  So you were, obviously, depending upon the level

             5   of disclosure and the accuracy of the disclosure that was

             6   being made in the marketplace.

             7             I'm surprised you're not shocked by what Enron did

             8   and Worldcom, to some extent.  I would think you would have

             9   the same righteous anger that we in the rating agency

            10   industry have about this.  

            11             MR. EGAN:  You can look at our Enron record and you

            12   can see -- and by the way, it's in the material that was

            13   included in the package that I placed -- that everybody

            14   should have.

            15             You see on June 27, 2001, we cut our rating from

            16   BBB -- that was our first negative action, and you see how we

            17   cut it to non-investment grade.

            18             MR. HARRIS:  I'm going to cut you off here.  Our

            19   purpose today is not to do a forensic investigation of what

            20   happened with Enron, except perhaps to allow us to understand

            21   more clearly what exactly ratings are.

            22             In the case of Enron, it is alleged that there was

            23   a lot of hanky-panky by quite a number of people, and, as has

            24   been stated here, the ratings can only be good as the

            25   information that is given.






             1             While ratings will never be perfect, they always

             2   could be better, we have some other issues to address.

             3             I want to return, though, to the question I asked

             4   before, which is this:  is there a problem with ratings that

             5   reverse?  That is to say, a rating that is perhaps -- let's

             6   not even talk about new issues, as Glenn spoke of earlier, 

             7   we have a seasoned issue.  It's rated AA.  It drops to A and

             8   then months or somewhat later it goes back to A.

             9             This doesn't happen very often.  I'm focusing on

            10   this because it is very important to understand whether the

            11   ratings are being used for their information content or

            12   whether they are being used for some other purpose.

            13             So the question is what is the market resistence to

            14   ratings that reverse too often?  Cynthia?

            15             MS. STRAUSS:  Thank you.  We also observe that that

            16   doesn't happen very often, and I think one of the reasons

            17   that it doesn't happen is that the agencies are conscious

            18   about the statistics they want to follow and have it so they

            19   are highly unlikely, given that that is one of the key

            20   measures of how well they're doing, they're not going to take

            21   their ratings up and down.  It actually is quite rare, unless

            22   there is a very clear event to justify that.

            23             So I don't know how the market would react.  When

            24   the market gets unhappy is when they don't understand why the

            25   ratings are moving, which gets back to this point of clarity






             1   of criteria.

             2             You made an interesting point, I thought, about the

             3   different and disruptive rating changes versus rating

             4   changes, and as Leo said, we can be in a volatile time where

             5   ratings may, due to the fundamentals, need to change very

             6   quickly because the company's profile is changing.

             7             But a disruptive rating change is when the ratings

             8   are changing very quickly and it's not observable to the

             9   market why they are changing so fast at this pace, and we

            10   have seen some of that, and I think that does trouble us.

            11             An example might be a rating downgrade, some of the

            12   telecom names, and the reason that the agency will say we're

            13   looking for the company to do certain things and then the

            14   company does those things and then the rating goes down.

            15             As a market participant, our only question with

            16   respect to the agencies is have you changed your criteria,

            17   because it seems like you're moving your ratings in a

            18   different way and that leaves the market uncertain and,

            19   therefore, I think, adds volatility and uncertainty.

            20             That's why we say we want clarity of criteria and

            21   transparency in living up to that, because it is the rating

            22   agencies that have to set their own criteria.

            23             That has happened a great deal, and I think we

            24   worry sometimes that that makes it very difficult for

            25   companies.






             1             MR. HARRIS:  I would like to go there, but not

             2   right now.  We're going to stay just a moment more on quality

             3   of the ratings in an attempt to understand exactly what this

             4   product is.

             5             I would like to ask Kent if he could briefly

             6   summarize some of the academic evidence, not necessarily your

             7   own, on quality of ratings.  

             8             MR. BAKER:  Just as was mentioned by the gentleman

             9   from S&P, if you look at the quality of the ratings in

            10   relationship to defaults over time, that evidence has been

            11   quite strong, very high correlations on what the ratings are

            12   and what the eventual defaults have been.

            13             There's really a substantial amount of evidence in

            14   support of that.  

            15             MR. HARRIS:  What of the relationship between

            16   ratings as predictors of default and credit spreads as

            17   predictors of default?  

            18             Again, recognizing that we're not predicting who is

            19   going to default, but the probability of defaulting, which is

            20   a subtle distinction, but extremely important, if credit

            21   spreads do as much or better than ratings, then perhaps

            22   ratings are doing something else that we haven't put our

            23   finger on yet.  

            24             MR. BAKER:  From my review of the literature, the

            25   jury on that particular issue may still be out in the sense






             1   that I can show you support for either one of those

             2   particular positions, and that's why I'm saying the jury may

             3   be still out.

             4             There is support in some of the literature that

             5   credit ratings do a better job.  On the other side, you do

             6   have that with the spreads.

             7             So I think the jury is out on that as far as my

             8   view would be concerned.  

             9             MR. ROOT:  Just one point, and I think it's

            10   important because on the issue of spreads and ratings, at 

            11   Dominion Bond Rating, our approach, our philosophy is to rate

            12   to a cycle and, again, it's anybody's own estimate or

            13   assessment as to whether a change is cyclical or structural. 

            14   That's an opinion. 

            15             So we try to maintain stability in our ratings, if

            16   you will.  I'm sure many other people on this panel will talk

            17   about spreads and spreads will certainly widen and tighten

            18   over that time frame.

            19             So people will say, well, this thing is trading at

            20   500 over, and yet their rating hasn't changed, I think you

            21   have to look at this over the entire time frame of the life

            22   of the security to determine whether or not the ratings and

            23   the spreads -- you know, at some point, they will come

            24   together, I believe.  

            25             Usually, they will come together because the issue






             1   will pay off and then the spreads will come back to where

             2   they were originally, but there may be cases where they

             3   default.

             4             So I guess my point there is, again, ratings, I

             5   think, are different than day-to-day spreads in the credit

             6   markets, and I think that's important because I think there

             7   is sometimes too much attention paid to spreads at any one

             8   point in time, and, therefore, that's a predictor or that's

             9   an indicator whether ratings are accurate or not, and I think

            10   that's wrong.

            11             MR. HARRIS:  Greg, let me paraphrase what you've

            12   said and ask Leo whether he is in agreement with my

            13   paraphrasing.

            14             That is to say that ratings are designed to assess

            15   the relative risk of default among the population of firms

            16   that are related, whereas credit spreads, to the extent that

            17   they are predictive, would be rating an absolute probability

            18   of default, and that the rating agency's interest is in

            19   assessing the relative risk, is that correct?  

            20             MR. O'NEILL:  I'm not sure I clearly understand, so

            21   maybe we can circle back on your point.

            22             But I will point out that spreads were at their

            23   narrowest, A to ten year treasuries, were at the narrowest

            24   days before the stock market peaked at a little over a 100

            25   basis points.






             1             Today those spreads are about 230 basis points over

             2   treasuries.  I'm not sure spreads don't follow a certain

             3   sense of their own view of what the conditions are, and I

             4   think -- and, again, but I think you have to look at any

             5   particular security in a spread.

             6             MR. HARRIS:  I hope, of course, that your point is

             7   that the spreads may not be as predictive as might be alleged

             8   as opposed to suggesting that perhaps we haven't seen the

             9   worst yet.

            10             MR. O'NEILL:  Also, Larry, I also use single A

            11   versus a ten year treasury, so I was doing it with a rated

            12   security or a rated universe.  It's an interesting

            13   discussion.

            14             I think our goal is to stay focused on the

            15   fundamentals and do what we do best, and the market uses

            16   spreads and that's great.  

            17             MR. HARRIS:  Sean, you had wanted to speak, as

            18   well.

            19             MR. EGAN:  Yes.  I agree, Leo, that is probably one

            20   of the few things that we agree on.

            21             MR. O'NEILL:  Oh, my god.

            22             MR. EGAN:  Write it down.  It won't happen very

            23   often.  We think there should be a decoupling of spreads from

            24   credit ratings and the information that is derived from it.

            25             What I mean is that the way we look at spreads is






             1   that is just static information on what the market believes

             2   of a particular security.  There may be there's a variety of

             3   other things, like supply and demand, that affect that.

             4             In the package I sent out, you can see some

             5   demonstrations of how the spread information doesn't quite

             6   capture a lot.  About six pages in, you see Worldcom's --

             7   this is not spread, this is prices, but you could just get

             8   the reverse of it and get spreads.

             9             You see how Worldcom, in fact, traded up from

            10   December 2001 to January of 2002, it was trading above a 100,

            11   and then it wasn't until February, March, and April that it

            12   started dropping.

            13             So if you are to take the information back in

            14   November of 2001, the conclusion would have been that this is

            15   a terrific company and, therefore, don't worry about it.  We

            16   think that's wrong.  You have to look at the underlying

            17   fundamentals.

            18             Another case where that is demonstrated, where it

            19   just sort of falls off very dramatically, is AT&T Canada,

            20   about two or three pages afterwards, again, is trading at 100

            21   from December of 2000, January of 2001.

            22             It wasn't until about February-March and there's a

            23   few months, this is printed off of Bloomberg, but it's not

            24   until later that it starts dropping dramatically to the point

            25   where it goes down to 20.






             1             So getting information, driving ratings from this

             2   type of pricing information we think is a mistake and if you

             3   do it, it will send real aberrations, and I can point to

             4   about 20 hedge funds that would love it if a mechanism like

             5   that were set up.  

             6             MR. FERNANDEZ:  If I may.  If the implication here

             7   is that for some reason spreads might be a substitute for

             8   ratings, I think that would be a disservice to everyone.

             9             Spreads are the reflection of the last trade in the

            10   marketplace, and that market may be wrong on any given day

            11   about the long-term fundamental value, the probability of

            12   default or ultimate recovery value of any security.

            13             Indeed, we have just gone through a period where

            14   the market collectively was wrong about quite a few issues in

            15   that regard.

            16             If you are also looking -- and Kent is absolutely

            17   right.  If you are going to look at the predictive value in

            18   terms of probability of default of either spreads or ratings,

            19   the jury is still out.  

            20             It depends upon the time series that you're looking

            21   at, the spreads that you're examining, because there isn't

            22   one single set of credit spreads.

            23             You can look at it with respect to global credits

            24   and emerging markets and say that these things predict 15 out

            25   of the last five defaults, in many cases.  






             1             The other thing is that you cannot even address

             2   this issue until you recognize that this is the flow of the

             3   impact, market impact of both spread changes and rating

             4   changes.  It's not unidirectional.

             5             There is clear feedback and very important

             6   threshold effects, and this is where I think you should

             7   develop this, because you bring up the issue of ratings

             8   triggers, which are becoming growing in their importance,

             9   just as the growing importance of proliferation of the user

            10   ratings themselves.  

            11             But the point being made here is that the people

            12   who are demanding this are the investors themselves.  They

            13   want the triggers in there.  It's not something that is being

            14   driven by the companies or by the rating agencies themselves,

            15   because they want a simple, accurate, quick benchmark for

            16   them to be responsive to an environment where the nature of

            17   risk is changing and becoming more difficult to assess.

            18             Risk management practices have to evolve and they

            19   are becoming more and more sophisticated, because we are

            20   going through a period of very high sustained near record

            21   levels of volatility.

            22             This has been true for four years now.  We have to

            23   recognize that we have both cyclical problems and structural

            24   problems in terms of the nature of risk and risk management

            25   that lead to higher probabilities of default, more rapid






             1   shifts in valuation and the perception of those shifts.  

             2             So to say or to look at any one of these indicators

             3   and say, gee, it has more value, these are one of a 100

             4   things that any good credit analyst is going to look at.

             5             MR. HARRIS:  Thanks, Frank, and thanks especially

             6   for bringing us to our next topic, the rating triggers.

             7             I want to ask Malcolm about the issues that Ford

             8   issues, do they have rating triggers in them?

             9             MR. MACDONALD:  No.  

            10             MR. HARRIS:  And to the extent that you are aware

            11   of the market for your issues, do you feel pressure from

            12   anybody to put rating triggers into your issues?

            13             MR. MACDONALD:  We have not come up with any great

            14   pressure from underwriters to go for rating triggers, but

            15   given where spreads are, I'm staying out of the unsecured

            16   market at the moment.

            17             MR. HARRIS:  And to the best of your knowledge,

            18   obviously, it's not in your experience, but you are certainly

            19   well informed in this area, why are rating triggers being

            20   pushed into these contracts?

            21             MR. MACDONALD:  The rating triggers, you mentioned

            22   that they can call for prepayment.  In some cases, a rating

            23   trigger will merely recoup on the bond and at that point in

            24   time, in effect, what we're doing is we're establishing an

            25   automatic mechanism that the investor is being better






             1   compensated for presumably a higher risk occurring with a

             2   lower rating.  

             3             MR. HARRIS:  And why do you suppose that the

             4   covenants are written based on rating triggers as opposed to

             5   the alternative, which would be coverage ratios of various

             6   types?

             7             MR. O'NEILL:  I think it's probably because of the

             8   lucidity of the identifier.  You don't have to get into

             9   having to judge what the appropriate earnings are, core

            10   earnings, operating earnings, pro forma earnings, that whole

            11   discussion.  It's clear.

            12             But I think we should also point out that rating

            13   triggers are only one type of trigger.  There's equity price

            14   triggers, there's material, there's change triggers.

            15             I think the ultimate goal by the investors or

            16   whomever it is putting these triggers in is to create, in

            17   effect, a preference in time for the repayment of their debt,

            18   that they are going to be out early or out first or if it is

            19   a complete repayment on it.

            20             It could be and I think many more of them are ones

            21   that, as you say, recoup on the debt or enter into maybe some

            22   kind of accelerated sinking fund or over time whatever.

            23             I think an unintended outcome of triggers is one

            24   that nobody intends when they do them, and that is to cause a

            25   sudden and sharp decline in liquidity of the corporation,






             1   which, in effect, creates a situation where the next

             2   available step is protection in bankruptcy.

             3             MR. FERNANDEZ:  That is becoming more likely now.

             4             MR. O'NEILL:  Which is becoming more likely.

             5             MR. HARRIS:  Certainly not intended, but certainly

             6   not unanticipatable, too.  So the next question is directed

             7   to Greg, first, then to Leo.

             8             What systems or what means do you have of obtaining

             9   information about the rating triggers so that you can take

            10   that into account, if you do, in forming your ratings?

            11             MR. ROOT:  To be honest, not a lot of the companies

            12   we rate actually have rating triggers, but certainly, in

            13   light of the events of the last year, we have a whole series

            14   of items that we will cover in the due diligence process with

            15   the issuers.

            16             So one of the key questions that we do pose to the

            17   issuers is are there rating triggers and if so, what are

            18   they.

            19             So that's just one more piece of information that

            20   we put into the puzzle, but, again, we haven't had it at

            21   DBRS, where that's been an issue at all.

            22             Again, I think disclosing rating triggers is not an

            23   issue.  Kind of going back almost what Leo said early on, we

            24   don't think disclosing rating triggers is a responsibility of

            25   the rating agencies, I don't anyway.






             1             MR. O'NEILL:  I agree with that and I would just

             2   say as the rating triggers are really just part of a larger

             3   discussion we have about the total liquidity of the

             4   corporation, if it is a corporation, and their ability to

             5   beat all the liquidity demands on it, triggers could be an

             6   important one.

             7             When we talk about rating triggers with them, we

             8   talk about alternative sources of funding, if, in fact, that

             9   trigger is really -- but we will not withhold a rating action

            10   because of the existence of a rating trigger.  

            11             MR. ROOT:  I knew that was probably going to come

            12   up.  At Dominion Bond Rating, that is absolutely the case.  

            13             MR. HARRIS:  You perhaps leave me a little bit

            14   confused.  If you would, please, rephrase, you will not

            15   withhold a rating action based on a trigger.  

            16             MR. O'NEILL:  If there's a rating trigger, let's

            17   say single A and we're at A-plus or something, we will go

            18   ahead and lower that rating to single A if, in fact, that is

            19   the thing we believe.  

            20             MR. HARRIS:  I understand.  I'm glad to hear that,

            21   of course.

            22             The question that I have, though, is this.  In

            23   deciding what the rating should be, would you take into

            24   account the rating trigger?  

            25             MR. O'NEILL:  Yes.  If we think that the rating






             1   trigger itself is the cause of the potential change in

             2   creditworthiness, then yes.  We really do.  And over the

             3   years, we have cautioned issuers about building into these

             4   rating triggers in there, because the presumption is that it

             5   could create a sudden and sharp decline in liquidity.

             6             And I think most of them have been very judicious

             7   as a result of that in building those in.  

             8             MR. HARRIS:  Thank you.  I want to turn to the buy

             9   side and a slight change of direction again, and ask them,

            10   we'll start with Debbie, in addition to your own work that

            11   you do on credit, you obtain information from the bond rating

            12   agencies and I would imagine, given your size, that you are

            13   also consulting with independent credit analysts.  Is that

            14   correct? 

            15             MS. CUNNINGHAM:  That is correct. 

            16             MR. HARRIS:  How do you value the different

            17   services you would get from an independent credit analyst

            18   from the services that you get from a rating agency?

            19             MS. CUNNINGHAM:  We would typically value the

            20   credit rating agency opinions on a higher plane, a higher

            21   echelon than we would the information that would result from

            22   Wall Street analysts.

            23             MR. HARRIS:  And that's based on your experience

            24   with the processes or what is it then that you're looking for

            25   from the analysts?






             1             MS. CUNNINGHAM:  It's based on our experiences with

             2   the processes, but it's also based on our alignment with

             3   effectively trying to create our own internal credit rating

             4   agency and knowing what the credit rating agencies do, whose

             5   information we are then utilizing as part of our own credit

             6   rating process.

             7             So we have an internal scale that similarly -- that

             8   is a rating scale that we want to adhere to, and I can tell

             9   you what a Federated One is versus a Federated Five. 

            10             I think what we get from the rating agencies and

            11   the information on the various types of analysis that we do,

            12   looking at liquidity, looking at cash flow, looking at

            13   capitalization, looking at earnings and the quality of

            14   earnings over time, all that matches up very nicely with the

            15   information that we are receiving from the rating agencies.

            16             As I said before, sometimes if we feel things are

            17   not necessarily as up to date in a written format, we are

            18   very much able to have conversations and get those updates

            19   from the rating agencies.

            20             On the other side of the equation, when we're

            21   dealing with Wall Street analysts, we typically have a good

            22   information flow of what is already publicly disseminated

            23   information and maybe a bit of an opinion based on that

            24   public information that may be a little bit different from

            25   our own, but there's normally not as much analysis or not as






             1   much emphasis placed on the analysis of some of the specific

             2   items that we look at through our own credit process.

             3             MR. HARRIS:  Cynthia, are things similar, do you

             4   want to add anything?

             5             MS. STRAUSS:  I think Debbie said it perfectly,

             6   very similar for us.

             7             MR. HARRIS:  Okay.  What information should a

             8   credit rating agency disseminate in addition to their

             9   ratings?  We have heard several people speak to the basis for

            10   the ratings and I'm just curious as to how deep should that

            11   information go.  Glenn?

            12             MR. REYNOLDS:  I would say there has to be some

            13   clarity, at least in the given financial metrics that are

            14   required for giving a rating for a given industry.  They vary

            15   considerably across different industry groups, depending on

            16   the volatility of their underlying revenues and cash flows.

            17             So you have to be very clear on what the

            18   expectations are, what needs to be maintained at a minimum

            19   and over what time horizon.

            20             It is very difficult, especially in some of the

            21   more emerging sectors, such as we have seen in telecom and

            22   media and tech in recent years, because they are changing so

            23   quickly, to set a time horizon, but that doesn't change the

            24   fact that people need to understand what the thought process

            25   is and just pure basic objective financial metrics.






             1             There probably also has to be some input on what

             2   the expectations of the risk profile of the industry is.  The

             3   telecom, it could be what their minimum expectation is for

             4   wireless subscribers, for example, for retail, what the

             5   expectation is for store sales, anything that is a key driver

             6   of the decision should be laid out there for people to

             7   understand, because then it's caveat emptor.  

             8             You either embrace those ratings given those set of

             9   criteria or you don't, or you can have your own set of

            10   forecasts around those variables.

            11             It allows you to partly predict their behavior,

            12   which is part of the game.  So one of the things that makes a

            13   negative downgrade is when you didn't expect it.

            14             At least this would limit the instance of

            15   surprises, but the rating agencies are entitled to their

            16   views on changing underlying variables, but they are really

            17   not entitled to keep the variables to themselves.

            18             MR. HARRIS:  Would it be fair to paraphrase what

            19   you've said as to say that the additional information is

            20   valuable because you don't always trust the ratings?

            21             MR. REYNOLDS:  That's fair.  That's fair.  Because

            22   if I don't understand the ratings, I don't trust them.  

            23             MR. EGAN:  Let me explain the process that we have

            24   gone through, and it has been very well received by the

            25   market.






             1             What we do is when we're looking at a target

             2   company, we compare it against other companies within the

             3   industry and we come up with benchmarks, if you will, for the

             4   different credit ratios that we look at, at, let's say, the

             5   AAA level all the way down to the single C level.

             6             So that investors can tell what we think is needed

             7   at the different gradation for credit quality.

             8             Then we provide the investors with historical

             9   financial statements, assumptions for projecting financial

            10   statements, for both the income statement, balance sheet, and

            11   cash flow, and then with those financial statements included.

            12             So there is a huge level of transparency.  They can

            13   see exactly where the company has been, how it stacks up

            14   against competitors, how it has developed over time, what we

            15   expect will happen.

            16             MR. EGAN:  Sean, I'm a little confused.  Given that

            17   that's all in the public domain, why is that a value added

            18   service, other than just packaging?

            19             MR. EGAN:  The assumptions for projecting financial

            20   statements are not in the public domain.  We put those

            21   together.

            22             Also, comparison against other companies is

            23   something that we drive.  You're not going to have all the

            24   data points, if you will, for, let's say, a forest products

            25   company.  You're not going to have a BBB rated, a BB rated, a






             1   single B rated or all the way up.

             2             MR. HARRIS:  And you provide this information to

             3   subscribers only or to the public as a whole?

             4             MR. EGAN:  We provide it to subscribers and we

             5   provide the rating to the public as a whole.  

             6             MR. HARRIS:  Now, we've had some discussion already

             7   about the possibility that the rating agencies add value not

             8   only by virtue of the quality of their analyses, but also

             9   perhaps by the high quality of their access to the firms

            10   through the exemption, through Reg FD, or perhaps through

            11   their market position.

            12             It has been suggested that rating agencies are able

            13   and need to obtain information that wouldn't otherwise

            14   publicly be available. 

            15             Now, the question is to what extent should that

            16   information be shared with the public beyond the rating

            17   itself and to whom.

            18             We know that some of the rating agencies have early

            19   warning services. 

            20             MR. O'NEILL:  Larry, on the one hand, the credit

            21   watch is a listing when there's a near-term expectation there

            22   will be a change.  On the other hand, in language that

            23   economists would understand, the outlook is a longer term

            24   change in the expectation of change.

            25             MR. HARRIS:  So the question is what about






             1   differential treatment between subscribers and the public as

             2   a whole?  Should subscribers be permitted to have a peak at

             3   information or more information than is available to the

             4   public?  Should they be allowed to obtain information

             5   earlier?

             6             MR. O'NEILL:  I would ask Malcolm to -- that's the

             7   issue, not necessarily ours.

             8             MR. MACDONALD:  I'm not sure, Leo, that it is in

             9   terms of subscribers.  Clearly, the point that I had made

            10   earlier I will reiterate, that we are comfortable in

            11   providing confidential data to the three rating agencies

            12   today, because our experience has been that they have been

            13   absolutely scrupulous in complying with the confidentiality

            14   provisions and because we believe it helps them make more

            15   informed judgments as to the credit quality of the company.

            16             MR. HARRIS:  I understand all about the

            17   confidentiality and we've been there and I don't believe that

            18   we need to go there again.  I have little doubt that there

            19   has been very little of confidential nature revealed.

            20             The more interesting question, though, is whether

            21   opinions that are based on confidential information are

            22   being revealed in an unfair way.

            23             So let me ask the question in a different way.  Who

            24   here would object if the SEC said that given the unique

            25   position of the rating agencies and their exemption from Reg






             1   FD, that they must display all information that they give to

             2   anybody to everybody and at the same time? 

             3             We've got some hands moving here.  Great.  

             4             MR. FERNANDEZ:  I think it brings us back.  The

             5   reason I would object to this is I think we are starting with

             6   a flawed understanding of the business model that is involved

             7   here.

             8             First of all, I don't think anybody has made the

             9   case for me that to provide a timely, a prescient credit

            10   valuation, or any kind of risk assessment, that you require

            11   access to inside information or selective disclosure.  I

            12   don't think that is the case and I don't think that is what a

            13   good analyst of any sort depends upon.

            14             MR. HARRIS:  Surely you wouldn't suggest, though,

            15   that if such information existed, that the analysts couldn't

            16   do better with it.

            17             MR. FERNANDEZ:  A trading advantage that dissipates

            18   very quickly.  I don't think that's what we're talking about

            19   here in terms of a rating agency that has to publish and

            20   stand by a rating that they can't change minute by minute. 

            21   If they were to disclose to provide somebody with a trading

            22   advantage, then we've got a whole different issue here. 

            23   We're talking about insider trading, and I don't think that's

            24   even the suggestion that we're dealing with.  

            25             MR. HARRIS:  Then if there is no advantage here,






             1   then why wouldn't we just have it displayed to everybody? 

             2   What is it that the subscribers are paying for?

             3             MR. FERNANDEZ:  The subscribers are paying for

             4   something that has value added.  To say that information

             5   should be freely available is fine, but you can't assume that

             6   it's costless to prepare.  Now, taking information that you

             7   have access to, performing analysis, coming to a valuation is

             8   hardly a cheap process.

             9             To do it on an ad hoc basis or for some segment, a

            10   sector or industry, fine, you can do that for something under

            11   eight figures.  But to do it in a comprehensive way, in a

            12   studious way, in a readily accessible, comprehensible way,

            13   and in a timely fashion, you have to do this across, how

            14   many, 6,400 and some odd equity securities, tens of thousands

            15   of fixed income securities, not to mention derivative

            16   structures that come off of these two type of things.

            17             This is a very heavy thing.  This is -- 

            18             MR. HARRIS:  The point is well taken.

            19             MR. FERNANDEZ:  No, it's not, because I think we've

            20   got a problem.  The SEC started with a premise in the last

            21   leadership that if we simply provided this as a free public

            22   good, we would empower investors out there and that they

            23   would be able to use raw information.

            24             Raw information is not particularly useful for an

            25   individual investor.  The analysis -- 






             1             MR. HARRIS:  Let me clarify just a bit.  First of

             2   all, I want to make it very clear that I'm not here to

             3   present any opinions and, in fact, the purpose of holding

             4   these hearings is that the Commission approaches this issue

             5   with an open slate.

             6             So my job here is only to bring out issues.  If I

             7   have to be provocative to get people to speak, that's where

             8   I'm coming from.

             9             So I do want to point out, though, that I think

            10   everybody here recognizes that it is very costly to do these

            11   analyses and that they have to be paid for.  At issue is not

            12   whether they're costly.  What is at issue is to the extent

            13   that rating agencies have special privileges that other folks

            14   don't have, is it appropriate that they can trade on that

            15   special privilege.  

            16             MR. FERNANDEZ:  They're not trading.  

            17             MR. HARRIS:  By trading -- 

            18             MR. FERNANDEZ:  By distribution of the services,

            19   perhaps you could say that, but what they're doing here is

            20   providing a quasi public good in terms of a rating.

            21             To the extent that they proffer from that, from the

            22   distribution of the ratings, clearly then this is a business

            23   they are engaged in.

            24             MR. HARRIS:  So you're argument then is that indeed

            25   there may be some of that, but the public good that they






             1   provide without being paid directly more than compensates 

             2   for -- 

             3             MR. FERNANDEZ:  Going back to what you use in the

             4   market data, yes.  They are generating positive

             5   externalities.  Who do these accrue to?  Hopefully to the

             6   individual investor more so than any institutional investor

             7   out there.  That is our hope.

             8             MR. HARRIS:  I notice that this issue is resonating

             9   with quite a few people.  I had Deborah first, and then we'll

            10   come to Leo and I suspect Cynthia also wants to speak.

            11             MS. CUNNINGHAM:  Despite the fact that I'm never

            12   really excited about the fact that the rating agency bills

            13   are probably one of my highest budgetary items within my

            14   group, nonetheless, as an investor, I feel comforted to some

            15   degree that I am paying for that service, because right now,

            16   the information that is disseminated from the rating agencies

            17   is paid for by the issuer and there are always questions

            18   about conflicts of interest and whether or not that payment

            19   from the issuer to the rating agency represents something

            20   more than just a payment for information received, that is

            21   then being publicly disseminated in an informational form.

            22             I guess I'm offset to some degree, by the fact that

            23   I am paying them in a different fashion for the subscription

            24   of those services and the dissemination of that information

            25   to my analysts.






             1             MR. HARRIS:  And just so everybody should be aware,

             2   exactly what is it that you receive when you pay for the

             3   service that you wouldn't otherwise obtain if you didn't pay

             4   for it, presumably for different channels?

             5             MS. CUNNINGHAM:  There are definitely different

             6   levels of service per agency and different levels of service

             7   across the various agencies. 

             8             But by and large, what you are paying for is the

             9   information that is key in understanding why their ratings

            10   are as they are.  

            11             MR. HARRIS:  Leo, Cynthia, then Malcolm.

            12             MR. O'NEILL:  The access to so-called confidential

            13   information.  Can I put it into context here?  I think there

            14   is a view, implied or otherwise, that there is this one

            15   single fact that drives the credit rating that there is one

            16   single fact that drives the credit rating in a situation and

            17   that is an inside secret.  Not true.

            18             S&P over the years has maintained many, many, many

            19   times that the disclosure that corporations make to the

            20   Securities and Exchange Commission is sufficient upon which

            21   to make a rating determination and if it wasn't, we would

            22   lobby hard and fast that it be sufficient.

            23             The information that we get, in most cases, is

            24   corporations, projections, call it what you will, their view

            25   of their future cash requirements, how their capital spending






             1   is going to go, what their cash flow is going to be to

             2   support that, what their access to the debt market might be

             3   in the future.

             4             I think the situation that Malcolm highlighted

             5   earlier about product plans, in many cases, those plans are

             6   used to supplement the number of what their capital

             7   expenditures might be and that sort of thing.

             8             It's pretty arcane, but it is supplementary in

             9   nature.  It's important, but it's supplementary.  

            10             COMMISSIONER GLASSMAN:  Does it change your

            11   ratings?

            12             MR. O'NEILL:  The information that is disclosed to

            13   us, yes.  It could very well change our rating, very much so.

            14             MR. HARRIS:  Cynthia?

            15             MS. STRAUSS:  The importance of our being able to

            16   speak to the agencies is high, but it's basically because we

            17   want to understand their analysis and, again, how they are

            18   thinking about the ratings, their criteria, because they have

            19   such incredible power on the marketplace in which we operate.

            20             So it's really pretty simple, but it's really

            21   critical to us.

            22             MR. HARRIS:  Malcolm?  

            23             MR. MACDONALD:  Two points.  I think, one, in terms

            24   of data made available, clearly, one of the things that we

            25   make available to the agencies is a fair amount of forward-






             1   looking data, which, by definition, is not made available

             2   without financial statements.

             3             Therefore, I would concur totally with Leo that

             4   that information has to be particularly useful in evaluating

             5   a forward-looking view of an issuer.  That is one point.  

             6             In response to your direct question, I would

             7   probably favor total release of all information in writing,

             8   because, quite frankly, I would like to hear some of the

             9   things that are said about Ford Motor Company as an issuer

            10   that are not necessarily included in the formal rating

            11   notice.

            12             MS. STRAUSS:  If I could just say, the clarifying

            13   point for me, and I think Debbie also mentioned it, by the

            14   fact that we pay for it, the rating agencies have tremendous

            15   influence on the markets.  It is huge, and we don't have a

            16   market voice back to them that is commensurate with that.

            17             So it's really important that we try to understand

            18   their analytical process and if you just, at least to date,

            19   look at what they have in writing, that is not sufficient to

            20   understand that.

            21             So that imbalance is somewhat helped by our ability

            22   to talk with them and say why is your analysis so, and we get

            23   that only because we're paying fees.  I know that we may be

            24   very big, because we get access to the agencies because of

            25   the magnitude of the fees we pay and that gives us, in other






             1   words, our countervailing force against the fees and the

             2   attention that would be put on issuers or underwriters on

             3   Wall Street.  

             4             So it kind of gives us a stake in the game.  I

             5   don't think it's evil, I don't think it's awful, but there is

             6   a natural imbalance here and that has influence on good

             7   people.

             8             MR. O'NEILL:  The balance we're trying to strike,

             9   Cynthia, and, obviously, we haven't done a good job of

            10   communicating that and it certainly appears that we're every

            11   bit as open and as transparent to our process as you and

            12   Deborah would like us to be, and we'll go to work on it.  

            13             But I think what the balance is we're trying to

            14   strike here is issuers pay us such a significant part of the

            15   fee.  Investors pay us just a small, small part of the total

            16   value proposition, if you will. 

            17             So we're trying to balance that, to some extent. 

            18   What can I tell you, I think it's -- in relationship to the

            19   cost that goes into the analysis that we provide investors,

            20   if we did not have a model that generated fees from issuers,

            21   I don't think we could continue to provide it into the

            22   marketplace.

            23             The cost to the investing public would be so, so

            24   great, that the economies of scale would certainly be lost.

            25             MR. HARRIS:  We are approaching lunch, but I want






             1   to turn direction yet again, but this time away from the

             2   credit rating agencies and to the SEC.

             3             We have spoken about the importance of financial

             4   disclosure to the rating agencies in the formation of their

             5   opinions.  It is extraordinarily important to essentially

             6   everybody who, in one way or another, forms an opinion about

             7   values in the markets.

             8             The question I would like to offer, and this may be

             9   a unique opportunity, it's not unique, you can always write

            10   us, is what additional disclosure should there be obligated

            11   that would improve the process?

            12             What more information would, say, Greg, what do you

            13   see in Canada that you would like to see done here or what

            14   would be your silver bullets for disclosure that you think

            15   would particularly benefit your clients?

            16             MR. ROOT:  It's probably best to ask the clients.

            17             MR. HARRIS:  I will.

            18             MR. ROOT:  I'll be honest with you.  I mean, I may

            19   have a little different view, kind of going back to what

            20   Malcolm and Leo were saying a little bit.

            21             I think in this day and age, disclosure is very

            22   good.  I started in the rating business back in the early

            23   1970s and you do have to go back that long, and the amount of

            24   public information out there was extremely limited, and to

            25   really do a credible job in any type of analysis, whether it






             1   be credit, equity, you name it, it was very difficult.

             2             If you look at Canada and you look at the United

             3   States today, I don't think that is the case for publicly

             4   traded companies.  We rate companies and entities that are

             5   not public and that haven't had access to information, it's

             6   critical.

             7             That's a whole different animal, I think, than

             8   we're doing here. 

             9             So I believe that you can do a very credible job of

            10   evaluating a company, from whatever perspective, with public

            11   information.  That said, obviously, to the extent that you

            12   have access to management -- access to management is very

            13   important, because one of the things I think is important

            14   here, and it's going to the issue of transparency, we do

            15   everything we possibly can, we make a strong effort to be as

            16   transparent as possible, because I know that's very

            17   important.

            18             But one of the things that people say, well, we

            19   want to know exactly what the parameters are for a rating

            20   change.  Therefore, they want three ratios that, if it's a

            21   ratio, a rating is going to change.

            22             Well, a rating is a much more comprehensive

            23   analysis than that.  What people want is something very

            24   simplistic that anybody can just say it it's there, boom,

            25   something is going to happen.  And that's not the rating






             1   business.

             2             So I think being transparent, conveying your views

             3   and what assessments and assumptions you are making is very

             4   important, but it's not such a mechanical issue, because if

             5   it was that mechanical, we wouldn't have a staff of analysts

             6   with the tremendous amount of training to go out and

             7   understand the industries they're following and the companies

             8   they're following and put that together in a comprehensive

             9   service, which is the rating, the analysis and the company.

            10             We do a lot of industry analysis.  We do a lot of

            11   industry study.  So I guess my long-winded answer is I'm not

            12   sure that public disclosure -- there's a lot being talked

            13   about here.  I'm not sure it's the critical issue in this

            14   whole conversation, quite honestly, because it's never been

            15   abused, as far as I'm aware, first of all, and, secondly, I

            16   think the value of that over the course of the rating has

            17   been overblown.

            18             I think it's being overblown, to an extent, because

            19   I don't think it is as important today as maybe the attention

            20   that it's being given.  I'm not trying to be negative, but I

            21   think that's our personal view on that.

            22             COMMISSIONER GLASSMAN:  I just have a quick

            23   question to follow up on that, and this is to the rating

            24   agencies. 

            25             How much of the rating is based on objective and






             1   measurable factors as opposed to the subjective issues, like

             2   quality of management?

             3             MR. O'NEILL:  I wish I could give you a definitive

             4   ratio.  I would have to say that the publicly available

             5   information, by and large, accounts for a vast, vast, vast

             6   percentage of the rating assignment.

             7             I think one of the roles that non-public

             8   information plays is it allows the issuer to, if you will,

             9   portray or posture their view of their future, what their

            10   plans are and how are they going to do that, and I think most

            11   rating analysts, I think virtually all of them accept that in

            12   the spirit which is intended, but also surrounded with a

            13   great deal of skepticism.  

            14             We're talking about the future here.  But I think

            15   it's important that it's an input.  It's a very important

            16   input, because it tells us what the expectation the issuer

            17   has for its future and where they're going, and it gives them

            18   the opportunity to disclose to us something that may be

            19   disclosed at a later date would cause uncertainty, a so-

            20   called surprise factor, cause some tremor in our industry.

            21             COMMISSIONER GLASSMAN:  What about, even more

            22   subjective, your view of them, management, and your belief

            23   that they can actually do what they're saying?  How important

            24   is that?

            25             MR. O'NEILL:  I think the -- I don't -- well,






             1   Malcolm, with all due respect, I don't think -- and we

             2   understand what is happening here.  I think it is

             3   management's longevity, management's credibility, the

             4   dialogue.  It's a continuum.  It's the dialogue that we have

             5   with that corporation that goes back, in some cases, 30 years

             6   and the continuity of management, continuity of thinking, of

             7   planning, strategy, financing.  

             8             That's all that really counts, and that, by the

             9   way, and I hope we get a chance to talk about it, that really

            10   is the essence of governance.

            11             MR. HARRIS:  Commissioner Campos?

            12             COMMISSIONER CAMPOS:  I have a quick question. 

            13   It's going back a little bit to the prior discussion.

            14             Let me ask it this way.  I understand the business

            15   model.  I understand you draw fees from issuers.  I

            16   understand you draw fees from subscribers.

            17             Assuming the fees could be adjusted, what is wrong

            18   with making publicly available the data that you provide

            19   subscribers?  What would be the negative of that?  

            20             MR. O'NEILL:  Well, we do make available all of the

            21   public data that we use in our rating process and all the

            22   rationales for it.  I think the issue is should we disclose

            23   the confidential information that the issuers provide to us. 

            24   I suspect that if that was our policy -- 

            25             COMMISSIONER CAMPOS:  I assume there is something






             1   different between what the public and what subscribers are

             2   getting.  I haven't studied lately, because I haven't been a

             3   subscriber, but I assume there is something in the subscriber

             4   materials that is different than what is publicly available. 

             5             MR. O'NEILL:  What we make publicly available over

             6   our web site is all our ratings and, in many of the most

             7   important issuers, the rationale behind the rating.  It's

             8   maybe three, four paragraphs long, of why we rated it the way

             9   we did and what the key factors are.  

            10             What we do also provide to subscribers is a much

            11   more in depth report that supports the summary rationale.

            12             COMMISSIONER CAMPOS:  What's wrong with having that

            13   publicly disclosed?  

            14             MR. O'NEILL:  Making it available gratuitously?  

            15             COMMISSIONER CAMPOS:  I said if you adjusted the

            16   fees and had issuers pay for it, what is wrong with doing

            17   that?

            18             MR. O'NEILL:  I don't think there's probably

            19   anything wrong with that.  I think all the third party

            20   providers of credit information might have some difficulty if

            21   all of us began disseminating this for free.  

            22             MR. ROOT:  From Dominion Bond Rating, I hope I'm

            23   not varying from my owner here, but I don't see anything

            24   wrong with it.

            25             I think your point is if we could offset in lesser






             1   revenue by some -- and, again, our fee structure is very low

             2   and anybody can have access to it.  We are not precluding

             3   anybody from accessing information.  I think that 

             4   is important.  So we don't want to say if you want to

             5   subscribe, you can't.

             6             But as far as I'm concerned, I don't think there is

             7   anything wrong with that, to the extent that we can be

             8   compensated and so we can maintain the quality of our

             9   efforts, which is critical to this whole discussion, by the

            10   way.  I see no reason why the information, especially in this

            11   day and age.

            12             In the old days, with having to mail everything,

            13   was very difficult.  Everything is on the web.  It's very

            14   easy to access.  So I personally would have no problem with

            15   that at all.  

            16             MR. O'NEILL:  Frank wants to make a comment, but

            17   let me just clearly point out.  The major users of this

            18   information are major investment institutions and the number

            19   of them is relatively small. 

            20             This information is not being sold to individual

            21   investors, per se.  The bond market is very much of an

            22   institutional marketplace.  So I guess it would make all this

            23   information available to individual investors, and then we

            24   would have to figure out how we're going to come to grips

            25   with that.  






             1             MR. FERNANDEZ:  The point I was trying to make was

             2   the one I was getting to before.  That would be fine, if you

             3   then provide for that.  If it is to be a public subsidy,

             4   great.  But the problem that I confront and I see out there

             5   is that that our government is very good at creating

             6   expectations of delivery and then not funding the mandate

             7   behind it.  

             8             COMMISSIONER CAMPOS:  I didn't say the government

             9   would take over.  I made it very clear in the hypothetical

            10   here that you could adjust fees.

            11             MR. FERNANDEZ:  As long as somebody pays for it,

            12   it's a value added product and somebody has to come up with

            13   the money to deliver it.  I don't think we've seen an

            14   economic model where anybody has suggested this replaces the

            15   marketplace in this regard.

            16             Indeed, if there were greater people willing to pay

            17   for this, then it would be provided in that manner.

            18             COMMISSIONER CAMPOS:  Why not go the other way? 

            19   Why have the issuers pay for it?  Why not the investors? 

            20   Then you get rid of the conflict of interest.

            21             MR. FERNANDEZ:  That's one of the issues that you

            22   can consider.  The second thing I want to -- 

            23             MR. HARRIS:  We will shortly be talking about

            24   conflict of interest in the next session.  I note, though,

            25   that even with the investors, there is a conflict of






             1   interest.  The holder has an interest in maintaining the

             2   current credit rating.  

             3             MS. STRAUSS:  You asked for some specific -- 

             4             MR. HARRIS:  The silver bullet.

             5             MS. STRAUSS:  What could the SEC do in terms of

             6   disclosure, is that not correct? 

             7             MR. HARRIS:  Yes.  That was the silver bullet

             8   question.  

             9             MS. STRAUSS:  Oh, sorry.

            10             MR. HARRIS:  So what is your silver bullet?  

            11             MS. STRAUSS:  I have a couple -- well, no.  I wish

            12   there was one.

            13             MR. HARRIS:  I'll give you a canon.  

            14             MS. STRAUSS:  The two we faced is -- one is

            15   requiring companies to disclose the full details of contracts

            16   which are critical to their short-term liquidity.  A great

            17   example is bank facilities.  That is now provided on a

            18   discretionary basis.  Some provide them, some don't.

            19             That is something that, again, we talk about Reg

            20   FD, it doesn't sound as bad, but it's one of the areas that

            21   we've had trouble with where people won't disclose it and

            22   it's critical for us.  

            23             MR. HARRIS:  Cynthia, the ones who don't disclose

            24   presumably are penalized in the market with higher credits.

            25             MS. STRAUSS:  No, that's not true.  They have a






             1   good rating.  

             2             MR. O'NEILL:  They do disclose it to us.

             3             MS. STRAUSS:  Right.  

             4             MR. HARRIS:  I see. 

             5             MS. STRAUSS:  So that's discretionary in terms of

             6   whether the company -- and, again, that puts -- we don't have

             7   that information and we don't always get the details of that

             8   from the rating agency, for good reason, because -- 

             9             MR. HARRIS:  And as a consequence, don't you avoid

            10   those issues?  

            11             MS. STRAUSS:  No.  Not necessarily, because our job

            12   is to look at -- that's a critical input to that, but, again

            13   -- and there will be other contracts.  I think more of this 

            14   -- Leo also mentioned that ratings triggers, in many cases,

            15   disclosure, that might come in through that as well, what

            16   could be a short-term support or drag on liquidity, again, a

            17   critical thing for debt holders.  So that might be one thing.

            18             Another thing is an area that is very esoteric and

            19   it is hard to get into, which is asset backed securities.

            20             Currently, under Rule 3a-7, under the Investment

            21   Company Act, that gives any asset backed securities a blanket

            22   exemption from all provisions of the 1940 Act.

            23             So there is not good disclosure on the details of

            24   asset backed securities.  This is a huge market.  It is

            25   growing in complexities.  Rating agencies are very important






             1   in that and they stand in -- yet another topic that I don't

             2   think we should go into now is the rating agencies are

             3   perceived as standing in in many, many areas in that, because

             4   disclosure is so weak.

             5             I'm not sure really they are undertaking, not that

             6   they are wrong, all the due diligence that one -- if one

             7   would look at it and say, well, if it's not disclosed, look

             8   at the complexity.  You only have the rating agencies, is

             9   this a reasonable balance.

            10             So that's an area to look into.

            11             MR. HARRIS:  Well, I thank everybody for their

            12   candor.  This was a very enjoyable session for me and I have

            13   learned a lot.  We will break for lunch now, and we will

            14   restart again at 1:30.  

            15             (Whereupon, at 12:24 p.m., a luncheon recess was

            16   taken.)  

            17                         AFTERNOON SESSION

            18             MS. NAZARETH:  This session, which will be

            19   moderated by John McCarthy, from the Office of Compliance,

            20   Inspections, and Examinations, is on potential concerns

            21   regarding the role of rating agencies.

            22             We will talk about things such as conflicts of

            23   interest and potential abusive practices.

            24             John?

            25             MR. McCARTHY:  Good afternoon.  During this






             1   session, we intend to explore the potential concerns

             2   regarding the role of credit rating agencies, particularly

             3   the potential for conflicts of interest in the credit rating

             4   business and the potential for credit rating agencies to

             5   abuse their power in the marketplace.

             6             On a number of occasions in the past, the

             7   Commission has studied the extent to which conflicts of

             8   interest in the credit rating business may influence the

             9   credit rating process.  

            10             In 1994, the Commission solicited comment on the

            11   practice of NRSROs, charging issuers for ratings and the

            12   appropriateness for an NRSRO to charge an issuer fees based

            13   on the size of the transaction.

            14             As a general matter, commenters at that time did

            15   not oppose NRSROs charging issuers for ratings.  Nonetheless,

            16   the Commission again solicited comment on this issue in 1997,

            17   after expressing concern that the rating agencies may be

            18   tempted to give a more favorable rating to a large issue

            19   because of the large fee and to encourage the issuer to

            20   submit future large issues to the agency.

            21             Presently, Commission staff is in the process of

            22   examining the role and the function of rating agencies in the

            23   securities markets and has focused a lot of their attention

            24   on the various potential conflicts of interest.

            25             Conflicts of interest in the equity research






             1   process are now known and they have been the subject of much

             2   recent media attention, such as the pressure on equity

             3   research analysts to maintain positive ratings on issuers in

             4   order to gain lucrative investment banking fees for their

             5   firms, and, also, to get into various nursery schools,

             6   apparently.

             7             One goal of this session is to discuss the extent

             8   to which conflicts, such as those that have been alleged in

             9   the equity research process, represent themselves in the

            10   credit rating process, and, obviously, I'm aware of the many

            11   differences.

            12             Further, we should identify and discuss any

            13   potential conflicts that may be unique to the credit rating

            14   process.

            15             Accordingly, we will press your opinion today as to

            16   whether potential conflicts of interest in the credit rating

            17   business influence the credit rating process.  I will outline

            18   the conflicts that I have identified and then hopefully we

            19   can discuss those in this forum.

            20             The first one is whether the fact that a credit

            21   rating agency is paid by an issuer calls into question the

            22   objectivity or quality of the ratings.  If so, what about the

            23   agency's practice of basing fees on the size of the debt

            24   issuance?  Does this practice increase the potential conflict

            25   to the extent the credit rating agencies could become






             1   dependent on a few large issuers for a disproportionate share

             2   of their revenue?

             3             Secondly, whether conflicts of interest are created

             4   when a credit rating agency provides consulting or other

             5   advisory services to issuers it rates.  And, thirdly, whether

             6   there are any other conflicts of interest in the credit

             7   rating business that influence the rating process.

             8             I would like to note there are a couple of the

             9   rating agencies present today that do not charge issuers for

            10   ratings and thus avoid certain influences of issuers.  We'll

            11   be interested to know each participant's views on whether a

            12   similar conflict of interest exists for those subscriber-

            13   based firms who could be subject to the influence of

            14   subscribers, particularly if the firm is experiencing

            15   economic pressures.

            16             The NRSROs also maintain substantial power in the

            17   marketplace.  An NRSRO can directly impact an issuer's cost

            18   of issuing debt and most issuers seek ratings from at least

            19   one NRSRO.  

            20             Accordingly, commenters have stated that the

            21   potential exists for the NRSROs to engage in abusive

            22   practices, such as improperly pressuring others who are to

            23   pay for ratings in which they don't maintain a relationship.

            24             In this regard, we will be interested to hear

            25   participants' comments on questions such as whether rating






             1   agencies rate issuers that have not requested a rating and

             2   whether they do this in a means to generate business or

             3   additional revenues, whether these -- and they are termed

             4   unsolicited ratings -- are less reliable than solicited

             5   ratings, and whether the use of unsolicited ratings should be

             6   restricted or regulated to a lesser or greater extent.

             7             Secondly, whether rating agencies engage in any

             8   practices that are coercive or anti-competitive. 

             9             To the extent you believe that conflicts of

            10   interest or abusive practices exist in the credit ratings

            11   business, we welcome your comments on ways to prevent such

            12   conflicts or ameliorate their consequences.

            13             So with that said, why don't we start by addressing

            14   the practice of issuer paid ratings.  Obviously, it has been

            15   touched upon in the morning session, but we will focus on it

            16   now.  

            17             Let me just tee up the question.  Does the practice

            18   of issuers paying for ratings create a conflict of interest,

            19   and if so, what effect does this have on ratings?  Leo, since

            20   you're the only NRSRO present.  

            21             MR. O'NEILL:  I'm shocked that you would ask me to

            22   start.  No.  I mean, obviously, what else would you expect me

            23   to say?  No.

            24             The fact that we're paid by an issuer, I don't

            25   think, creates a conflict of interest.  To the extent people






             1   believe it does, I think that conflict is extremely well

             2   managed with a rating process.

             3             All of our ratings are assigned by a committee.  No

             4   analyst has any financial stake in the outcome of his or her

             5   rating recommendation to that committee. 

             6             No one issuer accounts for any significant -- I

             7   mean, less than one-half of one percent of some very, very

             8   small amount, in terms of its rating fee.

             9             We all recognize, and perhaps this is the most

            10   important point, we know that the whole credibility of this

            11   process really depends upon our objectivity in the rating

            12   process.

            13             The bond market, I guess all markets are very, very

            14   strict disciplinarians.  And to the extent that those markets

            15   are very, very knowledgeable and very learned about ratings,

            16   and to the extent that those markets see practices seeped

            17   into it that are questionable by rating agencies in terms of

            18   ratings inflation or whatever, they would discipline.  They

            19   would discipline that organization to an extent that no

            20   organization I think could survive over the longer term with

            21   that sort of opinion hanging over its head.

            22             So there's strong internal controls, exceptionally

            23   strong incentives, and I guess the third one, as I say, we

            24   have been charging issuers since 1968, 34 years, I guess that

            25   is, as long as I have been with S&P, and I don't think there






             1   is any smoking gun that states acceptance of those fees by

             2   Standard & Poor's from those issuers has created any bias and

             3   it's in favor of issuers.

             4             I guess if there was, we wouldn't have lowered the

             5   ratings on how many thousands and thousands of issuers over

             6   that period of time.  

             7             COMMISSIONER GLASSMAN:  On what basis do you

             8   evaluate the performance of the analysts?  

             9             MR. O'NEILL:  On the basis of their recommendations

            10   to the rating committee, their insights.  We have peer

            11   reviews of the analysts.  We have reviews by their lead

            12   supervisors and we have -- it's a 360 process, how well they

            13   not only perform in their participation and recommendations

            14   on their own companies, but all our analysts also participate

            15   in rating committees where other analysts are presenting.

            16             So that's basically the system.  We won't get into

            17   the very specifics, but that's essentially it.

            18             COMMISSIONER GLASSMAN:  Thanks.

            19             COMMISSIONER GOLDSCHMID:  How about ratings when

            20   you don't have fees?  Where you're rating an issuer and

            21   they're not paying fees?  Any differences there?  

            22             MR. O'NEILL:  No.  As a practical matter, let's put

            23   it this way.  The only place where we may do an unsolicited

            24   rating is in the United States public securities markets,

            25   because we do believe, as I said earlier this morning, there






             1   is sufficient information provided through the SEC disclosure

             2   process that allows us to make a learned judgment as to the

             3   creditworthiness.

             4             As a practical matter, though, I must say that

             5   virtually no issuer that sells a meaningful, $50 million or

             6   more debt issues doesn't come to S&P and request a rating.

             7             I would be very uncomfortable, by the way,

             8   assigning an unsolicited rating in a market that doesn't have

             9   the disclosure requirements that we have in this country.

            10             MR. EGAN:  We at Egan-Jones take a little bit

            11   different view.  We think how people are paid, how

            12   organizations are paid are critical in how they behave.  

            13             If you have a five-year-old child and if that child

            14   misbehaves, you somehow punish them or restrict some

            15   compensation.  They don't have dessert if they hit their

            16   brother or sister.

            17             The same way with organizations.  If they are

            18   getting 85 or 87 percent of their compensation from the

            19   issuers, in the case of Moody's, if it's getting calls from

            20   the ex-Secretary of Treasury, the New York Stock Exchange

            21   Chairman, the heads of the major investment banks and

            22   commercial banks not to change a rating, it would be crazy

            23   not to think that it doesn't influence things.

            24             There is a basic conflict of interest.  We don't

            25   have the luxury that Standard & Poor's and Moody's has.






             1             The reason why nothing has changed, I mean, look at

             2   the rating history on Enron and on Worldcom and Global

             3   Crossing.  The Moody's earnings did change it all.  In fact,

             4   they didn't go down at all.  They went up 40 percent.  They

             5   went up 40 percent because there is no competition in this

             6   industry.  Zero.  It's a monopoly.  That's why they're able

             7   to get away with it.

             8             We think it's a huge problem and it needs to be

             9   addressed.

            10             As far as the percentage of each individual rating

            11   being relatively small for the overall revenue base, the same

            12   argument could be made for Jack Grubman and Henry Blodget of

            13   Salomon Smith Barney or CitiGroup.  Those are relatively

            14   small percentages, but it resulted, their actions resulted in

            15   -- they were pressured to maintain higher ratings than

            16   normal.

            17             So we think there is a big problem in this area

            18   that needs to be addressed.

            19             MR. ROOT:  Can I comment on this, please?  Because

            20   I actually have been on both sides of this, prior to joining

            21   Dominion Bond Rating, when I ran one of the NRSROs, which was

            22   Thomson BankWatch.

            23             Thomson BankWatch, for the first ten years of its

            24   existence, did not charge the issuer, it got all its revenues

            25   from the subscriber, from the investor. 






             1             Then when Thomson acquired BankWatch from an

             2   investment banking firm, we changed that strategy and we

             3   ended up charging the issuer.

             4             I would have to disagree very much, Sean, on that,

             5   and I concur totally with Leo.  In fact, Dominion Bond

             6   Rating, also, I should say, does charge the companies we

             7   rate.          From my 25 years of experience in the rating

             8   business and being on both sides of this, I absolutely see no

             9   evidence of any conflict of interest that has arisen or

            10   exists in this day and age, and for the many reasons that Leo

            11   cited.

            12             So as I say, I have seen this on both sides and I

            13   just don't think it's a real issue or has been an issue of

            14   abuse, if you will.  

            15             MR. BAKER:  If I can, just for a moment, give you

            16   some data from our survey, focusing upon issuers.  We did

            17   focus upon the area regarding whether or not there were

            18   conflicts of interest or perceptions of conflicts of interest

            19   as far as the incentive systems would go, and I just want to

            20   share a piece of data with you about these potential

            21   conflicts of interest as rating agencies, and these are data

            22   from issuing companies, as a matter of fact, a 112 issuing

            23   companies, on their perception.

            24             Slightly over 97 percent said that the rating

            25   agencies have an overriding incentive to maintain a






             1   reputation for high quality, accurate ratings.  They sort of

             2   live and die by the quality of the ratings and the

             3   perceptions in the  marketplace of the value that is added.

             4             Slightly less than three percent indicated that the

             5   current structure for paying rating agencies encourages

             6   agencies to assign high bond ratings to satisfy customers.

             7             So there was a small part of the three percent that

             8   the perception was that it could have some influence, but the

             9   vast majority, over 97 percent, believed that there were not

            10   conflicts of interest, at least on this particular issue.  

            11             MR. EGAN:  What about the investor side?  Want to

            12   address the percentages?  Over 28 -- 29 percent thought that

            13   rating agencies issued timely, accurate ratings.  So that

            14   would be, what, one percent of the investors.  

            15             MR. BAKER:  That's true.  

            16             MR. EGAN:  You have to look at it from the investor

            17   side, not the issuers.

            18             MR. REYNOLDS:  I would say we have to look at it

            19   from both sides.  

            20             MR. McCARTHY:  Malcolm, could you give us the

            21   issuer perspective on this issue?

            22             MR. MACDONALD:  I'd be happy to.  Certainly, in all

            23   my experience with the rating agencies, which is substantial,

            24   I have never come across nor even heard anything that would

            25   remotely suggest a conflict of interest.






             1             In saying that, I am speaking from a position where

             2   I have been actively negotiating fees with one of the

             3   national recognized agencies, at a time when the rating has

             4   been under review.

             5             At that point in time, the rating agency people

             6   involved recused themselves from consideration of a rating.

             7             So I am totally comfortable that there is no

             8   conflict of interest.

             9             With respect to Sean's comment, my view is on most

            10   polls, because 29 percent of the people say something, it

            11   doesn't mean that 71 percent of them say the opposite thing. 

            12   It may be that some percentage says the opposite thing and

            13   some percentage has no view at all.

            14             MR. McCARTHY:  I guess the question is do you feel

            15   like you are getting what you're paying for? 

            16             MR. MACDONALD:  The labor is worthy of its hire.  

            17             MR. McCARTHY:  So yes, I guess.  Deborah?  

            18             MS. CUNNINGHAM:  The answer I'm going to give is

            19   really not an answer.  I'm just going to give you some

            20   comments.  It's both from an investor standpoint, which is

            21   what I am, but I'm also an issuer.  My funds that are

            22   available for purchase in the institutional money market

            23   arena are, by and large, a large group of them are actually

            24   rated.

            25             So I go through two groups of rating agency people.






             1   On the issuer side, those that are rating are funds.  So I

             2   know what their credit analysis process is and I'm very

             3   comfortable that it is not a process where I am influencing

             4   them in a way that that would be considered a conflict of

             5   interest.

             6             That actually gives me some benefit, I think, in

             7   actually -- as an investor, it gives me a little bit more

             8   clarity.  

             9             I think if I were using the rating agency ratings

            10   as the end of my analysis, I would have a bit more concerns. 

            11   But in the process that we use it, which is from an input

            12   standpoint, one of many different inputs into the analysis

            13   process, we are comfortable with the fact that we do pay for

            14   a portion of it, although that payment is small in regard to

            15   the payment that the issuers make.

            16             We feel that that is compensation that needs to be

            17   adequately received by the rating agencies and because of

            18   that receipt by the rating agencies, guarantees us or gives

            19   us a little bit stronger conviction than what we receive from

            20   them as analysis is, in fact, very good.

            21             I also think that evidence that the process is not

            22   necessarily tainted on a biased basis can be seen from the

            23   asset backed marketplace, and, again, we talked about this a

            24   little bit earlier, but the asset backed market and the

            25   rating process that occurs there is a little bit different






             1   than what you see on the corporate side, and, on the asset

             2   backed side, it's a very iterative process.

             3             The sponsor of the program is essentially looking

             4   to achieve a rating.  It's not a corporation saying this is

             5   what I have, tell me what I get from a rating process

             6   standpoint.  It's going in and saying what do I need to do to

             7   achieve a AAA rating or what do I need to do, how do I need

             8   to structure this transaction to achieve a AA rating.

             9             And because it is an iterative process, I think

            10   that almost a 100 percent guarantees that that removes a lot

            11   of that conflict of interest.

            12             It's a process.  You know what the end result needs

            13   to be.  It's a question of taking the input as to how you get

            14   to that end result.

            15             MR. EGAN:  I would follow up to Malcolm's point.  I

            16   refer people, and I can give a copy of this later, this is a

            17   study that is done June 18, 2001, by Professor Baker, and

            18   looking at Table 9, it indicates that 71 percent of the

            19   respondents, this is the issuer respondents, say that, no,

            20   this is in regards to the timeliness of the ratings, 71

            21   percent believe that they are not timely.

            22             So it addresses the flip-side of that question. 

            23   Not only do 29 percent think that they are timely.  The bulk

            24   of them think that they are not timely.

            25             Also, obviously, this panel is not representing a






             1   huge portion of the market.  I made that comment in my

             2   letter.  It's not representing the medium and smaller

             3   issuers.  Forget about the individuals.  They should be here,

             4   too, because individuals do use credit ratings.  Some of the

             5   issues are targeted to individuals.  There is noone

             6   representing individuals here.

             7             They need timely, accurate ratings, and if you ask

             8   them, after Worldcom, after Global Crossing, after Enron, if

             9   there is something wrong, they will all respond that, yes,

            10   there is something wrong with it.

            11             Elliott Spitzer, I think, is resonating because he

            12   believes there is a conflict of interest.  Why is it any

            13   different in this field?  

            14             MR. FERNANDEZ:  I would just ask what timeliness

            15   has to do with the potential conflict.  I'm curious.  I don't

            16   see the connection.  

            17             MR. EGAN:  The problem is that they are not issuing

            18   timely, accurate ratings, and there is a vested interest on

            19   the part of the issuers to maintain as high a rating as

            20   possible.

            21             The environment that we are in now is that ratings

            22   were delayed in being cut.  With all these debacles, the

            23   issue is when were the problems reflected in the rating and

            24   whether or not there was a delay.  As a matter of fact, there

            25   was a delay in all of them.  






             1             MR. McCARTHY:  Thank you.  Would disclosure of

             2   payments or more specificity about the payments be a

             3   worthwhile disclosure?

             4             MR. EGAN:  Clean it up.  Clean up this industry. 

             5   It's a mess.  You have problems on the equity side because of

             6   misaligned interests.  Why not take a good look at this

             7   industry.  If you are going to recognize rating firms,

             8   certainly, you'll recognize those that have a conflict of

             9   interest. 

            10             Set it up so that you restrict the payment from the

            11   issuers.  Make it with the investors.

            12             You know, we can survive on it.  Why can't other

            13   firms survive on it?  Also, S&P and Moody's got started that

            14   way.  That's how they established a reputation.  

            15             MR. McCARTHY:  Glenn, did you have something to

            16   say?

            17             MR. REYNOLDS:  Yes.  I've never been known as

            18   necessarily a major fan of the rating agencies, but I think

            19   on this one there is not an inherent conflict of interest.

            20             Using the five year old-parent metaphor, I think we

            21   have to reverse on who is the parent and who is the five year

            22   old here, because Moody's is the one who is doing the

            23   spanking and S&P. 

            24             They don't necessarily have an inherent conflict of

            25   interest in making a ratings move, because we'll lose sight






             1   of the fact that as companies get downgraded, they still have

             2   financing needs.

             3             So they are going to get paid as a single A, they

             4   are going to get paid as a BBB, they're going to get paid as

             5   a BB.  They are going to get paid one way or the other.  So

             6   let's get straight who the parent is here.

             7             One other thing, too, does the market want the

             8   bonds rated?  Absolutely.  Do investors want to pay for it? 

             9   I haven't met too many investors who enjoy writing checks.

            10             So for the issuers and a system to work, just look

            11   at it this way and this is what the market has decided.  The

            12   spread on the issue without the ratings is going to be

            13   significantly higher than the all in costs of the spread with

            14   the ratings plus the fee.

            15             Therefore, the market is saying that this is an

            16   efficient way to get bonds rated, and we are totally

            17   supportive of that.

            18             We have some asterisks around the timing of rating

            19   decisions and the fee stream, but the actual idea that the

            20   issuer creates a conflict of interest, someone has to pay

            21   someone and if you are paid by investor, you could just as

            22   easily skew your research to not run down a company that he

            23   has in his portfolio because he is paying you.

            24             At some point, there has to be some trust in the

            25   system, but it has to be backed up with good execution.






             1             COMMISSIONER GLASSMAN:  I have a question for Leo. 

             2   Why did S&P change its model?  If I understand correctly,

             3   before '68, you were paid by the investors and you are paid

             4   by the issuers.  Why did you change?  

             5             MR. O'NEILL:  Actually, I said this morning, we

             6   started in 1916 and it as a part of our subscription products

             7   doing these credit ratings.

             8             In 1968, if we go back in time, if you recall what

             9   was happening at that point with the great society programs

            10   and the Johnson Administration and the war in Vietnam heating

            11   up, inflation took off, the economy went into a crunch,

            12   credit defaults began to rise dramatically.

            13             S&P took a look around and said, well, my god, we

            14   have a certain amount of resources dedicated to this.  They

            15   are going to be woefully inadequate for this new credit

            16   environment that has emerged in this country.

            17             So we embarked upon a research program.  We went

            18   out, we met with investment bankers, we met with issuers, we

            19   met with investors, and we said to them, look, we don't think

            20   that we can afford to support the business that we think the

            21   markets need in terms of rating without tapping into issuers.

            22             The response we got back, and I guess we still get

            23   back to say, is that's okay, but you better make sure you

            24   don't manage to that business model through your ratings

            25   process.  Keep the conflicts down.  Isolate the analysts from






             1   the financial aspects of the business.

             2             Much like a publication keeps its advertising

             3   separate from its editorials.  So that's what we did and

             4   that's when began charging the issuers.

             5             And I might add, just as a last statement, we began

             6   in 1968.  We started charging for commercial paper in 1969, I

             7   guess it was.  We began charging corporate issuers, I think,

             8   in 1972.  

             9             All of this started taking place and was bought

            10   into by the marketplace prior to the SEC designating S&P as

            11   an NRSRO.

            12             The model was in place.  The NRSRO status did not

            13   create the model.  I guess now the last thing I'm going to

            14   say is we understand all this.  We're going to maintain this

            15   status and we are just going to make sure that we do nothing

            16   in our business that impacts on our ability to maintain that

            17   status.

            18             It's there, it's reality, and we manage

            19   accordingly.  

            20             MR. McCARTHY:  Cynthia first, then Malcolm.

            21             MS. STRAUSS:  I did have a point I think Sean

            22   touched on, which is the timeliness issue.  We can come back

            23   to it later.  It is an issue for us on the timeliness.  I

            24   think that could be the perception and could be the reason

            25   why there is this issue on -- there is a problem with






             1   timeliness with some of the agencies.

             2             I don't know whether -- we haven't perceived it as

             3   the conflict of why the fee is being paid, in part, because

             4   we are right now watching the rating agencies downgrade many

             5   companies massively and really be very hard on them.

             6             So we don't see the fee element making them too

             7   much in a company's pocket.  I don't think we've seen that.

             8             We do, though, see a need for a balancing factor of

             9   holding the agencies accountable for their criteria and

            10   transparency, which gives us a voice to the open market. 

            11   We'll come back to that later.

            12             But that is why, Sean, we don't see that as the

            13   linkage of the timeliness and the fee so much, but we do see

            14   that there is an issue there.  

            15             MR. EGAN:  What we see is that for the large,

            16   important issuers in each industry, that they are given every

            17   benefit of the doubt.  That has changed within probably the

            18   past four months or so since the Enron debacle, but if you

            19   look at the ratings of these major -- the telecom, Worldcom,

            20   for example, Global Crossing, both huge issuers. 

            21             There's a lot of stickiness and it begs the

            22   question of whether or not the investor is being protected,

            23   whether the issuer's interests are being addressed.

            24             I know that, Malcolm, you don't think you have a

            25   rating that's high enough right now and that's typical.  But






             1   the medium and smaller investors' interests need to be

             2   represented, and they're getting hurt badly.  

             3             MS. STRAUSS:  I do have a specific example, or a

             4   few of them, where we have felt that the timeliness and

             5   transparency was not good and we have come to the rating

             6   agencies, where they've changed the criteria that we felt was

             7   inappropriate.  

             8             Our voices don't always get heard and boom markets,

             9   where -- and I've often had people say to me, "Well, we're

            10   not hearing that from any other investor," well, the

            11   investors don't often have voices, and we're not hearing that

            12   from the company or Wall Street.

            13             I mean, maybe there is a conflict that they are

            14   paying more of the fees and not.  I had a specific example

            15   with one agency, where I came in the late '90s and many of

            16   the agencies have reduced their requirements for backstop

            17   liquidity for commercial paper issuers.

            18             It was done in a boom market.  Nobody was worried

            19   about it, but a good, disciplined debt investor was -- we

            20   were all worried about it, and the agency said to me, "Well,

            21   noone else is interested."

            22             And because they don't really have to listen to us,

            23   they didn't, and I asked that same agency just this very year

            24   how do they feel now about having reduced the backstop

            25   liquidity requirements the way they did several years ago and






             1   they said they regretted it.

             2             Now, they have the right to change their criteria. 

             3   This agency did appropriately signal the change in the

             4   criteria to the marketplace, but there was no -- they were

             5   feeling more pressure clearly from Wall Street and the

             6   companies to why should we do it, the markets are great, and

             7   making them look a little more at the here and now in their

             8   costs.

             9             So maybe that's an example of where there's not an

            10   equal balance for the other voices in this.  

            11             MS. NAZARETH:  I just wanted to make one point to

            12   Sean, also.  Obviously, credit ratings are used for fixed

            13   income products and that market is overwhelmingly

            14   institutional.  But that is somewhat of a misnomer.  There is

            15   a lot of retail investment in fixed income products, but it's

            16   through the kinds of representatives who are here at the

            17   table.  

            18             So it certainly was not our intention to not

            19   represent the interests of individual investors here.  We

            20   just think that we have the folks here who, in fact, are the

            21   ones making investments for them.  

            22             MR. EGAN:  Understood.  Could I make one more

            23   point?  

            24             MS. NAZARETH:  I think, Sean, we have to move on.  

            25             MR. EGAN:  Okay.  






             1             MR. McCARTHY:  Malcolm, you wanted to make a point.

             2             MR. MACDONALD:  At this point in time, I would like

             3   to make two, and I will try to make them quickly.

             4             Firstly, just for the record, I can only speak for

             5   one institution, but I want to say very clearly that the

             6   concept of our being able to delay a rating is totally

             7   reprehensible and something I have never come across.

             8             As to the idea that the agencies have suddenly

             9   become proactive, I would ask that the facts speak for

            10   themselves.

            11             Between 1979 and 1981, my company was downgraded

            12   from AAA to BBB in 26 months.  That was 23 years ago.  

            13             Thank you.  

            14             MR. FERNANDEZ:  I, too, have to take exception to

            15   some of the things Sean said there.  First of all, I don't

            16   think that the small and medium sized investor or issuer are

            17   not represented here.  

            18             I think the staff will confirm that endless number

            19   of comment letters we find continue to warn about the dangers

            20   of some actions being taken that are disproportionately borne

            21   by small and medium sized businesses in this country.

            22             Particularly, I draw attention to some of the

            23   efforts to improve the situation with respect to information

            24   flow that are actually reducing research available on the

            25   small and medium sized stock listings.  Hardwick Simmons






             1   brought this point forward and I believe he is actually

             2   correct here.  

             3             It's also limiting the ability of small and medium

             4   sized issuers to approach capital markets.  These firms

             5   produce more in terms of jobs, profits, taxes, and

             6   contribution to the general gross national product than firms

             7   of comparable dollar for dollar compared to larger firms.

             8             So these are also our customers.  On the equity

             9   side it is more so.  The majority of the investors and the

            10   volume that we handle now are retail and not institutional.

            11             So that's the first thing.

            12             The second misconception here is that the

            13   appearance of a conflict of interest implies misconduct or

            14   even the lesser standard of inefficiency.  I think that is

            15   totally wrong.  These are very efficient firms that we're

            16   talking about.  Nor does the appearance of a duopoly or

            17   oligopoly or even a monopoly indicate that there is some

            18   inefficiencies prevailing.  

            19             All one has to do is look at a natural monopoly in

            20   DTCC and see some of the highest efficiency ratings around. 

            21   So, again, it's more about there are certain types of

            22   business that naturally lend themselves to certain types of

            23   market structure, with higher barriers to entry, high cost of

            24   product.  It lends itself to an oligopolistic structure.  

            25             The other thing is if you're looking for the reason






             1   why there is an issue of timeliness here, you don't have to

             2   look any further than this room.  

             3             I would like to read a quote here.  "SEC filings

             4   contain a wealth of under-utilized business, competitive and

             5   financial information and the market for this information is

             6   much broader and deeper than the old line data vendors

             7   realize.  The key to unlocking the hidden value in this data

             8   is to find ways to extract and deliver it in real time to the

             9   large number of people who can use this information to make

            10   business and investment decisions."  Harvey Pitt, May of

            11   2002.

            12             Now, this has been one of my soap boxes to get up

            13   on here.  This could easily improve the timeliness if,

            14   indeed, Congress had mandated that you conduct a study, which

            15   we haven't really even addressed two of the major points,

            16   impediments to the accurate appraisal of credit rating

            17   agencies and barriers to entry, yet in this discussion.

            18             If Congress, who mandates that you do this, would

            19   simply provide you with the funds that have already been

            20   promised, so that you could updated antiquated computer

            21   systems, move into the 21st Century before it's over.

            22             In terms of processing data that is already being

            23   supplied to you, that would improve the timeliness of the

            24   input that these gentlemen use and hence the timeliness of

            25   your output.






             1             If I'm wrong on this, Mr. O'Neill, please correct

             2   me.

             3             MR. O'NEILL:  You are absolutely correct.  

             4             COMMISSIONER GOLDSCHMID:  Let me ask, and I'm

             5   learning and finding this very helpful.  Whatever the

             6   conflicts out there, there are two basic constraints I have

             7   heard so far this afternoon.

             8             One is what I would call a market power constraint,

             9   that the rating agencies actually have lots of power compared

            10   to the issuers.  That I understand and it seems right to me.

            11             But then there is the question we are going to be

            12   taking up, which is what happens if we remove some of the

            13   entry barriers, and we'll have to think about how those two

            14   are going to interface.

            15             A second thing people have been counting on, Leo,

            16   you fairly raised this and there's vast economical literature

            17   about reputational gains.

            18             But one of the things that we know, too, from

            19   recent events is that the reputational story doesn't work

            20   perfectly.  

            21             It would have been viewed most avidly about the

            22   accounting profession.  So one thing you'll want to think

            23   about is how well the constraints will work, at least on some

            24   of these conflicts, as we keep working our way through.

            25             MR. O'NEILL:  Commissioner, if I may.  I believe






             1   you can fool some of the people some of the time.  You scam

             2   the game, if you will, for a while, but ultimately the

             3   pattern emerges and then when that emerges, then I think the

             4   market really makes it happen.

             5             I think what happened to Arthur Andersen had a

             6   visible impact within our organization.  I mean, I didn't

             7   think we had to get out there.  We don't go out there and

             8   preach every day about objectivity and all of that.

             9             But when we saw what happened at Arthur Andersen, I

            10   can assure you people were saying it won't happen here.

            11             COMMISSIONER GOLDSCHMID:  That is good to hear, and

            12   it is a powerful statement.  I mean, I don't want to

            13   underplay reputation.  I think it counts.  It's not perfect. 

            14             MR. O'NEILL:  That's correct.  

            15             MS. NAZARETH:  I'm not sure we'll have time to get

            16   to all of the issues, but one of the issues, analogizing to

            17   the accounting profession, isn't just the reputational issue,

            18   but involves a variety of the services provided by the rating

            19   agencies.

            20             Do we start running into the same issues and

            21   questions that arose in that industry, as well?  

            22             MR. McCARTHY:  This is a good time to take on

            23   conflict number two.  Conflict number two is the practice of

            24   NRSROs and, I guess, other rating agencies marketing

            25   additional products to issuers such as rating assessment






             1   services and other consulting services.  

             2             So let me frame it by does the marketing or

             3   provision of these products pose any potential conflicts? 

             4   For instance, the NRSROs that provide pre-rated assessment or

             5   valuation services, and that's basically where they will

             6   analyze a hypothetical fact scenario, such as a hypothetical

             7   merger or acquisition, and provide how they would, I guess,

             8   rate it if it were to be a real life situation.

             9             The fact that they provide this rating assessment

            10   service, does it become more difficult for them to deviate

            11   from the hypothetical rating that they gave if the issuer

            12   actually follows through with the situation that they paid

            13   for them to rate?

            14             Leo, of course.  

            15             MR. O'NEILL:  Obviously, Standard & Poor's has

            16   built a firewall around its rating activities.  We have, for

            17   many, many years, built a firewall around our rating

            18   activities and all the other businesses that Standard &

            19   Poor's engages in, including its equity research and

            20   whatever.

            21             That is because we do get into the rating business. 

            22   We get confidential information, and so we don't share that

            23   with anyone.

            24             So there is not a conflict there where we have our

            25   rating analysts doing things of another nature that I think






             1   is apparent in the accounting industry, where auditors are

             2   perhaps -- or the consulting business got so great that it

             3   had an impact. 

             4             As far as rating valuation services, rating

             5   assessments are done.  For many years, going back in time,

             6   corporations would come in to us and ask us questions like we

             7   intend to do a stock buyback; if we do it, what will happen

             8   to our rating.

             9             Then we would provide them with, well, if you do

            10   it, then we're going to change the rating or keep it the same

            11   or do whatever.

            12             We think it is an inherent part of the rating

            13   process itself.  It is part of the rating process.

            14             Obviously, if there is a change in the

            15   creditworthiness of the organization between the time that we

            16   get the theoretical answer and the time that the action is

            17   taken, we will change that rating, even though the action

            18   taken might be right in line with what they told us.

            19             We think that that is the value of the service, is

            20   that it gives the issuer the feedback.  We stay in a

            21   surveillance mode during the process and we rate the entity

            22   as we see fit at that time.

            23             So there is absolutely nothing in our best interest

            24   to do anything other than that.  

            25             MR. McCARTHY:  Malcolm, has Ford ever bought these






             1   services?

             2             MR. MACDONALD:  Yes.  Yes, we have.  I have to

             3   agree with Leo that, for certain items that are under

             4   consideration, our board of directors certainly wants to have

             5   a strong idea of what are the rating considerations

             6   associated with the action under review.

             7             Therefore, I agree it's an inherent part of the

             8   process.  The only place it breaks down, in my opinion, and I

             9   know of no way to solve it, is if we go in with something

            10   that perhaps could be considered extreme and ask what if and

            11   get an answer, it would be terrible, your rating would go to

            12   single B, and we don't do it.

            13             Have we, in fact, somehow sent the message about

            14   our thinking to the agency?  And we've known that going in

            15   and we accept that that is something we can do nothing about

            16   and we must live with.

            17             So I am very comfortable in saying this is an in

            18   integral part of the overall rating process.

            19             MR. McCARTHY:  Say you pay for the service and they

            20   say it's not going to affect your rating at all and then a

            21   week later you go through whatever the hypothetical was and

            22   they say things have changed in this week and now it actually

            23   will affect your rating negatively.  I can't imagine that you

            24   would say thank you very much.  

            25             MR. MACDONALD:  You are quite right.  I would be in






             1   Leo's office within four hours, I suspect.  

             2             MR. O'NEILL:  And I'd say I'm on the other side of

             3   the firewall.  

             4             MR. MACDONALD:  John, the only answer to that is

             5   I've never seen that. 

             6             MR. McCARTHY:  It's fair to say there is clearly a

             7   potential conflict, one that, given certain facts, may put

             8   pressure on.  

             9             MR. O'NEILL:  There would not -- again, Malcolm

            10   might be upset about it, but the fact of the matter is we're

            11   making the current judgment at that time.

            12             You can set up a theoretical here, a hypothetical

            13   that says in this very, very, very short period of time,

            14   something fundamentally changes.  I think it would have to be

            15   a very visible and cataclysmic sort of event in that sort of

            16   framework that clearly was outside the theoretical action

            17   they might take.

            18             MS. STRAUSS:  John, there is another situation, as

            19   I understand S&P's model.  There is another rating agency

            20   that I know -- it came to our attention that they were

            21   soliciting this advisory service that was for an extra fee. 

            22   It was clearly staying outside of the standard rating process

            23   that you're talking about as an advisory.

            24             And we were actually quite concerned about that, as

            25   a user of the ratings, because we did see that getting into a






             1   slippery slope.  In this situation, the analysts were

             2   involved.

             3             So it was not the model you're describing, Leo.  I

             4   wanted to add that when agencies get into other businesses,

             5   as well, where they are selling services, I can't say I would

             6   say it's a problem yet, but we do worry about if a rating

             7   agency has a group that is selling quantitative models and

             8   then their analysts use that quantitative model, doesn't that

             9   up the -- isn't that saying, well, then, we all have to use

            10   that quantitative model.

            11             I mean, there is some trickiness when you get in

            12   other business.  But your model we know goes on all the time

            13   and we feel perfectly comfortable about it, because the

            14   advice is part of the ongoing relationship and probably

            15   critical to it.

            16             But there are other models out there that are

            17   worrisome, from our point of view.  

            18             MR. McCARTHY:  Would you like to know which ratings

            19   are part of these other services?  Would that be helpful for

            20   you?

            21             MS. STRAUSS:  The issue is if an agency is getting

            22   into these other businesses, they need to make that very

            23   clear and very public and give descriptions of that to,

            24   again, the otherwise users of their basic traditional

            25   services, which I once again remind you that we are obliged






             1   to use because they have so much influence on the market and

             2   our regulations. 

             3             MR. McCARTHY:  It sounds like the specificity of

             4   the information hasn't been that clear.  It sounds like you

             5   only vaguely know about it.

             6             MS. STRAUSS:  I don't think that there is a lot of

             7   this going on, that I'm aware.  I only was aware of another

             8   rating agency that was embarking on this and their analysts,

             9   there was no firewall.

            10             But at some point, firewalls -- it raises another

            11   complication that has to be managed and I think you're

            12   definitely in dangerous waters when you're looking at it as

            13   an incremental revenue source, which, again, is not part of

            14   the model described here.  

            15             MR. McCARTHY:  Glenn, in your written submission,

            16   you mentioned this issue.  Would you like to comment?

            17             MR. REYNOLDS:  First of all, a lot of these

            18   services will be sold to clients they rate.  You start to get

            19   into a difficult area.  Regardless of the firewalls, my

            20   experience with firewalls, being on Wall Street for 16 years,

            21   is they work pretty well until it gets really hot, and you

            22   have to be very careful about that.

            23             If you're in one office pitching a million dollar

            24   risk advisory service and in the next office you're saying

            25   it's time for our annual ratings review, it's really tough to






             1   reconcile, even if it's all above board and a 100 percent. 

             2   There is going to be that rated entity, who is a potential

             3   customer, and the high value added service is going to have

             4   to be -- it's going to be pulling the collar a little bit,

             5   you know, how should I proceed here, what should be my

             6   approach.  

             7             So it's the same debate, the kind of debate that

             8   has been raging on forever, and that one was never resolved

             9   clearly and it still goes on even after the fact.

            10             There is no way to win or lose this argument, but

            11   it is an appearance problem.  If you consider that you have

            12   mutual funds that are rated, you have insurance companies

            13   with claims pending, you have banks that are being rated,

            14   these are the national users of the risk products and when

            15   you talk about the M&A pro forma product, then you're getting

            16   very close to Wall Street firms, the investment banks, and

            17   it's pretty hard to stay out of the gray zone whenever you

            18   walk into an investment banking department.

            19             So there is going to be an inherent skepticism in

            20   the marketplace about this.  

            21             MR. McCARTHY:  Anybody have any other thoughts on

            22   this issue?  I'll move on to the next conflict that I dreamed

            23   up last night. 

            24             This is, which we touched on earlier, the practice

            25   whereby a rating agency initiates a ratings process without






             1   first being requested by the issuer.  A lot of people term

             2   this area to be unsolicited ratings.

             3             Some commenters have alleged that this practice of

             4   conducting what are, in effect, unsolicited ratings places

             5   pressure on the issuers to pay for the ratings out of the

             6   belief that if they don't, then the rating will be negatively

             7   impacted. 

             8             So let me just open that up to anyone who has

             9   thoughts on the unsolicited rating issue.  Leo, I won't start

            10   with you, unless you want to.

            11             MR. O'NEILL:  No, no.  Just very simple.  We don't

            12   do unsolicited ratings.  I will qualify that.  We reserve the

            13   right here in the United States to do a rating on an issuer,

            14   an important issuer, because, again, we feel we have the

            15   information that is available to do it.

            16             But by and large, if we're not asked to rate, I

            17   mean, more than by and large, by and very large, we will not

            18   rate unless we are asked to rate.  

            19             MR. ROOT:  At Dominion Bond Rating, generally,

            20   again, similar to Standard & Poor's, generally speaking, we

            21   do not do unsolicited ratings, but, again, for the same

            22   reasons that S&P does here in the states, there are certain

            23   circumstances where we actually would.

            24             But I think this whole issue of unsolicited ratings

            25   gives a negative connotation and I think it's important to






             1   talk about the process one goes through in doing unsolicited,

             2   because I don't think unsolicited ratings necessarily are a

             3   bad thing.

             4             Obviously, if they are abused, that's one thing,

             5   but I think the important element -- is a couple things if

             6   you're going to engage in unsolicited ratings.

             7             One, to the extent -- and we do have a couple of

             8   the companies we rate.  We designate which ratings are

             9   unsolicited.  So first of all, at least the marketplace knows

            10   which ratings are unsolicited, which are not.

            11             Secondly, even in the case of unsolicited ratings,

            12   we go through the exact same process as rating situations. 

            13   So before doing an unsolicited rating, we will communicate

            14   with management.

            15             We will talk with them, we will go through whatever

            16   available -- we make every effort to approach that in a

            17   similar fashion as if they were a rated institution.

            18             Then to the extent we actually publish that rating,

            19   again, we will communicate that with management so that this

            20   is not something that they would be surprised about.

            21             I think the other important thing you have to look

            22   at is are the unsolicited ratings really -- does one think

            23   that they are being punitive because they are unsolicited.

            24             And I can tell you, again, going to the fact that,

            25   at least in Dominion Bond Rating, our success and our






             1   acceptance in the market is only as good as our credibility.

             2             To the extent that you go about doing unsolicited

             3   ratings as a means to generate business, it is going to come

             4   back and haunt you very, very quickly.

             5             So, again, I think unsolicited ratings can play an

             6   important element in the marketplace and I think they can

             7   certainly help the investors, which is, again, I think, the

             8   function of why we're here very much.

             9             So I think if properly disclosed and handled

            10   appropriately, there is absolutely nothing wrong with

            11   unsolicited ratings.

            12             Again, I can go back to the days when BankWatch was

            13   started, and that's how we got started.  If you want to call

            14   it unsolicited, the companies didn't come to us, but we did

            15   the ratings for the purposes of the benefit of the investors

            16   and we communicated that.

            17             So as I say, I don't think unsolicited is this

            18   dirty word that sometimes it gets viewed in the marketplace.

            19             MR. McCARTHY:  Deborah?

            20             MS. CUNNINGHAM:  First of all, I would say we don't

            21   see very many unsolicited ratings.  They are few and far

            22   between.  When we do, it is typically in conjunction with

            23   solicited ratings from another NRSRO.  So we oftentimes use a

            24   comparing contrast, sort of what does the solicited rating

            25   tell me versus the unsolicited rating, and, by and large,






             1   it's really typically not much differential between them.

             2             So I guess I agree that I don't think it's a

             3   terrible thing, at least not from an investor perspective. 

             4   Maybe from an issuer perspective, but not from an investor

             5   perspective.

             6             We see more private ratings than we do unsolicited

             7   ratings, and, again, I don't have any problems with those

             8   either, but there's really very few of the unsolicited.

             9             I would note that we, at points in time, if we note

            10   that there is an NRSRO missing from a transaction, an issue,

            11   we will ask the one that is missing if they, in fact, have

            12   looked at the transaction and turned it down, and they will

            13   tell us -- they won't tell us that without asking the

            14   question, but if we ask the question, they will answer that

            15   for us, and we find that very helpful.

            16             MR. McCARTHY:  Are the unsolicited ratings

            17   disclosed somewhere?  How do you know it was unsolicited?

            18             MS. CUNNINGHAM:  Typically, the issuer will tell

            19   you that.  The issuer will let you know if it is unsolicited,

            20   yes.  I've never seen it actually in the form of here is the

            21   rating and it's unsolicited.

            22             MR. ROOT:  I would just mention, again, for DBRS,

            23   we do actually put the designation "public information

            24   rating" when it is unsolicited.  So we do make sure that if

            25   anybody is looking at the rating, they will be able to






             1   differentiate between a solicited and unsolicited.  

             2             MR. EGAN:  I'd like to put this on the table. 

             3   There is an article from May 2, 1996, from the Wall Street

             4   Journal and it describes how Moody's issued unsolicited

             5   ratings in the municipal area, whereby apparently the

             6   municipality did not like either the charge or the initial

             7   rating that Moody's gave, and so it didn't decide to hire

             8   Moody's.

             9             Moody's went ahead and issued a punishment rating

            10   for the issuer.  The issuers sued and they were unsuccessful

            11   and the reason why they were unsuccessful is Moody's argued

            12   that the ratings were their opinion and they have the right

            13   to exercise their freedom of speech.

            14             This ties into the whole consolidated aspect of the

            15   ratings field.  If you had a vibrant market with a number of

            16   participants, they couldn't get away with things like this.

            17             Many of the issuers in this case have very little

            18   recourse.  They were forced -- according to this article, it

            19   cost one issuer close to a million dollars additional

            20   interest expense because they couldn't do anything.

            21             It would have been much cheaper for that issuer to

            22   pay the Moody's fee.

            23             So I'm not quite sure what the answer is, but I

            24   think it does tie back in to the consolidated nature.  

            25             We think that, as I mentioned earlier, that no






             1   ratings should be paid by the issuer.  So do with that what

             2   you want, but I can give this reference to anybody who wants

             3   it afterwards.  

             4             MR. McCARTHY:  Any other thoughts on this issue,

             5   this conflict?  

             6             MR. BAKER:  Just one brief comment.  We also

             7   investigated the issue of unsolicited ratings and found that

             8   there was a relatively small percentage that unsolicited

             9   ratings occurred, but there was an overwhelming view, at

            10   least from the issuers, that there would be a clear

            11   demarcation if there is an unsolicited rating, that it be

            12   identified.

            13             We then continued by asking the perceptions of the

            14   accuracy of the rating that was unsolicited compared to those

            15   that may have been ones they paid for.  

            16             Not surprisingly, none of the respondents felt that

            17   the unsolicited ratings were more accurate, because they

            18   have, of course, less information in order to try to come up

            19   with the judgments regarding that rating.

            20             I think the key point here is the importance -- at

            21   least as perceived by issuers, we didn't look at it from the

            22   investor side, of having that clear demarcation as mentioned

            23   by the gentleman to my left.  

            24             MR. O'NEILL:  But I think Deborah probably saw no

            25   substantial difference between unsolicited and solicited






             1   ratings.  I think I heard you say that, Deborah, which, if

             2   you did say that and that is your view, what that speaks to

             3   really is the importance of public information within the

             4   rating process and it really is strong evidence that we in

             5   this country are fortunate enough to have a disclosure that

             6   allows us to make credit judgments, buy/hold stock

             7   recommendations, that sort of thing, based upon the public

             8   disclosure.

             9             So we don't do them, as I say, and if we do them

            10   abroad, we indicate so.  But I think rating judgments can be

            11   made on the basis of the public disclosure.  

            12             MR. McCARTHY:  Our data actually supports that view

            13   in the sense that about 58 percent indicated they believed

            14   the unsolicited ratings were just as accurate as the

            15   solicited ratings, which indicates that public information is

            16   available in order to develop a rating.  

            17             COMMISSIONER GLASSMAN:  I may be wrong in this, but

            18   I thought there was some research that shows that the

            19   unsolicited ratings tend to be lower than the solicited.  Is

            20   that not accurate?  

            21             MR. O'NEILL:  I honestly don't know, Commissioner. 

            22   I'll have to defer on it.  I don't believe they are.  I

            23   actually have not heard that before.  I don't assume they

            24   are.  Again, we don't do them here in the United States. 

            25             MR. REYNOLDS:  I believe that was the case with






             1   asset backed and some of the accusations leveled against

             2   Moody's several years back.  That was the asset backed

             3   sector.

             4             MR. O'NEILL:  I think on the asset backed sector,

             5   there is no widespread public disclosure.  I think at the

             6   beginning of the transaction, the transaction structure.  So

             7   you don't have a database of knowledge on it.

             8             So if a rating agency should rate that on an

             9   unsolicited basis, which is something we would never do, the

            10   tendency would be, I guess, to -- because the information

            11   risk factor, you don't have the information, you might rate

            12   it lower.

            13             It's not an experience that we have.  

            14             MR. HARRIS:  Even if it weren't discounted, even if

            15   they were assigned on the basis of all available information,

            16   there is a significant selection problem in that the folks

            17   who are least likely to ask for a rating are the ones who are

            18   least likely to want to see what the rating would be.  

            19             MR. McCARTHY:  The next conflict, which was touched

            20   on this morning, it's not so much a conflict that affects

            21   maybe the quality of the ratings, but in talking to smaller

            22   institutions, et cetera, there is this perception that the

            23   institutions that may pay more from a subscriber perspective

            24   have preferential access or get information quicker.

            25             I'm wondering if that's a topic from the






             1   institutions.  Are your expectations in paying subscriber

             2   fees such that you feel that you have preferential access or

             3   expect preferential treatment vis-a-vis the information

             4   getting out to the general public?

             5             MS. STRAUSS:  I think we already went over this

             6   this morning, that the agency said that they actually release

             7   more to subscribers in detail in writing to begin with than

             8   they do to the public.  So that's already out there.

             9             We do, which was also discussed this morning, have

            10   access to be able to speak to an analyst and try to

            11   understand their analytical thinking.  So we do have that

            12   access.

            13             Is that something that the broader market is

            14   greatly missing?  I don't know.  I think particularly those

            15   conversations, those are -- because we talked already about

            16   maybe the written piece would be useful, but the

            17   conversations we have are typically kind of an analyst-to-

            18   analyst, my number of share whacks, how come you're doing

            19   this way, and about their criteria, we thought your criteria

            20   was X, how does this foot with that and how does that help us

            21   think in the future about how you're going to meet your

            22   ratings out on this issuer.

            23             I would say that's about 90 percent of what the

            24   verbal conversation is about.  So that's more of an analyst-

            25   to-analyst conversation.  






             1             We get our ratings electronically, Bloomberg. 

             2   They're pretty quickly released now.  In the past, we may

             3   have gotten a little quicker release data, but I don't think

             4   that's the case today.  

             5             MS. CUNNINGHAM:  I would tend to agree.  I think

             6   the discussions we have with the rating agencies is where we

             7   place most of our value and that's what we feel that we're

             8   subscribing for, that's what we're paying for.

             9             Whether that's -- I think what we're getting there

            10   is, as was said before, analyst-to-analyst discussion.  The

            11   general public would not be asking the questions that the

            12   analysts would be asking from an investment firm just because

            13   it's not general -- it's not typically information that they

            14   would have the ability to disseminate and try to interpret.

            15             So that type of conversation is where we derive

            16   most of the value from the subscription fees.

            17             I don't think it at all is a timing issue, though,

            18   because the public dissemination of the rating and any rating

            19   changes occurs just as quickly to anybody that wants to pull

            20   that information as it does to those that subscribe.

            21             It is only in the value of the information that you

            22   get with the analysts afterwards, questioning about that that

            23   we feel that our subscription services are being utilized.

            24             MR. O'NEILL:  And we also make very, very certain,

            25   when we have these conversations, that the information we






             1   impart to these institutions, and we don't limit that, by the

             2   way.  I mean, get dozens of calls from non-subscribers, as

             3   well, I might add, the media and sometimes others.

             4             We don't want to check to see if they're a

             5   subscriber, but the control we have is that the information

             6   that we provide is consistent in that conversation with what

             7   we provide in our printed publications or over the web.

             8             We're not imparting a different set of information. 

             9   Maybe more detailed and what have you, but it has to be

            10   consistent.  

            11             MR. HARRIS:  On occasion, the Commission has to

            12   discriminate between the providers of investment information

            13   and the providers of investment advice.  I am wondering

            14   whether our panelists can provide us with some advice on the

            15   subscriber services that we've been talking about now.  Are

            16   they clearly providers of investment information or are there

            17   occasions where they run into what we might call investment

            18   advice?  

            19             Let me ask the users of those services.  Cynthia?

            20             MS. STRAUSS:  I'm thinking on this, because I'm

            21   trying to understand the distinction between information and

            22   advice.

            23             MR. McCARTHY:  I wouldn't have asked if we weren't

            24   confused ourselves.  

            25             MS. STRAUSS:  Because I do think that what is -- in






             1   this front, the rating is a risk assessment.  I know Moody's,

             2   in particular, says this is just our view, but in essence,

             3   the way it's used in the marketplace, it is used as advice

             4   because it is a forward looking risk assessment and,

             5   therefore, people use it to say, oh, advice on how they might

             6   make their investments, but they don't specifically tell us

             7   how to invest.

             8             So it really is a gray zone.

             9             MR. HARRIS:  To what extent are your communications

            10   personalized for you?

            11             MS. STRAUSS:  We do not -- I mean, it is very

            12   clear, in our mind, that we do not get investment advice,

            13   absolutely not, from them, nor do we look to them.  I think

            14   we think our investments would be much poorer if we did.  

            15             Some of it is timing and some of it is, quite,

            16   frankly, we're in a different business.  They are in a

            17   ratings business, as so described.  We are in the investing

            18   business.

            19             So we spend a lot of time thinking about the

            20   markets and how our securities will perform and what our

            21   shareholders are looking for.  

            22             MS. CUNNINGHAM:  I think this goes back to one of

            23   the discussions we were having this morning, too.  Advice

            24   needs to take into account not just ratings.  That's part of

            25   the input for advice.  But it also needs to take into account






             1   what the market conditions are that are prevailing, what the

             2   spreads are that are in the marketplace.

             3             You may have a BBB issuer that has a very wide

             4   spread that, on an advice base from an investment advisor

             5   standpoint, looks relatively attractive in the marketplace

             6   and, on an advice basis, may be recommended for ownership of

             7   that particular security.

             8             On the other token, you may have a AAA rated issuer

             9   that clearly is much higher in quality, but much lower in

            10   spread and, on a relatively basis, versus other AA or other

            11   AAA types of investments, does not equate value on a relative

            12   scale.

            13             So I think you've got to look at the relative scale

            14   value in taking not only the rating of the issuer, but, also,

            15   the spread and the market conditions that are prevailing at

            16   the time.

            17             MR. ROOT:  Let me add.  One of the things that we

            18   make very clear, as a rating agency, is that people do not

            19   make any kind of recommendation, like this is a good buy or

            20   this looks like a good opportunity.  

            21             You could say that the rating itself does that,

            22   maybe, but we make it very clear that we're not to suggest

            23   that one should buy or sell or make any kind of investment

            24   decision.  That is something we avoid completely.  

            25             MR. FERNANDEZ:  To try and clear this up, I think,






             1   the best and still definitive source for this is Graham and

             2   Dodd from 1934, where they divided into three areas.  There

             3   is information, which is purely descriptive.  

             4             In this context, it's the filings at the SEC,

             5   whether they be twos, threes, fours, 144s, Qs or Ks.

             6             Then you go to the next level, which is analysis,

             7   and this is the advice element of it here, where you are

             8   actually putting together associative values of largely

             9   objective indicators and making some sort of an assessment

            10   based on your best judgment.  So there is an interrupt of

            11   some subjective evaluation that is provided.

            12             Then a third level is valuation and this is purely

            13   one that is a normative judgment here.  In the securities

            14   analysis side, this is where you provide the buy, sell, hold

            15   type of thing.

            16             But to me, I think the distinction is going to be

            17   easily drawn and even easily drawn in credit analysis as to

            18   whether it's securities analysis or risk analysis of any

            19   sort.  

            20             MR. McCARTHY:  Great.  Thanks.  The last thing I

            21   have is rating triggers, which was well talked about this

            22   morning.  

            23             So that's it, unless anyone has something they're

            24   dying to say.  

            25             Why don't we take 15 minutes and then come back. 






             1   Thanks.

             2             (A brief recess was taken.)

             3             MS. NAZARETH:  What I would like to do for this

             4   last session is to promise you that we will either finish

             5   when we're finished as opposed to talking til 4:45, or, at

             6   the very least, we will not end later than 4:45.  But I think

             7   there's a chance that we might be able to finish early and I

             8   think we can do that without embarrassment.

             9             Before I introduce the section on the potential

            10   barriers to entry, Mike Macchiaroli pointed out that there is

            11   one area that is an area of consideration for the report

            12   about which we could use a little bit more input from this

            13   group before we move on to the last topic.

            14             The topic is, and we did touch on it a little bit,

            15   the impediments to the accurate appraisal by credit rating

            16   agencies of issuers of securities.  That really goes to the

            17   question of what information is not public that would be

            18   helpful to be public, and I think Cynthia talked about some

            19   of those things, like loan documentation and the like that

            20   are understanding about ratings triggers and things of that

            21   nature, that perhaps there is not a requirement to be public.

            22   The other issue is, basically, is there some fundamental

            23   information that you find there is resistance on the part of

            24   issuers to giving you this information. 

            25             I think, again, we are being asked to analyze this. 






             1   I know, Frank, you said at the break that you had some

             2   comments to make on this, and then I will call on those who

             3   do credit ratings to tell us their experiences.

             4             MR. FERNANDEZ:  My concern is the same as Mike's

             5   and I think it grows out of the same source, and he spends a

             6   good deal of time watching what our risk management committee

             7   does and our risk management practices.

             8             I think they are quite distinct from the approaches

             9   to risk management that are done by the credit rating

            10   agencies and I'm arrogant enough to think that ours are

            11   superior.

            12             I think, one, they recognize, first that the nature

            13   of risk is dynamic and we are entering a period of very rapid

            14   structural and cyclical change.  That does influence the type

            15   of parameters that lead to payment interruptions and the

            16   frequency of those interruptions.

            17             So the type of analysis one needs to do needs to be

            18   a reflection of where you are at a particular point in time.

            19             The second thing, I think, the most critical

            20   impediment, in my mind, is the one I have already identified. 

            21             It is when we survey research units in how the cost

            22   of producing information and analysis, we find 30 to 35

            23   percent of the overall expenditures are spent on preparing

            24   standard statistical information, and it is done by every

            25   firm over and over and over again.






             1             Oftentimes, sophisticated senior analysts are

             2   simply taking numbers down from one source, reformatting them

             3   and putting them into another.  It's a huge economic

             4   efficiency loss.  

             5             That could be remedied by improving the

             6   organization processing and display of basic financial

             7   information filings.  

             8             The last impediment, I think, that exists that I

             9   think is significant, there's lots of them, but the

            10   significant one here is -- and then I get to be critical of

            11   S&P -- is the mix between evaluation and prospective views

            12   here.

            13             I think they seem to concentrate more on the

            14   current period and use -- I believe Mr. Fisher, in a recent

            15   speech, brought this point up.  Rather than looking out

            16   prospectively and the forecasting element of this, and it's

            17   almost like an 80/20 mix, it's often been described as that.

            18             I think more weight has to be given to prospective

            19   payments problems.  I think scenario analysis has to be used

            20   more exhaustively.

            21             One thing I have learned in the last few years is

            22   that anything you can conceive as a worst case is easily

            23   realizable and it is much more prudent to plan for those

            24   worst case estimates and be proven wrong than to neglect them

            25   and try and shoot for the middle of the road outcome.






             1             So these are not small things, because it changes

             2   the way you process information and the type of analysis that

             3   you apply.

             4             Leo?

             5             MR. O'NEILL:  Sure.  The whole thrust of what we do

             6   is to try to get it right and try to get it accurate.  I

             7   think we, obviously, input into our process a view of the

             8   future.  Obviously, you have to do that.  The bonds are going

             9   to be paid in the future.

            10             I think what the issue is really is that the future

            11   these days becomes -- I think the word that has been used

            12   many times today, much more volatile, much more difficult to

            13   predict, certainly much less reliant than perhaps in more

            14   stable economic times.

            15             So I think we try to do, Frank, what you are

            16   suggesting what we do and, obviously, as you might expect, I

            17   think we do it right.  But I think we would all agree that

            18   judging the future in these times is extremely difficult and

            19   you do so -- if you try to do it precisely, you do get into

            20   difficulty.

            21             On a somewhat light note, but accurate not, I think

            22   this whole idea of analysts in dealing with the statistics

            23   and -- I think there's a cultural thing that I have seen

            24   that's been around for about 35 years.

            25             The analysts like to do their own numbers, for some






             1   reason, and we really have this wonderful database called

             2   Compustat and we can provide these numbers any way the

             3   analysts want to see them and we stand ready to do that.

             4             Yet, we still, I'm sure, we do at S&P have analysts

             5   that still are cranking the calculator.  The only thing they

             6   don't do is flip it anymore.  

             7             I don't know how to get to that one.  But I do

             8   think the street pays an enormous amount of money on research

             9   and that perhaps is a discussion for another day on

            10   independent equity research and the amounts that are going

            11   there.

            12             But I think it's a real issue that needs to be

            13   addressed.  Again, I don't know anyone else -- 

            14             MR. ROOT:  Let me just add, from DBRS, a couple

            15   things.  Again, I tend to agree with Leo.  We try to make our

            16   ratings forward looking, prospective, but at the same time,

            17   maybe just in your issue there, Frank, you've got to build in

            18   what you think is a reasonable scenario, because ratings are

            19   just as wrong if they're too low as if they're too high and I

            20   think that's important here, because I know the focus today

            21   is on ratings that, after the fact, maybe were too high, but

            22   you want to be accurate.  That's the key.

            23             One can sit back and take a very pessimistic view

            24   of the future, rate everything very low, and then when a

            25   couple credits go bad, you raise up and say, boy, I got that






             1   right.  But what about all the others that you got wrong? 

             2   Noone talks about that.

             3             So I think the key is to try not to get too extreme

             4   on your prospective views, because I think that can be very

             5   dangerous, but, again, communicate what you are

             6   incorporating, what your scenario is for your ratings.

             7             This way, when I convey that, communicate that to

             8   whomever, if you're going to think that auto sales, to use an

             9   example, sorry, Malcolm, are going to be -- we think they're

            10   going to be 16 million or 16 and a half, and you think

            11   they're going to be 14, then you should maybe adjust

            12   accordingly.

            13             Another thing that we do in our written analysis is

            14   we do stress testing.  What if scenarios.  Not in a

            15   predictive nature, in the sense that we're suggesting that

            16   these things will happen, but as a means to show that if

            17   certain environments or issues do happen, what are the

            18   potential implications, assuming all other things being

            19   equal.

            20             So, again, I think the key is kind of what Leo

            21   says, the key is to try and be correct.  Again, we use our

            22   judgment, professional judgment and opinion, and that's why

            23   transparency is key and, again, trying to be accurate on both

            24   sides is as important in this whole issue as just trying to

            25   guess the next problem.






             1             That's my view.  

             2             MR. FERNANDEZ:  Still not to forget, though, that

             3   the great impediment to this recently, and will be again,

             4   will be the garbage in garbage out problem.  Until we get the

             5   corporate governance issues and the accounting issues solved,

             6   you're not going to improve the systems at all.  

             7             MR. REYNOLDS:  Just in terms of frustration on

             8   getting information flows.  We very often have to depend on

             9   the rating agencies.  A couple areas where we just know the

            10   disclosure is not adequate, it is garbage in and garbage out,

            11   also. 

            12             But the typical credit analyst is different than

            13   the typical equity analyst.  They tend to be less optimistic,

            14   saying we smell flowers and look around for a casket.

            15             But the main point is we need to get the downside

            16   scenarios covered.  Loan documentation was already addressed. 

            17   A lot of companies do not provide that information and

            18   structural risks have been real makers and breakers in this

            19   market, and we need to know if the agencies have looked at

            20   it.

            21             On the other side of the Reg FD wall, they can at

            22   least say they've looked at it.  So we can be aware, so we

            23   don't have to guess.  We don't have to necessarily provide

            24   that disclosure.

            25             On counter party credit, which has blown up the






             1   better part of the power sector this year, there the

             2   disclosure is wholly inadequate.  So if they have looked at

             3   the collateral postings and the liquidity flows within that

             4   business, we just need to know they have done that.

             5             I think it's possible to have faith in a third

             6   party to have done the work, but too often they don't

             7   highlight that that work has been done, because they hold the

             8   dialogue with the issuer, hold it confidential, and, very

             9   often, and we had this discussion directly with some senior

            10   people at Moody's, they said we won't even tell you the

            11   questions we've asked, which doesn't necessarily help when

            12   we're trying to make assessments.

            13             Another area, and this would probably be the last

            14   one I would highlight, is asbestos.  It is going to be the

            15   crippler of many cooperates right now and there is a

            16   tremendous amount of disclosure in terms of litigation with

            17   insurers, numbers of claims, the spread of the claims, two

            18   different legal venues.

            19             We don't have that information and maybe the

            20   agencies can at least take a look at it, because until the

            21   disclosure issues are addressed, it's going to continue to

            22   lurk as a confidence breaker in the market right now.

            23             MR. O'NEILL:  I think, again, our objective is to

            24   disclose all of the rationale, background data, whatever it

            25   is that supports the rating.






             1             I want to make sure that we are clear, and we have

             2   to be careful.  We are not the disclosure agency for issuers. 

             3   I mean, if there is valuable information that should be in

             4   the marketplace, I think they have the full first obligation.

             5             Our obligation follows close behind, and that's to

             6   make sure the market understands what it is we're rating, why

             7   we did it, and when we have more work to do in that, hey,

             8   give me a call, we'll set up a meeting, and we'll go to work

             9   on it and see if we can get this information to you.

            10             MS. NAZARETH:  Yes, Sean.

            11             MR. EGAN:  I think there should be more disclosure

            12   in the area of future pension fund liabilities.  It's not

            13   very good.  I think I'm sitting next to the right person

            14   here.

            15             Also, future -- 

            16             MR. MACDONALD:  I hope to retire soon.  You're

            17   quite right.  

            18             MR. EGAN:  I set you up for that.  

            19             MR. MACDONALD:  A few questions on the SEC and your

            20   retirement package would be welcome, maybe.  Just a couple

            21   routine questions.

            22             MR. EGAN:  Also, the liabilities for retiree health

            23   care costs, that hasn't been disclosed properly.  We don't

            24   like just one number, but give us the underlying assumptions,

            25   what kind of rates of return are being assumed in the pension






             1   fund, how quickly they're growing, so that people can do

             2   their own independent analysis.  

             3             Also, asbestos liabilities.  There are some

             4   companies that have significant asbestos liabilities.  They

             5   are not disclosing them because they, for whatever reason,

             6   they think that they can win the cases.

             7             So we think this is a problem.

             8             Lastly, in the asset backed market, there should be

             9   some kind of centralized data gathering source that is

            10   available to all investors in the market and make it much,

            11   much easier.

            12             You have a whole set of guidelines in the corporate

            13   area for filing 10-Ks, 10-Qs, 8-Ks, whatever, and you don't

            14   have the similar regulatory structure on the asset backed

            15   side.

            16             We saw some huge downgrades, I think it's probably

            17   a 12 notch downgrade for a major issuer within the past two

            18   weeks.  If we had that information available on a regular

            19   basis, we would have much deeper participation, you would

            20   have much more efficient markets.  

            21             It's a huge hole, from our perspective, in the

            22   financial markets.

            23             MS. NAZARETH:  Thank you.  I think we will switch

            24   now to our last topic, which is potential barriers to entry

            25   and regulatory treatment. 






             1             Just to tee it up a bit.  As you know, and it has

             2   been stated several times here today, this NRSRO concept that

             3   the Commission uses has found its way into not only the

             4   federal securities laws, but a number of other regulations,

             5   as well.

             6             To assess whether a rating agency may be considered

             7   an NRSRO for purposes of the Commission's rules, the

             8   Commission staff considers a number of criteria.

             9             The single most important criterion is that the

            10   rating agency is nationally recognized, which means that the

            11   rating organization is widely accepted in the United States

            12   as an issuer of credible and reliable ratings by the

            13   predominant users of securities ratings.

            14             Plus, the designation is intended largely to

            15   reflect the views of the marketplace as to the credibility of

            16   the ratings rather than to represent a seal of approval of a

            17   federal regulatory agency.

            18             As you know, the staff also considers and reviews

            19   the operational capability and reliability of each rating

            20   organization, and I won't go into all those criteria right

            21   now.

            22             Although the number of firms designated as NRSROs

            23   increased from three in 1975 to seven in 1991, as we said

            24   earlier today, we are back down now to three by virtue of

            25   consolidation.






             1             Several observers have commented that the national

             2   recognition requirement creates a barrier to entry for new

             3   credit rating agencies.  Generally, this argument is based on

             4   the premise that users of securities ratings have a

             5   regulatory incentive to use ratings issued by NRSROs rather

             6   than those that don't have the designation, so that new

             7   entrants don't find it difficult to achieve national

             8   recognition without having the designation in the first

             9   place.

            10             Because of the quasi public responsibilities of

            11   rating agencies, the importance given to ratings by investors

            12   and other market participants and the influence of ratings on

            13   the securities markets, we will also focus this afternoon on

            14   whether rating agencies should be subject to greater

            15   regulatory oversight or whether other adjustments should be

            16   made to the Commission's regulatory approach to rating

            17   agencies.

            18             Since the Commission began using credit ratings in

            19   its rules and regulations, it has considered a number of

            20   issues regarding oversight of credit rating agencies.

            21             Ten years ago, the Commission seriously considered

            22   whether it should seek from Congress more direct oversight

            23   authority of credit rating agencies, given the increased role

            24   in the financial and regulatory systems.  The Commission, at

            25   that time, did not reach a consensus on the need for






             1   regulation.

             2             In 1994, the Commission did, however, issue a

             3   concept release soliciting public comment on the appropriate

             4   role of ratings in the federal securities laws and the need

             5   to establish formal procedures for designating and monitoring

             6   the activities of the NRSROs.

             7             The Commission received 25 comment letters in

             8   response to that release, which generally supported continued

             9   use of the concept, but recommended that the Commission adopt

            10   a formalized process for approving NRSROs.

            11             Commenters generally opposed additional regulatory

            12   oversight of NRSROs at that time.

            13             In 1997, the Commission published a rule proposal

            14   that would have adopted a definition of the term NRSRO, that,

            15   among other things, set forth the criteria a rating

            16   organization would have to satisfy to be acknowledged as an

            17   NRSRO.

            18             Generally, under the proposed amendments, the

            19   Commission would consider the same criteria currently used by

            20   the staff in the no-action letter process.

            21             To a large extent, the proposal was designed to

            22   bring greater transparency to the existing process and to

            23   provide for a formal appeal process.

            24             The Commission, as of yet, has not acted on that

            25   proposal.






             1             So with this background, I hope our discussion with

             2   regard to regulatory oversight will shed light on two key

             3   issues.  First, whether rating agencies should be subject to

             4   additional regulatory oversight, and, if so, the appropriate

             5   form of such oversight.  Secondly, if participants believe

             6   that the NRSRO framework has merit and should be retained,

             7   whether the Commission should adopt its 1997 proposed rule

             8   amendments or if it should adopt additional rules to fine

             9   tune that framework.

            10             But I thought where we would begin is a topic that

            11   has been alluded to several times earlier today, which really

            12   goes to the barriers to entry in the business of acting as a

            13   credit rating agency.

            14             Some here have said that there are some natural

            15   monopolies.  I think it would be interesting at some point in

            16   this discussion to impose upon Gay to tell us what is it like

            17   in the world out there that doesn't have this designation and

            18   to learn, because clearly somewhere else in the world, people

            19   have figured this out.  

            20             Obviously, we're hoping to get some light shed on

            21   this.

            22             Frank, you seemed to have some views earlier about

            23   the sort of the economic model here.  Do you think there are

            24   barriers to entry?  Do you think there are some natural

            25   monopolies?






             1             MR. FERNANDEZ:  Yes.  I think there are some very

             2   high barriers to entry with respect to the NRSRO designation. 

             3   Some of them I believe are natural, some I believe are

             4   necessary.

             5             For example, the NR aspect of it.  I think if you

             6   didn't have that, the market would have to invent it, because

             7   by the very nature of having a bond rating, there has to be

             8   generalized acceptance of it in the mind of the investors.

             9             I think you see that by the consolidation that has

            10   occurred and by the fact that only a small percentage use

            11   Fitch.  We find that investors and issuers themselves seek

            12   out the two largest, simply because of the name recognition.

            13             So that constitutes a barrier of entry, because it

            14   takes years, it takes substantial financial resources to

            15   persist and grow large enough and to have broad enough

            16   overage over that period of time to obtain national

            17   recognition.

            18             So NR does impose that, but it may be a necessary

            19   barrier.  That's why I say there is a certain natural degree,

            20   because, if you're going to use a benchmark or a shorthand

            21   definition that you can apply that is easily recognizable, it

            22   has to be nationally recognized.

            23             COMMISSIONER GLASSMAN:  Is it possible to be

            24   nationally recognized, but not have a broad national scope?

            25             MR. FERNANDEZ:  You mean regional?






             1             COMMISSIONER GLASSMAN:  Either regional or in the

             2   industry sector.  

             3             MR. FERNANDEZ:  That does exist and those people

             4   are used and they provide a useful service and are a natural

             5   provider, and some of them have extremely high standards. 

             6             But that's not the same thing as providing a bond

             7   rating system.  

             8             MS. CUNNINGHAM:  Those are all the ones that have

             9   been consolidated into Fitch, too.  

            10             MR. FERNANDEZ:  Yes.

            11             MS. NAZARETH:  We actually designated NRSROs in a

            12   particular industry sector, for instance, with Thomson. 

            13   Greg, you can tell us.

            14             MR. ROOT:  I've had the luxury of having this NRSRO

            15   experience probably as much as Mike has.  I've become an

            16   authority on this.  

            17             But let me say a couple things, because I think it

            18   is certainly very important.  I think the barriers to entry

            19   need to be high as long as there is going to be an NRSRO

            20   designation and ratings are going to play the role they do. 

            21   They need to be high.  Not insurmountable, but high.

            22             So I think that's appropriate, however you want to

            23   define that.

            24             Is it virtually impossible or whatever to become an

            25   NRSRO?  No.  Again, I look at my previous employer, Thomson






             1   BankWatch, and, again, going to the issue of national

             2   recognition, as well.  I mean, we were a specialized agency.

             3             Actually, at that time, we didn't even -- we rated

             4   companies.  We didn't rate specific issues initially.  But I

             5   think the fact that we, over a period of time, provided what

             6   is viewed as a credible, valuable service in the marketplace

             7   and had all the other attributes, which I think are

             8   absolutely crucial to becoming an SRO, we were able to gain

             9   that recognition, as were some of the other firms.

            10             So I think the issue is not so much are the

            11   barriers to entry high.  I think the issue of national

            12   recognition is one that needs to be looked at for the

            13   reasons, because I don't believe you have to do everything to

            14   be viewed as a credible and invaluable provider of ratings

            15   within the context of what NRSRO is meant to do here in the

            16   United States.

            17             But, again, as I alluded to in my opening comments,

            18   I think the important thing, which you mentioned in your

            19   statement, and going back to 1997, the key is to define

            20   this, so at least people know what the ground rules are and

            21   what it takes to get there.

            22             Now, you don't want a situation where the barriers

            23   are so low, where you have an influx of participants that can

            24   destroy the whole concept of what NRSRO is meant to do, and I

            25   think that is very effectively in the marketplace.  






             1             So we really -- again, I went through this actually

             2   twice, believe it or not, and now with Dominion Bond Rating,

             3   we're, obviously, very involved and interested in this whole

             4   process.

             5             So I think if you want to say what's broken, I

             6   think what's broken is the fact -- I hope and I think that

             7   the people in SEC would agree that let's define this thing

             8   and have a clear road map for how you get there, and I think

             9   everybody would be better off.

            10             So I think the comments that were made, I think, by

            11   most constituents back in 1997 should be very seriously

            12   looked at and, in my view, obviously, adopted, and I think it

            13   will be for the betterment of this entire process. 

            14             COMMISSIONER CAMPOS:  Could I jump in here just a

            15   little bit?  Would it be wrong, if anything, if our

            16   definition at the SEC were to permit, under the nationally

            17   recognized standard, and maybe some could argue it already

            18   does, a specialized narrower scope, much as your prior

            19   employers were in, and if we ended up finding a way to

            20   encourage entry, albeit maybe in a specialized way?

            21             Maybe we are in a new era in terms of fast moving

            22   companies that are reaching prominence.  Capital can be

            23   raised quicky if somebody saw a business plan, an

            24   opportunity.

            25             There is no reason, it seems to me, that capital






             1   couldn't be put together to create another rating agency.

             2   What's wrong with that picture if that were to occur?

             3             MR. O'NEILL:  Speaking as one who -- we have the

             4   designation, I don't think there is really anything wrong

             5   with that, quite frankly.  I think the key is to have -- and

             6   Greg said it quite articulately -- to have an open and

             7   transparent process with clearly defined criteria as to what

             8   it takes, and I think the criteria really should begin with

             9   market recognition, that your ratings are used, that the

            10   investors and people at this table use those ratings, like

            11   those opinions, and they use them in their own investment-

            12   making decisions.

            13             And the other part of it is that the ratings are

            14   derived independently and objectively and that process is

            15   transparent, as well.  

            16             So I think, from Standard & Poor's standpoint,

            17   that's more of a critical need than it is to elect barriers

            18   that prevent other entrants into the marketplace.

            19             We think other entrants should be in this market,

            20   absolutely, and we just want to make sure that the process is

            21   open and it's transparent.

            22             Eventually, you will hear, I think, if you haven't

            23   already, that one of the concerns is this rating shopping,

            24   that agencies get in and they give high ratings and other

            25   rating agencies who may be calling it like it is don't get






             1   the business, that sort of thing.

             2             That might happen short-term, that could happen,

             3   but I think ultimately the market sorts it out and the market

             4   will recognize it and the market will do its thing for that

             5   rating agency.  

             6             Of course, that may not be very helpful for the

             7   Securities and Exchange Commission, who designated that

             8   NRSRO, but -- 

             9             MS. NAZARETH:  Also, it's a problem from a

            10   regulatory perspective if it's being used for regulatory

            11   purposes to sort of take a shot at it.

            12             COMMISSIONER GOLDSCHMID:  Let me follow up on this

            13   nationally recognized designation.  The second part of what

            14   you were saying, Leo, in terms of quality and independent,

            15   that kind of ground rule I understand.

            16             But why do you need nationally recognized as

            17   opposed to regionally recognized or not nationally

            18   recognized?  When I do a startup, I put together a large

            19   organization, the highest quality.  I don't have a customer

            20   out there, but I'm going to get them, or at least I hope so,

            21   and the market will work, presumably, if I've got quality and

            22   people think it's going to be reputable,  presumably people

            23   will come to me.

            24             If they don't, the market has said something, too. 

            25   Why wouldn't that work perfectly well?  






             1             MR. O'NEILL:  I think the two words national

             2   recognition were first used without a great deal of thought. 

             3   I think noone ever contemplated that would be a subject of

             4   discussion 25 years later at the Securities and Exchange

             5   Commission.  

             6             I don't adhere to national recognition.  There are

             7   some great institutions out there with some great research

             8   and I think they have market recognition.

             9             I think the larger issue, though, is the one

            10   Annette was mentioning, is how you put these ratings into the

            11   regulation or whatever and then it's is the quality

            12   maintained.  It creates -- I think eventually it sorts out,

            13   as I said, but it doesn't -- I don't think it's very helpful

            14   in a short term situation.

            15             MR. ROOT:  If I could just add.  I think, again,

            16   because of the importance of the NRSRO designation and the

            17   implications of the ratings, I think having a track record is

            18   very important because nothing to say that a startup company

            19   couldn't get there, but I do think because of the importance

            20   and the influence of ratings in this context, I think it's

            21   very, very important to have an established track record over

            22   an extended period of time, in addition to having all the

            23   other -- 

            24             MS. NAZARETH:  If I could just go back for a

            25   second.  Obviously, were we not using this designation for






             1   certain regulatory purposes, such as letting broker-dealers

             2   take lower haircuts on their capital because of positions

             3   that are investment grade, if we could throw it out for

             4   regulatory purposes, then, obviously, you could just let the

             5   marketplace decide. 

             6             So let the best rating agency win.  Whoever gets

             7   the most business, obviously, that is showing that people

             8   have a high degree of faith in that rating agency, which is

             9   why they're going there.

            10             But we've got this reverse situation.  Rightly or

            11   wrongly, many years ago, the Commission started using this

            12   designation as a proxy for the fact that the marketplace

            13   found certain of these rating agencies to be credible for

            14   purposes of letting, for instance, broker-dealers enjoy

            15   certain capital benefits, if some of the securities in their

            16   portfolios had certain ratings that were not shopped for, but

            17   obtained from nationally recognized agencies.

            18             Unfortunately, what happened with that was it

            19   became such a handy proxy, it was used not only for a variety

            20   of other purposes at this agency, but I'm sure, as Gay said

            21   earlier, it's not NRSRO per se, but the concept of the

            22   importance of credible ratings, and they have a different

            23   proxy of what credible is, I guess, in the new Basel accord.

            24   It's being used for any variety of purposes worldwide.

            25             So I think our dilemma is how do we balance it.






             1             Do we sort of throw out the NRSRO designation and

             2   try to find another proxy for this?  If there was, I know

             3   some economists have talked about, well, why don't you use

             4   credit spreads, just let the marketplace.

             5             Well, that doesn't work for new issues.  

             6             MS. STRAUSS:  I think there is something of a core,

             7   simple concept here:  that credit research is not easy.  It

             8   is not something that someone can assign themselves as a good

             9   credit analyst.  It is very difficult and the only way you

            10   have credibility is if you're able to mete it out with

            11   discipline and some success over time.  I mean, that's the

            12   way it goes everywhere.  

            13             So, unfortunately for this situation, someone has

            14   to have a proven track record and you can't let them self-

            15   assess that they're good at this.  I think the best way to

            16   lower the barriers, as many of us have said, is to possibly

            17   make it a more specialized area, because that also parallels

            18   how complicated research is today, that deeper specialization

            19   can ever bring better insights.

            20             Again, we have some great ones from those that

            21   started specializing in financial institutions.  There's a

            22   reason for that.  There are big issuers and they're

            23   complicated.  They are some of the tougher things to analyze,

            24   and that's why IBCA and Thomson got their start there.

            25             So I think perhaps encouraging, in many of our






             1   specialized areas, perhaps even asset backed or real estate,

             2   there's lots of areas, I think that could help what somebody

             3   saw and have a credible -- 

             4             I wasn't around for the national designation, when

             5   that came to fruition, but I think what it means is it's

             6   broad.  It has recognition, because it's good.

             7             COMMISSIONER GOLDSCHMID:  I take it you would look

             8   at their credentials, too, though.  In other words, we do use

             9   credentials in all kinds of areas, whether it's a member of

            10   the bar or wherever else.

            11             You might look at their credentials and have

            12   specialized areas and let them grow.

            13             MS. STRAUSS:  No.  I would say, unfortunately, good

            14   credit analysis is, like any analysis, there is no credential

            15   for it.  I mean, look at long term capital, look at other

            16   situations.

            17             Having great degrees in intelligence doesn't mean

            18   you have the discipline, the understanding of it, and a lot

            19   of this just takes discipline in doing it day in and day out

            20   and not losing your heads with the markets overly influencing

            21   you.  

            22             As all markets are more volatile, I see that's a

            23   big challenge for even our very well respected existing

            24   agencies.  It's tough. 

            25             But if you go in there, you show you understand the






             1   basics and you have the disciplines and are able to attract,

             2   as many are starting to do here, good talent, which means

             3   good talent attracts good talent, I want a big research job,

             4   that's the way you do it.  

             5             COMMISSIONER GLASSMAN:  Don't we have a chicken and

             6   egg problem here?  Isn't it difficult to grow, no matter how

             7   good you are, if you don't have the designation?  And, if you

             8   can't have the designation without a track record, then how

             9   do we ever get past where we are? 

            10             MR. EGAN:  I have a rating firm that we started, I

            11   guess the base firm was started about ten years ago, we

            12   started issuing ratings in December of 1995.

            13             We commissioned a survey of all the major users of

            14   credit ratings and the result of it -- we asked the question

            15   which other firm besides the current NRSROs do you recognize

            16   as issuing timely, credible ratings.

            17             Our name came up more than four times more than the

            18   next firm.  So my point is that it's possible to establish

            19   yourself in the market, to grow the firm, to get the critical

            20   mass, to have a sustainable operation.

            21             We have no problems, even when my partner refers to

            22   the NRSROs, no room, standing room only, we have no problems

            23   with the current rules as they are stated in 1997 or 1999.

            24             Our problem is the way that we are applied.  When

            25   we got into the process, and some of the criticisms are fair,






             1   but we feel as though the investors are intelligent.  The

             2   regulators should respect the regular users of these ratings

             3   as to whether or not a firm is nationally recognized.

             4             Don't need to get into how many analysts we have

             5   and whether we're more efficient than Standard & Poor's.  We

             6   have to be.  Otherwise, we won't survive.

             7             So we have established in the corporate area a very

             8   strong position to the point where many institutions will not

             9   invest in securities until they hear our ratings, and they'll

            10   throw out the ratings of what they consider to be the

            11   conflicted firm.

            12             So I think it's possible, in the corporate area, to

            13   establish a major national presence and it is just the issue

            14   of how big we have to be.

            15             We continue to grow, but we would like the rules to

            16   be applied in such a way that some of the non-conflicted

            17   firms can get into the NRSRO designation.

            18             MS. NAZARETH:  Greg, did you want to address the

            19   issue?

            20             MR. ROOT:  I just had a point here.  I don't think

            21   you actually have to do anything to establish credibility in

            22   the credit markets.  Basically, the way to get in, as well,

            23   is, in addition to -- is provide valuable research. 

            24             Basically, my view is the marketplace works.  If

            25   you provide a valuable service and you're effective in your






             1   execution and delivery, then the market will reward that, if

             2   you will.

             3             So you don't necessarily have to have rating

             4   authority, if you will, to establish and build credibility in

             5   a segment of the market, whether it be fully across the board

             6   or regionalized or certain industries or others.

             7             So, again, I'll go back to my predecessor, the

             8   BankWatch days, and, again, we were recognized as having very

             9   strong analysts who understood banking and that was the

            10   entry. 

            11             It wasn't the rating that got us into the business. 

            12   It was having good analysts who understood a very important

            13   segment of the market in a group.  

            14             MS. NAZARETH:  It was our experience with Thomson,

            15   I think, that Thomson had become very large and credible

            16   through the research side and, in fact, obviously, with the

            17   soft dollar business, there's plenty of money out there to be

            18   used for good research that people want and that that is how

            19   they grew and gained the national recognition.

            20             Maybe, Gay, you could talk about the European

            21   experience.  Obviously, you're not burdened with this

            22   designation, but maybe you can tell us how it works there.

            23             MS. EVANS:  There is quite little to say, I must

            24   admit.  I don't think the UK regulation actually creates any

            25   special regimes for any rating agencies.






             1             So we have no specific barriers to entry other than

             2   the normal commercial ones that we've talked about.

             3             Now, whether that's right or wrong, that's sort of

             4   something I think I mentioned earlier, Basel is going to

             5   change that, if Basel II goes through, but I'm not saying

             6   that we don't have a regulatory regime going forward.

             7             But what we do have now clearly is that it's a low

             8   key -- it's very hard to say this, because it's low key use

             9   of ratings and regulation.

            10             What they have done is a group of agencies, what we

            11   call and what are recognized for that purpose, and the

            12   criteria for inclusion into that is what they call market

            13   recognition.

            14             It's just pure market recognition.  It's based on a

            15   survey, not done by the regulators, of which agencies are

            16   used by banks for these purposes. 

            17             Now, we don't have the same issues, because the

            18   rating culture was not big in Europe and the UK until

            19   recently.  It has been growing recently with the enhancement

            20   of more U.S. institutions in the UK, but in the past, it's

            21   not been one of those things that one has wanted to -- they

            22   haven't used, and some of the foreign countries and European

            23   countries still don't use rating agencies at all.

            24             So they do a survey and right now the UK recognizes

            25   probably more than ten agencies and that is more than any






             1   other Basel banking committee.  

             2             There are probably at least about a 150 agencies in

             3   total around the world and they vary in size and scope.

             4             There is one that was brought to my attention,

             5   which is, in comparison to your service, they have about a

             6   160 analysts and they rate less than 800,000 companies or

             7   just a little over 750,000 companies.

             8             But they do it purely on an analysis of the

             9   financial data and that is well regarded and it is

            10   effectively, what I've been told, extremely transparent in

            11   terms of what are the criteria you use.

            12             So people can say this is the criteria we like,

            13   this is what we need, and if we want to add anything else to

            14   it, we can do so.

            15             So we in the UK have not done much to date at all,

            16   because there is no where in our regulation that mandates

            17   that we should do anything.

            18             Now, where we do do a little bit, I think, is

            19   listing rules.  It just goes back to the conversation from

            20   this morning about FD.

            21             In the UK, the rules surrounding selective

            22   disclosure do not allow companies to give any kind of

            23   information to the rating agencies.

            24             Now, I must admit, we, in our listing review which

            25   is underway, are under an immense amount of pressure from






             1   many institutions to change that with regard to Reg FD.  So

             2   being here today and listening to all this has been very

             3   valuable.

             4             Also, there are a massive amount of directives

             5   going through Europe right now with regard to financial

             6   regulation, one being a market abuse directive, and that is

             7   considering right now who and what receives this kind of

             8   privileged, selective information.  

             9             There has been a lot of discussion on whether

            10   rating agencies deserve that or not.  So it's coming all the

            11   way around from the UK to Europe, but I can say, at this

            12   point in time, our regulation doesn't create any special

            13   regimes.  So what's done is very, very minimal.  

            14             COMMISSIONER CAMPOS:  I'd like to pose a question. 

            15   Would there be anything wrong if, in our interpretation of

            16   nationally recognized, that we took into account the

            17   individual members of the credit agency.

            18             So for example, if people who had been in the

            19   business for a while were to make up a new company and they

            20   individually had years of experience doing credit ratings and

            21   having that expertise, could we give that particular firm

            22   the designation if these people had done work on a national

            23   basis and not worry if it was a startup, if it had otherwise

            24   capital to do business?

            25             MS. NAZARETH:  Maybe it would be helpful if I go






             1   through, because I skipped over it rather quickly, what the

             2   criteria is that we do look at.

             3             COMMISSIONER CAMPOS:  You're not going to let them

             4   answer my question.  

             5             MS. NAZARETH:  It actually is something that is

             6   taken into account, but it's only one of the factors.  The

             7   size and experience and training of the staff is an important

             8   factor, although, obviously it's something that requires

             9   judgment, which is part of the problem. It puts us in a

            10   position of, to some extent, anointing somebody with this

            11   designation.

            12             The best thing I heard from Gay is that they

            13   figured out a way to be out of the business entirely, which

            14   certainly would be the preferred approach.  

            15             The approach that we have is intended to be sort of

            16   a proxy for the marketplace making the determination, but it

            17   inextricably puts us in the middle.

            18             I think the factor that you raise, I mean, others

            19   can opine as to whether they think it's the correct factor,

            20   certainly is a factor in what we consider today, but we don't

            21   give weight as in, well, you've got so many experienced

            22   people that you don't have to have a history in this entity.

            23   Maybe someone like Deborah could say how you would view

            24   something like that as the buy side.

            25             MS. CUNNINGHAM:  I would rather go back to the






             1   specific industry or concentrated one more so than that one.

             2   That one I haven't really thought about.  It inherently makes

             3   a little bit of sense to me, but I would like to think about

             4   it a little bit more before I give you an answer.

             5             From the specific regional or specific industry or

             6   sector side, going through that particular mechanism, I think

             7   the danger lies there in what happens when that entity that

             8   is specified or is particular to one sector decides to go

             9   forward.

            10             And I think we've actually seen this, to some

            11   degree, when Keefe was analyzing banks.  That grew into

            12   broker-dealers.  That grew into ultimately finance companies,

            13   and I'm not sure whether those all link together of one sort

            14   or not, but the original recognition from an NRSRO standpoint

            15   for Keefe was through the banking world.

            16             Effectively, when Mercury Finance defaulted, it was

            17   considered a first-tier entity.  One of the NRSROs that

            18   gave it a first-tier designation was Keefe, and the question

            19   was, was that because of their experience in that finance

            20   company sector and as an NRSRO designee?  Were they thought

            21   about as being a broad-based designee versus an S&P and a

            22   Moody's?  Or were they thought of as being just simply a

            23   banking designee and somebody didn't realize the disconnect

            24   between those two?

            25             I think that is the danger that you run into when






             1   you're talking about specified firms.  You have to have a way

             2   then of disseminating to the marketplace what the specifics

             3   are of each of these.

             4             This is an NRSRO for just the Midwest region, this

             5   is an NRSRO just for municipalities, this is an NRSRO just

             6   for electric utilities.

             7             There's a whole host of other questions and

             8   problems in disseminating that information, I think, that

             9   comes about when you go that route.

            10             I don't think it's a bad route.  I think it poses

            11   other problems as to how you disseminate that information

            12   properly, so that people aren't using it in a way that is not

            13   appropriate.  

            14             MR. ROOT:  I'm not going to defend the Mercury. 

            15   Other than that, we were not alone.  It was one situation,

            16   but we were not alone.

            17             MS. CUNNINGHAM:  And, actually, we were kind of

            18   surprised how it -- it wasn't an issuer that we owned or

            19   followed and when we kind of reviewed the facts, we were kind

            20   of surprised about it.

            21             MR. ROOT:  And, again, going to, I think the common

            22   -- in general, we're not flawless, but I think the important

            23   thing, again, is -- you know, we had this discussion at

            24   Thomson with the SEC.

            25             To me, the issue is being recognized as a rating






             1   agency.  Let me use the argument I used at the time when we

             2   were first designated.  

             3             We were rating financial institutions and that's

             4   what we were given clear designation for.

             5             Then all of a sudden, the dot-com world grows up. 

             6   Now, no offense, Leo, but S&P had no history of following

             7   dot-coms.  Why should they be allowed to follow dot-coms with

             8   potentially inexperienced people - - I'm not saying you

             9   would, but -- and where we may have gone out and hired far

            10   more experienced people. 

            11             So to me, being in that world, we're coming to the

            12   regulatory aspect or whatever, but I think the key, again,

            13   even if you get the NRSRO, is you're not going to get very

            14   far if you don't have credibility.

            15             So I think the key is if you want to try and expand

            16   outside of what you are currently doing, the key is that

            17   you're doing it the right way, with the professional people. 

            18             And to the extent you do it the right way, the

            19   market will accept that.  And if you do it the wrong way,

            20   people like yourself, with user ratings, will see through

            21   that.  

            22             So I think that's the important thing.  You start

            23   with the company as an agency.  I don't think the SEC would

            24   want to go into each segment and say, okay, you guys do a

            25   good job in this sector and not so good here and that type of






             1   thing.

             2             And, again, obviously, as a company in this whole

             3   process, obviously, our motivation is to do everything right

             4   if we're going to be successful.

             5             So, again, we may have made some mistakes, but the

             6   point is that you approach a new area in the exact same way

             7   that you do at your existing business.

             8             MR. O'NEILL:  I think the only thing I would

             9   disagree with you on, Greg, is that I think the presumption

            10   would be, because of our long track record, that we would go

            11   out and bring the resources to bear on the problem.

            12             MR. ROOT:  So would we.  That's what I'm saying. 

            13   That was my point, but I know you would, and we will do the

            14   same, so why should we be any different in that respect.

            15             MR. O'NEILL:  The proof, though, as you point out

            16   is in the performance.  You know, it's interesting, I would

            17   just make one little observation.

            18             When was Mercury?  Was it 1991 was it or 1989?  

            19             MS. CUNNINGHAM:  It was 1997.  

            20             MR. O'NEILL:  But there you go, five years or 12

            21   years later, the people who are in the market are still

            22   commenting on and, in some respects, I guess, criticizing the

            23   role of rating agencies and what we do.

            24             And I think that's what I said earlier, the market

            25   really does enact a lot of discipline on how rating agencies






             1   behave.  This market has a vested interest in how we do it,

             2   and I recognize the national recognition problem the SEC has,

             3   but I do believe the market is pretty tough on those.

             4             MS. STRAUSS:  I have a response and then maybe a

             5   suggestion.  On the response on whether you can just take a

             6   group of people that are experienced and say they are

             7   independently experienced, and, therefore, as a group, they

             8   can do ratings well and mete out some kind of a rating

             9   system, I just don't think that works.

            10             A group of smart people in different environments

            11   perform differently when you're asking them to do a task, and

            12   I still think that there needs to be a corporate culture, a

            13   set of standards.

            14             Perhaps you say, just like S&P, we can trust them

            15   because they have a corporate environment that they have been

            16   able to show that they can hire the right people to follow a

            17   new sector, just a group of smart people will not give you

            18   what you need.  They need a track record together.

            19             The suggestion I might make is one where, I think

            20   Debbie made some good points, as well, but how do we make

            21   sure rating agencies continue -- perhaps they start narrow,

            22   but how do they continue strong.

            23             It's a suggestion that there really is, as part of

            24   the NRSRO process, a formal element which requires that there

            25   is public assessment and feedback on a regular basis about






             1   those ratings.  

             2             That could help you in something where, say,

             3   someone is starting narrower.  That's why, for you all, we're

             4   market practitioners, there's a lot of people out there that

             5   could come back and say these ratings don't look as good. 

             6   Here are some examples:  You have a chance for the

             7   marketplace to say maybe they're a little out of their league

             8   and they could get that feedback.  Similarly, for the bigger

             9   rating agencies, and, again, you say there isn't a market

            10   dynamic.  There are only three.  There isn't a nice way for

            11   us, other than perhaps trying to make a silence, and while,

            12   in the right markets, we'll be listened to, to perhaps, in a

            13   constructive way, say you're getting a real -- maybe this

            14   doesn't work as well.

            15             These are the issues that you've heard many of us

            16   say.  For example, right now, I think you'd hear back on

            17   consistency and using a criteria that we know about.

            18             There are things going on in the marketplace that

            19   you're not going to get to know, but it's our everyday

            20   business and if there was part of this systematic feedback, I

            21   think it would make the system strong.

            22             It could allow you to do more flexible things.  I

            23   know we were one of many who made comments in your 1997

            24   process, and we talked a lot about that.

            25             A good point, I mean, in there is in other quasi






             1   regulatory areas, such as radio stations and so forth,

             2   there's a process to get systematic feedback from the public

             3   on how is someone doing, and that's not done here.  I think

             4   it really could make the current process stronger and give

             5   you a better way to be more creative in the future.  

             6             COMMISSIONER CAMPOS:  I think the basic question

             7   here, and I'm jumping the gun here and stealing your thunder,

             8   is do we need the government to be in this business at all?

             9             What I'm hearing is, in fact, there are barriers

            10   and maybe they're not insurmountable, but they're pretty

            11   close to it.  Indeed, you have a company and you can't put

            12   experienced, talented people together and be able to do this

            13   work.  Then you have effectively a de facto monopoly that is

            14   going to continue, it seems to me, forever.

            15             That's the side comment.  The real issue is, in

            16   light of what Gay said seems to work in Europe, and maybe

            17   this is just a broad issue here, why wouldn't a system like

            18   that work here?

            19             If we somehow were willing to do the effort to take

            20   away all our regulatory references to NRSROs, a lot of work,

            21   but let's say we were to do so, just a big hypothetical, what

            22   would be the downside?

            23             Would the marketplace be able to take over and

            24   handle good ratings?

            25             MS. STRAUSS:  Let me just quickly jump in.  With






             1   full respect for the European markets, the U.S. has a much

             2   more, a much deeper, a much longer history in their debt

             3   markets, where many more investors are going directly into

             4   those markets.  I would start with the money market funds,

             5   where there is a regulation where your ratings are very much

             6   embedded in that.

             7             That is a humongous market that does not exist in

             8   Europe and so it's not a handwave to say let's look at

             9   Europe.  I think Europe is more, as Gay suggested, trying to,

            10   as they are building their capital markets and opening them

            11   up, trying to look at where to add our regulations. 

            12             So, just an aside on that.

            13             MS. CUNNINGHAM:  I would think, too, that what we

            14   have in Europe is essentially  migrating from what has been a

            15   "I know this company, I recognize the name, I know the people

            16   that run it because they happen to be on the school board of

            17   my kid's -- of the educational system that we're in,"

            18   basically a knowledge base of the regional investors in the

            19   marketplace has been what that market has been based on.

            20             To a large degree in Germany, to a very large

            21   degree in Spain, lesser degree in the UK, but other

            22   countries, as well.  I think as that market opens up and

            23   becomes more developed and realizing the small problems that

            24   have occurred in that market, that have basically been bailed

            25   out by the banks, which have ultimately been bailed out by






             1   the countries themselves, have not taken place in the U.S.

             2   and is not going to continue as the markets grow and develop

             3   and become larger and stronger and bigger issuers there.

             4             So there has to be some sort of a tie-in to high

             5   credit quality and just individual assessment and knowledge

             6   basis on who the issuer is is no longer going to be the

             7   precedence.

             8             COMMISSIONER CAMPOS:  Bailouts in the U.S.?  

             9             MS. CUNNINGHAM:  They have occurred.

            10             MR. REYNOLDS:  The European front, though, I used

            11   to run, for several years, their credit research department

            12   at Deutsche Bank, and they are rife with problems in terms of

            13   inefficiencies and information flows. 

            14             You have the slew of unrated bonds out of the

            15   Milschtein that are just starting to come home to roost right

            16   now in the downturn.

            17             So what's going on in Europe right now is really,

            18   three years into it, a change in the credit cycle and a

            19   change in how companies borrow.  Disintermediation has really

            20   just kicked in.

            21             COMMISSIONER CAMPOS:  I'm sorry, but knocking

            22   Europe really isn't getting to the question.  

            23             MR. REYNOLDS:  I'm not knocking Europe.  I'm just

            24   saying the structure.  

            25             MS. STRAUSS:  It's not a good parallel.






             1             COMMISSIONER CAMPOS:  That's fine, but what if the 

             2   marketplace took over and allowed credit rating agencies to

             3   exist on a free-market basis.

             4             MR. REYNOLDS:  I don't necessarily disagree with

             5   the point.  Take the NRSRO designation away and when the

             6   smoke clears, Moody's and S&P will dominate if you leave it

             7   there.  Moody's and S&P will dominate.

             8             I totally agree with that.  I'm just saying that to

             9   go totally away from a model where you have some type of

            10   oversight, I think the government still needs to stay in this

            11   business, at least from a regulatory and oversight

            12   standpoint, to assure quality, because in this country in

            13   particular, the dispersion of holdings of debt instruments

            14   throughout the system from the institutional level to the

            15   retail level requires some additional oversight, as we have

            16   seen in dramatic fashion over the past year.

            17             I think Europe is just starting to see that now,

            18   because so many bonds have been put in the market over the

            19   past three years since the advent of the Euro, they're in the

            20   credit cycle now where they're starting to feel the pain and

            21   they're going to sit back and say, okay, how do we make sure

            22   there is a better mechanism in place to assure there is some

            23   independent body watching the quality of these securities.

            24             MS. NAZARETH:  Perhaps I should clarify, because I

            25   think Roel's question sort of raises this issue.  Clearly, I






             1   think everybody thinks there are some barriers to entry for

             2   credit rating agencies, but are the barriers to entry because

             3   of this NRSRO designation or are they separate and apart from

             4   what the Commission has done or what the designation has

             5   done?   

             6             MR. FERNANDEZ:  I'd like to answer that and then to

             7   come back to Harvey's question, which never really got

             8   answered in the first place, which is similar.

             9             To me, I kind of do a reverse engineering here.  If

            10   that were the case, why don't we have them now.  What is it

            11   that is an effective barrier?  

            12             We do have various credit rating agencies and I

            13   think you'll agree that are of good quality that could step

            14   up and become an NRSRO.  I don't see anybody clamoring for

            15   that designation at the moment.

            16             Maybe I'm wrong.  Why do we need it then?  Because

            17   I think there are already certain standards one has to meet

            18   to meet that.  

            19             Having put that forward there, please, let me get

            20   through this, I think the first thing you have to have, it's

            21   been identified, Cynthia identified some of them, Greg

            22   identified some of them, you have to have a track record, you

            23   have to have a good team, you have to have the management,

            24   you have to have all these things in place, and you have to

            25   be prepared to lose money for an extended period of time.






             1             It takes a while to build this kind of expertise, a

             2   while to build the name recognition, the brand recognition. 

             3   So you have to be adequately in capital and funded through

             4   this period.

             5             So let's say you do all those things.  The business

             6   model fails you to take the next step, in my opinion, because

             7   how do you get there, well, you develop expertise and the

             8   higher value products, selling your research to institutional

             9   investors who are willing to pay for it.

            10             But then you're going to be asked to broadly

            11   disseminate this as a public good, where you're not going to

            12   be adequately compensated because who you are providing it to

            13   is a totally different audience.  Now you're talking about

            14   providing this to a broad spectrum of individual investors

            15   who are not disposed to pay for it, who don't see an adequate

            16   need for anything more than two ratings.  

            17             Because this is what they have -- the market has

            18   already decided.  They would, I think, find it confusing to

            19   have a panoply of ratings.  If you go back historically, when

            20   there were more, again, people developed preferences for who

            21   has the greatest integrity and the greatest standard or brand

            22   image out there.

            23             So when you have someone who has reached the

            24   critical mass, who has paid for the track record, who has

            25   reached this threshold, I think that they are not willing to






             1   give up the higher value added product to produce something. 

             2             This is the same problem we have with independent

             3   equity research here.  Sure, maybe you want to step up, but

             4   institutional investors might not find that S&P tear sheets

             5   provide the same level of analysis that they get from some of

             6   the more sophisticated boutiques who could provide

             7   independent equity research.

             8             So it's almost that old saying, is that the more

             9   broadly disseminated something is, the less value it has.  So

            10   that's part of the answer.  And, again, how many do you need? 

            11   If you need comfort levels in terms of rating, if the job is

            12   well done, and I think it is, how many do you need?

            13             Are we going to be better served with six as

            14   opposed to three?  I don't know.  Tell me in the economic

            15   literature, what is the critical point in an oligopoly?  I

            16   mean, you do get better efficiency, but I don't see it.  

            17             I don't see that you gain much by going too far

            18   out.

            19             COMMISSIONER CAMPOS:  So are you saying government

            20   should maintain two or three and that should be our

            21   objective?

            22             MR. FERNANDEZ:  No.  I don't know if that's the

            23   answer either.  I'm just trying to answer your question of

            24   why haven't they naturally -- what would it take to 

            25   stimulate -- 






             1             COMMISSIONER CAMPOS:  There's a lot of regulation.

             2             MR. FERNANDEZ:  Right.  That's part of it.  There

             3   are also natural barriers that the markets and the investors

             4   themselves impose, and I think part of it has to do with the

             5   way that we value information and analysis, which is very

             6   bizarre and not market oriented.  

             7             COMMISSIONER GOLDSCHMID:  Frank, but if it's a

             8   natural barrier, and I think there are some natural barriers

             9   here, the answer is if you get rid of it all, the natural

            10   barriers will remain and that's how it works.  You've got to

            11   come further than that to say what we're getting here is

            12   something more efficient, broader, of higher quality, the

            13   kind of looking to market that's giving us more.

            14             Now, that may be the case. 

            15             Assuming we're going to keep the barriers for the

            16   second and assuming they work to some degree, which appear to

            17   be the case, what are we losing by not having a more dynamic,

            18   more wide open system?

            19             If I gave Malcolm what you've got here and said no

            20   one can sell automobiles in the United States unless they put

            21   100,000 on the road, then it would be wonderful for the auto

            22   company, but not so good for the consumer.

            23             Now, you say this market is different than autos. 

            24   Tell me why, how it's working and what we're gaining and what

            25   we lose.






             1             MR. FERNANDEZ:  It may not be that different than

             2   autos, to be quite honest.  

             3             MR. O'NEILL:  Commissioner, I think it is

             4   different.  The key difference is what we're dealing with

             5   here is intellectual property and there are no barriers to

             6   entry to intellectual property.

             7             There are people -- we say that, well, we created

             8   this oligopoly or these three rating agencies, well, I submit

             9   that, again, both of us doing it for 85 years or something,

            10   and all that, has its own merits.

            11             But there are hundreds of fixed income -- thousands

            12   of fixed income analysts in the marketplace who are looking

            13   at our ratings, assessing their own views of

            14   creditworthiness, questioning, criticizing, Sean's role,

            15   others.

            16             I don't think we have an oligopoly of intellectual

            17   opinion here.  I think we've got a multitude of intellectual

            18   opinion.

            19             I think the issue and the problem are that what

            20   we've done has found its way into regulation, and that is

            21   really it.  

            22             MS. NAZARETH:  That's the problem.  The question

            23   is, could we wean ourselves off this designation?

            24             Whatever happens, from an economic perspective,

            25   happens.  The marketplace sort of votes with their feet in






             1   their pocketbooks, but is there some substitute for this?

             2             Obviously, what we're concerned about is because of

             3   the way it's used in the regulations.  You don't want issuers

             4   to have the ability to just shop for a rating to get the

             5   benefits that each of these many, many disparate regulations

             6   provides.

             7             Is there a substitute for that?  Is there some

             8   other way that you could have that assurance?  Again, some

             9   other market based substitute?

            10             MS. STRAUSS:  Just one thing.  I think, also, in

            11   the regulations, I mean, these ratings are in regulations,

            12   whenever the research is done, I think there should be

            13   situations, which is a little tougher, to talk about whether

            14   those regulations have protected people, meaning that the

            15   regulations where ratings -- 

            16             Again, the ratings have a pretty good track record. 

            17   They are in regulations for good reason.  In many places,

            18   they have protected investors through those regulations.

            19             So if you dilute it by saying we will have any

            20   rating agency with a group of six smart people, to the

            21   extreme, then you could have that flow back through the

            22   regulations and, in essence, not have those you're trying to

            23   protect through those regulations left unprotected.

            24             So, again, some of the regulations I'm familiar

            25   with that relate to us, I think a lot of them are good






             1   regulations.

             2             So the question shouldn't be just how to let any

             3   rating agency get into those regulations.  It's how to find

             4   something -- and I'm not sure, in the debt markets, that it's

             5   so easy to find a market-based regulatory factor.

             6             Don't forget, debt securities, by their nature, are

             7   different.  They have very little upside and tremendous

             8   downside.  On the shorter end, it's typically seen for

             9   safety.

            10             Except for the high yield market, which is really

            11   quite small, most investors are looking for relative safety

            12   here and so it's looking at this downside that I find rather

            13   difficult.  You need somebody looking at it and helping

            14   people through looking at the downside of this.

            15             So it's an odd thing, just as a general backdrop to

            16   thinking about this.

            17             COMMISSIONER GOLDSCHMID:  Are you hearing the end

            18   users and the issuers saying this system is working fairly

            19   well, even when the imperfections or barriers are drawn?  

            20             MS. NAZARETH:  Did you say that, Malcolm?

            21             MR. MACDONALD:  No, but I will happily comment.  I

            22   do think the system is working fairly well.  I think Cynthia

            23   put her finger on it.  

            24             The requirement for a rating agency from the

            25   issuer's perspective is competence, rigorous analysis, and






             1   ultimately credibility in the marketplace.

             2             Now, quite frankly, I find it interesting.  If lots

             3   of people had wanted to jump in to the rating game and get

             4   the designation, I'm amazed that five companies ended up

             5   commingling into Fitch.

             6             I would have argued that somebody would have come

             7   in and said here's my entry, but we didn't see that.  

             8             So I would be happier if I had six, because I would

             9   not say I want to go shopping, but I would like the idea, if

            10   I found one incompetent, I could get rid of them.

            11             At the moment, where there are three, that puts --

            12   that makes it very difficult to do.  

            13             MR. HARRIS:  The government has written ratings

            14   into its regulations and, indeed, its statutes to address

            15   various agency problems.  This is the reason there are laws

            16   in the first place.

            17             There were alternatives available to the drafters

            18   at the time that probably weren't thought of, it really seems

            19   ridiculous to think of it in the following way.

            20             They could have tried to draw an entire list of

            21   what they were talking about.  These securities are risky and

            22   these aren't, and they needed to discriminate between the

            23   different types of securities for a variety of purposes.

            24             Clearly, they decided not to do that, because such

            25   a list wouldn't be enduring, it wouldn't be stable, and






             1   various other problems.

             2             They also could have hired people to maintain such

             3   a list, but they also decided not to do that, and instead

             4   looked out and saw that there were rating agencies out there

             5   who provided such lists because there was a private demand

             6   for them.  They decided to free ride or piggyback off of

             7   those rating agencies, and, in doing so, established rating

             8   agencies in the law through the NRSRO designation.

             9             We've been talking about how many we ought to

            10   establish, but I would like to pose, as an alternative, the

            11   following question.

            12             Clearly, the NRSROs have benefitted from this

            13   establishment.  That is the whole purpose of this discussion

            14   here.  And once established, given that the government, by

            15   intention or by accident, has conferred a fair amount of

            16   benefit to these entities, the question is what

            17   responsibility do those entities owe the government or

            18   otherwise?  What responsibilities does the government have

            19   over people for whom they have given special privilege?

            20             Normally when we give people privilege, we have a

            21   regulatory oversight.  So the question here, no matter how

            22   many we have, is what regulatory oversight should the SEC

            23   exercise over the NRSROs? 

            24             And the issue that we face, as the SEC, is not

            25   whether we presently have a problem, I think we're all agreed






             1   that the three main entities seem to be doing a reasonably

             2   good job, with some of us dissenting, but, by and large, that

             3   seems to be the perception.  The issue is not whether they

             4   are presently doing a good job, but whether they will always

             5   be doing a good job, because it will be on our watch that a

             6   failure will occur.

             7             So what is necessary to ensure that there will be

             8   no such failures in the future?  To what extent should the

             9   government be able to reach in and look over the shoulders of

            10   the people at S&P or Fitch or Moody's or anybody else and

            11   ensure that having given them privilege, that we are not

            12   creating a situation that will be a lurking time bomb.

            13             MR. EGAN:  I have a comment.  If your oversight

            14   gets into the underlying ratings that are issued, I think

            15   it's a big mistake.

            16             Let me explain our experience.  We are not always

            17   bearish, but we have been bearish for probably the last two

            18   years, and we have been taken to task for a lot of our

            19   ratings.

            20             Worldcom, Enron, Ford, our clients thought that our

            21   ratings lacked credibility because they are significantly

            22   below the major rating agencies.  

            23             When Ford was cut three notches by Standard &

            24   Poor's and then put on negative watch, they started believing

            25   that we knew what we were talking about.






             1             Likewise, with some of these other major calls.  So

             2   don't get into the business of trying to second guess these

             3   things, as you are going to be pressured by the issuers.

             4             MR. HARRIS:  My guess is that there probably won't

             5   be any dissent anywhere on this table for that position.  But

             6   what of the things like document retention?  Should we be

             7   allowed to inspect these firms to ensure that the

             8   compensation contracts of the analysts are further unlinked

             9   to the results that they produce?  

            10             Remembering, again, that what's not necessary now

            11   may someday be necessary, and it's our job to ensure that

            12   nothing blows up on our watch.

            13             COMMISSIONER CAMPOS:  Let's be more specific.  I

            14   think the major NRSROs are essentially taking the position

            15   that they are voluntarily part of the investment advisory

            16   situation and that they are reserving, at least, the right

            17   not to provide documents based on inspections, and that there

            18   has been resistence to our compliance audits.

            19             So that should be addressed.

            20             MR. HARRIS:  In particular, should any firm wanting

            21   to be an NRSRO waive the First Amendment defense and subject

            22   themselves to oversight as a quasi or directly an investment

            23   advisor as opposed to being treated as a publisher of

            24   information, much like a newspaper.

            25             Should that be the condition of the NRSRO






             1   designation presented in exchange for the privilege of the

             2   franchise?  

             3             MR. O'NEILL:  I'm glad you got back to the

             4   privilege of the franchise.  I think that the privilege was

             5   granted by the marketplace long before the SEC granted its

             6   privilege, in all due respect.

             7             I think they exist today because of the market

             8   recognition, the national recognition, and not because of the

             9   NRSRO status.  As I've said, I think, several times, these

            10   ratings are looked at every day.  They are challenged every

            11   day.  They are assessed every day, and I think that is what

            12   really creates the power behind this rating methodology.

            13             And if we were not an NRSRO, for some reason, I

            14   don't think Standard & Poor's would just -- I mean, we would

            15   go right on doing what we're doing and we would do it just as

            16   aggressively as we have in the past, quite frankly.

            17             I don't think that we should be asked to waive our

            18   rights under the First Amendment.  I think there are ways

            19   that the SEC can monitor the progress of NRSROs, taking a

            20   look at some of the things, codes of ethics, insider trading

            21   policies, factors that bear on the economic and political

            22   independence.

            23             If you want to look at the compensation, we don't

            24   have contracts with our analysts, but the compensation

            25   arrangements of our analysts to ensure that there is no






             1   direct tie, we would be happy to share that with the

             2   Commission.

             3             Track record I think is really critically

             4   important, a visible track record, default studies,

             5   transition studies, market research to the investment

             6   community, what do you think, how do you think they're doing,

             7   and, quite frankly, we do that market research every couple

             8   of years as to how our ratings are being used by investors

             9   and issuers, and I've heard some things today and we did some

            10   market research today and we're going to go work on that when

            11   I get back.

            12             But I think, quite frankly, the point that the SEC

            13   should really be careful, and I guess you've said it and I

            14   agree, I don't think you really want to participate in the

            15   rating process through regulation and I think that would be a

            16   tremendously, tremendously negative thing to happen in our

            17   capital markets.

            18             MS. NAZARETH:  Let me ask this question more

            19   explicitly.  As you know, currently, each of the NRSROs is

            20   registered as an investment advisor.  Certainly, we've heard

            21   from each of the rating agencies in the past, that the

            22   regulatory construct really doesn't fit your business.  On

            23   the other hand, it does bring you within our jurisdiction. 

            24   We certainly take the position that you have to retain books

            25   and records and we have examination authority and the like.






             1             I guess what you were talking about here was the

             2   kinds of things that you think that the Commission should be

             3   looking at or you certainly would find appropriate, whether

             4   that's done in a separate regime or whatever is another

             5   issue.

             6             You said that you did conduct some surveys.  Was

             7   that a one time survey?  I thought it sort of tied in a bit

             8   with what Cynthia had said about getting feedback from the

             9   marketplace, staying up with whether rating agencies are sort

            10   of doing their job.

            11             It shouldn't be the case, clearly, that you give

            12   someone this designation and then never look at it again.  

            13             MS. EVANS:  And I think we're lucky, fortunate.  As

            14   I said before, we don't have anything about rating agencies

            15   in any of our regulations.

            16             So that sort of saves us from all of this.  But I

            17   think in terms of when we do say, okay, how do you go forward

            18   for that little bit of regulation that's included in terms of

            19   designating whether you're investment grade or not investment

            20   grade, those are done by some of the trade associations.  So

            21   there's a little bit of difference.  

            22             So it's not like the BBA being done by banks.  We

            23   would work with them and say, okay, could you do that, let's

            24   talk through it afterwards.

            25             So that is really how it has been done in the past,






             1   but we do keep dialogue and have technical discussions with

             2   rating agencies, but that's about it.

             3             I actually thought Commissioner's Campos' question

             4   of could you have a market based solution for all this is

             5   really quite interesting.  You're right.  Europe is different

             6   and actually now we're getting into more cross-border

             7   business, the debt business is growing, and may rival,

             8   obviously, the U.S. at some point in time if you looked at

             9   national debt, et cetera.

            10             But I think one of the issues in the Basel approach

            11   is that some of these European countries do not use rating

            12   agencies, as we still know, they use internal ratings.  Now,

            13   there are criteria on what is an internal rating, and then

            14   here come Cynthia and Debbie about how much they do in

            15   research.  Yes, it's valuable to have a rating agency's input

            16   on other aspects, because that's another check and balance,

            17   but you've got to question -- and I'm not saying we could

            18   deal without rating agencies, but why would that now ever

            19   work.  

            20             Why not be another solution?  You have rating

            21   agencies that provide it, you change your rules, but I think

            22   the whole thing, to put it on the table and have it answered,

            23   why can't a market-based approach work, is actually quite

            24   interesting and I don't think I actually heard a real answer

            25   to that.






             1             MS. STRAUSS:  Market-based, I don't know what you

             2   mean by market-based, a lot of that term is broad-based.  I

             3   think one thing I thought you meant market-based by the fact

             4   that each of us do our own independent research.  We have

             5   some excellent regulation on that front.

             6             I mentioned, again, Rule 2a-7, which incorporates

             7   the ratings, but also very clearly says that we must do

             8   independent assessments.  It's very powerful and it works

             9   really very well, because it holds us accountable, as we

            10   should be held.

            11             It also allows a smaller shop.  It helps set a

            12   standard, which is well respected, which are the rating

            13   agencies, and it could help a smaller shop that can do some

            14   additional research, but maybe not as much.

            15             It's a nice mix.  So it's a combination of both,

            16   which I think, having lived under it for years, I think it

            17   works very well because it holds us accountable.

            18             So if market based means that we're supposed to do

            19   our own research, I think that's great.

            20             So often, though, and particularly in today's new

            21   world, market based means look at market prices as a proxy

            22   for credit analysis.

            23             That's really dangerous, and I think most people

            24   here know enough to know that.  I cannot tell you how

            25   frequent it is, and including from our own rating agencies,






             1   many of which have been thinking about the big three, all

             2   have been under pressure to have your ratings be more market

             3   predictive.

             4             It is very much en vogue, it is very powerful here. 

             5   There are academic papers written about it, but that's really

             6   dangerous territory, because market prices are more short

             7   term driven and influenced by many other things.  

             8             MS. NAZARETH:  Because we're talking about credit

             9   ratings in the debt markets, notwithstanding all of our

            10   regulation, the debt markets still remain somewhat the dark

            11   corner of our own securities markets.  They do not have

            12   anywhere near the level of transparency that we have in the

            13   equity markets or the ability to, for instance, influence

            14   credit spreads through a small number of trades in order to

            15   achieve benefits under our existing regulations could be

            16   relatively high.

            17             So I agree with you that the market based solution

            18   could have some consequences if it's not controlled in some

            19   way.

            20             MS. CUNNINGHAM:  I think that existing regulations

            21   is the key phrase there, because I agree with what Leo is

            22   saying, that if S&P and Moody's and even Fitch, to some

            23   degree, did not have NRSRO ratings, the marketplace today

            24   would still interpret and utilize them in a way that is very

            25   similar to what our current pattern is.






             1             But because they are built into the regulations,

             2   there needs to be -- it's already in Rule 2a-7, it's in other

             3   parts of statutory, municipality criterion.  All of that

             4   leads to the need then for some sort of oversight, because

             5   it's already built in as part of the mechanism.

             6             I think you've got two paths you can take.  Take it

             7   out and have no oversight, in which case then you go back to

             8   market based without any type of underlying kind of cushion

             9   that the rating agencies currently provide or that they can

            10   continue to provide, but without the NRSRO designation, or

            11   keep the NRSRO designation, but provide some mechanism of

            12   oversight.

            13             Oversight can be taken from many different avenues

            14   of oversight that the SEC currently does, and sort of the way

            15   that an inspection regime develops can evolve.

            16             MR. HARRIS:  There is a third alternative that

            17   maybe we should explore and ask about, and that is to write

            18   into our regulations and statutes what we mean by a rating

            19   and then tell everybody who has to comply with the statutes

            20   that they have to get their ratings and if the ratings aren't

            21   of sufficient quality, then we will expose them to liability

            22   for failing to do what's proper.

            23             So, in this way, we don't establish a national

            24   NRSRO designation, but instead put the liability upon the

            25   corporate directors and the fund managers and so forth to






             1   obtain quality ratings.

             2             Does anybody see the pros and cons of that

             3   proposal?

             4             MR. EGAN:  I think it will substantially increase

             5   the cost to the rating firms and it will just erect another

             6   entry barrier, and that is the liability for making a wrong

             7   call.

             8             MR. HARRIS:  The liability would not be on the

             9   rating firms, but rather on the people who use the ratings to

            10   comply with the various laws.

            11             How do you feel about that, Cynthia?

            12             MS. STRAUSS:  We already feel that, I don't know

            13   what the form of it would be, but we already feel that we

            14   have pretty serious liability anyhow.

            15             MR. HARRIS:  You have serious responsibility.

            16             MS. STRAUSS:  Right.  We have responsibility,

            17   again, already under Rule 2a-7, it's specifically in the

            18   regulation.  I think it is very powerful.

            19             Then we have it through what we feel is our

            20   fiduciary duty on our other funds.

            21             So it's intriguing.  We would, as Debbie already

            22   said, probably use similar rating agencies that we use now

            23   and if new ones come forth, we would assess them certainly

            24   analytically.

            25             So I don't know, when you say the word liability,






             1   of course, what does that mean.  We would use them in our

             2   process.

             3             Are you saying we would be held accountable to use

             4   whatever rating agencies we see appropriate or we find

             5   appropriate?  

             6             MR. HARRIS:  That's correct.  The law, for whatever

             7   purposes, distinguishes between certain types of debt and

             8   some more appropriate for some purposes, according to

             9   whatever the wisdom of the folks who wrote this stuff.

            10             And then, the question is, how do we classify

            11   various securities, and one way is we say whatever the NRSROs

            12   say.

            13             The other way is to say this is what we mean by the

            14   classification, you've got to do it yourself, you should rely

            15   on one or two opinions, you solicit the opinion, but if you

            16   don't do it right, you're going to be exposed to liability

            17   through civil action or through the enforcement efforts of

            18   the Commission.  

            19             MR. MACDONALD:  Larry, forgive me, but I think

            20   we're going off on a wild goose chase, because let me tell

            21   you, ratings are not a six sigma item.  You cannot have a 100

            22   percent accuracy. 

            23             If you could have a 100 percent accuracy, I think

            24   you would have something, but you can't.  If you take a small

            25   company that is being rated and a meteor falls on them, I'd






             1   love to hold Leo accountable for it, but I don't really think

             2   it's reasonable.  

             3             MR. O'NEILL:  It's a risk I'll take.

             4             MR. MACDONALD:  But you can wipe a company out from

             5   an event that is totally and completely unpredictable.  

             6             MR. HARRIS:  Again, the liability is not on the

             7   rating agency, but it's on the people who are applying the

             8   ratings, and, of course, the issuer would make a responsible

             9   choice.

            10             The reason I'm pressing this is because the

            11   Commission has in front of it this problem, which is how

            12   would you get a market based solution to this problem.

            13             That is, the debt, I think, is the marketplace

            14   solution and if it's a problem, we need to know about it so

            15   that we can rest more confidently with the status quo.

            16             COMMISSIONER GLASSMAN:  Wouldn't it further

            17   entrench the existing brand names, because they would be the

            18   safest choice?  

            19             MR. HARRIS:  I certainly suspect so.

            20             COMMISSIONER GLASSMAN:  So it would be a further

            21   barrier to entry, because people would go to the ones that

            22   they already know.

            23             MR. HARRIS:  That's probably the case.  

            24             MR. FERNANDEZ:  Not necessarily.  We have an actual

            25   example of this, and I'm going to turn it to Gay here,






             1   because I think we've both been dealing with this nightmare

             2   for how long now?

             3             MS. EVANS:  Too many years.

             4             MR. FERNANDEZ:  We're actually trying to assign

             5   products into risk buckets, and this is the Basel II, and

             6   we're trying to do this to avoid the use of the rating

             7   agencies as the be all and end all and come up with a market

             8   solution.

             9             I have only been dealing with it for three years. 

            10   I don't know how long you have been working on it.

            11             But it's possible, yes, we can do this.  It's not

            12   as easy as anybody ever thought when we headed down this

            13   road.

            14             The whole idea, I think, correct me, was to try to

            15   find a way to harmonize the cross-border standards and to

            16   come up with something that was a little bit easier to deal

            17   with on international issues.

            18             You can relate your own stories on this one.

            19             MS. EVANS:  Well, I think it's a little bit off

            20   track, but clearly it's the concept of risk buckets and if

            21   you use rating agencies to make a simplified format, that

            22   would be easy.

            23             Then it goes back, then it's, oh, you can have

            24   internal risk buckets and internal analysis and that allows

            25   you risk buckets.  But you have to break all that down and






             1   that has been taking an immense amount of time.

             2             So when you get into this concept of risk and

             3   opening up to the wide variety, you just have to make sure

             4   you use the right credit rating in the long run or use your

             5   own internal analysis to back it up.

             6             We can go on forever, because that's a whole --

             7             MR. HARRIS:  And it will go on forever.  

             8             MS. EVANS:  Years.

             9             MR. O'NEILL:  From our perspective, I just don't

            10   think it's workable.  You will hear one of the other rating

            11   agencies, at some point, make the point that a bond has

            12   really only two things, it either pays off or it doesn't and

            13   it's binary that way.

            14             But a rating talks about the relative likelihood

            15   and it ranks it out, and I guess what would happen is all

            16   those bonds that defaulted would give a cause of action or

            17   something against the purchasers of those bonds, I guess, and

            18   I don't think that should be a liability or risk the

            19   purchasers of bonds, albeit for the benefit of their ultimate

            20   customers, should take on.

            21             MR. EGAN:  From our perspective, it would be a big

            22   positive, because what would happen is that the institutions

            23   would have to make the assessment who has the credible

            24   ratings and who doesn't have the conflict of interest, and it

            25   would be great for us.  It would be terrific.






             1             MS. NAZARETH:  Cynthia?

             2             MS. STRAUSS:  Sometimes if you put the burden, you

             3   get this secondary behavior if you put greater liability on

             4   us, and, then, again, I think I would fear that our behavior

             5   would be that we would just then, with that additional

             6   liability, why take any risk.

             7             We would always stick to the same traditional ones

             8   and then we would go on doing what we always do, which is, as

             9   we do now, we look at everything in the marketplace.

            10             So I don't know that that really fundamentally

            11   opens it up and makes a more welcoming marketplace for it.

            12             MS. NAZARETH:  The NRSRO process, if it were

            13   retained, and, obviously, I think we've got a lot of open

            14   questions here, if it were retained, is there any reason to

            15   argue against the whole process being more transparent.

            16             I think you are aware of what the Commission had

            17   proposed several years ago.  Does anybody have any reason to

            18   object to go to transparency there?  

            19             MR. O'NEILL:  No.  We would endorse a lot more

            20   transparency around how the designation is made, clearly. 

            21   However, again, I would caution that if that transparency,

            22   under the guise of that transparency, becomes a direct

            23   oversight regulation of the opinions that are coming out of

            24   the rating agencies, then we'd have -- 

            25             MR. ROOT:  I totally agree.  Again, I think the






             1   oversight should be that once you set up the standards for

             2   becoming an NRSRO, that you've got to continue to meet those,

             3   and that, to me, is the regulation, and if you no longer meet

             4   those, then you should lose that designation, the same way

             5   you should never have gotten it in the first place if you

             6   didn't have those standards.

             7             But as long as the process becomes transparent, I

             8   think -- I don't think it's broken, I guess, personally. 

             9   There's been a lot of talk here, but overall, I don't think

            10   the whole concept of the activity of ratings in the

            11   marketplace is broken.  I think it's very efficient.

            12             MS. STRAUSS:  Again, I don't want to -- but I do

            13   think a nice way, Larry, as you mentioned, of looking ahead

            14   and what are the issues ahead is to get some more regular

            15   market feedback about what we're feeling in the trenches

            16   today.

            17             Again, I started off my comments today, I don't

            18   think it's broken, but I do think that we are gathered here

            19   because it's not perfect, which is fine, but how do we get

            20   some mechanisms to keep it strong.

            21             MS. NAZARETH:  Does anyone else have any last

            22   words?

            23             COMMISSIONER CAMPOS:  I have a question.  Back to

            24   Larry's discussion a minute ago.

            25             There's a certain intellectual elegance to what he






             1   was proposing, which is that companies buy their own ratings. 

             2   I, for one, am not convinced that just because there's two or

             3   three overwhelming companies, that it would always be the

             4   case that they would always have the business.

             5             Indeed, Mr. Egan is eager to try to convince

             6   companies that he can provide something better.  I guess

             7   there used to be an old saying that no office manager ever

             8   lost his or her job when they selected IBM to do their office

             9   xerox.  Well, times have changed and times do change.  We

            10   have an ongoing economy and market forces and things move

            11   very quickly these days.  

            12             So I would be interested to know more about why

            13   that wouldn't work.  I realize we got off into, well, the

            14   topic of there's too much liability, but I don't think that's

            15   really the issue.  The liability regime can be dealt with and

            16   tweaked and so on.  But issuers buying and being responsible

            17   for their own credit ratings, why not?  

            18             So maybe you can send us back notes on that.  I,

            19   for one, would be interested in it.

            20             MR. EGAN:  Just one final point.  We are not paid

            21   by any companies and we don't want to.  Hopefully, we can

            22   continue that business model, it's been very successful, of

            23   stripping out the conflict of interest.  So it's just being

            24   paid.  We're only paid by the investors, mainly institutional

            25   investors.






             1             MS. NAZARETH:  Does anyone else have a final point?

             2   Well, thank you very much.  We've finished a full three

             3   minutes early.  

             4             Thank you very much for your help.

             5             (Whereupon, at 4:42 p.m., the hearing was

             6   concluded.)

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