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97–016 PDF 2004

THE RATINGS GAME: IMPROVING

TRANSPARENCY AND COMPETITION

AMONG THE CREDIT RATING AGENCIES

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTEREPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

SEPTEMBER 14, 2004

Printed for the use of the Committee on Financial Services

Serial No. 108–110

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

RICHARD H. BAKER, Louisiana 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

DOUG OSE, California 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

PATRICK J. TOOMEY, Pennsylvania 

CHRISTOPHER SHAYS, Connecticut 

JOHN B. SHADEGG, Arizona 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

MELISSA A. HART, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

TIM MURPHY, Pennsylvania 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

CHRIS BELL, Texas 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED

ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman 

CHRISTOPHER SHAYS, Connecticut 

PAUL E. GILLMOR, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

FRANK D. LUCAS, Oklahoma 

EDWARD R. ROYCE, California 

DONALD A. MANZULLO, Illinois 

SUE W. KELLY, New York 

ROBERT W. NEY, Ohio 

JOHN B. SHADEGG, Arizona 

JIM RYUN, Kansas 

VITO FOSSELLA, New York, 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

GARY G. MILLER, California 

PATRICK J. TOOMEY, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

MELISSA A. HART, Pennsylvania 

MARK R. KENNEDY, Minnesota 

PATRICK J. TIBERI, Ohio 

GINNY BROWN-WAITE, Florida 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

PAUL E. KANJORSKI, Pennsylvania 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

(V)

C O N T E N T S 

Page 

Hearing held on: 

September 14, 2004 .......................................................................................... 1

Appendix: 

September 14, 2004 .......................................................................................... 23

WITNESSES 

TUESDAY, SEPTEMBER 14, 2004

Egan, Sean, Managing Director, Egan-Jones Ratings Co. ................................... 10

Kaitz, James A., President and CEO, Association for Financial Professionals .. 4

Pollock, Alex J., Resident Fellow, American Enterprise Institute ...................... 9

Putnam, Barron H., President and Chief Economist, LACE Financial Corporation ........................................................................................................................ 6

APPENDIX 

Prepared statements: 

Oxley, Hon. Michael G. .................................................................................... 24

Gillmor, Hon. Paul E. ....................................................................................... 26

Kanjorski, Hon. Paul E. ................................................................................... 27

Egan, Sean ........................................................................................................ 29

Kaitz, James A. ................................................................................................. 31

Pollock, Alex J. ................................................................................................. 52

Putnam, Barron H. ........................................................................................... 55

(1)

THE RATINGS GAME: IMPROVING 

TRANSPARENCY AND COMPETITION 

AMONG THE CREDIT RATING AGENCIES 

Tuesday, September 14, 2004

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, 

AND GOVERNMENT SPONSORED ENTERPRISES, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 10:04 a.m., in Room 

2128, Rayburn House Office Building, Hon. Richard H. Baker 

[chairman of the subcommittee] presiding. 

Present: Representatives Baker, Gillmor, Biggert, Capito, BrownWaite, Kanjorski, Moore, Ford, Lucas of Kentucky, McCarthy, and 

Scott. 

Chairman BAKER. [Presiding.] I would like to call this meeting 

of the Capital Markets Subcommittee to order. 

The purpose of this morning’s hearing is to again review the performance and regulatory authority for the conduct of what are commonly known as the credit rating agencies. On April 2, 2003, this 

committee convened a hearing in the course of its normal review 

of market sector performance to hear from a representative of the 

SEC and others concerning the status of and performance of the 

rating agency community. 

To date, there is not clearly established a methodology by which 

a corporate entity may become recognized as a rating agency. 

There is no ongoing supervision as to the methodologies utilized in 

performing their duty, and there is not a method to formally decommission an agency once having been designated. 

The purpose of today’s hearing is to receive additional comment 

as to the advisability of either SEC rule or legislative action to provide additional transparency, to provide sufficient disclosure as to 

methodologies, and to evaluate the very manner by which these 

agencies engage in their rating practices. 

The Investment Company Act requires the maintenance of at 

least two rating agency analyses before issuance of public debt, and 

therefore there is a statutory requirement that public corporations 

utilize the services of these rating agencies. That makes it all the 

more important for us to make sure that market participants fully 

understand their function and the methodologies by which these 

ratings are issued. It is clear, at least to me, that we are a long 

way from that type of functioning system. 

2

Secondarily, it is extraordinarily important that the agencies engage in and conduct arms-length evaluations to ensure the ratings 

which are used by many in the market for various purposes are reliable and professional. It is troubling to realize the superficial nature by which many of the ratings have been issued and the reliance that many have placed upon that data. We only have to return to the bursting bubble a few months back and painfully look 

at the ratings issue just prior to many prominent corporations’ announced bankruptcies. 

How is it that these events came to pass? What is it that needs 

to be changed to ensure that it does not occur again in the future? 

And are there other options available to us to obtain the necessary 

financial data without perhaps mandatory reliance on the rating 

agency system as it is structured today? 

For all these reasons, the committee meets. We will be pleased 

to hear the comments of those who have agreed to testify, and 

would point out that Standard & Poor’s, which was invited to participate, notified the committee as of yesterday they would be unable to attend here today. We look forward to hearing from them 

on another occasion. 

With that, I yield to the gentleman from Pennsylvania. 

Mr. KANJORSKI. Mr. Chairman, we meet for the second time in 

the 108th Congress to examine the issue of credit rating agencies. 

Entities like Moody’s, Standard & Poor’s and Fitch have long 

published their views on the creditworthiness of the issuers of debt 

securities. The importance of these opinions has grown significantly 

in recent years as a result of the increases in the number of issues 

and issuers, the globalization of our financial markets and the introduction of complex financial products like asset-backed securities and credit derivatives. 

As you know, Mr. Chairman, I have made investor protection one 

of my top priorities. I believe that strong regulation helps to protect 

the interests of America’s investors. 

Accordingly, I am pleased that we have worked diligently during 

the last several years to augment the resources available to the Securities and Exchange Commission, enacted sweeping reforms of 

auditing and accounting practices, restored accountability to investment banking and analyst research, and improved the conduct of 

business executives and corporate boards. Although credit rating 

agencies received some scrutiny after the recent tidal wave of corporate scandals, we have not yet mandated any substantive 

changes in their practices. 

Nevertheless, this issue is ripe for examination and action. At 

hearings before our committee last year, the commission’s Director 

of Market Regulation noted that while credit rating agencies have 

generally performed their work well for nearly a century, they have 

also missed some colossal failures in recent years. A Senate investigative report also found that the monitoring and review of 

Enron’s finances ‘‘fell far below the careful efforts one would have 

expected from organizations whose ratings hold so much importance.’’

After last year’s hearing, I was hopeful that the commission 

would take swift action regarding these matters. It did belatedly 

issue a concept release to examine the issues surrounding rating 

3

organizations in June of 2003. Since that time, the commission has 

continued to study these matters without reaching any conclusion. 

The commission, I should note, has been examining these matters 

for more than a decade. 

Although a formal proposal for improved oversight of credit rating agencies has yet to emerge, a top official at the commission did 

suggest in a recent speech that additional legislative authority may 

be needed I this area. 

I have previously urged the commission to act promptly and prudently in these matters. It is therefore my expectation that it will 

move expeditiously in the coming months to finalize its opinions on 

credit rating agencies and advise us about the most appropriate 

steps to take in these matters during the 109th Congress. 

When we revisit these matters next year, it is also my hope that 

we will be able to put together a more inclusive and comprehensive 

hearing. We are fortunate today to have with us two rating professionals. We will also hear from the Association for Financial Professionals, which has taken a leading role in examining the need and 

identifying ways to improve the oversight of credit rating agencies. 

Rather than rushing to hold a hearing, our proceedings would 

have greatly benefited if we had waited and been able to receive 

the testimony of the commission, major credit rating agencies, and 

other interested parties. 

In closing, Mr. Chairman, we are at a crucial moment in the evolution of our capital markets. We must act to ensure the continued 

integrity of the rating agencies and the credit rating process. I also 

look forward to continuing to work with you as we move forward 

deliberately on these important matters. 

[The prepared statement of Hon. Paul E. Kanjorski can be found 

on page 27 in the appendix.] 

Chairman BAKER. I thank the gentleman. 

Mr. Scott? 

Mr. SCOTT. Thank you, Mr. Chairman. 

Due to the development of complex financial products and the 

globalization of the financial markets, credit ratings have been 

given increased importance. The credit ratings affect the securities 

markets in many ways, but the Securities and Exchange Commission has not performed any significant oversight over rating agencies. Several of the large corporate scandals at Enron, WorldCom 

and other companies were not brought to the attention of regulators by the rating agencies. 

Since 1994, the SEC has developed proposed rulemaking to provide better oversight of rating agencies. I believe that it is time for 

the SEC to try to provide a better standard for oversight of rating 

agencies. In that regard, Mr. Chairman, I look forward to hearing 

from our distinguished panel about recommendations for the SEC 

review of the credit agencies. 

Chairman BAKER. Thank you, Mr. Scott. 

Ms. McCarthy, did you have a statement? 

Mrs. MCCARTHY. Thank you, Mr. Chairman. I will hand in my 

opening statement. I would rather hear the testimony. 

Chairman BAKER. Thank you, Ms. McCarthy. 

If we could please have our witnesses come forward, we would 

like to recognize you at this time. This morning, we are pleased to 

4

have Mr. Sean Egan, managing director of Egan-Jones Rating 

Company; Mr. James A. Kaitz, President and CEO, Association for 

Financial Professionals; Dr. Barron H. Putnam, President and chief 

economist, LACE Financial Corporation; and Mr. Alex J. Pollock, 

resident fellow, American Enterprise Institute. 

Since Mr. Egan is a little behind this morning, we are going to 

start first with Mr. Kaitz. 

Welcome, sir. 

STATEMENT OF JAMES A. KAITZ, PRESIDENT AND CEO, 

ASSOCIATION FOR FINANCIAL PROFESSIONALS 

Mr. KAITZ. Thank you, Congressman. 

Good morning, Chairman Baker, Ranking Member Kanjorski, 

and members of the committee. I am Jim Kaitz, President and 

CEO of the Association for Financial Professionals. 

AFP welcomes the opportunity to participate in today’s hearing 

on improving competition and transparency among the credit rating agencies. As we have continually noted, AFP believes that the 

credit rating agencies and investor confidence in the ratings they 

issue are vital to the efficient operation of global capital markets. 

AFP represents more than 14,000 finance and treasury professionals representing more than 5,000 organizations. Organizations 

represented by our members are drawn generally from the Fortune 

1000 and the largest of the middle-market companies from a very 

wide variety of industries. Many of our members are responsible 

for issuing short-and long-term debt and managing corporate cash 

and pension assets for their organizations. 

In these capacities, our members are significant users of the information provided by credit rating agencies. Acting as both issuers 

of debt and investors, our members have a balanced view of the 

credit rating process and a significant stake in the outcome of the 

examination of rating agency practices and their regulation. 

When I appeared before this committee more than 17 months 

ago, I shared the results of a survey conducted by AFP in September 2002. In summary, that survey found that many of our 

members believe that the information provided by credit rating 

agencies is neither timely nor accurate and that the Securities and 

Exchange Commission should take steps to foster greater competition in the market for credit ratings and improve its oversight of 

rating agencies. 

AFP is currently conducting an update to the 2002 survey and 

preliminary results indicate that confidence in the credit rating 

agencies has not improved. We will be releasing the results of the 

updated survey later in the fall. 

In June of 2003, the SEC issued a concept release on rating 

agencies and the use of credit ratings under the federal securities 

laws. That concept release asked 56 questions about the nationally 

recognized statistical rating organization, designation, recognition 

criteria, the examination and oversight of NRSROs, conflicts of interest, and anticompetitive, unfair and abusive practices. 

The concept release asked market participants to provide answers in less than 60 days. Yet more than 15 months after this 

concept release and more than a decade after a similar concept reVerDate 0ct 09 2002 13:46 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 G:\DOCS\97016.TXT FIN1 PsN: MICAH
5

lease in 1994, the SEC has yet to provide a single answer of its 

own. 

To address many of the questions raised by the SEC and market 

participants, the Association for Financial Professionals in April of 

this year, along with treasury associations from the United Kingdom and France, took the initiative and developed an exposure 

draft of a Code of Standard Practices for Participants in the Credit 

Rating Process. 

We are currently reviewing comments we received on the exposure draft and intend to release our final recommendations later 

this year. We developed the draft code in an effort to improve investor and issuer confidence in the credit rating agencies and the 

ratings they promulgate. This is particularly important in light of 

the SEC’s continued inaction. 

I have submitted a copy of the code, along with my testimony. 

However, I would like to take a minute to summarize the key 

themes. The code contains recommendations for regulators, as well 

as rating agencies and issuers. To be clear, the code is a privatesector response intended to complement rather than replace regulation. 

Regulatory recommendations in the code of standard practices 

focus on establishing transparent recognition criteria based on 

whether a credit rating agency can consistently produce credible 

and reliable ratings over the long term. Establishing clearly defined recognition criteria is a crucial step to removing barriers to 

entry and enhancing competition in the credit ratings market. 

The regulatory recommendations also include improving ongoing 

oversight of approved rating agencies to ensure that NRSROs continue to meet the recognition criteria. The code also urges regulators to require that rating agencies document internal controls 

that protect against conflicts of interest and anticompetitive and 

abusive practices that may arise from ancillary services such as 

corporate governance reviews and ratings advisory services. 

For rating agencies, the code includes suggestions to improve the 

transparency of the rating process, protect non-public information 

provided by issuers, protect against conflicts of interest, address 

the issue of unsolicited ratings, and improve communication with 

issuers and other market participants. 

Finally, recognizing that the credibility and reliability of credit 

ratings is heavily dependent on issuers’ providing accurate and 

adequate information to the rating agencies, the code of standard 

practice outlines issuer obligations in the credit rating process. 

These obligations are intended to improve the quality of the information available to the rating agencies during the initial rating 

process and on an ongoing basis, and to ensure that issuers respond appropriately to communications received from rating agencies. 

Other organizations have also taken steps to address this critical 

issue. The International Organization of Securities Commissions, 

IOSCO, in September 2003 issued a statement of principles regarding the manner in which rating agency activities are conducted. In 

February of this year, IOSCO also announced the formation of a 

special task force chaired by SEC Commissioner Campos to develop 

6

a code of conduct for credit rating agencies. We expect IOSCO to 

issue that code shortly. 

In July, the Committee of European Securities Regulators, at the 

request of the European Commission, issued a call for evidence on 

possible measures concerning credit rating agencies. The committee 

intends to review comments, develop a consultation paper, hold an 

open hearing, and approve and publish its final advice to the European Commission in March 2005, I would note, less than 8 months 

after the commencement of its activities. 

Despite all this activity, the SEC remains silent on the appropriate regulation of credit rating agencies. At hearings before the 

Bond Market Association in January, a senior SEC official admitted that the commission needs to come up with an approach or 

‘‘cede the area’’ to other rulemakers. By its continuing inaction on 

this issue, the SEC is abdicating its responsibility to capital market 

participants and potentially subjecting issuers, investors and rating 

agencies to a fragmented, duplicative and overly prescriptive regulatory regime. 

A reasonable regulatory framework that minimizes barriers to 

entry and is flexible enough to allow innovation and creativity will 

foster competition among existing NRSROs and those that may 

later be recognized and restore investor confidence in the rating 

agencies and global capital markets. Rather than excessively prescriptive regulatory regimes, innovation and private-sector solutions, such as AFP’s Code of Standard Practices, are the appropriate responses to many of the questions that have been raised 

about credit ratings. 

Restoring issuer and investor confidence in the credit ratings 

process is critical to global capital markets. We commend you, Mr. 

Chairman and the committee, for recognizing the importance of 

this issue and its impact on all institutional and individual participants in global capital markets. We hope this hearing will motivate 

the SEC to action. 

In addition, regulators should require rating agencies to develop 

policies to insure against the inappropriate use of nonpublic information to which the rating industries are privy because of their exemption from regulation FD. Recently, the SEC took action against 

a former credit rating agency employee who used nonpublic information regarding pending mergers for personal enrichment. While 

we cannot comment on the specifics of this case, this again highlights the need for the SEC to take an active role in the oversight 

of credit rating agencies. 

Thank you. 

[The prepared statement of James A. Kaitz can be found on page 

31 in the appendix.] 

Chairman BAKER. Thank you very much, sir. We appreciate your 

comments. 

Dr. Putnam, please proceed. 

STATEMENT OF BARRON H. PUTNAM, PRESIDENT AND CHIEF 

ECONOMIST, LACE FINANCIAL CORPORATION 

Mr. PUTNAM. Thank you, Mr. Chairman and other distinguished 

members of the committee. My name is Barron Putnam and I am 

President of LACE Financial Corporation. I am a former staff 

7

member of the Federal Reserve Board here in Washington. While 

I was at the Fed, I chaired the committees that put together—this 

is a three-interagency bank committee that put together the off-site 

rating system for the Fed. I also set up the Bank Holding Company 

Analysis Program for the Fed and I directed for the Fed the surveillance of all banks and bank holding companies for a period of 

10 years. 

I left the Fed in 1984 and established LACE Financial Corporation. LACE Financial rates approximately 20,000 institutions. We 

have issued over a period of 20 years about 1.2 million credit ratings. We have never received a complaint from a regulator, be it 

state or federal or any regulator, nor have we ever had a serious 

threat of a lawsuit. We have actually rated banks and other financial institutions prior to Moody’s and Standard & Poor’s entering 

the market. 

I have been in the banking business for more than 25 years. I 

would like to say that it is an honor for me to sit here today before 

your committee. 

I would like to address two areas of concern to your committee, 

the NRSRO designation process and the anticompetitive effects 

that the SEC net capital rules and the NRSRO designation have 

on a rating company like ours. 

First, we submitted our application for NRSRO status back in 

1992. Eight years later, we received a phone call from a lawyer at 

the SEC stating that our application was denied. I asked him what 

the reason was, and he could not give that to me over the phone. 

So I said, well, would you put it in writing. He was a little surprised that I asked for that, but they sent it to me and the denial 

was based on the fact that we only had three financial analysts. 

I wrote back to them saying this was an error; that in fact we had 

10 financial analysts and that eight were involved in the ratings 

process. 

We received another letter, which stated the NRSRO criteria, 

which I am sure most of you are familiar with. It is very detailed 

and lengthy. And then they stated at the bottom of the letter that 

our application had been denied because you did not meet the criteria above. They did not say what part of the criteria. When we 

saw that Congress was interested in this issue as well as the press 

we appealed our application. We sent our appeal in and it has been 

now 2 years and 3 months and we have not heard anything from 

the SEC. 

To me, this is deja vu. I think that given what we have gone 

through, I do not feel that any person or corporation should go 

through something in this manner. It is just that an agency of the 

government should not act in this way. Obviously, there needs to 

be transparency in this process and the application process needs 

to be expedited. 

I also would like to say that I feel that the SEC staff, and I think 

it is the policies, not necessarily the staff members, have more of 

an adversary view towards companies like ours. It should be the 

other way around. They should be proactive. If a company does not 

meet the criteria, they should state why and let the company come 

back and show that in fact what it is that they need so that they 

can go on and eventually become an NRSRO company. 

8

Now, the other point I would like to speak to the committee on 

is the effects of both the net capital rules and the NRSRO designation on the ability of a company like ours, a small company, to effectively compete with other NRSRO companies. First, Moody’s, 

Standard & Poor’s and Fitch have tremendous name recognition 

and market share. That is a tough act to compete against. However, from the very beginning, all we wanted was to be on a level 

playing field with these companies. The problem is, and people at 

this table know this well, that we are prohibited by law, federal 

law, the SEC regulations, to compete with these existing NRSRO 

companies. 

The designation and the use in the bylaws of large corporations 

prohibit companies like ourselves from being able to use these companies as clients. To put it in other words, if the company does not 

have an investment-grade rating from an NRSRO company, those 

are the only ratings they can use, either credit ratings or buy securities of those companies. That keeps us, we cannot compete with 

a very large portion of the AFP members. Although we do have 

several clients in that organization, many of them are prohibited 

from using us. I used to get, and finally the gentleman gave up, 

from GE Capital, an e-mail asking me when we were going to get 

that status because they want to use us. Finally, he just gave up 

because I sent him back I was not sure. 

But it is a very tough problem. In 1992, about the time we submitted our application, Thompson Bank Watch received NRSRO 

status. Our revenues prior to that time were growing about 25 or 

30 percent a year. For 10 years, they just stopped growing. They 

stagnated. Only until recently have our revenues starting picking 

up and growing about 20 percent because we have entered into new 

security issues. We have kind of broken into that market, but it 

has taken us 20 years to do so. It is a very tough game for a nonNRSRO company to basically stay in this business. 

If you want to bring competition into this industry, you not only 

have to recognize companies like ours, Sean’s company, also there 

are several others out there that are very credible companies, but 

they have to aid these companies in becoming larger and better 

competitors. The NRSRO status is a double-edged sword. It keeps 

you from competing, but if you receive the designation it will help 

you a great deal in growing because clients will come your way if 

you are good and credible. Companies like ourselves have to grow 

about 40 percent a year to become effective competitors to the 

NRSRO companies. 

Moody’s and Standard & Poor’s, I do not know exactly, but they 

are growing about 20 percent a year, about what we are, but our 

size is so small relative to theirs that we will not become effective 

competitors unless we grow faster. We cannot do it unless we have 

the NRSRO status. 

Thank you, sir. 

[The prepared statement of Barron H. Putnam can be found on 

page 55 in the appendix.] 

Chairman BAKER. Thank you very much. 

Welcome back, Mr. Pollock. I think this is your first appearance 

in your new capacity. 

9

STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, 

AMERICAN ENTERPRISE INSTITUTE 

Mr. POLLOCK. It is, Mr. Chairman, and thank you very much. 

Mr. Chairman, Ranking Member Kanjorski, and members of the 

committee. It is a pleasure to be here to present my views, which 

focus on the unintended cartel-like effects of the SEC’s regulation 

of rating agencies through its NRSRO designation. 

I must say I find Dr. Putnam’s comments very convincing. He expresses in a specific case many of the same things I am going to 

say in a somewhat more abstract way. I then want to talk about 

what steps might be taken to reduce these barriers to competition. 

The theme of my work at the American Enterprise Institute is 

to examine ways to inject greater economic efficiency and market 

choice into situations in which the government in one way or another has created noncompetitive structures. 

What do we find in the rating agency sector? As Professor Larry 

White of New York University has written, ‘‘The problem concerns 

the SEC’s regulation of the bond rating industry. Incumbent bond 

rating firms are protected; potential entrants are excluded, and 

new ideas and technologies for assessing the riskiness of debt, and 

therefore the allocation of capital, may well be stifled. This entry 

regulation is a perfect example of good intentions gone awry.’’

The fundamental source of the problem is that the designation 

‘‘nationally recognized statistical rating organization’’ or NRSRO 

has become embedded in numerous rules of numerous regulators. 

The only way to get to be an NRSRO is to be designated as one 

by the SEC, and this involves, as many commentators have pointed 

out, a practically insuperable Catch-22. 

The SEC’s own concept release, which was referred to earlier by 

the ranking member, on the subject states that in order to become 

a recognized NRSRO, ‘‘The single most important criterion is that 

the rating agency is widely accepted in the U.S. as an issuer of 

credible and reliable ratings by the predominant users of securities 

ratings.’’

To summarize their position, you cannot be widely accepted by 

the predominant users unless you are an NRSRO, but you cannot 

become an NRSRO unless you are already widely accepted. That is 

the Catch-22. The same SEC release says, ‘‘Some commenters believe that the NRSRO designation acts as a barrier to entry into 

the credit rating business.’’ There seems to be no doubt that these 

commenters, which include the Department to Justice, are correct. 

It seems to me that we should simply consider that when John 

Moody published his first ratings in 1909, or when Poor’s Publishing Company published its first ratings in 1916, or the Fitch 

Publishing Company published its first ratings in 1924, they were 

not yet ‘‘widely accepted by the predominant users.’’ They all had 

to discover a market need, and compete their way into becoming 

nationally recognized in time. 

Dr. Putnam also touched on the natural barriers to entry in the 

credit rating business, which seem to be pretty substantial, including the need to establish reputation, reliability and integrity; a 

definite prestige factor involved in the purchase of opinions and 

judgments; and natural conservatism of the users of ratings. To 

10

add to this a ‘‘distortionary entry restriction regime,’’ to use Professor White’s phrase, ensures a noncompetitive outcome. 

What could be done to make this business more competitive? I 

suggest four possible actions. First, it is clear that what NSRSO 

really means is ‘‘SEC approved rating agency.’’ The term ‘‘NRSRO’’ 

with its implication that is represents some sort of a market test, 

which 30 or 40 years ago it did, but it no longer does, should be 

dropped altogether. If the SEC continues to require its own approval of raging agencies for regulatory purposes, at least we could 

get the designation accurate and just make it ‘‘SEC approved.’’

Second, if the SEC continues to require its approval of rating 

agencies, the Catch-22 criterion of having to be ‘‘nationally recognized’’ in advance should be simply eliminated. 

Third, the approval of rating agencies for specialized purposes, as 

the SEC has sometimes done in the past, should be encouraged. 

Such specialization might be an industry, for example, financial institutions; a country, for example, Japan; or any other logical domain defined by competence and knowledge. This would allow new 

entrants to create competition based on their skills and where they 

are best able to compete, to demonstrate in those specialized domains their value, and if they succeed, then to grow organically. 

Fourth, in my opinion, in the best case, not only the term 

‘‘NRSRO’’ but also the requirement of designation by the SEC 

would be dropped. Instead, the responsibility to choose among rating agency alternatives should belong to investors, financial firms, 

securities issuers and other users, in short, the market. Every firm 

should have among its financial and risk management policies its 

approved policies for how it uses credit ratings and whose ratings 

can be used for what. 

These policies should be appropriately disclosed, and could be examined by any relevant regulators. Under these circumstances, 

which rating agencies turn out to be nationally recognized would 

reflect a true competitive market test, and that competition would 

provide its normal benefits of innovation, improved services, lower 

cost, choice and efficiency. 

Thank you very much for the opportunity to testify, Mr. Chairman. 

[The prepared statement of Alex J. Pollock can be found on page 

52 in the appendix.] 

Chairman BAKER. Thank you, Mr. Pollock. 

I wish to welcome Mr. Sean Egan, managing director, EganJones Rating Company. 

Welcome. 

STATEMENT OF SEAN EGAN, MANAGING DIRECTOR, EGANJONES RATINGS CO. 

Mr. EGAN. Thank you. I apologize for being late. 

Chairman Baker, members of the subcommittee, good morning. 

I am Sean Egan, managing director of Egan-Jones Ratings Company, a credit ratings firm. By way of background, I am a co-founder of Egan-Jones Ratings, which was established to provide timely, 

accurate credit ratings to institutional investors. 

Our firm differs significantly from other rating agencies in that 

we have distinguished ourselves by providing timely, accurate ratVerDate 0ct 09 2002 13:46 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 G:\DOCS\97016.TXT FIN1 PsN: MICAH
11

ings and we are not paid by issuers of debt, which we view as a 

fundamental conflict of interest. Instead, we are paid by approximately 400 firms consisting mainly of institutional investors and 

broker-dealers. We are based in a suburb of Philadelphia, although 

we do have employees that operate from other offices. 

The rating industry currently is suffering from a severe lack of 

competition. S&P and Moody’s dominate the industry, which has 

caused the following problems. One, issuers pay too much for capital because they are underrated; and two, investors are not provided with sufficient warning about failing firms such as Enron, 

WorldCom, and Parmalat. 

By way of interest, we receive a lot of publicity for our identifying problem companies. That is because reporters like to report 

on that. But in reality, we have pointed out many more cases 

where companies are underrated, that is they are paying too much 

for capital. 

There are few industries where the two major firms do not directly compete, and yet control over 90 percent of the revenues. 

Since two ratings are needed to issue debt, the two major firms do 

not compete and therefore are not subjected to the normal checks 

and balances. Even after the recent credit rating debacles, S&P 

and Moody’s revenues have continued to grow because of their lock 

on the market. 

To put the industry structure in perspective, it is as though there 

are only two major broker-dealers for corporate securities and the 

approval of both were required before any transactions could be 

completed. Some other manifestations of the limited competition include abuses in the use of unsolicited ratings and heavy-handed 

marketing of related corporate services such as issuer governance 

ratings. 

Regarding Egan-Jones, we have provided warning for the Enron, 

Genuity, Global Crossing and WorldCom failures. We did not rate 

Parmalat. Furthermore, we regularly identify improving credits. 

Most of our ratings have been above S&P’s and Moody’s over the 

past 2 years, thereby providing issuers with more competitive capital. Our success has been recognized by the Federal Reserve Bank 

of Kansas City, which compared all our ratings since inception in 

December 1995 to those of S&P and Moody’s. You can read the 

quote from that study. It is available online. 

Stanford University and the University of Michigan drew similar 

conclusions. That also is available online. In August 1998, we applied for recognition by the SEC as a ratings firm, i.e. NRSRO status. We continue to provide information to the SEC and hope to 

eventually be recognized. 

To reform the ratings industry, we recommend the following 

changes. One, recognize some rating firms which have succeeded in 

providing timely, accurate ratings. Two, wean rating firms from 

issuer compensation. We think that is a fundamental conflict, just 

like the equity analyst problem. Three, adopt a code of standard 

practices for participants in the credit rating process issued by the 

ACT, AFP, and AFTE. And four, encourage SEC action. This area 

has been under review since the early 1990s and is in dire need 

of reform. The costs of delaying the recognition of additional rating 

firms is far greater than the benefit of additional study. 

12

There are two additional points that I would like to make. That 

is, one of my colleagues brought up the issue of national recognition criteria being dropped. We disagree with that. We believe that 

the successful firms can achieve national recognition. We have national recognition. A recent firm that was admitted by the SEC, 

DBRS, according to outside studies did not have that recognition 

in the United States. We take issue with the application of those 

criteria. 

The second problem is that it may be worth finding out why it 

is that there has been such a delay in taking action. We tend to 

believe that it is because the SEC has bought into the notion offered by S&P and Moody’s that more competition in this area 

would lead to problems. That is, there would be rate shopping. We 

think in those cases where the rating firm is not paid by the 

issuers, that is not a problem. But there has to be some fundamental cause for the huge delay in action in this area, and this 

may be one of them. 

Thank you very much. 

[The prepared statement of Sean Egan can be found on page 29 

in the appendix.] 

Chairman BAKER. Thank you very much, Mr. Egan. 

I appreciate each of your perspectives on this important issue. It 

is clear to me there is not an objective standard by which a corporation may comply and be assured it will achieve a NRSRO status. There really is no oversight of an entity once it has received 

a designation, and there is not an official decommissioning process 

by which such an award may be removed. 

Secondly, it is not very clear as to what standards of review the 

rating agencies utilize in determining a public corporation’s rating; 

that prior to the rating being made public, the agency can meet 

with a subscriber and go over the information or release it previously prior to public disclosure; that an agency can send a bill to 

a public company without having solicited the rating, which creates 

an interesting problem for the company, I am sure; and that at the 

end of the day the rating agency performance in the midst of the 

corporate crisis we faced was frankly marginally, if better at all, 

than the broader market controls that seem to have failed us generally. 

It leads me to the question or the observation, this may be one 

area where the Congress can actually act and not make matters 

worse. There is no room for us to go downhill from here. In light 

of that, we have had a concept release as early as 1994 by the SEC, 

subsequent concept release, and to date still no recommendation for 

action either for the SEC or for the Congress. 

I am very troubled by this because of the Public Company Investment Act requires the maintenance of at least two ratings prior to 

issuance of public debt, and there appears to be great reliance on 

these ratings by many stakeholders without understanding fully 

the mechanisms by which these ratings are issued. 

I even have read of late where Basel is considering utilizing the 

rating agency determinations for determination of capital adequacy 

for financial institutions, which is a shocking turn of events given 

what I think I know about the agency’s performance to date. 

13

I know that each of you has suggested that enhanced competition 

may be the ultimate reform that is most beneficial. But I am very 

concerned that that potential could have been exercised over the 

last decade, where resources could have been brought to bear, and 

as Dr. Putnam’s case indicates, the languishing in response from 

the SEC to be told no for 2 years is not the most professional 

standard of conduct. 

Is there anything short of incentivizing additional competitors? 

For example, some have suggested that utilization of credit spreads 

might be more beneficial in getting real critical examination of financials than looking with a retrospective view that apparently the 

rating agencies use. 

What other rating alternatives might there be available to us? 

Are there any? And is the only hope SEC action and competition? 

I just make that observation and question to the panel. 

Mr. EGAN. Regarding credit spreads, we have a variety of clients 

including a number of hedge funds. I think if there is a turning to 

credit spreads as being the rating proxy, it would be fairly easy for 

sophisticated traders to manipulate it. 

Basically what they would do is buy up the company’s securities 

and sometimes the float is not that great so it does not take much 

time to control the float; move down the spread, which would imply 

a higher rating; let other institutions get into that security and 

then move out. You can do that multiple times. It is very, very easy 

to manipulate a system like that. 

Also, there is some suggestion for pure quantitative systems. We 

started out, probably about 12 or 13 years ago when the firm was 

founded, as purely a quantitative shop. We found that it did not 

get us where our clients wanted to go. That is, we were maintaining 95 percent-plus accuracy. With a pure quantitative system, it 

would be between 85 and 90 percent. Typically, these quantitative 

systems rely on equity prices, and again you have mixed signals. 

For example, if a company announces a share buy-back, its share 

price will go up, but that would be a negative for credit quality. 

Chairman BAKER. But in the current circumstance, though, the 

rating agency to a great extent relies on representations made by 

management. They do not appear at least to rely on audit or underlying financial examination to a great degree. How assured can we 

be that the manipulative effects you are concerned about are not 

already in the market? 

Mr. EGAN. Sometimes they are and sometimes they are not. I 

think that the best safeguard is to have a viable competitive market, which we do not have. 

Chairman BAKER. My time has just about expired, and I do have 

other members, but just one other question that concerns me about 

the way these markets function. Wouldn’t it seem likely, given the 

way in which the review is now done, that the bigger the corporation the less scrutiny one might receive, and the further down the 

food chain you go the more likely the rating agency is to actually 

get involved into the real financials to make their determination? 

Mr. EGAN. Sometimes there is greater scrutiny of the larger companies, but they are given the benefit of the doubt. 

Chairman BAKER. Thank you. 

Mr. Kanjorski? 

14

Mr. KANJORSKI. Thank you, Mr. Chairman. 

Mr. Egan, you have been here so often you are starting to get 

the demeanor of a member of Congress. 

Mr. EGAN. My wife is wondering about my multiple trips to 

Washington. 

[Laughter.] 

Mr. KANJORSKI. Welcome. 

I do not know, if I were sitting at the table I sense a great deal 

of frustration. Am I correct? 

Mr. EGAN. Yes. 

Mr. KAITZ. Yes. 

Mr. PUTNAM. Yes. 

Mr. POLLOCK. Yes. 

Mr. KANJORSKI. We obviously can give the authority for the SEC 

to regulate a particular industry or activity, but after that it is in 

their hands. 

Dr. Putnam, you indicated 8 years your application was pending? 

Mr. PUTNAM. Yes, sir. 

Mr. KANJORSKI. And, Mr. Egan, yours is 6 years? 

Mr. EGAN. Ours is since 1998, so yes. 

Mr. KANJORSKI. Six years. 

Do you think it is time that we throw up our hands and say that 

obviously the SEC does not want to be the regulatory body and we 

take the proposals of the professionals and craft authorization and 

assign it to the Federal Reserve and see if we have a better activity 

there and maybe you can create competition between the regulators. 

If a regulator does not seem to want to assert its authority in a 

field, let us find another regulator. What is your thought to that? 

Mr. PUTNAM. I am from the Fed, so I would look in that direction. But no, I think that the SEC should do it right. 

Mr. KANJORSKI. What if we cannot make them? Obviously, 10 

years, Doctor. 

Mr. PUTNAM. Then it is time for change. There are obviously very 

serious problems, but it seems so simple, to be able to expedite an 

application and be more positive. 

Mr. KANJORSKI. What do you think the underlying proposition 

for the delay is? 

Mr. PUTNAM. I think it is to maintain the status quo. 

Mr. KANJORSKI. I mean, is there restriction of competition? Do 

they just want the majors in the field and nobody else? 

Mr. EGAN. Our feeling is that if the area is not cleaned up; if the 

SEC cannot take action in the near future, that they should step 

away from regulating the area. Our relationship with the SEC has 

gone through different stages. At one point, they would not return 

our phone calls and simply ignored our requests. At this point, it 

appears as though we are making progress, but it is very easy to 

sidetrack that progress. 

It is very easy for them to compare us to S&P and Moody’s and 

say you are significantly smaller, and therefore even though you 

have all these ratings correct, you warned investors about Enron, 

WorldCom and Global Crossing and Genuity, you still do not look 

big enough compared to them. At which point, we think that we 

15

would be fairly upset, because neither the investors nor the corporations are being served by the current arrangement. 

Mr. KANJORSKI. What do you want? To hang in for another 6 

years? 

Mr. EGAN. No, I do not have that patience. 

Mr. KANJORSKI. What do you want us to do? Myself, I am convinced after the second year of hearings that we will be back next 

year in the 109th, and we will just have to have larger handkerchiefs. 

[Laughter.] 

Mr. EGAN. If there is not significant progress in the next 6 

months, consider withdrawing their ability to regulate this area. 

Mr. KANJORSKI. As I say, why don’t we prepare a model statute 

with the criteria set out of what the regulation should be and what 

the standards should be, and give them a year to promulgate rules 

and regulations and act to regulate, or automatic action that the 

authority transfers to the Federal Reserve. 

Mr. EGAN. There are some other changes that are needed, too. 

The issue of compensation is something that is going to continue 

to cause problems. There are some issuers that pay multimilliondollar fees and they are given the benefit of the doubt. If there is 

a collapse, and there are some problem companies out there right 

now, it will cause huge problems for investors. 

The flip side is that there are some corporations that are being 

basically shaken down by the major rating agencies for their governance ratings, which is wrong. Also, some issuers are not given 

the opportunity to respond to ratings. 

Mr. KANJORSKI. You have convinced me. You made your argument and you convinced me. Now I am just trying to find a remedy. 

Mr. POLLOCK. Congressman, if I could comment from this end. I 

support your idea that you ought to go ahead and try to take some 

action, and that more competition on the regulatory front is not a 

bad idea either. 

As I read the history of the NRSRO designation, it was something of an accident. It started off as part of the haircut capital 

rules for securities firms and which ratings you held in inventory 

determined how big a capital haircut the position got. It grew into 

this preferred designation of firms. This looks to me something by 

historical accident, as other regulators then picked up the theme 

of whose ratings could count for various regulations. 

So I think your notion to do something to move it along is correct. 

Mr. KANJORSKI. Mr. Kaitz? 

Mr. KAITZ. I would also support that at AFP. 

Also the code of standard practice, as we have proposed, as you 

have suggested, lays out regulatory recommendations for both the 

issuer as well as the credit rating agencies; talks about transparency in the process; talks about all the issues that have come 

up here today that need to be addressed by some regulatory body. 

But we would very much support Congress pushing the SEC into 

some action based upon the code of standard practice, with a limited regulatory framework. 

Mr. KANJORSKI. Do you sense that if we took such action like 

that it may reflect on what happened with FASB and the stock opVerDate 0ct 09 2002 13:46 Dec 10, 2004 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 G:\DOCS\97016.TXT FIN1 PsN: MICAH
16

tions question? That at that point the regulatory agencies would 

run up here to the Congress and at least disclose themselves that 

they want to maintain a monopoly? 

Mr. KAITZ. I think you can draw a lot of comparisons to the accounting profession, as well, as has been noted by Sean and the equity analysts on the research side. These are all the same issues 

of separation of responsibility. They are as critical to global capital 

markets and U.S. capital markets as those two professions. So I do 

not know what the SEC would do. Are you referring to the credit 

rating agencies coming up here? 

The other thing you could speculate is that the SEC does not 

want to address this issue because they realize they do have regulatory authority here and they would have to enforce that authority 

to more firms. So I do not know what kind of resources that would 

take, but it seems to me that there has been a compelling case 

made for the SEC to take action here today. 

Mr. KANJORSKI. I am particularly impressed with the fact that 

you make the point that there is a greater cost for capital because 

of the failure to have competition in a broader rating agency marketplace. I think that is a very compelling argument. We tend to 

think that five, 10, 15 basis points do not make a difference. 

Mr. EGAN. It is far greater than that. 

A typical company would be Nextel. Nextel is a vibrant, exciting 

company that is changing the telecommunications industry. It is 

still not rated investment-grade even though, from the traditional 

measures, just taking them out 6 or 12 months, it is very clear that 

this is a strong, vibrant company that has a high chance of being 

bought out by some of the other highly rated companies in the industry. 

So the bottom line is that it is not just five or 10 basis points. 

It is closer to about 50 or 100 or 150 basis points, and you are talking about $5 billion to $10 billion worth of debt. 

That is significant, and it is hurting young, growing companies. 

Sometimes there are older companies that have improved, but it is 

hurting companies like that, where they do not get a fair chance 

in the capital markets. 

Mr. KAITZ. Also, to the extent that the European countries implement their own regulations, which is likely to happen, you are 

going to have a fragmented process here, and that is definitely 

going to raise the cost of capital because a U.S. multinational company that wants to raise debt in other countries is then going to 

have to comply with multiple rules and multiple companies, and 

you know who is going to be paying for that. 

Mr. KANJORSKI. So you think if we concluded, if the Chairman 

and I get together and put a piece of legislation together to set up 

your criteria for a regulation and offer certification of these agencies, that we will either get them to move or appropriately improve 

the industry. 

Is there anyone here at the table that thinks that this would be 

injurious to the rating agencies? 

Very good, thank you. 

Chairman BAKER. I thank the gentleman. 

Ms. Brown-Waite? 

Ms. BROWN-WAITE. Thank you very much, Mr. Chairman. 

17

I would like to ask Mr. Pollock a few questions, and if any of the 

other gentlemen would like to jump in. 

First of all, I am what is called a freshman, a little old to be a 

freshman, but I moved to this committee. Has the SEC ever revoked NRSRO designations? And what would you anticipate if you 

could wave a magic wand? What should be the criteria for such 

revocation? 

And also, if I understand this correctly, each of the four SEC-approved rating agencies derives the bulk of its revenues actually 

from fees charged to the companies they rate. Isn’t this a blatant 

conflict of interest? Am I missing something here? Should we be 

concerned, as we have been about the conflicts created by equity 

analysts being compensated based on the investment banking business that they bring in? 

I think if the average investor out there had any clue, they would 

really use the term, a fox watching over the chicken coop. I would 

just like to hear your views on this. 

Mr. EGAN. No rating agency has had its NRSRO designation 

withdrawn. What has happened in the industry is that the firms 

have consolidated. As of about 5 years ago, there were about seven 

NRSROs. Three of them merged into Fitch. That was Thompson 

Bank Watch, Duff & Phelps and a London firm called IBCA. So 

there has been no withdrawal of the NRSRO designation or threat 

of withdrawal. 

We tend to think that there should be some basis for threatening 

that designation. In the case of Enron, it was rated investmentgrade 4 days before it went bankrupt. So basically, it just took the 

time for the bankruptcy attorneys to put together the papers and 

then it was in bankruptcy. That is outrageous. 

What should have happened, in our opinion, is that their license, 

if you will, in the investment-grade area or else in the energy or 

utilities area, should have been on probation for 6-, 12-or a 24-

month period. There has to be some threat. 

There are other horror stories in the manufactured housing area, 

the securitization whereby AAA ratings had been downgraded to 

junk in the period of just an hour or so. In that case, it shows clear 

negligence on the part of the ratings firm. There should be some 

process where the license is suspended or in some kind of penalty 

box-type area for a period of time when things like that happen. 

Lastly, you mentioned the conflict of interest. That is a problem. 

It is a huge problem. This industry is basically accepted because 

of the lack of competition. People throw up their hands and say, 

well, it is S&P and Moody’s; they really designate the ratings; we 

strongly disagree with that, but they have become the currency, if 

you will, in this area. 

First of all, that should be disallowed. It might take some time. 

Maybe they have to do it over a 5-year period, but that should not 

happen. You are waiting for another huge accident. The incentives 

are in the wrong place. 

Secondly, they should not be allowed to use the term ‘‘independent.’’ They are not independent. Take it away. You are misleading the people who need the protection the most. They think 

that these terms are independent and they are being paid huge 

fees by selected issuers. 

18

So that is our response to those three issues. 

Mr. POLLOCK. Congresswoman, I would only add, it would be better to have a competitive market instead of having a cliff-type decision that a regular would have to make. ‘‘I am now taking away 

your license,’’ is a very hard decision for people to make. 

The market, if there is poor performance, like the examples just 

cited, can little by little take the business away if there are in fact 

alternatives. From an investor point of view, if investors like better 

the idea of having ratings that the rated entity did not pay for, 

that they paid for themselves, why then would they gravitate to 

those ratings. If they thought it was okay to have the issuing company pay for ratings, they could purchase them. But none of that 

can happen if you do not have alternatives in the market available 

to the users of ratings, investors and others, to choose from. 

Mr. BAKER. Thank you, Ms. Brown-Waite. 

Ms. McCarthy? 

Mrs. MCCARTHY. Thank you, Mr. Chairman. 

I am just curious, Mr. Chairman, are we going to have another 

hearing with the SEC and find out why this is happening? Or have 

you had it and I did not see it. I was not here. 

Chairman BAKER. We had one about 18 months ago which was 

particularly painful for the SEC at that time. 

Mrs. MCCARTHY. Okay. 

Chairman BAKER. I do not see how we can avoid revisiting this 

subject at some appropriate time. I need to visit further with my 

chairman and Mr. Kanjorski on any initiatives that might be contemplated. But be assured, this is the beginning, not the end of our 

process. 

Mrs. MCCARTHY. Because again, even though we both came on 

the committee 18 months ago, I probably had no idea what I was 

hearing. I am sorry. It takes a while to learn this stuff. 

The questions that I was going to ask actually have been answered in a number of give and take back, so I am not going to 

bother with that. But it has been a real eye-opener for me on a 

number of things. Let us face it, the majority of people do not understand it. I did not know there was anything else out there, but 

the two competitions are there. I thought that was just the way it 

was, so this has been fascinating for me. 

I thank you for the testimony and I thank you for bringing this 

hearing forward. 

Chairman BAKER. Thank you, Ms. McCarthy. 

Ms. Biggert? 

Mrs. BIGGERT. Thank you, Mr. Chairman. 

I, too, think that the really basic questions have been asked, so 

I will just have a couple of questions. The Northern Trust Company 

submitted a comment in response to the SEC’s concept release in 

which it stated that the major rating agencies have requested payment for unsolicited ratings, and in some instances paid the invoices in order to preserve the goodwill with the rating agency. 

So my question from that is, how would enhanced competition in 

the rating industry prevent this type of abuse? That would probably be for anyone who would like to answer. 

Mr. PUTNAM. I would like to answer that question. First, Northern Trust is a very financially sound organization. It has one of our 

19

highest ratings. However, we are not an NRSRO company, so they 

cannot divert to that. That competition will help in that area. 

I would like, if I can grab the microphone, to make a point that 

it is not just that some people are paying a very high price for capital. Some of them do not have access to capital markets. The fees 

charged by Moody’s and Standard & Poor’s and Fitch are so high 

for a rating that it may be 5 percent of the issue. Small companies 

cannot afford to raise capital in that arena. We are providing information to the committee showing that we have rated some companies as small as $23 million in asset size. This is a very serious 

problem. 

Another very serious problem that I do not believe has really 

been addressed by the SEC is that there are billions of dollars of 

excessive, and I feel the fees are very excessive, fees that are being 

paid by municipalities and by corporations for these ratings. Competition can bring these prices down considerably if in fact it can 

be generated. That I think is a very tough thing to do. 

The expertise in a rating agency is very hard to develop. It takes 

time to do this, and usually these companies, like Sean and myself, 

we specialize in a certain area. Once you get the NRSRO status, 

then you can branch out and then hopefully you can bring somebody in that helps you build your company and the SEC or the new 

regulator allows that to happen. You have to be very proactive in 

this arena. 

Mr. EGAN. The reason why I think Northern Trust paid those 

fees is because they are afraid of alienating the two, in their mind, 

only two firms in this industry. It is another manifestation of the 

lock that they have on this industry. An example might be if your 

utility in the dead of winter overcharged you $50 or $100 or $200. 

You are far more likely to pay that additional amount than be 

faced with the threat of having the utility cut off. 

That is the case here. These companies, issuers cannot afford to 

be cut off. This industry has deteriorated to the point where there 

are only two firms in many participants’ minds, and it is highly 

unhealthy and it is going to cause some additional Enrons in the 

future. It is going to cause some other companies to continue to pay 

much more for capital, so it has to be cleaned up. 

Mrs. BIGGERT. Do you think that not only are these firms afraid 

not to go to these companies, but also do you think that the rating 

fees then affect the ability of some of the largest rating firms to 

provide objective rating analysis? 

Mr. EGAN. There is no question that they do. There is another 

problem that comes up with the issuer compensation, and that is, 

it was about 8 years ago in the municipal area whereby two municipalities refused to pay Moody’s. It is in the Wall Street Journal, 

and I can send the reference in later. It was in the Wall Street 

Journal where these issuers refused to pay the rating fees that 

were being charged by Moody’s. And Moody’s just said, well, you 

should participate in our process. 

The issuer said, no, we are not going to. Moody’s said, we have 

enough information in the public domain and we are going to give 

you a rating, period. And they gave them what I call a punishment 

rating, which significantly increased the cost of floating that issue. 

The municipalities subsequently sued and they were unsuccessful. 

20

They were unsuccessful because Moody’s said the ratings are opinions and we are entitled to the freedom of speech. So it is just another indication of this unhealthy industry. 

Mrs. BIGGERT. I know that you would like to get into this. 

Mr. EGAN. We already are issuing ratings. There are a number 

of clients that want to use our ratings for regulatory purposes and 

we told them they cannot until we get the designation. 

Mrs. BIGGERT. Okay. But the current NRSROs have already absorbed three companies. 

Mr. EGAN. Yes. 

Mrs. BIGGERT. So how are you going to do this? 

Mr. EGAN. There are two things that distinguish us. One is our 

success, and no one can match that in flagging Enron, WorldCom 

and these others, number one. And number two, we do not charge 

the issuers. We think we can continue our success and do very 

nicely. 

Mrs. BIGGERT. Thank you. 

Thank you, Mr. Chairman. I yield back. 

Chairman BAKER. Thank you, Ms. Biggert. 

I want to just go back for a few brief points. I know other members may have follow-up questions. 

As to the elements that possibly should be considered in our construction of some remedy, it would appear to me that requiring an 

enhanced standard of disclosure for material facts, that it would 

seem that the agencies today rely to a great extent on representations made by management, without the benefit of a true audit. 

To have a requirement on management to disclose to a rating 

agency in the course of its inquiry any material fact that a reasonable man would assume would have some positive or negative or 

any impact on shareholder value would be sort of a minimum opening requirement; that in the course of developing whatever standards of review the rating agency determines is appropriate, that 

the elements that go into a rating determination be made public; 

the process by which you get from beginning to end. 

I also think it is important to disclose whether or not nonpublic 

information is utilized. Not that you disclose it, but simply the 

statement that we are using only publicly available information 

would tell any outside observer, they are only feeding us back what 

is readily available in the market, or we have insight to information you do not have, therefore this rating is based on that information. I think those are very helpful tools. 

And then finally, before reaching the ultimate rating determination, that that decision not be made available to the subscriber before it is being made available to the public. This goes back to our 

old analyst-investment banker problems where we had people able 

to get access to important information even hours, much less days 

ahead of time, seems to be an obvious, well, I hate to say impropriety, but certainly something that needs to be addressed. 

Then the rating outlooks that are made available by the agencies 

are troubling. Now, we are making a determination about current 

value based on representations of management without an audit. 

So at best, you can say the critical analysis of present-day value 

ought to be carefully examined, but we are going to permit a national rating agency to do a forecast for the next 18 months? 

21

There seems to be a little problem here in my mind with just 

sending someone an invoice for services you did not ask for, and 

the ability to forecast what you are going to look like 18 months 

from now. Now, I do not know if that bothers you, but I am from 

Louisiana and I can see that one coming. 

And then lastly, it was an issue in Sarbanes-Oxley, consulting 

services. It seems to me to be highly questionable as to whether or 

not you ought to be able to consult with someone for whom you are 

being asked to issue a public rating on which others may make 

their investment decisions, which certainly speaks directly to the 

issue of fees and the appropriateness of fees being paid to great extent for someone who is going to give you your report card. 

Any adverse comments about those observations or problematic 

observations, anyone? 

Mr. KAITZ. I would just say that almost all the issues that you 

addressed, Mr. Chairman, have been included in the code of standard practices, both for the credit rating agencies, as well as the 

issuers. So we would be very supportive of your framework. 

Mr. PUTNAM. I think a very serious problem with the existing 

NRSRO companies, if they issue ratings, they do not show the date 

necessarily that the rating was issued, nor do they show the data 

from which the rating was derived. I think that is very, very important, because if you do that and you show that for many other companies as well, and one rating does not adjust to that data, you can 

see that something is wrong. 

In our comments to your committee, we had made a suggestion 

that one way, I do not think the fee problem is going to be resolved 

right away. We do not charge for our credit ratings. We do charge 

for new issue ratings. You cannot help but do it. The financial analyst involved in this and the discussions with management are just 

so important. 

But one point that you made, I do not think a rating agency 

worth its salt should ever take what management says they are 

going to and base a rating on that. You have to judge the financial 

condition of an institution based on its financial soundness. LACE 

comes from liquidity, asset quality, capital and earnings. Those are 

the major determinants of financial soundness. 

If you take those and you show these determinants, along with 

the rating, that helps. Plus, these rating agencies, existing 

NRSROs should rate more frequently. They charge so much money. 

The balance sheets and income statements of these companies are 

put out quarterly. They are generally audited, and you can take 

that information and you can confirm or deny a rating, rather than 

just change that rating somewhere in the timeframe of a company. 

But if you show that information, you are going to bring more 

credibility to the rating process. 

Chairman BAKER. What is it that is gained from a rating company analysis that is not already available from the quarterly 

statement? 

Mr. PUTNAM. Interpretation, analyst interpretation. 

Chairman BAKER. So if we went back and looked at the outlook 

forecast for S&P and compared it to say the analyst community, we 

ought to be astounded by how well S&P is able to forecast. 

22

Okay, thank you. I think I have exercised all the time I should 

take. 

Any further questions? Ms. McCarthy? 

Mrs. MCCARTHY. Thank you. 

I think part of the question was answered, because when you 

said earlier conflict of interest on the pay, and then you came back, 

because I was sitting here wondering how do you guys make any 

money. 

Mr. EGAN. We get paid by institutional investors. 

Mrs. MCCARTHY. Okay. 

Mr. PUTNAM. We get paid by subscribers primarily, but about 20 

percent of our revenues are derived on new issue ratings, and we 

do charge for that. But we do, as I have said, show those ratings 

every quarter. I provided to the committee, on some of the pools 

that we rate for structured preferred stocks, for community banks. 

We will actually follow that pool each quarter, re-rate the pool 

each quarter, and re-rate every member of the pool each quarter. 

We have a follow-up rating report that does that. It is the most advanced report in the industry that exists. That has been supplied 

to the committee. That is what should be done. 

Mrs. MCCARTHY. Okay. Thank you. 

Chairman BAKER. There being no further questions, I want to express my appreciation to each of you for your participation. You 

have been most helpful. As I have indicated earlier, this is just another step in our review of this sector. We do have a lot of additional work ahead of us, and we appreciate your contribution. 

The meeting is adjourned. 

[Whereupon, at 11:20 p.m., the subcommittee was adjourned.] 

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A P P E N D I X

September 14, 2004

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